In the law, what you say can become really important years down the line in a way that couldn’t be foreseen. In this article, I’ll discuss why the help that most of my clients seek — asset protection — can sometimes backfire when the plan actually needs to protect their assets.
The “Asset Protection Trust”
Some states, like Nevada, Delaware, and Ohio, allow the formation of what is typically termed a “domestic asset protection trust.” This is a statutory arrangement that allows someone to create what we call a “self-settled spendthrift trust” in the business. Here’s a breakdown of what that term means:
Self-settled. This is where the person putting the assets into trust (the “grantor”) is also the primary beneficiary of the trust. This is common in the most frequent type of trust, the revocable living trust.
Spendthrift trust. This type of trust is designed to keep the beneficiary, who perhaps is a “spendthrift,” from going out on the town and blowing all the trust money as soon as he or she can get to it. The most common restriction we see is a clause that only allows trust assets to be spent on the “health, education, maintenance and support” of the beneficiary, or “HEMS.” Funds that aren’t used for these purposes remain in the trust so that our “spendthrift” is restrained by the trustee.
Even in the case where the beneficiary is not a profligate spender, the spendthrift trust serves an important purpose: it prevents the beneficiary’s creditors from drawing down the trust assets. Here’s an example. Your grandfather, a wise old guy, put $10 million in trust for your benefit, which contained a spendthrift provision. The trustee pays your rent, educational expenses, and food costs.
Let’s assume you are involved in a tragic accident where you negligently kill a neurosurgeon. You are sued for wrongful death and now must pay a $10 million judgment, which is more than you own personally. You have to declare bankruptcy as a result. The bankruptcy trustee now takes control of everything you own, but can’t access the funds in the spendthrift trust.
In some cases, “supercreditors” like the IRS or someone you owe child support can tap into the assets of such trusts. What critically matters, however, is why the trust was created.
This is where blithely telling a judge that this is an “Asset Protection Trust” can really hurt you.
Even in the case where your trust is titled “Asset Protection Trust,” it can still affect the outcome.
The reason for this is the concept of law called the fraudulent conveyance.
Generally speaking, a fraudulent conveyance is any transfer that is designed to defraud or cheat your creditors. In the example above, if you deed your house to your brother for $1 after you lose the lawsuit, that transfer will almost certainly be considered a fraudulent conveyance and will be reversed.
Why is this important to the Asset Protection Trust?
Because any transfer made with the intent to hinder, delay or defraud creditors can be considered a fraudulent conveyance, subject to reversal and collection. If that defrauded creditor can prove that the conveyance was made to defraud any creditor, the creditor can access those funds.
When the creditor tries to get to the funds in your Asset Protection Trust, the line of inquiry will be this: why was the trust formed?
If your estate planning documents declare that the purpose of the trust is to “protect assets from creditors,” you’re in hot water now!
If you tell the judge that you wanted to shelter your assets from creditors, the judge might call your trust a fraudulent conveyance whether you did it before the neurosurgeon died or not. It doesn’t matter that the wrong creditor got defrauded.
Here’s a real-life example coming to us from California.
Kilker v. Stillman, No. G045813, 2012 WL 5902348 (Cal. App. 4th Dist. Nov. 26, 2012)
Kilker was a soil engineer who did some soil testing for a client in the year 2000.
In 2004, he formed three trusts and transferred all of his assets to one of the trusts.
It turns out that soil engineers are frequently sued, and Kilker faced a lawsuit in 2008 resulting from the soil testing performed in 2000. He settled out of court, but didn’t pay the judgment. The creditor then tried to levy the trust assets, claiming they were fraudulent conveyances intended to defraud creditors.
Although Kilker tried to point out that he had no creditors he was trying to avoid in 2004 when the trust assets were transferred, and that the current creditor was completely unforeseen at the time. He did admit, to his later detriment, that his primary objective in creating the trust was “[a]sset protection…so that his ‘creditors could not go after any equity that [debtor’s] trust, his personal trust, owned in [said] property.’” Kilker, at *2 (emphasis added).
The court found that under California law, the fraudulent conveyance statute does not distinguish future creditors from current creditors, and that all the creditor has to do is prove that “the transfer was made to hinder, delay or defraud any creditor.” Kilker, at *4 (emphasis added).
This case is an example of a do-it-yourself estate plan gone wrong. Had the estate plan been made with other objectives in mind, like providing for children or charitable purposes, Kilker might have been able to save his trust assets. As it were, he employed his accountant to help him with his estate plan, and ended up creating a bad estate plan.
Always make actual estate planning your top priority when structuring your estate plan. You can reap the rewards of asset protection all the same, and the benefits are many, but it cannot be your only objective. As always, seek the advice of a competent and professional estate planning attorney before you pull the trigger!