Your Client's Estate Plan: Asset Protection Planning

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

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).