- The ultra-rich can save millions on taxes using trusts, but they have another advantage.
- Parents can set up trusts for their children to protect assets from ex-spouses and creditors.
- Four lawyers to the wealthy told Insider how these spendthrift trusts work.
The rich often use trusts to pass on wealth to their heirs and pay as little tax as possible. Laurene Powell Jobs, widow of the Apple founder, saved at least $200 million in estate and gift taxes using trusts, per ProPublica. Nike founder Phil Knight has used trusts to transfer billions of dollars worth of Nike shares to his heirs tax-free.
But taxes are not the only big advantage of trusts, lawyers to the uber-wealthy told Insider. The rich can also use them to shield their family fortunes if their heirs get embroiled in bitter divorces or messy lawsuits.
“It’s so much more than just the tax,” said Karen Yates, partner at Withersworldwide. “Your parents can give you better creditor protection than you can buy for yourself at almost any price.”
Wealthy parents set up irrevocable trusts for the benefit of their children – or any third party — that have a spendthrift clause, which protects assets from creditors’ claims. The spendthrift clause dates back to an 1875 Supreme Court case and is widely used today.
“You’d almost be negligent as an attorney if you didn’t put in the trust that creditors can’t get access to the trust assets,” BNY Mellon Wealth Management tax strategist Jere Doyle told Insider.
How spendthrift trusts work
Spendthrift trusts can be used to defend an heir in virtually any kind of legal dispute. For example, if an heir gets in a car accident and is sued by the other party for damages, their inheritance would be protected, said Doyle.
Spendthrift trusts often come up in divorces. If an heir receives guaranteed payments from the trust, those payments may be considered for spousal support. But if the payments are at the trustee’s discretion (the party in control of the trust), it is much harder for a soon-to-be ex-spouse to claim them. If the trust has multiple beneficiaries, such as a group of siblings, this also strengthens an heir’s defense that they do not have certain entitlements.
“The trust acts as a barrier that makes sure the assets are not comingled with the marital assets,” said Yates.
These trusts can function as a prenuptial agreement, she said. Prenups are often done in a hurry, and some clients don’t want them for sentimental reasons. They also require disclosing a lot of personal information, which heirs might not even know, in order to be enforceable.
Robert Strauss, partner at Weinstock Manion, does not view spendthrift trusts as a substitute for prenups. But they are valuable, particularly in states like California, where all property and assets acquired during a marriage belong to each spouse equally. One of his clients was the trustee and beneficiary of a trust, which could have weakened his defense. But the spendthrift trust still worked in his favor.
“He never did have to provide his spouse with any benefit from the trust at all,” said Strauss. “The protection is pretty real.”
There are a few strings attached, however
Spendthrift trusts are not a “Get Out of Jail Free” card and should for certain requirements and guidelines to hold water in court, including:
- The trustee and beneficiary should be separate people.
It is risky to have a beneficiary also serve as trustee because, in the event of a lawsuit, a judge could compel the trustee to make disbursements to a plaintiff, according to Strauss.
Having separate beneficiaries and trustees is just one way to strengthen a spendthrift trust’s power. Cindy Brittain, partner at Karlin & Peebles, recommended having external investment advisors and professional, respected trustees. It also helps to have a business purpose for the trust, such as preserving privacy or taking advantage of another jurisdiction’s tax laws, she said.
- The trust assets are vulnerable for a set period of time, depending on its jurisdiction.
A trust can be contested anywhere from six months to six years after the trust is established, depending on the state where the trust was set up. If the individual who creates the trust files for bankruptcy, the statute of limitations extends to 10 years from the petition for bankruptcy per federal law.
If the trust is set up when a legal dispute is foreseeable or ongoing, this can rankle a judge. The estate or the trustee may be held liable for deliberately putting assets out of reach, known as fraudulent conveyance. The asset transfer can be voided to repay the creditor. Convictions of fraudulent conveyance can come with jail time.
- The beneficiary has limited to no power over the assets.
For the strongest asset protection, the beneficiary should have limited access to any trust assets, meaning they cannot use them as collateral or reassign the income to someone else. There are ways to craft the trust so the beneficiary isn’t completely powerless, such as allowing the beneficiary to make withdrawals for specific purposes such as medical expenses or education.
- The trust has to be set up by a third party.
Trusts that are set up to benefit yourself, known as self-settled trusts, do not enjoy the same protections even if they have a spendthrift clause, according to Doyle.
But, as always with lawyers to the high-powered, there are backup options. A few states provide exceptions for self-settled trusts such as South Dakota. Domestic asset protection trusts set up in a trust-friendly state like Delaware are very secure, he said.
“The spouse is pretty much out of luck in trying to get money out of that trust,” said Doyle.
Read the full article here