Asset Protection Planning
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As society becomes increasingly litigious, the topic of asset protection becomes increasingly important. There are a number of tools available for California residents who are looking to protect their assets from creditors. Trusts are one of the most popular tools for asset protection worldwide. Is a California asset protection trust one of them? In a word, no. But there are asset protection trust options for California residents; the most powerful of which is an offshore trust. For those who call the Golden State home, the availability of different forms of trusts and their use for asset protection are discussed below.
Trusts are fiduciary arrangements which allow third parties to manage assets on behalf of beneficiaries. The person who manages the assets is referred to as the trustee. The person who forms the trust is known as the settlor of the trust. There are numerous different types of trusts available. They may be structured in a variety of ways and can prescribe how and when beneficiaries may access trust assets.
Trusts work by splitting the beneficial interest of assets from their legal ownership. Beneficiaries of trusts hold equitable interest in the assets held within the trust. However, they do not own legal title to the assets held within the trust. The legal title of the assets held within the trust belongs to the trustee. As a result, the trustee acts as a fiduciary for the beneficiary or beneficiaries. The trustee’s sole obligation is to administer the assets held within the trust for the benefit of the beneficiaries under the terms of the trust. They trust quite often instructs them to disregard the interest of any other parties with regards to the management of the trust.
Trusts are one of the most common tools used for asset protection worldwide. When drafted correctly, trusts provide some of the strongest asset protection available. This is because creditor’s ability to make claims against assets held in a trust are limited to the debtor’s control over that trust. For this reason, trusts used for asset protection are structured to limit the influence of the beneficiary. A risk of the beneficiary’s assets in the trust is determined by the amount of control that the beneficiary is able to exert over the assets held in the trust. The less control a beneficiary has, the lower the ability of the beneficiary’s creditors to make claims against the trust’s assets. As a result, certain types of trusts are preferable over others for use in asset protection planning.
While some jurisdictions allow for the spendthrift protection of self-settled trusts, California law specifically prohibits this practice. (We define these concepts below.) If a spendthrift trust in California is self-settled, it will not provide any degree of asset protection for the settlor. This point is significant because it means that there is no such thing as a California asset protection trust; that is, a trust where the settlor who created the trust also retains rights as a beneficiary. There is handful of US states and, better yet, offshore trust jurisdictions, that do have self-settled asset protection trusts.
Revocable Living Trusts
Revocable trusts are trusts which are often used in California to for estate planning. These types of trusts are commonly referred to as living trusts or family trusts. Revocable trusts transport the ownership of assets upon one’s passing. They work by allowing a person to allocate property to a designated beneficiary or beneficiaries upon his or her death. The settlor of a revocable trust has the ability to control the assets held within the trust during their lifetime. They also have the ability to change or cancel the trust at any time.
However, if a debtor is the settlor of a revocable trust, the trust will not provide the settlor with any significant degree of asset protection. This is a mainly a result of the settlor’s ability to revoke the trust. The ability to revoke the trust demonstrates the ability to control the assets held within the trust. A judge can force one to use that control to name one’s enemy-at-law as the new beneficiary. As a result, the creditors of the settlor will be able to attack the trust’s assets.
As California is a community property state, revocable trusts can become a point of contention in divorce proceedings. For this reason, many trust agreements contain specific provisions regarding what will happen to the trust and its assets in the event of divorce. If a trust does not contain these provisions, California law prohibits spouses in divorce proceedings from changing or revoking trusts. A California court will make the final determination on whether or not a revocable trust can be changed or revoked during divorce.
Irrevocable trusts are designed for the long-term management of assets. They are commonly used in estate planning. There are several different types of irrevocable trusts designed to suit specific purposes. However, all irrevocable trusts have one common characteristic. This characteristic is that the settlor of the trust gives up control and ownership of the property held within the trust.
Irrevocable trusts are commonly used for asset protection. In this regard, the law uses the “step into their shoes” theory. That is, whatever debtors could do, personally, the creditors can step into their shoes and do the same. The settlor of an irrevocable does not have direct access to the assets held in the trust. As a result, creditors of the settlor generally cannot reach the assets held within the trust. California law does, however, include exemptions to this rule. These exemptions include child support claims, alimony claims, federal tax claims, and state tax claims.
Despite the irrevocable name, it is also possible under California law to draft the trust in such a way that changes are permitted. This is possible through the use of different legal devices, such as a trust protector. Trusts protectors are disinterested parties who take on fiduciary responsibilities for the trust. Trust protectors, who are often accountants or attorneys, have limited oversight powers regarding the trust. It is also possible for the trust deed to allow for the reservation of certain powers by the settlor to make adaptive changes to the trust. Generally speaking, the more powers a settlor retains, the less valuable the trust will be in providing asset protection for the settlor.
Qualified Personal Residence Trusts
The qualified personal residence trusts or QPRTs are a form of irrevocable trust which is frequently used in estate planning and asset protection. Qualified personal residence trusts work by moving the settlor’s personal residence out of their estate. They do so by assigning the residence a low gift tax value. Once the residence has been placed in the trust, both the property itself and any future appreciations are excluded from the settlor’s estate.
Qualified personal residence trusts are considered to be split-interest trusts. The settlor retains the right to live in the residence rent-free for a predetermined number of years. The remainder of the interest in the residence is allocated to the beneficiaries of the trust, such as their children. So, the beneficiaries live in the property for, say, 20 years. From there forward they rent the property from their children. Legally speaking, the interest which the settlor retains in the residence would not be protected from the claims of creditors. However, in practice, we have not seen a creditor to attempt to attach claims to a settlor’s remaining interest. This is because it would be very difficult to sell this interest in a foreclosure sale. So, it has proven itself as a viable option to protect a home in California from lawsuits.
Spendthrift trusts are designed to prevent trust beneficiaries from squandering their funds. They do so by limiting or altogether removing the ability of beneficiaries to transfer or assign their interest in the trust. These restrictions apply to both the income and the principal of the trust. Nearly all modern trusts incorporate a spendthrift clause.
Because beneficiaries do not retain control over their interest in the trust, their creditors are unable to attack the assets held within the trust. However, this protection applies solely to assets held within the trust. Once the property has been distributed to the beneficiary, it is subject to the claims of creditors. The exception to this rule is the extent to which the distribution will be used for the support of the beneficiary.
In a discretionary trust, the trustee has discretion with regards to the timing and amount of distributions of assets held within the trust. They also have discretion with regards to the identity of the beneficiary. Discretionary trusts must not contain controlling provisions which mandate distributions of trust assets. They may, however, include provisions which set standards for how trustees make distributions. Beneficiaries have no property rights with regards to the assets held within a discretionary trust. As a result, it is a challenge for a beneficiary’s creditors to pursue the assets of a discretionary trust.
Domestic Asset Protection Trusts (DAPT)
Most people seeking asset protection are seeking to protect their own assets, rather than the assets of beneficiaries. To accomplish this, one needs a self-settled trust. Self-settled means the settlor or grantor who created the trust is also a trust beneficiary.
As mentioned previously, self-settled spendthrift trusts are not permitted in California. As a result, many California residents choose to establish trusts in jurisdictions where this practice is allowed. As of this writing, there are currently sixteen states in the United States which permit domestic asset protection trusts or DAPTs.
In order for a trust to be considered a domestic asset protection trust, it must be irrevocable and contain a spendthrift clause. It must also have a trustee who is a resident of the state where the trust is established. Additionally, some administration of the trust must take place in the jurisdiction where the trust is settled. The settlor of a domestic asset protection trust may not act as the trustee.
Though their track records are shaky, domestic asset protection trusts are preferable to the various California asset protection trust options in protecting the assets of the settlor. Notably, they are far inferior to offshore trusts for two reasons. First, domestic asset protection trusts are subject to the judgments of US courts. This includes judgments regarding the California Fraudulent Transfer Act, which nullifies the protection afforded by the trust. Second, California judges typically enforce the California asset protection laws and disregard those in the foreign trust jurisdiction. Third of all, domestic asset protection trusts are generally not protected from the claims of exemption creditors. These claims include child support claims, alimony claims, federal tax claims, and state tax claims.
Offshore trusts provide the most exhaustive protection available to California residents seeking to protect their assets. Like domestic asset protection trusts, self-settled offshore trusts are available in many jurisdictions. They also contain spendthrift clauses.
The advantage of an offshore trust is that, in many jurisdictions, foreign judgments are not recognized by local courts. As a result, creditors who want to attack the assets held in an offshore trust must travel to the foreign jurisdiction. They must then spend the time and money necessary to have their case re-adjudicated through the local court system. Often times, this proves to be more trouble than it is worth and creditors will drop their claims. Additionally, offshore jurisdictions often have much shorter statutes of limitations on claims of fraudulent transfer. Once the clock runs out on the statute of limitations, assets held in an offshore trust are virtually untouchable. Finally, offshore jurisdictions usually do not identify exemption creditors. As a result, offshore trusts can prove particularly advantageous in protecting assets in the event of divorce. So, for those seeking a California asset protection trust, to protect one’s own assets and have them available for use at a later time, they do not exist under California law. So, that is why so many Californians seeking asset protection opt for the power of the offshore asset protection trust managed by our offshore law firm.
The bottom line is that there are no such thing as California Asset Protection Trusts in the modern sense of the phrase. That is, trusts in California that protect assets where the settlor is also a trust beneficiary is not in the law books. But there are some very favorable potions, especially offshore asset protection trusts, that can securely protect the assets of Californians.