Trusts are popular for estate planning, and for good reason. They allow individuals to keep property out of probate court. This can make it much easier and faster to transfer property to heirs and save money on probate costs and taxes. One of the most common types of trust used to avoid probate is the revocable trust.
A revocable trust is an effective tool for shielding assets from probate. But some people think that putting property in a revocable trust also protects it from creditors and plaintiffs from civil lawsuits. Meanwhile, others believe that they need to avoid putting certain assets in a revocable trust to protect the trust's assets from exposure to liability. But neither belief is true.
This article will identify and explain the limitations of the revocable trust as well as other potential threats to trust property. But there will also be a discussion about other estate planning and financial strategies that are available to manage these risks.
Revocable versus irrevocable trusts
There are two main types of trusts, revocable and irrevocable. There are probably dozens of different types of trusts available for estate planning and/or asset protection purposes, but the majority will fall under one of these two types.
A revocable trust (also known as a revocable living trust or RLT) is a trust that gives the grantor (also known as the settlor or trustor) the right to change the terms of the trust. This includes who will benefit from the property placed in the trust (beneficiaries). The grantor can also add or remove property in the trust or end the trust. Upon the grantor's death, an RLT will become an irrevocable trust.
In contrast, an irrevocable trust does not allow the grantor the ability to modify the trust. The primary exception is if the grantor receives permission to make changes from the beneficiaries. Practically speaking, once a grantor creates the irrevocable trust, the major aspects of the trust are permanent.
In general, revocable trusts can't protect assets from creditors, although an irrevocable trust often can. This key difference is because even though both types of trusts can have property titled in the name of the trust, the grantor retains full control over that property in a revocable trust. In an irrevocable trust, the grantor has no such ability.
Liability risks of an RLT
Because the grantor retains control of property placed in an RLT, the trust property is within reach of creditors. This includes a plaintiff winning a lawsuit against the grantor on a matter unrelated to the trust.
Even if the grantor retitles the trust property so that the trust itself is the legal owner, if the grantor gets sued and has to pay out a court judgment, the plaintiff from that suit can go after property in the RLT. How might this happen? There are many possibilities.
Maybe the grantor causes a car accident which results in personal injuries and property damage to another driver that exceeds your car insurance policy limits. If the other driver finds out the grantor has an RLT, they'll go after the trust's property.
Or perhaps the grantor owns a business where they're a sole proprietor. This means the grantor is personally liable for the legal liability their business. If the grantor were to get into a contractual dispute, the grantor's legal opponent could go after both his business assets and personal assets, too. And this includes the property in the revocable trust the grantor created.
There's another common misconception about asset protection in an RLT. Because some people assume the trust property is protected from lawsuit or financial creditors, they assume they can do things to lose this asset protection.
This misunderstanding often manifests itself in the idea that you shouldn't put your car or house into the trust. The fear is that the asset will become involved in an incident creating liability. For example, if someone visiting your house gets hurt during the visit, they could sue you for the harm they suffered. If your homeowner's insurance policy doesn't cover the loss (or doesn't provide enough coverage), some people think that the house or other property in the trust could be used to pay the visitor who got hurt.
But this understanding isn't true. That's because the RLT never could protect trust assets from legal liability in the first place. It doesn't matter that the property was or wasn't titled in the name of the trust. Because the grantor has control over the assets, the property is at risk as long as the grantor remains alive.
Ways to protect a trust's assets
If you want to protect the property in a trust from creditors and legal judgments, one of the best things you can do is create an irrevocable trust. There are numerous options available, but three commonly used types include:
- A spendthrift trust
- Domestic asset protection trust
- Foreign/offshore asset protection trust
A spendthrift trust
A spendthrift trust is a trust where the beneficiary has restricted access to the trust and its property. Because the beneficiary has no direct access to the trust property, neither do creditors. So how does the beneficiary gain any benefit from the trust? Through the trustee, who will have discretion to decide how to distribute trust property to the beneficiary as required by the terms of the spendthrift trust.
As you can imagine, creating a spendthrift trust will require the grantor to carefully prepare the trust so the trustee will carry out the grantor's original wishes. The grantor will also want to choose a trustee that they can rely on to honor those wishes.
A domestic asset protection trust
A domestic asset protection trust is a type of spendthrift trust in that there's a trustee who decides how the trust's assets are to be used for the benefit of the beneficiary. However, in a domestic asset protection trust (DAPT), the grantor is the beneficiary.
Most states don't recognize DAPTs, and the ones that do will have their own rules in how they work and the level of asset protection they provide. For example, the trust may need to have a trustee who is a resident in the state where the trust was created. There could also be a requirement where some or all of the trust property is located in the trust's state.
As for asset protection, states could differ on the exceptions they allow concerning asset protection. This might include ex-spouses or children who are trying to recover unpaid alimony or child support payments.
Because of these differences in how DAPTs work, it's strongly recommended that you find an estate planning attorney who has plenty of experience creating DAPTs. They should know the laws of many of the states that allow for DAPTs and help you find the right state to meet your estate planning needs.
A foreign asset protection trust
A foreign asset protection trust (also known as an offshore asset protection trust) is just like a DAPT, except the trust is located in another country and controlled by that country's trust laws. The trustee will also be from that country. One of the benefits of a foreign asset protection trust (FAPT) is that it makes it even harder for creditors to gain access to the trust property.
But this added protection is a double-edged sword. While domestic creditors may no longer have access to the trust and its property, the same applies to the laws of the United States. So if the FAPT consists of a bank account, that bank account is subject to the foreign jurisdiction's laws. That means no Federal Deposit Insurance Corporation protection for that money if the bank goes under.
Another way to protect the assets in a trust is to ensure they're adequately insured. This means raising coverage limits if needed to cover the full value of the asset. You may also want to consider getting a liability umbrella insurance policy. Finally, think about adjusting your coverage to more accurately reflect how your use the property.
For instance, let's say you have a personal vehicle that's a trust asset. It's insured with a conventional car policy, but you also use your vehicle to make deliveries for an app-based food delivery service.
If you were to get into an accident while making a food delivery run, there's a good chance the accident wouldn't be covered by your car insurance due to the business use exception. This bars coverage when you're using your vehicle for business purposes. To avoid this, you can probably purchase business-use coverage from your current car insurance company.
Umbrella insurance is a type of liability insurance that supplements the insurance coverage you already have. This often means adding extra coverage to your home or car insurance policies. But another feature of umbrella insurance coverage is that it pays out for incidents that don't relate to insured property.
So there could be an incident that you become personally liable for, which has nothing to do with your car or home (which are both insured). Depending on the circumstances, your umbrella liability insurance policy will pay for any legal damages you could owe.
When buying an umbrella policy, you'll need to change your approach in deciding how much coverage you need. Instead of looking at the cost of the property you're trying to insure, look at the potential monetary judgment you'll have to pay if you become liable for a tort you commit.
Despite the large amount of coverage it offers, umbrella insurance is very affordable. That's because they often only payout after an underlying car or home insurance policy's limits have been exhausted.