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1. What is an Inheritance Protection Trust?
An Inheritance Protection Trust is an irrevocable trust established through a deceased person’s estate plan typically for benefit of a surviving child. Although the term “Inheritance Protection Trust” could generally describe many types of beneficiary trusts, it usually refers to a trust established for a responsible adult beneficiary who is willing and able to manage an inheritance. This type of trust is usually drafted to continue for the lifetime of the beneficiary (or until all assets have been spent), rather than end at a predetermined time or age of the beneficiary. The beneficiary is usually named as sole trustee of the trust and is given the right to name an independent trustee, if desired; thus, an Inheritance Protection Trust is commonly described as a “beneficiary-controlled trust.” An Inheritance Protection Trust is used as an alternative to outright distribution when the amount of inheritance is expected to be substantial (generally more than $100,000 per non-spouse beneficiary). Its protective features are promoted as benefits to the beneficiary, not the trustor, because the trust is usually established after the trustor's death. But it is possible to establish and fund an Inheritance Protection Trust during the trustor's lifetime by having the trustor make irrevocable lifetime gifts into the trust. This is relatively uncommon because the usual incentive for gifting is to reduce estate taxes and very few people are wealthy enough to be concerned about it. 2. What are the benefits of an Inheritance Protection Trust? By receiving inheritance in a trust, rather than receiving inheritance outright, the beneficiary can protect assets from various threats:
3. How is the Inheritance Protection Trust established? The trustor's personal representative or successor trustee, depending on whether the trust provisions are drafted into a Will or living trust, establishes an inheritance trust by giving the separate trust a name and applying for its Taxpayer ID number. The provisions in the Will or living trust document govern the new trust, although it may be permissible for the trustee to restate the terms of the separate trust with a new document. This process is called trust decanting in Arizona. 4. Who should serve as Trustee? In most cases the beneficiary will serve as the initial trustee. However, if creditor protection is a paramount concern, the beneficiary should not serve as trustee. Rather an independent trustee – such as a bank, trust company, or accountant – should be appointed. This enhances the level of creditor protection by eliminating the conflict of interest held by a beneficiary who also serves as trustee. If an independent trustee is appointed, the beneficiary may be given a right to remove and replace the independent trustee. A common drafting option is to name the beneficiary as initial trustee and grant the beneficiary a power to resign and appoint an independent trustee. This gives the beneficiary the discretion to choose the level of creditor protection desired. 5. How much does an Inheritance Protection Trust cost? Typically the addition of one or more Inheritance Protection Trusts to a Will or living trust will substantially raise the fee for preparation of the estate plan. When compared to outright distribution of inheritance, the benefits of the Inheritance Protection Trust offer a clear and present value to both the trustor and beneficiary.
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The Arizona homestead exemption amount increased from $250,000 to $400,000 in 2023. The homestead exemption, which is automatic in Arizona, is intended to protect an Arizona resident's primary residence ("homestead") from creditors. But the new law includes several intricacies that make it more complex than it initially appears. For example, the new law requires any existing judgment liens (recorded in the same county) to be paid when the homeowner either sells or refinances the residence. The prior law stated that a homeowner with less equity than the exempt amount could still refinance a home loan without having to first pay off any existing judgment liens. The new law does the opposite - effectively preventing the homeowner from exercising a cash-out refinance.
The homestead exemption is also complicated by federal bankruptcy laws. If the home was acquired within 1,215 days (3 years, 4 months) of filing the bankruptcy case, the exemption amount is currently limited to $189,050. If this rule applies to you, be sure to investigate further with a bankruptcy attorney because there are exceptions that may help you out. Your health care power of attorney may permit your agent to restrict visitation.
In 2021, the Arizona legislature enacted A.R.S. 36-3211, which prescribes an assortment of rules and procedures regarding whether and how a health care agent may restrict visitation of an incapacitated person. The law now requires a health care agent to "encourage and allow contact" between the principal (the incapacitated person) and other persons who have a significant relationship to the principal. The health care agent may not restrict reasonable contact between the principal and any other person without prior court approval. But there is an exception, and you will probably want to use it. You can include a provision in your Arizona health care power of attorney that specifically permits your agent to limit, restrict, or prohibit reasonable contact between you and any other person. This provision gives your health care agent the right to determine who is permitted to interact with you while you are incapacitated. Your agent will be able to restrict visitation by people who he or she believes might try to fraudulently persuade you to change your estate plan or others whose involvement in your life brings strife. For example, an ex-spouse or estranged child. It is now common, and recommended, to include the following provision in an Arizona health care power of attorney: "I authorize my Health Care Agent to limit, restrict, or prohibit contact between me and any other person not named as an eligible Health Care Agent in this instrument." On the other hand, you might also view the issue another way. Perhaps you are concerned that your health care agent might unreasonably restrict visitation by your children from a prior relationship. In this case, you might choose to intentionally omit this provision in your health care power of attorney and rely upon the default law. Either way, it's an issue worth considering. 1. What is Asset Protection Planning?
Asset protection planning is the process of using legal strategies to shield personal and business assets from frivolous lawsuits and predatory creditors. It is intended for responsible individuals who wish to proactively shield assets from future threats, and not as a responsive measure to a clear and present danger. Asset protection planning has now become a regular component of comprehensive estate plans in the United States.[1] Most Americans with any significant accumulated wealth recognize the danger of leaving assets exposed to unnecessary legal risks, even when liability insurance is secured. 2. Are any assets protected automatically by law? Yes. Arizona residents qualify for many asset protection exemptions, which are codified by statute and protect certain assets automatically. Here are three examples:
But these exemptions do not work for everyone. Many people own brokerage accounts holding non-retirement investments. These investments are exposed to creditors. Others own investment real estate and small businesses, which are also at risk. 3. What about using liability insurance to mitigate the risk? Liability insurance is an excellent way to mitigate the risk, however, your insurance company may use exclusions in your policy to deny coverage precisely when you need it. Also, you may be sued for an amount higher than your coverage limits. I recommend you maintain a reasonable amount of liability insurance, including an umbrella-type personal liability policy. The insurance coverage should at least pay for a legal team to defend your case. 4. Should I establish a Limited Liability Company to protect my assets? A limited liability company (LLC) is highly recommended for ownership of small businesses and investment real estate. An LLC is very simple to register in Arizona and does not require an annual fee or annual report. The primary benefit of assigning your ownership to an Arizona LLC is that it isolates the risk between your LLC and your other assets. For example, if a tenant is injured at your rental property and you were not personally at fault, the tenant may sue the LLC as owner, but not you personally. This is called inside liability and Arizona LLC laws are designed to shield you personally from the LLC’s inside liabilities. Arizona LLC laws are also designed to protect the LLC’s assets from outside liabilities. For example, if you seriously injured someone in an auto accident and you were driving for a personal reason, the injured person may sue you personally and then attempt to collect from your LLC. However, Arizona law will only grant the injured person a charging order against the LLC, which acts like a lien. The charging order would redirect any distributions from the LLC to the injured person, but the manager of the LLC would likely suspend any distributions until a settlement is reached. But it should be noted here that a single member LLC will not protect you in the above example if the matter is being litigated in a federal bankruptcy court. There is substantial precedent for the bankruptcy court to treat a single member LLC differently than a multi-member LLC. The court will disregard the single member LLC and Arizona law when there is an outside liability creditor attempting to penetrate the LLC. If you are concerned about this kind of liability then think long and hard before filing for bankruptcy. For more information about this topic, read this excellent article by fellow WealthCounsel member Richard Keyt: Warning: Single Member LLCs Lack Asset Protection if the Member Files for Bankruptcy 5. Will a Limited Liability Company protect my personal residence and other investments? No, because the LLC must have a legitimate business purpose. A business purpose would include providing a service, product, or usable space to an unrelated person or company. Every small business provides a service or product, or both, to the general public, while investment real estate provides a place to live or do business. Your personal residence does not have a business purpose and neither does your personal investment brokerage account. Arizona residents qualify automatically for a homestead exemption, which protects up to $400,000 of equity even if a judgment creditor forces a sale of the home. For homeowners with more than $400,000 of equity, I may recommend either a major increase in homeowners liability insurance coverage or transferring the home into an irrevocable Arizona-based hybrid asset protection trust. Neither solution requires a business purpose to implement. Other reasons you should not transfer your personal residence into an LLC are (1) loss of exclusion of taxable gain upon sale of a personal residence, (2) loss of mortgage debt interest deduction, (3) loss of homestead exemption, and (4) possible increase in property taxes. Likewise, while some may argue that a personal investment brokerage account has a business purpose, most would not. Therefore, I would be wary of transferring a brokerage account into an LLC unless perhaps combined with other assets that do have a business purpose. The safer approach is to either increase umbrella-type personal liability insurance coverage or transfer the brokerage account into an irrevocable Arizona-based hybrid asset protection trust. 6. What is an Irrevocable Arizona-based Hybrid Asset Protection Trust? Many people I meet would benefit from an irrevocable asset protection trust, a strategy generally assumed to be too complicated and too expensive. But I am not referring to families with vast inherited wealth or the Mark Zuckerberg-type entrepreneurs. So how do you know if an asset protection trust might be right for you? Consider the value of these assets you may own:
If the combined value of these assets exceeds $1,000,000, then you are an excellent candidate for an asset protection trust. So how does the asset protection trust work? An asset protection trust is created when a person transfers ownership of an asset into an irrevocable trust, which is managed by a trustee for benefit of one or more beneficiaries. The assets you contribute to an irrevocable trust may qualify for protection from your future or unknown creditors.[3] The catch is that you cannot name yourself as both trustee and beneficiary like you would normally in a revocable living trust for probate avoidance. In other words, you cannot establish your own irrevocable asset protection trust and retain the sole discretion to make distributions back to yourself. This arrangement does not provide any asset protection and is against public policy in all 50 states. Some states like Wyoming and Nevada[4] do permit self-settled asset protection trusts using a third-party trustee in that state, which means residents of those states may remain a beneficiary of the trust and, after any applicable statute of limitations expires, protect the trust assets from their own future or unknown creditors. Although Arizona law does not permit self-settled asset protection trusts, an Arizona trustor may still obtain the desired creditor protection by establishing the trust in Arizona, excluding the trustor as an eligible beneficiary, and relying on spendthrift or discretionary trust provisions available under Arizona law to protect the trust assets from creditors of the eligible beneficiaries. This “hybrid” approach omits naming the trustor as an initial beneficiary (i.e., not self-settled) but permits an independent trust protector to later add the trustor as an eligible beneficiary, subject to the then-applicable qualified spendthrift trust rules. For Arizona residents, I recommend two options when naming trust beneficiaries: Option #1- Family Gifting Trust (Trustor’s Children are Lifetime Beneficiaries) In Option #1 you would name one or more children (or other non-spouse beneficiaries) as eligible beneficiaries during your lifetime, excluding yourself or your spouse. The advantage is that you may serve as trustee and maintain full control of the assets in the irrevocable trust. The trust may be established as an individual trust or a joint trust. Although your beneficiaries would have a right to information about trust assets, you retain discretion whether to make any distributions to them during your lifetime. The trust assets are protected from your future or unknown creditors - because you are ineligible to receive distributions - and from creditors of the beneficiaries (using spendthrift or discretionary trust provisions available under Arizona law). Option #2- Spousal Lifetime Access Trust (Trustor’s Spouse is a Lifetime Beneficiary) In Option #2 you would include your spouse as an eligible beneficiary during your lifetime, and if desired, name your spouse as trustee. Similar to Option #1 the trust assets will be protected from your creditors during your lifetime - because you are ineligible to receive distributions - and from creditors of your spouse and beneficiaries. The difference here is that your spouse is an eligible beneficiary, allowing your spouse to receive distributions from the trust if there is a legitimate need. The trust must be established as an individual trust with any contributions coming from your separate property or your one-half of community property after partition. Both approaches may be referred to as hybrid asset protection trusts because either may be drafted to include a provision giving an independent person or company called a trust protector the power to move the trust to another state or country that permits self-settled asset protection trusts. This change of governing law might permit the trust protector to add you as an eligible beneficiary later. 7. What are the tax consequences of establishing an Arizona-based Hybrid Asset Protection Trust? The next design issue is to choose whether you want the asset protection trust optimized for income tax avoidance or estate tax avoidance. If your net worth is not high enough to trigger an estate tax upon your death[5], you may wish to design your trust to be included in your taxable estate. The advantage is that trust assets will receive a full step-up in income tax basis upon death. Your beneficiaries will be able to liquidate investments with little or no capital gains tax to pay. Income tax optimization is usually achieved by permitting you to redirect distributions during lifetime or to reallocate the trust assets upon your death to different beneficiaries than you initially named in the trust document. But if you want to exclude the trust from your taxable estate, then you must relinquish any rights you might have to reallocate distributions among beneficiaries during your lifetime or to reallocate the trust assets upon your death. And although technically permitted with careful drafting, the safer approach is to exclude yourself as an eligible trustee. 8. May I simply gift my assets to someone else in order to protect them from creditors? While gifting an asset outright to a spouse or other relative would clearly be fraudulent if a claim is known or reasonably foreseeable, it may also be foolish when no claim is imminent. If you gift an asset to your spouse, and then your spouse later divorces you, your ex-spouse keeps the asset and you get nothing. Likewise, your other relative would have no obligation to gift an asset back to you, or use the asset for your benefit, when you might want it back in the future. Even the act of your spouse or relative gifting an asset back to you may serve as evidence the initial gift was made, in fact, to hinder or defraud a potential creditor. A gifted asset is also exposed to creditor claims against the spouse or relative. For example, if your spouse is at fault in an auto accident, the asset you were trying to protect would be exposed to a potential new claim outside your control. Also consider the possibility that your relative might later get divorced and the relative’s ex-spouse becomes entitled to one-half of an asset that was originally yours. The better approach is to rely on liability insurance, LLCs, and irrevocable trusts to protect assets. For example, an irrevocable trust with spousal access provisions may be drafted to define your spouse as the person you are married to and not necessarily the person you were married to at the time the trust was established. Similarly, an irrevocable trust for your children may be drafted to protect trust assets from creditors and ex-spouses of the children. Click here for a printable PDF of this article including a design choice chart. About the Author Thomas J. Bouman provides legal counsel in the areas of estate planning, estate settlement, and asset protection. He brings a highly systematic approach to the practice of law, which is critically important when wading through the complex, and often bizarre, legal requirements associated with estate and trust law. Mr. Bouman is author of the Arizona Estate Administration Answer Book and a prominent member of Wealth Counsel, LLC, the nation’s premiere organization of estate planning attorneys. [1] The asset protection techniques described in this article will not protect assets from existing known creditors, i.e., creditors who have already brought a cause of action or claim for relief; or provide immediate protection from potential creditors when an applicable statute of limitations applies. I will not represent anyone who expresses intent to hinder, delay or defraud any known or reasonably foreseeable creditor. A client must be willing to sign an affidavit evidencing intent to remain financially solvent after any transfer and to refrain from fraudulent transfers. [2] Term life insurance policies do not include an investment component so there is no asset to protect during the insured’s lifetime. [3] There are exceptions to this general rule. For example, Arizona law does not shield the trust assets from child support claims. Also, the strategy is not likely to work if you transfer all your personal assets to the trust. You must remain solvent on your personal net worth statement, even after contributing assets to the irrevocable trust. [4] 19 states permit self-settled asset protection trusts in some variation. The most well-known are Alaska, Nevada, Wyoming, and South Dakota. Unfortunately, the full faith and credit clause of the U.S. Constitution makes it unlikely an Arizona court would respect the governing law of a self-settled asset protection trust established in one of these states for an Arizona resident. Foreign asset protection trusts avoid this problem in theory, but if the full protection of the trust is triggered by an actual threat, case law has shown the beneficiary also loses access to the trust assets unless willing to move permanently outside of the United States. This is an unintended consequence most people are not willing to accept. [5] As of 2023 the federal estate tax law exempts up to $12,920,000. However, this number is subject to the political winds of change. In order to be successful as an estate planning lawyer, I must break down complex topics to manageable teaching points. Here are a couple examples:There are 3 tools in the estate planning toolbox for transferring assets upon death:
1- Beneficiary designation 2- Will 3- Trust There are no more tools. Every estate plan will use a combination of these tools and each has its advantages and disadvantages. My job is to determine which tool is best suited for each asset, while making sure the client is comfortable using the tool. There are 3 ways to leave inheritance to a beneficiary: 1- Outright 2- Restrict 3- Protect The outright approach is simple and everyone understands it. The restrictive approach is useful when the inheritance would be subject to an identifiable clear and present danger (spendthrift habits, special needs, susceptibility to undue influence, need to maintain beneficiary’s qualification for government-sponsored health benefits or supplemental income benefits). The protective approach is useful when there is a desire to protect the inheritance from future threats (lawsuits, divorce, debt collectors). I have found these teaching points to be very effective in explaining key concepts in estate planning. |
AuthorTom Bouman, Attorney Archives
June 2024
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