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Using A Self-Settled Trust To Protect Assets

Trusts can serve many purposes, from transferring wealth to furthering philanthropic goals. If asset protection is a priority, a self-settled spendthrift trust can be a valuable tool for wealthy individuals and their families.

Self-settled spendthrift trusts, often called self-designated trusts, have become increasingly popular for those who wish to protect their assets from future creditors (or future exes). A self-settled trust is a type of irrevocable trust in which the grantor is also the primary beneficiary.

To maximize the trust’s usefulness in protecting the grantor’s assets, its structure must prohibit the grantor, or his or her creditors, from accessing trust assets. This feature is known as the spendthrift provision, from which the trust takes its name. An independent trustee controls all trust distributions. The trustee can, and often does, make distributions to the grantor; however, the trustee is not required to do so unless he or she deems it appropriate. This provides the trustee with the flexibility to cease distributions in the event of a claim against the grantor from a creditor or a former spouse.

While this can be a valuable arrangement for a person concerned about asset protection, it cannot be made in hindsight. Regulations prevent the creation of a self-settled trust expressly to hinder or defraud current creditors. Only 14 states specifically allow for the creation of such trusts at all, and the rules for how existing creditors may react vary by state.

Nevada is a popular jurisdiction for the creation of self-settled spendthrift trusts because of an unusually short period in which creditors may act. In Nevada, a grantor’s known creditors have either a two-year window from the trust’s creation or a six-month period after they discover a property transfer (or reasonably should have discovered the transfer), during which they may challenge any transfer of property into a self-settled trust. In many other states, including Alaska, Delaware and Rhode Island, a creditor has up to four years to challenge a transfer, leaving the grantor exposed for a longer period.

As long as you are not subject to any claims from creditors at the time you create the trust, you can protect assets from future creditors by transferring them. Assets in a self-settled trust will generally be protected should a future claim arise. This can be particularly appealing for those who face an increased likelihood of personal lawsuits stemming from their professions, such as doctors, lawyers or business owners.

Of course, as with anything in life, nothing is guaranteed. As previously mentioned, any hint of a transfer to the trust in response to or in anticipation of claims by creditors will put the trust’s assets at risk. Further, there are other actions by a grantor that the courts will view unfavorably, such as making a transfer to the trust that renders the grantor insolvent. A recent bankruptcy case in Seattle suggests that judges in some jurisdictions may even try to disregard seemingly valid trusts.

While self-settled trusts are designed primarily for asset protection, they can also be useful wealth-transfer vehicles if structured properly. For example, an individual with an $8 million estate wants to take advantage of the current $5.25 million lifetime gift tax exemption, but is worried that the remaining $2.75 million may not be enough to support him for the rest of his life. He could make a gift of $5.25 million to a self-settled trust, designating himself as one of several beneficiaries and assigning an independent trustee who would have the ability, but not the obligation, to make distributions to the grantor throughout his life. At the grantor’s death, the remaining assets in the trust, including any appreciation, would pass to the other beneficiaries free of estate tax. Those interested in making large wealth transfers to younger generations but who fear they may still need the assets may be willing to use a self-settled trust with this additional flexibility.

Self-settled trusts provide many obvious benefits, but also have a few disadvantages. Foremost is the independent trustee’s power over distributions and the grantor’s inability to force the trustee to make them. Coupled with the fact that the trustee must reside in the state where the trust is created, this can make it difficult for grantors to find suitable trustees. For example, if someone wanted to take advantage of Nevada’s rules governing self-settled trusts but didn’t know any suitable Nevada residents who could serve as trustee, then she might need to rely on a trust company or financial institution with which she had no prior history to make decisions on distributions. Understandably, this situation can make the idea a nonstarter for some.

In addition, self-settled trusts are irrevocable. Once the assets are transferred, they cannot be transferred back to the creator of the trust except as a distribution to him as a beneficiary. This only becomes an issue when the trustee opts not to make distributions, but such a decision is within the trustee’s rights. Thus, again, it’s vital that the trustee be someone the grantor respects and trusts to manage his or her assets appropriately.

Self-settled trusts are a relatively new estate-planning vehicle. This has led some to question their viability, particularly for individuals who live in jurisdictions that do not allow their creation but who establish one elsewhere. For example, if a grantor in New York established a self-settled trust in Nevada, a claimant would have to pursue the claim there. If Nevada rejected the claim, the claimant might take action in New York in an attempt to get the Nevada ruling reversed. There is not a long history of courts vetting self-settled trusts, so no one knows for certain what the result of such legal action would be. Further, that result could vary from state to state. Most planners recognize, however, that a properly structured self-settled trust established under non-fraudulent circumstances creates some level of asset protection, as well as a deterrent to creditors, compared with owning assets outright.

Though we have described them broadly in this article, in practice, self-settled trusts are quite technical and should be drafted only by an experienced and knowledgeable attorney. Even the states that do permit self-settled spendthrift trusts have their unique statutes. It is imperative to understand the legal ramifications and risks of the decision prior to establishing the trust, a perspective that only a professional can provide.

Despite the complications, the benefits of self-settled trusts are clear. Self-settled trusts offer the winning combination of asset protection and estate planning with one technique.

Vice President David Walters, who is based in our Oregon office, contributed several chapters to our firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55, including Chapter 5, “Estate Planning,” and Chapter 6, “Transfer Taxes.” He was also among the authors of the firm’s book The High Achiever’s Guide To Wealth.