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).
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