Lawsuit Proof Protecting Your Assets From Lawsuits and Claims
By Robert J. Mintz, Esq. and James Jay Rubens, Esq.
HOW TO USE IRREVOCABLE TRUSTS
Some additional problems of an outright gift giving program can be eliminated or mitigated through the use of an irrevocable trust. The distinguishing feature of an irrevocable trust is, as the name implies, that the trust cannot be revoked or canceled by the settlor. The irrevocable trust is a written agreement between the settlor and the trustee in which the trustee agrees to hold property transferred by the settlor on behalf of certain specified beneficiaries.
Typically, the beneficiaries will be the children or grandchildren. The parents will transfer to the trust the annual exclusion amount of $20,000 per year for each beneficiary. If the parents' estate is large enough and they can afford to do so, they may make a larger gift, using all or a portion of their combined $1,200,000 unified tax credit. The greater the amount of the gift, the more significant will be the estate tax, income tax and lawsuit protection achievements.
Advantages of the Irrevocable Trust
The irrevocable trust solves a number of problems posed by the outright gift giving program. If the parents are the trustees, even if they have transferred substantial assets into the trust, they will still enjoy the management and control over that property. Although the trustees cannot use the property for their own benefit, they may retain some degree of discretion regarding the investment of trust asset and the amount and timing of any distributions to the beneficiaries. This ability to maintain effective control over the transferred property will alleviate one of the parents most frequent concerns.
Second, a child's interest in this kind of a trust can be protected from the child's spouse in the event of a divorce, or from creditors in the event of a judgment. Although the outcome on these issues depends in part upon the law in your particular state and the language which is used in drafting the trust agreement, protection from spouses and potential creditors is a major advantage which can be accomplished using this type of a trust.
The third advantage is that the trust mechanism allows for gifts to be made to minor children or grandchildren. Since minors cannot hold the property in their own name, the use of a trust is essential in order to provide them with the benefits of property ownership and in order to accomplish the gift program.
Tax Savings and Lawsuit Protection
Property which has been transferred to the trust by gift will not be included in the parents' estate when they die. If the transfers begin early enough and continue over a period of years, a significant amount of estate tax savings can be realized. If the parents have, for example, five children and grandchildren, a total of $100,000 per year can be transferred into a trust like this without gift tax consequences. Over a ten year period, $1,000,000 has been removed from the parents' estate. If the parents are in a maximum estate tax bracket of 50%, a total of $500,000 in family wealth will be preserved.
Income tax savings can also be achieved when the trust is in a lower tax bracket than the parents and the beneficiaries are fourteen years or older. An irrevocable trust is a separate tax paying entity, apart from the parents, and the income which the trust earns on its assets is taxable to the trust. Income which is distributed from the trust to a beneficiary is not taxable to the trust, but is instead taxable to the beneficiary. If the parents are in the maximum effective tax bracket and the trust beneficiaries are in lower tax brackets, annual income tax saving can be accomplish through this difference in the tax rates. Over a period of time, this annual tax savings can add up to a substantial amount of money.
The irrevocable trust also provides a significant degree of lawsuit protection for the parents. Because the trust is irrevocable and cannot be canceled or modified in any manner by the parent, and because the parents have no interest in the trust as beneficiaries, property which has been transferred to the trust will be protected from the claims of the parents' creditors.
Factors to Consider
In deciding whether to use an irrevocable trust to accomplish these objectives, there are two primary factors which must be considered. First, this trust cannot be revoked, altered or modified in any manner. Once the parents have transferred property into the trust, it cannot be retrieved. If the financial circumstances of the parents change in the future they still will not be able to reach the property. The parents, must ask themselves: "How much can I afford to transfer?" and "How much do I need to keep to meet my personal needs during my lifetime?" Clearly, if parents transfer all of their assets into the irrevocable trust, the parents must have sufficient income from other sources meet their own needs.
The second important issue is a practical one which involves the manner in which assets are physically transferred to the trust. If the parents' estate consists substantially of investment assets - bank accounts, stocks, and bonds - it is a simple procedure to transfer ownership of those assets to the trust each year. Transfers of real estate or other illiquid assets are more difficult to accomplish.
For example, the parents' major asset may be a piece of commercial real estate. If they wish to make annual gifts to the trust under the annual gift tax exclusion, they will have to deed a fractional interest in the real estate to the trust each year. This can be done but it is a cumbersome process. A greater problem comes from the valuation issues which arise. The parents may consider that the commercial property has an equity of $1,000,000. In order to transfer $20,000 worth of property, they would have to deed a 2% interest. But if the IRS later determined that the actual value of the equity was $1,500,000 rather than $1,000,000, the 2% interest would be equal to $30,000, rather than $20,000 thereby creating a gift tax liability for that year. To avoid this difficulty an annual appraisal of the property can be obtained to provide credible evidence of the actual value on the date of the transfer. However, an appraisal will be relatively expensive and inconvenient, and may still be subject to challenge in the event of a future IRS audit.
The irrevocable trust is an effective device for reducing estate and income taxes through a program of lifetime gifts to children and grandchildren. Amounts which have been transferred by gift cannot be reached by the parents' creditors, unless the gift is considered to be a fraudulent conveyance. Problems involve the loss of beneficial ownership by the parents and valuation of real estate or illiquid business interests.
In subsequent Chapters we will see how the Family Limited Partnership and the Asset Protection Trust can be used together to eliminate many of the difficulties associated with irrevocable trusts, and how these techniques can be combined to produce the highest degree of total asset protection.