Myth #3: Assets in Trust are Protected from Creditors

Myth #3: Assets in Trust are Protected from Creditors

by on April 30th, 2020 in Estate Planning Law, Wills, Trusts and Probate

PART III “The 4 Most Common Estate Planning Myths”

There are many different types of trusts. There are trusts designed to minimize taxes. There are trusts designed for beneficiaries with special needs. There are even trusts specifically designed to own vacation residences and second homes. In estate planning, the most common type of trust is called a revocable trust, and its primary purpose is to avoid probate court proceedings when the person who created it dies. Because there are so many different types of trusts, and because trust law varies from state to state, it is no wonder so many people misunderstand the extent to which trusts protect their assets from creditors.

What is a Revocable Trust?

A revocable trust is a trust you establish during your lifetime to hold the bulk of your assets. It is “revocable” because you reserve the right to modify it or even revoke it entirely, as long as you are alive and have the mental capacity to do so. There is no limitation on how many times you can modify your revocable trust: the terms can be changed as your family dynamics, asset holdings, and overall net worth change, as well as in response to changes in the law. When you die, because the revocable trust (and not you individually) owns your assets, your assets bypass probate and pass to your intended beneficiaries free of court interference. For a $1 million estate, avoiding probate translates to a savings of more than $60,000.00 in attorneys’ fees, executor fees, and court costs. For larger estates, the savings can be in the hundreds of thousands. It is easy to see why so many clients choose to establish revocable trusts to avoid probate (and the hefty price tag that goes with it).

What is an Irrevocable Trust?

Irrevocable trusts, on the other hand, generally do not allow the creator (known as the “settlor” or “grantor”) to modify the trust after formation. Thus, irrevocable trusts tend to be less flexible compared to revocable trusts, but they do serve other important purposes that are beyond the scope of this article.

Do Revocable Trusts and Irrevocable Trusts Protect You Against Creditors?

For both revocable and irrevocable trusts created under Florida law, the rule of thumb is simple: assets you place in trust for your own benefit during your lifetime are not protected from your creditors; on the other hand, assets you place in trust for the benefit of someone else generally are protected from their creditors.

  • Application to Revocable Trusts: Recall that the main benefit of establishing a revocable trust during your lifetime is probate avoidance; your revocable trust does nothing for you from an asset protection standpoint. However, when you die, your revocable trust becomes irrevocable (because you are no longer alive to modify it). When this happens and trust assets are held in further trust for the benefit of your beneficiaries (for example, your children), such assets will be protected from your children’s creditors, as long as the trusts are considered “spendthrift” trusts under Florida law.
  • Application to Irrevocable Trusts: Similarly, Florida law does not allow you to place assets in an irrevocable trust for your own benefit and circumvent your own creditors, whether such creditors exist now or arise in the future. However, when you fund an irrevocable trust during your lifetime with assets for the benefit of a third party beneficiary, such assets will be protected from the beneficiary’s creditors, as long as the trust is considered a “spendthrift” trust under Florida law.

What Is a Spendthrift Trust?

A spendthrift trust is a trust established by one party as “settlor” (e.g., a parent or grandparent as “settlor”) for the benefit of a third party as “beneficiary” (e.g., children or grandchildren) and is protected from the third-party beneficiary’s creditors and predators. Potential creditors include not only judgment creditors, but also predators such as a divorcing spouse. For this reason, many of my clients devise their children’s inheritance in further trust, as opposed to outright, to ensure that a divorcing spouse does not assert that they are entitled to half (or more!) of the child’s inheritance in a divorce proceeding.

Over the past several years, I have noticed a trend in my practice where parents are requiring that their children sign marital agreements in order to receive trust distributions from their spendthrift trusts. This means that if the child is not already married but intends to be married when the trust is funded (typically shortly after the parent dies), she will have to sign a prenuptial agreement with her intended spouse in order to enjoy distributions from her spendthrift trust. If the child already is married when her trust is funded, then a postnuptial agreement can solve the problem. If the child sees the benefit of having a prenuptial agreement to protect her separate property in a divorce, but she is too timid to raise the issue with her intended spouse, in some cases having the terms of the parent’s trust require a prenuptial agreement can help shift the burden (and the blame).

How Do You Create a Spendthrift Trust Under Florida Law?

At minimum, the trust should use the word “spendthrift” in the title. But the best practice is to include a detailed provision in the trust document that restrains both voluntary and involuntary transfer of the beneficiary’s interest. Specifically, Florida Statute 736.0502(2) provides, “A term of a trust providing that the interest of a beneficiary is held subject to a spendthrift trust, or words of similar import, is sufficient to restrain both voluntary and involuntary transfer of the beneficiary’s interest.” Section 736.0502(3) further provides:

A beneficiary may not transfer an interest in a trust in violation of a valid spendthrift provision and, except as otherwise provided in this part [of the Florida Trust Code], a creditor or assignee of the beneficiary may not reach the interest or a distribution by the trustee before receipt of the interest or distribution by the beneficiary.

Put another way, the assets in a beneficiary’s spendthrift trust cannot be reached by the beneficiary’s creditors even if the beneficiary tries to pledge, promise, or sign the assets away, because the beneficiary has no legal right to do so. Only the Trustee has control over the trust assets.

There are other important factors to consider in designing the terms of a beneficiary’s spendthrift trust. For example, who will be the Trustee? The Trustee is in charge of managing the trust assets and making distributions to or for the benefit of the beneficiary. While the beneficiary is allowed to be her own Co-Trustee, there must be at least one Independent Trustee to serve alongside the beneficiary – otherwise a creditor may be able to set aside the trust by arguing that the beneficiary has unfettered access to trust assets.

Should the Beneficiary’s Trust Last for Her Lifetime? or Should It Terminate at a Certain Age?

Some clients choose to terminate a child’s spendthrift trust at age 35 or 40, while others feel the trust term should be for life and give the Independent Trustee broad discretion regarding how trust assets are utilized over the course of the beneficiary’s lifetime. A qualified estate planning attorney will guide you through your options for designing the distribution provisions of a beneficiary’s spendthrift trust in accordance with your personal goals and values.

Spendthrift trusts are an effective way to safeguard your beneficiaries’ inheritance upon your demise; however, under Florida law, you cannot “spendthrift” assets for your own benefit during your lifetime. Still, a revocable trust serves an important purpose by avoiding time-consuming and expensive probate proceedings, and by setting forth the terms of your beneficiaries’ spendthrift trusts. To read about permissible ways to protect your assets from your creditors during your lifetime, please read my asset protection blog: Safeguarding Your Assets.

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