Your Client's Estate Plan: Asset Protection
Planning
Attorneys can give clients added value by
structuring the ownership of family and business assets to maximize
protection from creditors when creating a comprehensive estate plan.
by Randall M. Miedaner & Mark S. Poker
Traditionally, the estate planning attorney's goal is to implement
client desires for the benefit of the client's family and other
beneficiaries following death, reduce transfer taxes, and minimize
estate administration costs and delays. The attorney also may expand
these goals to include preserving and protecting the client's net worth
for his or her lifetime and future generations by incorporating asset
protection features into the estate plan. The recently enacted Economic
Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA) will help to
reduce the estate tax burden. As the tax burden decreases, it is likely
that clients will consider nontax planning strategies such as asset
protection planning. This article reviews several commonly used estate
planning techniques that attorneys can use to protect and preserve
client wealth.
Overview of Asset Protection Planning
The risk of exposure to potential lawsuits exists in every aspect of
today's society. As a result, over the last decade many clients have
become more concerned about exposing family wealth to creditors' clams.
Individuals who once were moderately motivated to do estate planning may
become highly motivated when they realize that several techniques used
in traditional estate planning also may be used to further protect and
insulate one's wealth.
Asset protection is defined as structuring one's wealth and business
affairs in advance so as to minimize exposure to potential lawsuits
and/or creditors. Asset protection incorporates techniques that follow
state statutes, federal law, and judicial decisions. Proper asset
protection is not the concealing of assets. To the extent the estate
planner can advance asset protection goals consistent with family estate
and tax planning objectives, the counselor can give clients additional
value in performing estate planning services.
Every plan must consider both federal and state fraudulent conveyance
laws.1 In the absence of actual fraud, an asset
transfer can be set aside on a finding of constructive fraud. Courts
have held that a continuation of established estate planning may not
constitute a fraudulent transfer.2 Consequently, the
most effective defense to a fraudulent conveyance claim is the passage
of time from the date of transfer and a demonstration that the asset
protection planning is only one part of an overall estate plan.
With minor adjustments, many of the techniques used in traditional
estate and tax planning can be used in asset protection planning. The
following represent some examples.
Transferring Assets
In developing an asset protection plan, examine dividing assets
between spouses to minimize creditor exposure. Generally, the separate
property of one spouse cannot be seized to satisfy the liability of the
other spouse. For creditor protection purposes, it may be useful in
community property jurisdictions to classify property as one spouse's
separate property. The "transfer" of assets to a spouse could be
completed through a lifetime marital trust or a limited partnership.
Through a marital trust the donor spouse can control the ultimate
disposition of property. In a limited partnership the donor spouse could
continue to hold the general partnership interest and thereby retain
effective control over the underlying assets.
One popular technique used for reducing estate and income taxes
involves gifting $10,000 annually under the annual gift tax exclusion,
or perhaps gifting even larger amounts against the client's $675,000
lifetime exemption equivalent. Under EGTRRA, the lifetime exemption
equivalent will be raised to $1 million in 2002 and higher thereafter.
Over time, a gifting program can save a family a significant amount of
taxes. Because the donor no longer owns the property that was gifted,
and assuming there are no fraudulent conveyance issues, the donor
implements a fundamental asset protection premise which provides, "if
you don't own it, you can't lose it."
There are numerous gifting techniques, other than outright gifts,
that can be used. The qualified personal residence trust (QPRT) is an
estate planning technique in which the grantor conveys a remainder
interest in the grantor's primary residence or vacation home in trust to
his or her heirs while retaining a term interest in the property for a
specified time. Because the original owner of the property splits the
property ownership into a term interest and a remainder interest,
limited asset protection is achieved because a creditor will find less
value in a split real estate interest.
Other split interest estate planning techniques where the settlor
retains an annuity, such as grantor retained annuity trusts (GRAT) and
chartable remainder trusts (CRT), also lessen the value of the
underlying property from a creditor's perspective. An annuity received
from a GRAT or CRT may be protected by an exemption under state law. The
remainder interest in the trust is protected from creditors because the
settlor no longer has an interest in the remainder.
Trust Planning
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Randall M. Miedaner, Louisiana State
University 1987, is of counsel to the firm, practicing in estate and
business transition planning and family wealth planning. He is a CPA and
Certified Financial Planner, and a frequent author and lecturer.
Mark S. Poker, Marquette 1988, LL.M.
1990-Taxation with distinction, is a partner in Michael Best &
Friedrich LLP, Milwaukee. He practices in and coordinates the firm's
estate and financial planning practice area. He is a frequent instructor
in estate and tax planning courses.
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While gifted property no longer is
subject to the donor's creditors, this is not the case with the donee.
Therefore, it may be prudent to advise your client to structure these
gifts in a properly drafted trust, because a trust can be established
that protects assets from the claims of the donee's creditors. In
designing the estate plan, both a client and the beneficiary may prefer
ownership in a properly designed trust versus outright ownership of a
gift or inherited property.
In addition to using a trust for lifetime gifting purposes, various
trust arrangements can represent the foundation of a family's estate
planning, including the family credit shelter trust, marital trust, life
insurance trust, generation skipping trust, minor's trust, CRT, GRAT,
and the QPRT. All of these trusts, if properly drafted, may provide
significant income and/or estate tax savings.
Generally, a beneficiary's interest in a trust established by another
is protected from the beneficiary's creditors if a specific protective
clause, referred to as a spendthrift clause, is included in the trust
document. Once created, a trust that includes a spendthrift clause has
the ability to protect a beneficiary's interest in the trust income and
principal. The validity of the spendthrift clause is well established.3 Wisconsin specifically recognizes the spendthrift
clause, provided that a settlor expressly provides in the creating
instrument that the interest in the income or principal of a
beneficiary, other than a settlor, is not subject to voluntary or
involuntary alienation.4 The following is an example of
this spendthrift language:
"The beneficiary's share of the income or principal of such trust
shall not be liable in whole or in part, for the debts of such
beneficiary or to any claim of any creditor of the beneficiary or to any
claim of the spouse of the beneficiary in any divorce or other marital
proceedings, nor be subject to bankruptcy proceedings, garnishments, or
other legal or equitable process."
While capable of protecting assets from the claims of most creditors,
even in a bankruptcy, a spendthrift clause is not effective against the
Internal Revenue Service for unpaid taxes.5
Furthermore, a spendthrift trust generally is ineffective in protecting
against claims for child support and public support.6
Taking the Trust to the Next Level
In designing an estate and asset protection plan, variations within
the trust instrument may be incorporated into the trust document to
provide creditor protection. A discretionary trust that does not
obligate the trustee to distribute income or principal provides
significant flexibility and protection. Because a beneficiary of a
discretionary trust has no predetermied right to any income or
principal, the beneficiary's creditors also generally would have no such
rights. An example of discretionary distribution language follows:
"The trustee, in its sole discretion, may accumulate the income,
and/or may distribute or apply any part of all of the income and
principal of the trust to, or for the benefit of, the beneficiary as the
trustee determines is appropriate for the purposes."
Another variation provides a forfeiture clause, providing that the
beneficiary's interest in the trust will cease or shift to a
discretionary trust upon the beneficiary's attempt to assign the
interest or if the creditors attempt to attach the interest. The
following is an example of forfeiture language:
"The trustee, in its sole discretion, shall be able to amend the
provisions of this section in order to affect or alter the manner,
timing, or amount of any distributions of income or principal."
Generally, once trust funds are distributed to the beneficiary, such
funds may be reached by a beneficiary's creditors regardless of the
existence of spendthrift or other trust language. Incorporating a
provision in the trust document allowing the trustee to make
distributions for the "benefit of the beneficiary directly" represents
one technique to address this potential problem.
Self-settled Trusts
United States trust law generally provides that a person cannot
establish a spendthrift trust for his or her own benefit and obtain any
asset protection benefits.7 For example, in Wisconsin,
a creditor of the settlor of a self-settled trust may satisfy a judgment
to the extent of the settlor's proportionate contribution to the
trust.8 Recently, several states, including Alaska,
Delaware, Nevada, Missouri, and Rhode Island,9 have
enacted legislation permitting a settlor to be a trust beneficiary and
at the same time receive creditor protection. To obtain this level of
protection, the trust must be irrevocable, have a qualified trustee, and
be administered in a particular manner. With a limited number of states
enacting this type of selfsettled trust protection, the issue of
enforceability outside of these states still appears unresolved.
Furthermore, the gift and estate tax implications of the self-settled
trust appear unsettled. The IRS has privately ruled that a transfer to
an Alaska trust would be a completed gift but declined to rule on
whether the assets would be excluded from the settlor's estate.10 However, in the offshore trust context, the IRS has
ruled that where a settlor only retained a discretionary right to
distributions from the trust, the transfer was a completed gift and the
assets were not included in the settlor's estate.11
In contrast to the United States, many foreign jurisdictions permit a
settlor to create a spendthrift trust that shields assets from current
or future creditors. Various foreign jurisdictions have enacted
legislation that creates virtually impenetrable legal and logistical
barriers against creditors. Moreover, in the absence of a treaty, a
foreign jurisdiction is not obligated to honor a judgment from a U.S.
court. Therefore, a creditor may be forced to relitigate the same case
in a foreign jurisdiction.
However, in recent years the United States tax regulation of offshore
trusts has increased and courts have viewed such trusts with greater
scrutiny. For example, in Federal Trade Commission v. Affordable Media12, the settlors of an offshore trust were held in
contempt of court and jailed for six months after the offshore trustee
refused to honor the settlor's request to repatriate asset. For clients
who hesitate to move assets offshore, the domestic asset protection
trust provides a viable alternative. Including a "flee clause" in a
trust document, providing that the trust situs may relocate to a more
beneficial jurisdiction at a later date, may provide added flexibility.
The following is an example of such flexibility:
"I hereby consent to the trustee changing the situs of this trust,
the assets held hereunder, and the administration hereof to one or more
U.S. or non-U.S. jurisdiction(s) that would facilitate preservation of
such trust assets."
Exempt Asset Planning
Exemptions from creditors' claims are available in both bankruptcy
and nonbankruptcy situations. In the bankruptcy situation, the debtor is
entitled to exemptions under the laws of the state in which the debtor
is domiciled. Moreover, the debtor also may use the federal exemptions,
unless the state has opted out. In the non-bankruptcy context, the local
law of the forum generally determines what debtor property within the
state is exempt from execution. However, the conversion of a nonexempt
asset to an asset exempt from the claims of creditors can constitute a
fraudulent transfer. Nonetheless, estate planning techniques can be
crafted to take advantage of exemptions laws. The court in In re Bruski,
ruled:
"The debtors are permitted the full use of available exemptions and
will not be penalized for ordering their affairs in such manner as to
take the best advantage of the exemptions. The so-called exemption
planning is not so far removed from tax planning, and in both instances,
debtors are entitled to structure their affairs in the most favorable
manner."13
An individual's retirement plan and residence typically represent a
significant portion of one's net worth. As such, it is not surprising
that exemptions are, in part, available for such assets. Section
815.18(3) of the Wisconsin Statutes sets out those assets considered
exempt under Wisconsin law. Included in this provision, an exemption
specifically is provided for retirement benefits described as "assets
held or amounts payable under any retirement, pension, disability, death
benefit, stock bonus, profit sharing, annuity, individual retirement
account, individual retirement annuity, Keogh, 401(k), or similar plan
or contract." This language provides a broad listing of the types of
retirement plans and other benefits the statute considers exempt. For
instance, annuity plans and stock bonus plans, which are routinely
implicated in planning, appear to fall into the exempt asset category.
However, a careful reading of the statute is necessary because several
exceptions may apply in the case of owner-dominated plans, child support
payments, family maintenance payments, or divorce judgments.
The Employee Retirement Income Security Act of 1974 (ERISA) also
provides protection from creditors for ERISAcovered retirement plans.
ERISA requires that a qualified retirement plan include an
anti-alienation clause, preventing creditors from reaching retirement
plan assets. The Internal Revenue Code contains a similar antialienation
provision.14 Courts have held that compliance with
every provision of the Code and ERISA is not a prerequisite to
protecting pension benefits from a participant's creditors.15 Neither ERISA nor Code protections apply to assets
held under individual retirement accounts (IRAs). IRAs are protected in
many states, including Wisconsin, by state law exemption.
The U.S. Supreme Court has held that ERISA's prohibition against
alienation is a restriction that is enforceable under applicable
nonbankruptcy law.16 Cosequently, the debtor's
interest in an ERISA pension plan is excluded from the bankruptcy estate
and is not subject to attachment. Some courts have held that ERISA's
protection extends to benefits in pay status.17
The federal protection afforded to qualified plans and the protection
provided to IRAs under state exemption statutes underscores the benefit
of maximizing contributions to such plans. In light of the enhanced
protection of qualified plans and IRAs, careful planning must be
undertaken before distributions are made from such plans.
In addition to retirement plans, most states allow a homeowner to
designate a personal residence and the adjacent land as the homestead.
Within the limits defined by state law, the homestead is exempt from the
claims of most creditors. Some states, such as Texas and Florida,
provide for an unlimited homestead exemption. Wisconsin provides for a
$40,000 homestead exemption.18
Asset Protection Planning with LPs and LLCs
Limited partnerships (LPs) and limited liability companies (LLCs)
have become important planning entities when developing an estate plan.
When LPs or LLCs are used for estate planning purposes, a limited
interest in the LP or member's interest in the LLC can be gifted to the
junior generation, thus removing assets from the donor's estate for
federal tax purposes, at a discounted value. Typically, the estate and
gift tax savings of LPs and LLCs become the focus in planning. From a
nontax perspective, the donor in effect also is creating fractional
interests in the underlying property contributed to the LP or LLC, which
reduces its value from a creditor's perspective. The governing LP or LLC
document can be structured to disallow the sale or liquidation of a
limited partner's or member's interest. As a result, a creditor of a
partner generally is limited to obtaining a charging order against the
partner's economic interest.19 A charging order does
not give the creditor a right to attach partnership assets to satisfy a
debt.
The combination of an LP or LLC with a subsequent transfer to a trust
for the benefit of other family members provides a further level of
asset protection. In a combined arrangement, an LP or LLC is established
in which the senior family members serve as the general partners or
managing members, and a trust serves as the limited partner or
nonmanaging member. The trust receiving the limited or member's interest
can include a spendthrift and/or forfeiture provision, discussed above.
In such cases, income distributed from the LP or LLC to the trust can be
retained by the trustee and insulated from creditors. If the individual
establishing the LP or LLC desires to retain an income stream for a
period of time, then the limited partnership or member's interest could
be assigned to a GRAT. If the GRAT holds the assigned interest, then a
further splitting of the property interest has occurred, which enhances
creditor protection.
Conclusion
Structuring the ownership of family and business assets to provide
the maximum protection from creditors should be incorporatd into a
comprehensive estate plan. Asset protection planning techniques
frequently correspond to estate tax goals. Advisors, however, need to be
careful when counseling clients in protecting assets to ensure that
there are valid business, tax, or other family wealth planning
purposes.
Endnotes
1 Wisconsin has enacted the
Uniform Fraudulent Transfer Act under Chapter 242 of the Wisconsin
Statutes.
2 In re Atkinson, 63
B.R. 270 (Bankr. W.D. Wis. 1986).
3 Nichols v. Eaton,
91 U.S. 716 (1875).
4 Wis. Stat. § 701.06
(200001).
5 United States v. Bank
One Trust Co., 80 F. 3d 173 (6th Cir. 1996), United States v.
Riggs Nat'l Bank, 636 F. Supp. (D.C. 1986).
6 Wis. Stat. §§
701.06 (4) and (5) (200001).
7 Restatement (Second) of
Trusts, § 156 (1957); Wis. Stat. § 701.06(1) (200001).
8 Wis. Stat. § 701.06(6)
(200001).
9 See AS § 34.40.110, 12
DCA § 357076, Nev. Rev. Stat. 166.040, Mo. Rev. Stat. 456.080
(1992), R.I. Gen. Laws § 189.21.
10 PLR 9837007.
11 PLR 9332006.
12 FTC v. Affordable
Media, 179 F.3d 1228 (9th Cir. 1999).
13 In re Bruski,
226 B.R. 422, (Bankr. W.D. Wis. 1998).
14 I.R.C. §
401(a)(13)(A).
15 In re Sewell,
180 F.3d 707 (5th Cir. 1999).
16 Patterson v.
Shumate, 504 U.S. 753 (1992).
17 Smith v.
Mirman, 749 F.2d 181 (4th Cir. 1984); Travelers Ins. Co. v.
Fountain City Fed. Credit Union, 889 F.2d 2164 (11th Cir. 1989).
But see, In re Johnson, 218 B.R. 813 (Bankr. E.D. Va.
1998).
18 Wis. Stat. § 815.20
(2000-01).
19 Wis. Stat. §§
179.63 and 183.0705 (2000?01).
Wisconsin Lawyer