A Primer on Asset Protection

By: J.P. Fernandes, Esq.

Milwaukee, Wisconsin

Introduction
One of the primary objectives of estate planning is wealth preservation. Historically, the
principal threat to this objective has been transfer taxes imposed by state and federal
governments. However, with the lifetime exemptions from the federal estate and generationskipping transfer tax currently at $2 million per person, and significant increases in the amount
of those exemptions on the horizon, for many, transfer taxes are not as significant a threat to
wealth preservation as they once were.
Instead, creditor claims have become a more significant threat to wealth preservation. Whereas
in the past many clients focused on protecting their wealth from gift, estate and generationskipping taxes, today it is very common for individuals to focus on preserving their wealth from
claims resulting from divorce, litigation and bankruptcy.2 Fortunately, estate planners are well
equipped to help their clients shield their assets against such claims. This article discusses a
variety of concepts that an estate planner can draw upon when assisting clients with asset
protection.
Types of Creditors
In general, creditors claims can be divided into two categories: tort claims and non-tort
claims. A tort is a civil wrong causing injury to another as the result of negligence or by fraud.
Non-tort claims typically arise as the result of a breach of contract or are based on a violation of
criminal law.
There are three classes of creditors that can bring tort or non-tort claims. The class to which a
creditor belongs depends on when his or her claim arises in relation to the date an asset
protection strategy was implemented.
a. Known Creditor. A known creditor is one that has a claim before the asset protection strategy
was implemented. For example, a person who has been injured in a car accident is regarded as
a known creditor, even if he or she has not yet filed a lawsuit.
b. Potential Creditor. A potential creditor is one that may reasonably be expected to bring a
claim, but does not have a basis for filing a claim at the time the asset protection strategy
is being implemented. A doctors patients are examples of potential creditors.
c. Unknown Creditor. An unknown creditor is a creditor that is not reasonably foreseeable at the
time an asset protection strategy is implemented. An example is a creditor that brings a claim

for an injury sustained after the asset protection strategy is implemented.

Marital Status
A persons marital status can also affect the extent of his or her liability to others. For example,
Wisconsins Marital Property Act provides that both the individual property of the debtor spouse
and all marital property are available to satisfy a claim if the claim arose out of an activity that
was originally undertaken for the benefit of the family.3 For this purpose, earnings of a married
person and assets acquired with such earnings are marital property.4 Individual property is
generally limited to assets brought into the marriage, acquired during the marriage by gift or
inheritance.5 When individual property is mixed with marital property, the individual property is
reclassified as marital property, unless the individual property component can be traced.6
2

In 2005, the average divorce rate in the United States was 17.7 per 1,000 married women. (Sharon Jayson, Divorce
Declining, but so is Marriage, www.usatoday.com). For the 12-month period ending March 31, 2006, a total of
1,794, 795 Americans had filed for bankruptcy. (Bankruptcy Filings Drop 61 Percent in March 2007 12-Month
Period, www.uscourts.gov/Press_Releases/ banruptcyfilings062707.html).
3
Wis. Stats. 766.55 (2)(a) (Thompson/West {2007}). For example, an obligation created by a spouse during
marriage that resulted from a tort committed by that spouse during marriage, may be satisfied by both the property
of that spouse that is not marital property, and from that spouses interest in marital property. (Wis. Stat. 766.55
(2)(cm) (Thompson/West {2007}).

Fraudulent Conveyances
Virtually every state prohibits individuals from transferring or otherwise structuring the
ownership of his or her assets so as to prevent recovery from known creditors. Such
arrangements are considered to be fraudulent, and therefore will be disregarded when
determining assets that can be obtained to satisfy creditors claims. Fraudulent transfers may also
subject the transferor to civil and criminal liability.7
Transactions are deemed to be fraudulent, and therefore void, if accomplished with the actual
intent to defraud a known creditor at the time of the transfer. Under appropriate circumstances
creditors may also be able to set aside transfers as fraudulent. An unknown creditor is usually
not allowed to have an asset protection arrangement set aside as fraudulent, since there cannot be
an intent to defraud a creditor without knowledge of his or her possible claim.
Since intent is often difficult to prove, the courts will look for specific fact patterns, or badges
of fraud that may be evidence of an intent to defraud.8 Frequently recognized badges of fraud
include the continued possession or control of the transferred assets by the transferor after the
transfer; the transfer of assets shortly before or after a claim arises; and the existence of facts and
circumstances at the time of the transfer which make it likely that the transferor will be sued.9 In
addition, in most instances, a transfer will be considered fraudulent if it renders the transferor
insolvent, regardless of the transferors intent.10
Exempt Assets
Certain assets are exempt from creditor claims as a matter of public policy. The determination of

Page 2 of 36

what assets are exempt depends on the statutory exemptions found in state debtor/creditor law
and the Federal Bankruptcy Code.
Where the debtor can choose between state and federal bankruptcy exemptions, the choice must
be made before he or she files for bankruptcy.11 However, the debtors state of domicile may
opt out of permitting its residents from availing themselves of the Federal Bankruptcy Codes
exemptions.
4

Wis. Stats. 766.31 (4) (Thompson/West {2007}).

Wis. Stats. 766.31 (7) (Thompson/West {2007}).
6
Wis. Stats. 766.31 (Thompson/West {2007}).
7
See, New York, N.Y. Debt & Cred. 273 (McKinney {2007}); California, C.A. Civil 3439-3439.12.
(Thompson/West {2007}).
8
Duncan E. Osborne & Leslie C. Giordani & Arthur T. Catterall, Asset Protection and Jurisdiction Selection, 33
Phillip E. Heckerling Inst. on Estate Planning 1401.2 (1999).
9
Id.
10
7A U.L.A. 639 (1985); Wis. Stat. 242.02 (2007).
11
AMJUR Bankruptcy 1396 (2007). The Federal Bankruptcy Codes exemption statute lists many examples of
assets that may be exempt from the estate. (11 U.S.C. 522 (2007)). For example, the debtor may exempt up to
$15,000 in his or her aggregate interest in property that the debtor or a dependent of the debtor uses as a residence.
(11 U.S.C. 522 (d)(1)). The debtor may also exempt up to $2,400 in value for one motor vehicle; $1,000 in value.
5

Asset Protection Strategies

The following summary of asset protection strategies is intended to provide an overview of the
numerous options available to shield ones assets from creditors claims. It is important to
remember that each strategy may not be appropriate for every individual. For this reason, when
selecting a strategy, it is important to balance its effectiveness and cost to implement with its
potential impact on the clients lifestyle and other planning objectives.
Liability Insurance
Maintaining adequate levels of homeowners, automobile, liability and professional malpractice
insurance (where applicable) is perhaps the most fundamental component of any asset protection
plan. A review of the frequency and amounts of recent claims should provide the basis for
determining the appropriate level of coverage. Maintaining such coverage will reduce the need
to rely on other asset protection strategies to preserve wealth.
Umbrella liability insurance is an excellent complement to the standard liability insurance that
a client will typically already have in place. In general, umbrella insurance provides additional
protection over the insureds general liability, automobile liability, homeowners insurance, and
other forms of traditional liability coverage. Umbrella insurance may also provide coverage for
injuries or losses not covered by the insureds other liability policies, usually subject to a
minimum deductible per occurrence. The amount of coverage provided by an umbrella
insurance policy ranges between $1 million and $25 million or more per occurrence. However,
umbrella policies rarely provide insurance for business related activities.
Life Insurance

Page 3 of 36

The Federal Bankruptcy Code and most state statutes afford some degree of protection to life
insurance benefits. The rationale behind this special treatment is that life insurance is often
essential to provide for the financial well being of a debtors family, and may be needed in the
event of the debtors demise as to prevent the family from becoming a burden to the state.
Insurance policies owned by a debtor offer only minimum protection under the Federal
Bankruptcy Act. In general, only up to $8,000 of the policy value (adjusted periodically for
inflation), is exempt from creditors claims.12
of the debtors personal property; social security; veterans benefits; unemployment and disability benefits; alimony
to the extent reasonably necessary to support the debtor and any of his or her dependents; and payments received
pursuant to a pension, stock bonus, or similar plan on account of illness, disability, age, length of service, or death.
(11 U.S.C. 522 (d)(3), (d)(4), (d)(10) (Westlaw 2007 through Pub. L. No. 110-80)).
12
11 U.S.C. 522 (d)(8) (Westlaw 2007 through Pub. L. No. 110-80); 11 U.S.C. 104(b) (Westlaw 2007 through
Pub. L. No. 110-802).

The amount of cash value that is exempt from creditor claims under state law varies widely from
state to state. In some states, such as Florida, the entire cash surrender value and the entire death
benefit is exempt from the claims of the creditors of the insured.13 By comparison, Wisconsin
provides that the amount of policy value exempt from creditor claims is limited to a maximum of
$150,000.14 Moreover, if the policy was issued or funded less than 24 months from (i) the date
the exemption was claimed, or (ii) the date on which a creditor filed an action for execution that
resulted in the claimed exemption, the total exemption is limited to $4,000.15
By comparison, under Wisconsin law if the debtor was a dependent of the insured, an unlimited
amount of life insurance proceeds paid after the insureds death are exempt from creditor claims
to the extent reasonably necessary to support the debtor or the debtors dependants.16
The Federal Bankruptcy Code exempts insurance proceeds that are payable to a debtor upon the
death of another, and does not impose any specific dollar limitation on the exemption. Rather,
insurance proceeds are exempt to the extent they are reasonably necessary for the support of
the debtor and any dependents of the debtor.17 However, for the exemption to apply, the debtor
has to be a dependent of the insured at the time of the insureds death.18
Joint Property
Joint ownership of property can have the undesirable effect of subjecting all of the jointly owned
property to creditor claims of both owners. As a result, it is typically best to avoid joint
ownership if creditor claims are a concern.
In contrast to the foregoing, joint ownership of property by married couples as tenants by the
entirety may provide significant asset protection benefits. A spouse cannot alienate his or her
interest, nor terminate the tenancy by the entirety without consent of the other spouse.19 As a
result, most states and the Federal Bankruptcy Act exempt property owned as tenants by the
entirety from creditor claims so long as both owners are living and are married to each other.
However, this form of property ownership is not available in all states, and the protection is lost
once the property becomes solely owned, whether as a result of divorce, death of a spouse, or
Page 4 of 36

otherwise.
Retirement Account Contributions
Assets contributed to a qualified retirement plan are exempt from the claims of creditors pursuant
to the anti-alienation provisions of the Employee Retirement Income Security Act of 1974
(ERISA).20 In addition, recent decisions by the United States Supreme Court and provisions of
the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) have resulted in
qualified retirement plan balances that are rolled over into IRAs being entirely exempt from
creditor claims.21 All other individual retirement accounts are exempt up to $1 million.22
13

Fla. Stat. Ann. 222.14 (Thompson/West {2007}); Fla. Stat. Ann. 222.13 (Thompson/West {2007}).
Wis. Stat. 815.18 (3)(f)(2) (Thompson/West {2007}).
15
Wis. Stat. 815.18 (3)(f)(3) (Thompson/West {2007}).
16
Wis. Stat. 815.18 (3)(f)(2) (Thompson/West {2007}).
17
11 U.S.C. 522 (d)(11)(c) (Westlaw 2007 through Pub. L. No. 110-80).
18
11 U.S.C. 522 (Westlaw 2007 through Pub. L. No. 110-80), et. seq.
19
Gideon Rothschild, Protecting the Estate from In-Laws and Other Predators, 35 Phillip E. Heckerling Inst. on
Estate Planning 1710.3 (2001).
20
29 U.S.C. 1001 (Westlaw 2007 through Pub. L. No. 110-80), et. seq.
14

Federal law preempts state law regarding assets held by qualified retirement plans. For this
reason, individual state law cannot diminish the extent to which a qualified retirement plan is
exempt from creditor claims. Thus, an effective creditor protection strategy is to contribute to
such accounts to the maximum extent permitted by the Internal Revenue Code.
Homestead
In general, the Federal Bankruptcy Act provides that state law governs the extent the value of a
debtors principal residence is exempt from creditors claims. This amount varies substantially
from state to state. Florida and Texas have an unlimited homestead exemption if certain
requirements are met.23 Wisconsin, on the other hand, exempts a maximum of $40,000 in
homestead equity from creditor claims.24
BAPCPA imposed limits on the extent to which a creditor may rely on the homestead exemption
of his or her state of domicile. It requires a debtor to have lived in a particular state for two years
prior to filing a claim for the states homestead exemptions.25 Furthermore, the value of
homestead interests that can by protected from creditor claims is limited to $125,000, unless the
homestead was acquired more than three years and four months before filing for bankruptcy.26
In the event that the equity in ones residence exceeds the available homestead exemption
amount, it may be wise to consider transferring the residence to a qualified personal residence
trust (or QPRT) in which the grantor converts his or her interest in the residence from an
absolute interest, subject to foreclosure and sale, to the right to retain the rent-free use of the
residence for a term of years (the Term Period).27 Upon the expiration of the Term Period, the
grantors spouse and children can become the beneficiaries of the QPRT. Under such
circumstances, the remainder interest in the residence should be protected from creditors

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(assuming the original transfer to the Trust was not a fraudulent conveyance).28
21

Patterson v. Schumate, 504 U.S. 573 (1992); See, Bankruptcy Abuse Prevention and Consumer Protection Act of
2005, 224 (2005).
22
See, Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, 224 (2005).
23
Fla. Stat. Ann. 222 (Thompson/West {2007}); Tex. Const. art. 8, 1-b ({2007}); Tex. Tax Code 11.13
({2007}).
24
Wis. Stat. Ann. 815.20 (Thompson/West {2007}).
25
See, Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, 224 (2005).
26
Id.
27
Gideon Rothschild, Protecting the Estate from In-laws and Other Predators, 35 Phillip E. Heckerling Inst. on
Estate Planning 1703.3 (2001).
28
See, Wis. Stat. 240.01 (Thompson/West {2007}) et. seq. In addition to possible creditor protection, there can be
significant estate tax advantages to establishing such a QPRT. If the grantor survives the Term Period, the Trust
principal, including both appreciation in the value of the residence and rent paid to the QPRT (if any), will escape
estate taxation. (If the grantor fails to survive the Term Period, then the assets of the QPRT will be subject to estate
taxes.) While the creation of a QPRT results in a taxable gift, the amount of the gift will be reduced by the value of
the retained interest. Therefore, it may be more difficult for a creditor to demonstrate that that the grantors intent
was to defraud his or her creditors, rather than realize these estate tax savings. See generally, Susan L. Miller

Business Activities
Protecting ones personal assets from claims attributable to business activities is an essential
component of an asset protection plan. One way to accomplish this is incorporation, since in
most circumstances corporate creditors cannot attach the assets of the corporations shareholders.
In many situations, a limited liability company (LLC) can be an attractive alternative to
incorporation. A limited liability company is a hybrid business entity, which is most often
treated as a partnership for tax purposes, but treated as a corporation with regard to owner
liability.
One of the potential advantages and asset protection benefits of an LLC is that membership
therein is regarded as personal to the individual member by most states, and thus each member is
regarded as owing a fiduciary duty to all other members with respect to the activities of the LLC.
As a result, the remedy available to creditors seeking recovery against investments held by an
LLC is limited in many states to a charging order with regard to the debtor members interest
in the LLC.29
A charging order does not allow a creditor to force the liquidation of the LLC to recover the
assets that the LLC owns (assuming the transfer of assets to the LLC was not regarded as a
fraudulent conveyance). Instead, the creditor is limited to receiving the distributions, if any, that
are associated with the LLC interests covered by the charging order. Furthermore, the creditor
may be subject to taxes on the income associated with those LLC interests even if no such
income distributions are made.
It is important to recognize that in certain circumstances the veil of limited liability for
shareholders of a corporation and the members of an LLC may be pierced, in which case the
shareholders and members can be subjected to personal liability for the debts of the corporation
or the LLC. Creditors may be successful at piercing the corporate veil if they can demonstrate,

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(i) that corporate or LLC formalities have not been observed, (ii) that the corporation or LLC is
really the alter-ego of its majority shareholders or members, or (iii) that the corporation or
LLC is not adequately capitalized.30 As a result, it is important to establish the corporation or
LLC in accordance with state law, to maintain appropriate records, to ensure that personal
business is not carried out through the corporation or LLC, and to avoid any commingling of
corporate and personal assets. It is also important to be able to demonstrate that the corporation
is adequately capitalized; that is to say, it has a reasonable amount of assets given the type of
activities in which it is engaged.
Practical Problems and Solutions in Establishing a Qualified Personal Residence Trust, Journal of Taxation,
February 1997.
29
It is not uncommon for states to also allow creditors to seek a judicial foreclosure sale of a members interest in an
LLC. See, Duetsch v. Wolff 7. S.W. 3d 460 (MO. App. 1999).
30
Wis. Stats. 183.1203 et. seq. (Thompson/West {2007}).

Gifting
Only assets that an individual owns are subject to creditors claims. Thus, assets that
individual gifts to others will be protected from the claims of the donors creditors provided
the gift is not a fraudulent conveyance.31
The annual exclusion from the federal gift tax allows each individual to give away up to $12,000
per year (or $24,000 jointly) to as many persons as he or she desires without being subject to
transfer taxes. In addition, each person is afforded a lifetime exemption of $1,000,000 with
respect to gifts in excess of, or which do not qualify for, the annual exclusion.
The Federal Bankruptcy Act and some states also provide creditor protection to funds deposited
into an educational savings account.32 Earnings on a 529 account are tax deferred, and
withdrawals are tax free if the money is used on qualified education expenses.33 The amount
that can be gifted tax free to such a 529 account is $12,000 annually.34 However, an individual
can also gift 5 times the annual exclusion amount to the 529 account in one single year, by
allocating his or her annual exclusion for five years to the gift.35
An LLC can also be particularly well suited for funding gifts, since an LLC enables its members
to move illiquid assets such as real estate assets out of his or her estate by gifting LLC interests
to his or her children. Moreover, the LLC could be structured to have 2% voting interests and
98% non-voting interests. In that event, the gifting member can continue to manage the assets
held by the LLC by retaining the voting interests and designating himself or herself as manager.
The non-voting interests could be gifted, thereby reducing the members interest in the LLC that
may be subject to a charging order by the members creditors.
Private Annuities
A private annuity involves the sale of assets to another in exchange for the right to receive
specified payments over a specified period.36 Often the purchaser is a member of the sellers
family, or a trust for their benefit. Because the sellers retained interest will typically have
significant value, the purchase price is heavily discounted.

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A private annuity will not trigger the imposition of transfer taxes if the value of the annuity
equals the value of the property being sold. The value of the annuity is determined actuarially by
reference to valuation tables proscribed by the Internal Revenue Code.37 However, if the
purchase price exceeds the sellers tax basis in the asset being sold, proposed Treasury
Regulation 1.001(j) may cause the entire gain to be taxable in the year of sale.38
31

As discussed above, any assets gifted with the intention of removing them from the claims of a present creditor
will likely be considered a fraudulent transfer and will be ignored.
32
11 U.S.C. 522 et. seq. (Westlaw 2007 through Pub. L. No. 110-80).
33
Id.
34
Id.
35
Id.
36
In many instances the purchaser is a family member or the settlor of a trust established for the benefit of family
members.
37
IRC 7520.

The asset protection utility of a private annuity is that the remainder interest is shielded from
creditors of the individual that is receiving the income payments. In other words, if a creditor
sought as a remedy the assets of a debtor owning the income interest in a private annuity, the
creditor would be able to succeed to the debtors income interest, but would not be able to take
possession of the property generating the income.39
Trusts
In some cases, combining a traditional domestic irrevocable trust with an LLC can provide an
appropriate level of asset protection. With such an arrangement, the LLC is capitalized with
both voting (98%) and non-voting (2%) membership interests. The membership interests are
then transferred to an irrevocable trust for the benefit of the trust grantors spouse, children, or
other intended beneficiaries. So long as the transferor has the power to act as or select the trustee
of the irrevocable trust, he or she will be able to retain a significant level of control over the
LLC. And, while the non-voting membership interests may be attachable by the transferors
creditors, those units will likely be of little or no appeal to creditors, for reasons previously
mentioned.40
Generally, any trust established by an individual for that individuals own benefit (a selfsettled trust) is subject to the claims of that individuals creditors. However, several states have
enacted legislation that allows a person to establish a trust for his or her own benefit and still
protect the assets of those trusts, and ensure that these assets shall not be available to satisfy the
claims of the grantors creditors.41 This type of trust is commonly referred to as a domestic
asset protection trust, or domestic APT.
Although several states have adopted legislation in hopes of becoming an attractive venue for
domestic asset protection trusts, the United States Constitution may limit the effectiveness of
such legislation. For instance, the Full Faith and Credit Clause requires the courts of each state
to recognize the judgments of all other states. In addition, the state laws that are intended to
facilitate domestic asset protection trusts may violate the Constitutions Contract Clause.42
38

See Prop Reg 1.1001-1(i)(1) REG 141901-5; IRS News Release IR-2006-161 (October 17, 2006).

Page 8 of 36

39 Annuities

are also often used to reduce estate and gift taxes. When assets are sold to family members for
anannuity, the value of the gift is limited to the difference between the value of the actuarial income interest and
the value of the property being sold. Because the actuarial value of the income interest depends on current interest
rates, a private annuity could result in the transfer of a remainder interest in the asset being sold to the individuals
family for little or no transfer taxes if the income generated by the property being sold supports a high enough
annuity payment. See generally, Elliot S. Shaw Private Annuities: Dead or Alive, Florida Bar Journal, February
1996.
40

Transferring the voting LLC interests to an irrevocable trust should also help protect those interests from a judicial
foreclosure sale in those states that provide creditors with that remedy. See footnote 30, infra.
41

See, e.g., Alaska, Alaska St. 13.36.105 ({2006}) et. seq. and Alaska St. 34.40.110 ({2006}) et. seq.; Delaware,
Del. Code Ann. tit. 12, 3570 ({2007})et. seq.; Nevada, Nev. Rev. Stat. 166.001 et. seq.; Utah, Utah Code Ann.
25-6-14 (Thompson/West {2007}) et. seq.; Rhode Island, R.I. Gen. Laws. 1956 18-9.2-1 ({2006}) et. sq.;
Oklahoma, Okla. Stat. tit. 31, 10-18 (Thompson/West {2007}); South Dakota, S.D. Codified Laws 55-16-1
({2007}) et. sq.; and Missouri, Mo. Rev. Stat. 456.1-101 (Thompson/West {2007}) et. sq.
42
U.S. Const. Art. I, Sec. 10.

Moreover, the Constitutions Supremacy Clause prevents any state statute from conflicting with
federal law.43
For this reason, the degree of creditor protection afforded by a domestic APT is still unsettled.
This uncertainty has led to the continued use of off-shore asset protection trusts established in
foreign jurisdictions such as the Cook Islands, the Bahamas, Bermuda, and Nevis. These
countries have adopted legislation that is intended to protect assets held in a trust situated within
its borders from the claims of a grantors creditors, even if the grantor is the primary beneficiary
of the Trust.44 Moreover, creditors are often reluctant to pursue assets held in a foreign trust
because of the expense associated with such a claim.
Another advantage to an off-shore APT is that court decisions in the United States are generally
not enforceable in foreign court systems. Furthermore, the statute of limitations period for
attacking a transfer as fraudulent in foreign locations can be relatively short, often two years or
less.45
Establishing an off-shore APT usually requires naming a local financial institution or individual
as trustee. Furthermore, if maximum asset protection is desired, the assets that are intended to be
sheltered should be transferred to the foreign jurisdiction. This type of arrangement severs all
jurisdictional ties with the U.S. federal and state judicial systems over the transferred assets,
making it difficult for a creditor to successfully satisfy a U.S. judgment against the transferor.46
However, this will result in the local trustee in the foreign jurisdiction having control over the
transferors assets.47
Alternatively, the transferor can select a foreign jurisdiction with laws that will purportedly
protect the transferors assets even if they remain physically located in the United States.48
Under this arrangement, the assets that are to be protected are transferred to a domestic legal
entity such as an LLC, followed by a transfer of some or all of the domestic legal entity
ownership interests to the foreign APT.49
While foreign APTs have proven to be successful creditor protection vehicles in appropriate

Page 9 of 36

circumstances, they too have drawbacks, including: (i) the cost of establishing such a trust, (ii)
federal income tax complexities created by such a trust, and (iii) the risk of instability of the
government where the trust is located. Furthermore, if the debtor either resides in or comes to
the United States, there is a real risk that he or she can be found in contempt of court for refusing
to repatriate assets that had been transferred to an off-shore trust.50
43

U.S. Const. Art. VI, Sec. 2.

See, Cook Islands, Cook Islands International Trusts Act 1984, 13B(3); Bahamas, The Bahamas Banks and
Trust Companies Regulation Act 1965, 10 (No. 64 of 1965), as amended in 1980; Bermuda, Bermuda Exempted
Undertakings Tax Protection Act (1996); Isle of Man, IM Tax Act of 1970 (as amended) 1; Nevis, Nevis Intl
Exempt Trust Ordinance 43.
45
See, Bahamas, The Bahamas Banks and Trust Companies Regulation Act 1965, 10 (No. 64 of 1965), as
amended in 1980; Cook Islands, Cook Islands International Trusts Act 1984, 13.
46
Id.
47
Duncan E. Osborne & Leslie C. Giordani & Arthur T. Catterall, Asset Protection and Jurisdiction Selection, 33
Phillip E. Heckerling Inst. on Estate Planning 1405.1 (1999).
48
Id.
49
Id.
44

Conclusion
There are many legitimate ways of insulating ones assets from the claims of unknown and
potential creditors. Careful consideration should be given to each of the strategies available
before implementing an asset protection plan. Although each option has its own benefits and
drawbacks, a properly structured asset protection strategy can be tailored so as to be well suited
for a clients particular lifestyle, objectives, and risks.
Source: Advanced Planning Bulletin, September 2007
This publication is not intended as legal or tax advice; nonetheless, Treasury Regulations might
require the following statements. This information was complied by the Advanced Planning
Division of The Northwestern Mutual Life Insurance Company. It is intended solely for the
information and education and/or promotional purposes of Northwestern Mutual Financial
Network. It must not be used as a basis for legal or tax advice, and is not intended to be used and
cannot be used to avoid any penalties that may be imposed on a taxpayer. Financial
Representatives do not give legal or tax advice. Taxpayers should seek advice based on their
particular circumstances from an independent tax advisor. Tax and other planning developments
after the original date of publication may affect these discussions.
- To comply with Circular 230

50

See, Federal Trade Commission v. Affordable Media, L.L.C., 179 F.3d 1228 (9th Cir. 1999).
The information contained herein is intended solely for the information and education of Northwestern
Mutual Financial Representatives and the advisors with whom they work. It is not intended as tax or legal
advice or for use in a sales situation.
2005 The Northwestern Mutual Life Insurance Company, Milwaukee, WI

ASSET PROTECTION PLANNING

Page 10 of 36

I.

INTRODUCTION

A.

The traditional focus of financial planning is the accumulation of wealth. Conventional

wisdom tells us that the objective of a good estate plan is the transfer of that wealth. But
what about protecting it?

B.

We protect everything else we own: our children, our homes, our cars, our ability to earn
income, and, of course, our lives. What about our assets? To some degree, its done
everyday: protecting personal assets is the reason many businesses are operated as
corporations, and certainly the only reason professionals carry liability insurance.

C.

Beyond this, though, is the notion of planning to make assets unavailable to potential
creditors. Our focus here on this facet of planning. Although there are massive treatises on this
subject, our purpose is to make readers familiar with the methodology of protecting and
preserving assets and the different ways it can be done.

D.

This outline discusses rules based on uniform laws (and their application in selected court
cases) and federal laws. The reader must consult specific state statutes and case law to assess
whether these rules apply in their situations.

II.

MAXIMIZE EXEMPT PROPERTY

All assets are not created equal. Some are endowed by their legislature with an exemption from
creditors claims while other assets are not. Owning exempt assets means that a creditor has
fewer assets to attach.

A.

LIFE INSURANCE AND ANNUITIES.

1. Life insurance.
a.
Death benefit. Many states exempt the policys death benefit from the claims of the insureds
creditors. Some do not. Others have a set dollar amount. Most states protect the death benefit
from the beneficiarys creditors, although once the benefit has been paid to the beneficiary that
protection typically ceases.
b.

Cash values. Some state laws exempt all cash values from the policy owners creditors.
Page 11 of 36

Some exempt none. Most states fall somewhere in-between. Generally the beneficiarys
creditors have no right to the policys cash values because the beneficiary doesnt.
2.

Annuities. Annuity values and/or payouts are also protected from the owners creditors by some
but not all states. The protection of an annuity payment may be limited, sometimes by a
specific dollar amount, sometimes by a formula, and sometimes by a reasonableness standard
as determined by a court.

3.

Many on-line services contain analyses of state creditor protection statutes and cases. Some are
even available free of charge. Riser Adkisson, LLP, a law firm specializing in asset
protection, has an outstanding site (www.risad.com/state_resources.htm) with links to the
relevant state statutes for life insurance and annuities.

B.

PRIMARY RESIDENCE.

1.

Many states provide a homestead exemption, protecting a portion or all of the equity in a
primary residence from creditors. As with life insurance and annuities, the homestead
exemptions vary significantly by state. See www.risad.com/state_resources.htm for links to
homestead exemption statutes.

2.

Under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA)
any state law exemption in excess of $125,000 applies only if the residence was acquired at
least 1,215 days before filing the bankruptcy petition. There is no protection if the court
determines the debtor's bankruptcy petition is abusive or if the debtor has debts arising from
certain conduct, including securities fraud or a crime causing serious injury or death. BAPCPA
322. The residence is not protected if the debtor uses non-exempt property to buy it
within 10 years of the bankruptcy filing with the intent to hinder, delay or defraud a
creditor. BAPCPA 308. While BAPCPA becomes effective October 17, 2005, the
homestead provisions apply to bankruptcy petitions filed after April 20, 2005. BAPCPA
1501.

C.

QUALIFIED RETIREMENT ACCOUNTS & IRAs.

1.

Non-bankruptcy creditors.

a.

Qualified retirement plans are exempt from non-bankruptcy creditors. ERISA governs qualified
retirement plans and precludes assignment and alienation of covered plans. Patterson v.
Shumate, 504 U.S. 753 (1992).

b.

IRAs are not governed by ERISA. Instead, state law dictates the extent of creditor protection,
if any, outside of a bankruptcy proceeding. This protection can vary not only from state to

Page 12 of 36

state, but also between types of IRAs.

2.

Bankruptcy creditors.

a.

Certain qualified plans are granted unlimited protection from bankruptcy creditors claims,
including:

(1)

Qualified pension, profit-sharing, stock bonus plans and 401(k) accounts ( 401);

(2)

Tax deferred annuities ( 403);

(3)

Traditional IRAs ( 408); and

(4)

Roth IRAs ( 408A). BAPCPA 224.

b.

The exemption for plans governed by 401 and 403 (which include SEP and SIMPLE plans)
is unlimited; the exemption for traditional and Roth IRAs is limited to $1 million. The $1
million cap can be increased by a bankruptcy court in the interests of justice. The $1
million IRA and Roth IRA cap is an aggregate amount and is indexed for inflation. The
cap does not apply to rollovers from qualified plans and the earnings on those rollovers.
Amounts rolled from one IRA to another IRA are included when determining the $1 million
IRA exemption. In other words, IRA funds traced to qualified plan money, including
earnings, have no cap; IRA funds which cannot be so traced have a cap of $1 million. BAPCPA
224.

D.

OTHER EXEMPT PROPERTY.

1.

Personal possessions and household goods are often exempted by state but not federal law. A
state exempt property list often provides surprises and makes for amusing reading. For
example, Oklahoma exempts from the bankruptcy estate 5 milk cows, 100 chickens, 2 horses,
1 gun, 10 hogs and 20 head of sheep. However, all these items must be held primarily for the
personal, family or household use of the debtor. Okla. Stat. 31-1 A. In Michigan, not only
are 10 sheep, 2 cows, 5 swine, 100 hens and 5 roosters exempt; so is a seat, pew or slip in a
house of worship. Mich. Stat. 600.6023(1). The family burial plot is excluded in
Connecticut, as are arms, military equipment, uniforms and musical instruments owned by a
member of the militia or armed forces. Conn. Stat. 52-352b.

2.

The Bankruptcy Code lists property which is exempt from a bankruptcy estate. 11 U.S.C.
522. States may opt out of the Bankruptcy Code and provide their own list of exempt
property. A debtor must use either the federal or state list. A state exempt property list may
be more generous than the federal exempt property list. For a list of state exemption statutes,
see www.risad.com/state_resources.htm.
Page 13 of 36

III.

TRANSFER NON-EXEMPT PROPERTY

A.

TO A SPOUSE.

1.

We start with a basic tenet of asset protection planning: if you dont own property, your
creditors cant reach it. What if your spouse owns the property?

2.

Community/marital property state.

a.

In general, community/marital property is available to both spouses creditors. See, e.g.,

Wis. Stat. 766.55(2) (limited to obligations incurred in the interest of the marriage or the
family).
Use a written agreement to classify assets as the spouses separate/individual property; but
consult state law to ensure that this classification in fact shields the property from the other
spouses creditors.

b.

c.

State law might require notification to potential creditors of the existence and terms of the
agreement in order for the creditor to be bound by its terms. See, e.g., Wis. Stat. 766.56.

3.

Common law state.

a.

Property titled in one spouses name is generally not subject to claims of the other spouses
creditors.

b.

Certain forms of title offer varying levels of asset protection. There are three basic forms:

(1)

Tenancy by the entirety. This exists between spouses only and typically protects the property
from a creditor of one spouse, but not a creditor of both spouses.

(2)

Tenancy in common. This offers no protection of the asset because a co-tenants interest is
generally severable. Its worth noting, however, that a creditor needs a judicial partition,
which offers at least a procedural hindrance to satisfying a judgment with a tenants in
common interest.

(3)

Joint tenancy. As with a tenancy in common, a creditor of a joint tenant can usually reach a
debtors joint tenant interest, but must seek judicial partition of the property. If the debtor
tenant dies, her interest passes by operation of law to the co-tenant, making that property
unavailable to the debtors creditors.

Page 14 of 36

c.

4.

Gift tax. A taxable gift could result if the donee spouse is not a
U.S. citizen and the amount in any given year exceeds $100,000, as indexed ($117,000 for
2005). 2523(i).
Spouses creditors.

a.

If both spouses want to protect their assets, then other forms of ownership must be
considered. Namely, neither spouse can own the assets. So the question becomes:

b.

Who should own them?

B.

TO CHILDREN AND/OR GRANDCHILDREN.

1.

The loss of control over and enjoyment of the transferred property must be weighed against the
clients asset protection objectives.

2.

Any time the transfer of an asset is considered, fraudulent transfer rules must be considered.
See Section V.

3.

The client can give away $12,000 per person tax-free every year.
2503(b). Gifts of cash and marketable securities at or less than this limit do not require the
donor to file a gift tax return or require the donee to report the gift.

4.

Each person has a $1,000,000 lifetime gift exemption. 2505. Gifts using this exemption
require the donor to file a federal gift tax return by April 15th of the year after the gift is
made. Consider whether there is a state gift tax.

5.

What if the donor doesnt want the donee to own or control the property? Here are some
options:

a.

If the donee is a minor, the donor can establish either a custodial arrangement or a trust. For
a further discussion of trusts, see Section D. below.

b.

529 savings accounts.

Whether the account is protected from creditors is determined by state law. Conceptually,
given the account owners broad rights and that the creditor steps into the role of the
owner/debtor and can exercise those rights, it seems the account is not protected. However, at
least seventeen states offer some protection from creditors of a 529 account: Alaska,
Nevada, Colorado, North Dakota, Nebraska, Wisconsin, Kentucky, Ohio, Pennsylvania,

Page 15 of 36

Maine, Rhode Island, Virginia, South Carolina, Louisiana, Tennessee, Florida and Texas.
(a)

What if an individual establishes an account in a state where the account is protected, but the
account owner is not a resident of that state? No court has addressed this question yet, but
any court that does must consider the full faith and credit clause of the Constitution (discussed
further in Section F.).

(b)

The safest approach? Name someone other than the potential debtor (i.e., a grandparent or a
trust) as the account owner.

(2)

BAPCPA creates protection for 529 accounts, with some important limitations: amounts
contributed within 365 days of the bankruptcy filing are not protected; the exemption is limited
to $5,000 for amounts contributed between one and two years before the bankruptcy filing; the
account beneficiary must be the debtor's child, stepchild, grandchild or step grandchild; the
account cannot be pledged as collateral; and excess contributions are not protected.
BAPCPA 225.

(3)

Though designed as a tax-favored way to save for education, the unusual and very favorable
transfer tax provisions of 529 also make the account an attractive wealth transfer vehicle.

(a)

For example, Dad creates and funds a 529 savings account for Son. Dad owns the account
and can change the beneficiary. If this were a trust, the property would be in Dads
estate at his death.
2036(a)(2). But under 529, the account is not in Dads estate. 529(c)(4)(A). Better still,
Dads transfers to the account qualify for the gift tax annual exclusion and are GST
exempt.
529(c)(2)(A)(i). For an in-depth discussion of the estate planning benefits of 529 accounts,
see Maier, Joseph M. and Henning, Brian, The Northwestern Mutual Guide to
Education Savings, November 2003 (F.O. 22-4355).

(b)

But are these favorable, albeit somewhat bizarre, rules here to stay? In its Option to
Improve Tax Compliance And Reform Tax Expenditures (January 27, 2005), the Joint
Committee on Taxation noted that [p]resent law regarding the transfer tax treatment of
section 529 accounts imposes transfer taxes in a manner that is inconsistent with
otherwise applicable transfer tax provisions. The Committee recommended modifying the
rules to match the otherwise applicable transfer tax provisions (that is, the rules youd expect
to apply to 529 accounts). To review the Committees January recommendations, visit:
http://www.house.gov/jct/s-2-05.pdf (see Section XI. E. at page 412).

6.

Give away a remainder interest in the residence.

a.

The remainder can be protected from creditors and the donors retained life estate is of

Page 16 of 36

little value. However, be sure the life estate is protected, because chances are the states
homestead exemption will not apply to the debtors life estate.
b.

The residences entire value is included in the life tenants (donors) estate, so this
technique makes sense only in a non- taxable estate.

7.

Sell property in exchange for a private annuity or self-cancelling installment note

(SCIN).

a.

A private annuity is an arrangement between two parties, neither of whom is in the business of
selling annuities, where the seller transfers property to the buyer in exchange for the buyers
unsecured promise to pay an annuity to seller for the rest of his life.

b.

A SCIN is an installment note with an obligation to pay that ends at the sellers death, even if
that occurs before the end of the notes stated term.
In either case, the only amounts the sellers creditors should be able to attach are the
annuity/note payments, meaning the property sold is protected.

c.

C.

TO A CREDIT SHELTER TRUST AT THE FIRST SPOUSES DEATH.

1.

The credit shelter trust (also known as a bypass trust) is a staple of a comprehensive estate
plan. Its use, even in smaller estates, is often overlooked as an effective and easily established
asset protection vehicle. It protects trust assets from the surviving spouses potential creditors
for two primary reasons:
The survivor did not establish the trust (it is not self-settled, see Section F.), and

a.

The trust is irrevocable and should contain a spendthrift clause, forbidding the survivor
from using trust assets to satisfy a legal obligation.

2.

The credit shelter trust offers additional estate and GST tax benefits, as well as the ability
of the trustee to transfer money and property to the children without the need for a gift from
the surviving spouse.

D.

TO A LIFETIME IRREVOCABLE TRUST.

1.

Another frequently overlooked asset protection technique. Maybe because its viewed
exclusively as an estate planning tool? While many clients and advisors are drawn to complex
and costly asset protection structures, a flexibly designed and properly funded irrevocable
trust offers many of the same benefits as its more elaborate counterparts, but with greater
flexibility, less audit risk, and at a lower cost.
Page 17 of 36

a.

Properly designed, a lifetime irrevocable trust allows:

(1)

Protection of trust property from creditors of both the grantor and the trust beneficiaries.

(a)

The grantors creditors cannot reach the trust property because the grantor has no right to it.
See the discussion on self-settled trusts in Section F. below.
The beneficiaries creditors cannot reach the trust property because, again, the trust is
irrevocable and if properly drafted will contain a spendthrift clause.

(b)

(2)

Family use of trust income generated by trust property.

(3)

Family use of trust property held in trust.

(4)

Ability of the grantors spouse to transfer property to herself, her children, and even back to the
grantor through a limited (or special) power of appointment, while keeping the property
out of the grantors and spouses estates. 2041.

b.

What property can the irrevocable trust hold? Anything! For example: life insurance, on a
variety of people, but careful trust design is particularly important here to ensure the life
insurance proceeds are not unwittingly subjected to estate and GST taxes; closely-held
business interests (but if its S corporation stock, make sure the trust is a qualified shareholder
under 1361); marketable securities; or real estate.

c.

Who are the trust beneficiaries? Whomever the grantor decides when establishing the trust. In
most cases, its the grantors spouse and children; however, establishing a trust for
grandchildren is common, especially in larger estates that stand to benefit from lifetime
use of available GST exemptions through the use of life insurance and other appreciating
property.

2.

Another irrevocable trust to consider is the retained annuity trust (GRAT). A GRAT is an
irrevocable trust to which a grantor transfers property in exchange for a set annual payment for
a fixed number of years. At the end of that term, the remaining property either remains in trust
for or is distributed tax-free to specified beneficiaries. When the GRAT is funded, the gift
equals the value of the contributed property less the grantors retained interest. The retained
interest is valued using a formula provided by the I.R.S. Depending upon the GRAT term
and the interest rate, it's possible that the contribution results in no gift at all (a so-called
zeroed- out GRAT). Audrey J. Walton v. Commissioner, 115 T.C. 589 (2000), acq. I.R.S.
Notice 2003-72, 2003-44 I.R.B. 964 (October 15, 2003).

a.

Only the annuity payments should be reachable by creditors.

Page 18 of 36

b.

A GRAT should not be employed as an asset protection technique unless it otherwise makes
sense from the standpoint of the clients estate and financial planning.

3.

One more option is to transfer a residence to a qualified personal residence trust (QPRT). A
QPRT is an irrevocable trust to which a grantor transfers his residence in exchange for the
right to live there rent-free for a fixed number of years. As with a GRAT, when the term
expires, the residence either remains in trust for or is distributed tax-free to specified
beneficiaries. Its common for the grantor to continue to live in the house after the term
expires, but he must pay rent. When the residence is transferred to the QPRT, the grantors gift
is the value of the residence less the value of his retained interest. The retained interest is
valued using a formula provided by the I.R.S. 2702 and 7520.

a.

The grantors interest in the residence is limited to his right to live there rent-free, which should
be an unattractive interest for a creditor to attempt to attach. The remainder interest in the
residence should not be available to the grantors creditors.

b.

The QPRT should not be used to protect the residence from creditors unless it is otherwise
consistent with clients estate and financial planning objectives.

E.

TO AN OFFSHORE SELF-SETTLED ASSET PROTECTION TRUST.

1.

What is it? A trust created under the laws of a foreign jurisdiction.

a.

A spendthrift clause protects a beneficiarys interest in a domestic trust from creditors, but not
if the beneficiary is the grantor.

b.

What if the grantor wants to be a beneficiary and protect the transferred assets from creditors?
Thats where the self-settled offshore trust comes in.

(1)

Self-settled means that a trust is created and funded by the same person who is a
beneficiary.

(2)

Offshore means the trust is created according to the laws of another country. Why bother to
go offshore? Because of the belief that a creditor cannot reach the assets.
Generally, both the trustee and the trust assets are located in the foreign jurisdiction.
Common asset protection trust jurisdictions include: Cook Islands (regarded as having the
most debtor-friendly trust laws in the world); Nevis; Cayman Islands; Bahamas; Isle of Man;
and Turks and Caicos Islands.

2.

Advantages.
does not?

Whats the big deal? What do offshore jurisdictions offer that the U.S.

Page 19 of 36

a.

Greater asset protection. Heres why:

(1)

The country does not recognize a foreign judgment.

(2)

There is a short statute of limitations for fraudulent transfers.

(3)

There is a higher burden of proof for a creditor alleging a fraudulent transfer. Typically, the
standard is proof beyond a reasonable doubt.

(4)

The laws authorize a self-settled spendthrift trust.

(5)

The losing party might be required to pay the winners attorneys fees. The risk of that
aside, the plaintiff may have to post bond before commencing the action against the trustee.

(6)

Normally, the assets are protected if the property is transferred to the foreign jurisdiction,
administered there, and subject to the foreign trustees control (usually an offshore bank or
trust company).

b.

Difficult (maybe impossible), time consuming and expensive for a creditor to reach offshore
assets. Consider the normal cost of a lawsuit in the U.S. Now factor in the costs of tracking
down and identifying assets, assessing the chances of success in a foreign country, and
hiring foreign counsel, and the debtor has created a serious deterrent for a creditor. The
stakes will have to be significant for a creditor to incur these costs with no guarantee of
success.
Grantor retains broad powers, including powers of appointment, trustee removal, and
revocation/amendment.

c.

3.

Disadvantages.

a.

To most effectively shield assets from creditors, a foreign trustee must be named and the
assets must be located offshore. Holding assets offshore may be unacceptable to many
clients because it means giving up control.

b.

Risk that a U.S. court will consider transfers to the trust fraudulent. Or, in a bankruptcy
proceeding, the transfers could be evidence of fraud that result in a denial of discharge for the
debts.

c.

Risk that a court will order the assets returned to the U.S. A courts ability to do this will

Page 20 of 36

depend in large part on the powers retained by the grantor over the trust and what the laws
of the foreign jurisdiction say about those powers. For example, under
13C of the International Trusts Act 1984 (Cook Islands), the grantors retention of the
right to revoke the trust does not make the trust assets available to the creditor (as otherwise
might happen under common law).
d.

Uncertainty regarding which laws control and whether the foreign laws (if they control) will
provide the expected protection. For example, in determining whether the transfers to the
trust were fraudulent, there is a risk the U.S. court will apply the state law of the debtors
residence. See In re Morse Tool, 108 B.R. 384 (Bankr. D. Mass. 1989) and Restatement 2d
Conflict of Laws (1971) 244(2). If the trust owns real estate, the laws of its location will
apply.

e.

A judge might hold the grantor in contempt (and throw him in jail) for refusing to bring
property back to the U.S. when the Court orders it. See Federal Trade Comm'n v. Affordable
Media L.L.C., 179 F.3d 1228 (9th Cir. 1999) and In re Lawrence, 251 B.R. 630 (S.D. Fla.
2000).

f.

Costly and complex to establish and maintain.

g.

Political instability and legislative uncertainty. Nothing prevents the foreign jurisdictions
legislature from changing its laws (retroactively, perhaps) as part of a policy to enhance
relations with the U.S.

F.

TO A DOMESTIC SELF-SETTLED ASSET PROTECTION TRUST.

1.

What is it? An alternative to an offshore trust. The idea is to obtain the same level of asset
protection as an offshore self-settled trust (have your cake) without moving your property
offshore (and eat it too).

a.

U.S. state laws normally do not protect the assets of a self-settled trust from the grantors
creditors.

b.

In order to have self-settled trust assets avoid creditors, an offshore trust was requireduntil
some states decided to offer a domestic alternative.

2.

States that offer asset protection to self-settled trusts established under their laws:

a.

Alaska. The first state to protect from creditors the assets of a domestic self-settled trust.
1997 Alaska Sess. Laws ch. 6 (effective April 2, 1997). The assets are not protected if:
their transfer was fraudulent; the grantor can revoke the trust without the consent of an adverse
Page 21 of 36

party; distributions to the grantor are mandatory or; the grantor transferred property to the trust
while in default of child support payments for over 30 days. Alaska Stat.
34.40.110(b)(4) (2003).
b.

Delaware. Three months after Alaskas Act became effective, Delaware followed suit. 1997
Del. Laws. Ch. 159 (H.B. 356). Of note in Delawares law is the inability to protect assets from
support or alimony obligations or from any person who suffers death, personal injury or
property damage on or before the date [of the transfer to the trust], which death, personal
injury or property damage is at any time determined to have been caused by [the grantor]
Del. Code. Ann. tit. 12, 3573 (2003).

c.

Nevada. Nevadas statute is best known for its very short statute of limitations for fraudulent
transfer claims. Creditors at the time of transfer to the trust are barred from bringing an action
unless the action is commenced within two years of the transfer or six months after the creditor
discovers (or should have reasonably discovered) the transfer whichever is later. And, if
someone becomes a creditor after the transfers to the trust, he cannot bring an action against
the trust unless he commences the action within two years of the transfers. Nev. Rev. Stat.
166.170 (2001).

d.

Rhode Island. The statute is very similar to Delawares, including a limitation on protecting
assets from support or alimony obligations or from any person who suffers death, personal
injury or property damage caused by the grantor. R.I. Gen. Laws 18- 9.2-5(a) and (b)
(2003).

e.

South Dakota. The statute is effective for trusts settled on or after July 1, 2005. It generally
mirrors the Delaware statute. S.D. Senate Bill 93 (2005).

f.

Four other states provide a lesser degree of protection.

(1)

Missouri. The Missouri statutes protection is available only if the grantor is not the sole
trust beneficiary or does not have the right to a specific portion of the trust. Mo. Rev. Stat.
456.080(3) (2003). The Eight Circuit Court of Appeals cast a cloud over use of this statute in
In re Markmueller, 51 F.3d 775 (8th Cir. 1995), where it found that the common law rule
against self-settled spendthrift trusts was apparently still valid in Missouri. A curious
finding given the statute.

(2)

Utah. The law is effective for trusts created after December 31, 2003 and lists eleven
situations in which the trust assets are not protected. Utah Code Ann. 25-6- 14(2)(a).
Colorado. The Colorado statute is worth mentioning because it provides that a self-settled trust
shall be void as against the creditors existing of the grantor. Colo. Rev. Stat. 38-10-111
(2004) (emphasis added). The obvious inference is that self settled trust assets are protected
from future creditors, and one court agrees. See In re Baum, 22F.3d 1014 (10th Cir. 1994).
Page 22 of 36

(3)
3.

Oklahoma. There is a $1,000,000 limit on how much can be transferred to an Oklahoma

asset protection trust. 31 Ok. Stat. 12 (2004).
What does this mean?

a.

A person can create and fund a trust and be a discretionary beneficiary; and

b.

potentially protect the trust assets from creditor claims.

4.

Basic requirements.

a.

The trust is irrevocable.

b.

Trust assets are held in the state whose laws govern.

c.

At least one trustee is a resident (a corporation or individual) of that state.

5.

Advantages.

a.

Assets remain in U.S.

b.

Can have additional, non-resident trustees.

c.

Easier and less costly to establish and maintain.

6.

Disadvantages.

a.

There is no case law regarding their ability to protect trust assets.

b.

It is not clear whether the Constitutions Full Faith and Credit Clause (Art. IV, 1)
requires the trustee to recognize a judgment from another state.

c.

The Constitutions Supremacy Clause (Art. VI, 2), which says if federal and state law conflict,
federal law wins.

d.

These disadvantages raise yet another concern: if the assets are available to the grantors
creditors, they are included in the grantors estate. Treas. Reg. 20.2036-1(b)(2).

Page 23 of 36

e.

Assets transferred to a self-settled trust within ten years of a bankruptcy filing are not exempt if
the grantor transferred the assets with the intent to hinder, delay or defraud a creditor.
BAPCPA 1402.

G.

TO AN ENTITY.

1.

A creditors ability to reach entity owned assets is based on the same premise as assets in a
spendthrift trust: you cant lose what you dont own.

2.

Corporation. A corporation shields its shareholders personal assets from corporate creditors
because a shareholders liability is limited to his investment in the corporation.

a.

Example. Dad operates his grocery store business as a corporation. Neighbor slips and falls on
some salad dressing in the store. Neighbor has a cause of action against the corporation and both
the corporations insurance and its assets are available to Neighbor if he obtains a judgment
against corporation; but Neighbor cannot reach Dads personal assets.

b.

The corporation is ignored (the corporate veil will be pierced) if a shareholder ignores the
corporation. This means the shareholder becomes liable for corporate debts.

(1)

Limited liability for shareholders derives from the corporation as a separate and distinct
legal entity; so it follows that failure to treat it as separate and distinct means a loss of limited
liability.

(2)

If the shareholders respect the corporation, the courts will do the same when a creditor seeks
to pierce the corporate veil and reach a shareholders personal assets. Examples of respecting
the corporation include: not commingling corporate and personal assets; keeping current and
accurate corporate records and; adequately capitalizing the corporation.

3.

Limited partnership (LP) or limited liability company (LLC). A primary motivation for the use
of an LP or an LLC is that the entitys owners are afforded unique treatment under state law
with respect to creditors.
Generally, LP and LLC interests are not ideal assets for a judgment creditor, because a
creditors rights are limited and because of potential adverse income tax treatment to the
creditor. (For an in- depth discussion of the asset protection aspects of LPs and LLCs, see
Estate Planning With Partnerships and LLCs, Northwestern Mutual Advanced Planning
Seminar Outline, 2003-2005.)

a.

b.

The charging order remedy. A charging order is a court order that a partners LP interest or a
members LLC interest must be applied to pay a judgment against the partner. The intention of
this limited remedy is to avoid disturbing the partnerships business and adversely affecting

Page 24 of 36

the non-debtor partners, which could result from allowing a creditor to attach partnership
property for the debts of an individual partner.
(1)

There must be a judgment against the debtor, followed by the creditors application to the
court for a charging order. Entity distributions related to the debtors interest must be paid to
the judgment creditor at the courts direction. The charging order effectively re-directs profit
distributions and liquidation proceeds (if any) from the debtor to the creditor.

(2)

An important question surrounding the charging order is whether it is the creditors exclusive
remedy against a debtor partner or member? Case law and the Revised Uniform Limited
Partnership Act conflict as to whether the court can go beyond granting a charging order and
order a sale of the debtors limited partnership interest.

(a)

RULPA 702 does not authorize a sale of the owners entity interest.
On the other hand, at least seven state courts have held that a partnership interest can be sold
when the judgment creditor receives nothing pursuant to the charging order. Those states are:
California (Crocker v. Natl. Bank of Perroton, 208 Cal. App. 3d 1, 255 Cal. Rptr. 794
(1989) and Hellman v. Anderson, 233 Cal. App. 3d. 846 (1991)); Arizona (Bohonus v.
Amerco, 602 P.2d 469, 124 Ariz. 88 (Ariz. 1979)); Connecticut (Madison Hills Ltd. v.
Madison Hills, Inc., 35 Conn. App. 81, 644 A.2d 363 (Conn. App. 1994), cert. denied, 231
Conn. 913, 648 A.2d 153 (Conn. 1994)); Maryland (Lauer Constr., Inc. v. Schrift, 123 Md. App. 112,
716 A.2d 1096 (1998) and Ninety-First St. Joint Venture v. Goldstein, 691 A.2d 272, 114
Md. App. 561 (1997)); Nevada (Tupper v. Kroc, 88 Nev. 146, 494 P.2d 1275 (Nev. 1972));
New Jersey (FDIC v. Birchwood Builders, 240 N. J. Super. 260, 573 A.2d 182 (N. J. 1990));
New York (Princeton Bank & Trust Co. v. Berley, 394 N.Y.S.2d 714, 57 A.D.2d 348 (1977)
and Beckley v. Speaks, 240 N.Y.S.2d 553, 39 Misc. 2d 241 (N.Y. 1963)).

(3)

It is widely believed that a charging order obtains certain unwelcome income tax results for
the judgment creditor. However, based upon the I.R.S. litigating position as well as Treasury
Regulations under I.R.C. 704, there is more to this often stated conclusion than meets the
eye. See
II.B.7 of Estate Planning With Partnerships and LLCs.

IV.

PLAN YOUR INHERITANCE

A.

Once an individual inherits property, it becomes subject to claims of her creditors.

Unfortunately, many estate plans provide simply for an outright distribution of property to
children and grandchildren, and miss the chance to protect the inherited property from the
claims of the beneficiaries creditors and from potential divorce claims.

B.

What makes this planning different is that it is being touted to the generation that will inherit
the property, rather than to those who will transfer it.
Page 25 of 36

C.

The trust can offer the beneficiary flexibility, such as:

1.

Control: the ability to serve as trustee or co-trustee, as well as the ability to appoint co-trustees
and successor trustees.

2.
3.

Enjoyment: the use of trust property (i.e., trust owns a residence that beneficiary uses).
Transfer: a limited power of appointment that allows the beneficiary to direct the disposition
of the property. In effect, this lets the beneficiary amend the trust terms.

D.

The trust can also offer:

1.

Estate and GST tax benefits.

2.

The ability to spell-out the beneficiarys use of trust income and assets. This is especially
important in the case of a special needs beneficiary when the objective is to avoid an
inheritance that could jeopardize eligibility for government assistance.

V.

BEWARE OF FRAUDULENT TRANSFERS

A.

Certain property transfers are voidable by creditors. Transfers with the intent to hinder, delay
or defraud any creditor of the transferor are fraudulent and can be set aside.

B.

Transfers for which a reasonably equivalent value is not received in exchange can be set aside if
the transferor was engaged or was about to engage in a business or a transaction for which the
remaining assets of the debtor were unreasonably small in relation to the business or
transaction Uniform Fraudulent Transfers Act (UFTA) 4(a).

C.

Since the intent of a transfer is often unknown, courts have established badges of fraud:
conduct evidencing an intention to hinder, delay or defraud a creditor. Examples in UTFA
4:

1.

Transfers to a relative. The Comment to UFTA 4 states that the fact that a transfer has
been made to a relative has not been regarded as a badge of fraud sufficient to warrant
avoidance when unaccompanied by other evidence of fraud. The courts have uniformly
recognized, however, that a transfer to a closely related person warrants close scrutiny of the
other circumstances, including the nature and extent of the consideration exchanged.
When a debtor exchanges property for an interest in a limited partnership LP or a limited
liability company, the debtors interest is not as valuable asthe transferred property. The UFTA

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provides that this is conduct evidencing a badge of fraud. Another instance of conduct
evidencing fraud is a debtors transfer of an interest in the entity.
2.

Transferor retains control of the transferred property.

3.

Transferor was sued or threatened with the suit before the transfer.

4.

The transfer was of substantially all of the transferors assets.

VI.

SHIFT THE RISK: INSURANCE

Insurance helps protect assets by compensating an individual for financial losses and
indemnifying against adverse judgments. Ultimately, it preserves and protects property by
guaranteeing that the insured will not need to sell assets to compensate for a financial loss or
satisfy obligations. Different types of insurance protect assets by indemnifying against
different types of losses.

A.

LIFE INSURANCE. PRESERVES EXISTING PROPERTY BY PROVIDING MONEY AT

THE DEATH OF THE INSURED TO PAY ESTATE TAXES OR SATISFY DEBTS.

1.

Personal/trust owned life insurance.

a.

Indemnifies against a financial loss due to the death of the insured by providing a generally
income tax-free payment to the beneficiaries. As a result, existing property does not need to
be sold.

b.

The death benefit can be used to pay estate taxes, for education funding, paying off debts
such as the mortgage, and providing liquidity for day to day expenses.

2.

Key person life insurance.

a.

A business can insure the lives of its valued and skilled employees to partially indemnify the
business for the loss sustained upon the death of the key person. The death benefit can pay off
called loans, solidify lines of credit or even prevent the calling of a note by reinforcing the
capital structure of the business.

b.

During the life of the key person, policy cash values can strengthen the credit of the business and
provide cash for emergency needs.

B.

DISABILITY INCOME INSURANCE.

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1.

One in every five people will become disabled through injury or illness for a period of three
months or more during their work life. 1985 Commissioners Disability Table A. While
disabled, income is lost and assets meant to be preserved for the family may have to be
sold to pay bills. If assets cannot be sold in a timely manner or for full fair market value,
bankruptcy is the inevitable result.

2.

Disability income insurance replaces the income lost to disability during the working years.
Lost future income can be significant, especially in cases of total disability. The policy can
cover living expenses such as a mortgage, car payments, and education and help maintain a
standard of living.

Current Age

Current Income

Lost income through

age 65 assuming 4%
annual
increase
in
salary

30

$50,000

$3,682,611

40

$75,000

$3,123,443

50

$100,000

$2,002,359

3.

Disability insurance can protect against partial or full disability. It can insure against the
inability to perform either the clients own occupation or any occupation.

C.

LONG-TERM CARE INSURANCE.

1.

Planning for long-term care is an integral part of a retirement and estate plan. Historically it
was not seen as an important piece of the puzzle, and in many cases it was viewed as a
separate, unrelated issue. If ignored, it has the potential to undermine and destroy a retirement
or estate plan.

2.

If a client does not have sufficient income or wealth to pay the care costs, she will be forced
to liquidate assets. Long-term care insurance helps preserve the value of the estate so that it
can pass according to the estate plan.
Example: Assume that a 60 year old will have a long-term care event beginning at age 85

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that lasts for 5 years. Also assume that care costs of $250 per day (at todays rates) increase at
an inflation rate of 5% per year. The potential cost would be $1.52 million, or about 30% of a
$5 million estate. Annual long-term care insurance premiums of $7,087 paid for 25 years to
cover comparable costs would reduce that same estate by only 7%.1 Premiums paid for ages
60-84 total $355,154 while the cost of care for ages 85-89 totals $1,524,880.
D.

PROPERTY, CASUALTY AND LIABILITY INSURANCE.

1.

Property and casualty insurance protects against damages to the insured or his property by
providing cash to replace stolen, damaged or destroyed assets. This helps keep retirement and
estate plans intact.

2.

Liability insurance indemnifies for claims made against the insured for damages such as
injury to or the death of others caused by the insured. It can make certain that the insured does
not need to sell property to satisfy an adverse judgment.

E.

UMBRELLA COVERAGE.

1.

Umbrella policies offer excess insurance above the coverage limits of a standard property and
casualty or liability policy. Umbrella policies can also fill any gaps in basic policies.
1

Coverage and premium based on a 60 year old purchasing Northwestern Mutual Long-Term Care Insurance at
$250/day, 91 day beginning date, 100% home health care, lifetime benefits with the Automatic Benefit Increase
(ABI) at 5%. The cost of ABI is $4,630 of the $7,087 annual premium.

An umbrella policy is a necessity for those in highly litigious professions and industries to help
ensure that a large adverse judgment does not force the liquidation of assets or
bankruptcy.Postscript: there are a variety of in-depth works about asset protection. Here are a
few:

Spero, Peter, Asset Protection: Legal Planning, Stratgies and Forms, published by Warren,
Gorham & LaMont

Osborne, Duncan, Asset Protection, Domestic and International Law and Tactics, published by
Clark Boardman Callaghan

Bove, Alexander A., Asset Protection Strategies, published by the American Bar Association

Rosen and Rothschild, 810-2nd T.M., Asset Protection Planning, published by Tax
Management, Inc., a subsidiary of the Bureau of Nation Affairs, Inc.

Page 29 of 36

A PRIMER ON ASSET PROTECTION

Part II
Introduction
Part I of this Article, which appeared in the Advanced Planning Bulletin, September 2007 edition
of this Newsletter, included an overview of various types of creditor claims and the various
strategies individuals can use to shield ones assets from creditor claims. In Part II, we consider
the ability to use a trust to protect amounts given to others both during life and at death from the
claims of the creditors of the trust beneficiaries.
Gifts and bequests can become subject to creditor claims in a variety of ways. For example, if
the recipient is in debt, assets received by gift or inheritance will be vulnerable to the claims of
the recipients creditors. If the recipient is sued, the assets received are subject to garnishment or
court issued judgments. If the recipient is divorced, the amounts received could become subject
to division, especially if commingled with the former couples marital estate.
In comparison to outright transfers, transfers in trust for anothers benefit are much more
difficult for creditors to attach, as indicated in Part I of this Article. In this respect, trusts can be
divided into two broad categories: (1) self-settled trusts and (2) non-self-settled trusts.
Self-settled trusts are created by the grantor for the benefit of the grantor. These trusts are
typically not creditor protected. Non-self-settled trusts are trusts established for the benefit of
persons other than the grantor. Non-self-settled trusts can be an effective way to protect assets
given to the trust (either during life or at death) from the creditors of the trust beneficiaries.
Longstanding principals of equity and common law support the protection afforded to the
beneficiaries of a non-self-settled trust. From an equitable standpoint, subject to limited
exceptions, a person is not legally obligated to support or to otherwise give his or her property to
anyone other than a spouse or a minor child, during life or at death. Therefore, a creditor should
not anticipate an inheritance will be available to satisfy an adult childs monetary obligations.
As a result, allowing a parent to take steps that prevent a creditor from attaching the inheritance
does not cause the creditor undue hardship. As a result, a parent who decides to leave a child an
inheritance should be free to impose restrictions on how the inheritance may be spent, including
a prohibition on using the inherited funds to pay the childs debts.
From a legal perspective, legal ownership of property that is held in trust is vested with the
trustee, rather than the trust beneficiaries. As a result, if the trust includes provisions that do not
grant to the beneficiary the right to sell, transfer or assign his or her beneficial interests in the
trust, then a creditor should not have the legal right to attach the assets of the trust in order to
satisfy a financial obligation of the beneficiary.
A creditors ability to attach trust property is determined by state law. As a result, careful
consideration must be given to state law when a trust is to be used to protect gifts and
inheritances from the beneficiaries creditors. If the laws of the state of the grantors domicile

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are unfavorable, consider selecting the laws of a different jurisdiction to govern the
administration and distribution of the trust.1
Uniform Trust Code

A thorough discussion of the ability to select a trusts situs, and the impact of trust selection on creditor claims, is
outside the scope of this Article. For more information on this topic see: Richard W. Nenno, The Trust from Hell:
Can it be Moved to a Celestial Jurisdiction?, Vol. 22 No. 3, 60, Probate Property May/June 2008 (A
Publication of the Real Property, Trust and Estate Law Section of the American Bar Association). See also
Malcolm A. Moore, Choice of Law in Trusts: How Broad is the Possible Spectrum? Available at
http://www.dwt.com/practc/trust_es/10-02_LawInTrusts.htm.

The Uniform Trust Code (UTC) was completed by the Uniform Law Commissioners in 2000,
and amended in 2001, 2003, and 2005.2 The UTC has been adopted in 21 states, and bills
proposing adoption of the UTC are pending in the House Judiciaries of Oklahoma,
Massachusetts, and Connecticut.3
According to the Uniform Law Commissioners, the purpose of the UTC is:
To provide a comprehensive model for codifying the law on trusts. While there are numerous
Uniform Acts related to trusts, such as the Uniform Prudent Investor Act, the Uniform
Principal and Income Act, the Uniform Trustees' Powers Act, the Uniform Custodial Trust
Act, and parts of the Uniform Probate Code, none is comprehensive. The UTC will enable
states which enact it to specify their rules on trusts with precision and will provide
individuals with a readily available source for determining their state's law on trusts.4
The UTC has generated much discussion and controversy. Perhaps the most controversial
portion of the UTC is Article 5, which addresses creditors rights. Many commentators believe
that Article 5 grants greater rights to creditors than had previously existed.
If asset protection is a principal objective for establishing a trust, it is important for the trust
agreement to be drafted with the most protective language possible. Provisions to be considered
include spendthrift clauses, discretionary distribution provisions, and selection of an independent
third party trustee. The UTC provides guidance as to how the provisions of a trust agreement
affect creditor rights.
Spendthrift Clause Requirement
A spendthrift clause is a provision in a trust agreement that precludes a beneficiarys creditors
from reaching the trust assets in satisfaction of a claim against the beneficiary. In most
jurisdictions, this prohibition is enforceable.
An example of a spendthrift clause is:
Notwithstanding any other provision of this Agreement, the Grantor intends that the assets
held in trust pursuant to this Agreement be protected from the claims of the creditors of the
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beneficiaries thereof. Except as may be herein provided, the interests of the beneficiaries of this
Agreement are created for their personal enjoyment, protection and welfare and shall not be
subject to assignment, alienation, pledge, attachment or claims of creditors, including any
claims for maintenance or related payments from a spouse in a divorce or related proceeding.
2
3
4

http://www.nccusl.org/Update/uniformact_factsheets/uniformacts-fs-utc2000.asp.
http://www.nccusl.org/Update/ActSearchResults.aspx.
http://www.nccusl.org/Update/uniformact_factsheets/uniformacts-fs-utc2000.asp.

The enforceability of a spendthrift clause is based upon the principle that a grantor may
condition gifts. According to the UTC, a trust provision stating 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 beneficiarys interest.5
For maximum asset protection, the spendthrift clause should prohibit both voluntary and
involuntary transfers of the beneficiarys interest.6 It should also specifically mention that the
clause applies to both the trust income and principal. The spendthrift clause should also state
that it applies to creditors of all the trusts beneficiaries.
The consequences of failing to include a spendthrift clause can be severe. To the extent a
beneficiarys interest is not subject to a spendthrift provision, the court may authorize a creditor
or assignee of the beneficiary to reach the beneficiarys interest by attachment of present or
future distributions to or for the benefit of the beneficiary.7
Mandatory v. Discretionary Distributions
Trusts that grant the trustee discretion over distributions provide greater asset protection than
trusts that require the trustee to make mandatory distributions. However, all trusts under the
UTC, including trusts with discretionary language, are subject to the claims of exception
creditors (discussed further below).
1.

Mandatory Distributions
The UTC allows creditors to attach overdue mandatory trust distributions.8 After a beneficiary
receives a mandatory distribution, the beneficiary owns the property outright and is also at risk to
the creditors claims. Even before a mandatory distribution is made, many states also allow
creditors to step into the shoes of the beneficiary and attach the beneficiarys mandatory right to
receive payments. As a result, assets in trusts requiring mandatory distributions are often subject
to the claims of the beneficiaries creditors. If asset protection is a goal for the trust grantor,
mandatory distribution provisions should be avoided.
Mandatory distributions are subject to attachment by creditors regardless of whether the trust
contains a spendthrift clause.9 Unlike trusts with discretionary language, the trustee will not be
able to prevent distribution to the beneficiarys creditors.

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5
6
7
8
9

2.

Uniform Trust Code (UTC) 502(b).

UTC 502(a).
UTC 501.
UTC 506.
Id.

Discretionary Distributions
Although discretionary language does not guarantee asset protection, the UTC generally
prohibits a beneficiarys creditors from reaching trust assets if distributions are subject to the
trustees discretion.10 Therefore, a non-self-settled trust should grant the trustee discretion to
decide when and why trust assets are distributed. The trustee should also have discretion to
distribute assets to some beneficiaries and not others. The trustee will then be able to withhold
distributions from a beneficiary who may become subject to the claims of creditors.
If a principal purpose is to protect trust assets from the claims of the beneficiarys creditors, then
the trust agreement should allow the trustee to withhold distributions to a beneficiary
indefinitely. Better yet, the trust agreement can allow the trustee to terminate a beneficiarys
interest in the trust should the beneficiary be subject to extensive claims and/or judgments.
Although very drastic, termination of the beneficiarys interest would provide the trust assets the
greatest protection from creditors.11 In this event, the trust agreement should name more than
one beneficiary, and should indicate how the remaining trust assets are to be distributed after the
termination of a beneficiarys interest.
Exception Creditors
Under the common law, trusts were traditionally divided into two categories: (1) support trusts
and (2) discretionary trusts.12 In simplest terms, a support trust is one where the trustee must use
the trust assets to support a beneficiary. A discretionary trust is one where the trustee may
distribute assets to one or more beneficiaries, as the trustee deems appropriate. Support trusts
were subject to creditor claims, but discretionary trusts provided reliable asset protection under
the common law. However, the UTC has eliminated this bright-line distinction between
discretionary and support trusts.13 Under the UTC, all trusts may be subject to the claims of
exception creditors.14

1.

Child and Spousal Support Exception

The UTC and the laws of most states create a statutory exception to the protection of a
spendthrift clause for child and spousal support.15 A beneficiary ordered to pay child support
may be required to pay the child support out of their interest in trust income or principal.16
However, under the UTC, a spouse or child claimant may only compel a distribution to the
extent the trustee has abused discretion or failed to comply with a standard for distribution.17
10

UTC 504.
Dennis M. Sandoval, Drafting Trusts for Maximum Protection From Creditors, WG&L Journals
(2003). Available at http://www.aaepa.com/documents/0306_EPJournal_AssetProtection_DS.rtf.
A support trust directs the trustee to spend the trust assets as necessary for the beneficiarys support. A
discretionary trust allows the trustee to decide when and if the beneficiary is to receive a distribution.
11

12

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13
14
15
16
17

2.

Comment to UTC 504.

UTC 504(c).
Wis. Stat. 701.06(4), UTC 503.
Wis. Stat. 701.06(4).
UTC 504(c).

Public Policy Exception

A public policy exception allows courts to order the assets in a spendthrift trust to be used to
satisfy a tort judgment (especially for intentional or gross negligence). Where a beneficiary is
guilty of intentional or gross negligence, a court of law may conclude that, as a matter of public
policy, the trust assets should be attachable by the beneficiaries creditors. For example, the
Supreme Court of Mississippi has held that a beneficiarys interest in a spendthrift trust may be
reached to satisfy a judgment for the beneficiarys intentional or gross negligence.18 Similarly,
some state legislatures, such as Georgia and Louisiana, have made statutory public policy
exceptions to the protections of spendthrift trusts.19
A public policy exception is not widely recognized at this time. However, it is possible that
more courts and legislatures may create public policy exceptions in the future.

3.

Additional Exceptions
The Uniform Trust Code creates several additional exceptions that allow assets of a spendthrift
non-self-settled trust to be reached by creditors. These exceptions include: (1) a judgment for a
creditor who provided services to protect the beneficiarys interest in the trust; and (2) a claim of
the State or the United States to the extent the States statutes or federal law so provides.20
Who Should Be the Trustee?
One of the most important issues to consider when utilizing a trust to protect assets from a
beneficiarys creditors is whether the beneficiary should be allowed to serve as his or her own
trustee. While the use of an independent third party trustee often provides the greatest degree of
asset protection, the grantor often will want to give the beneficiary as much control as possible
over the assets set aside in trust for his or her benefit.
The risk that allowing a beneficiary to act as his or her own trustee will subject the trust assets to
creditor claims originates from a legal doctrine referred to as merger. This doctrine is
described in 341(1) of the Restatement (Second) of Trusts as follows:
Except as stated in Subsection (2) [when the beneficiary becomes a trustee without his or her
consent], if the legal title to the trust property and the entire beneficial interest become united
in one person who is not under an incapacity, the trust terminates.21

18

Sligh v. First Natl Bank of Holmes Co., 704 So. 2d 1020 (Miss. 1997).

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19
20
21

La. Rev. Stat. Ann. 9.2005 (West 1991); Ga. Code Ann. 53-12-28(c) (1996).
UTC 503(b).
Restatement (Second) of Trusts 341(1).

In order for the doctrine of merger to apply, the trustee must also be the sole beneficiary of the
trust. As a result, the doctrine of merger should not apply so long as someone other than the
trustee is also a beneficiary of the trust.
The Uniform Trust Code adds credence to the notion that the assets of a non-self-settled trust are
not more likely to be attachable by creditors just because the trustee is also a beneficiary.
Section 504(e) reads:
If the trustees or co-trustees discretion to make distributions for the trustees or co-trustees
own benefit is limited by an ascertainable standard, a creditor may not reach or compel
distribution of the beneficial interest except to the extent the interest would be subject to the
creditors claims were the beneficiary not acting as a trustee or a co-trustee.22
The Internal Revenue Code defines an ascertainable standard as one relating to the health,
education, support or maintenance of a beneficiary.23 As a result, a trustee may have broad
latitude with respect to distribution for himself or herself without necessarily subjecting the trust
assets to creditor claims. However, the result could be different in states that have not adopted
the UTC.24
Notwithstanding the foregoing, there is also authority for the proposition that creditors may reach
the assets of a discretionary trust where the beneficiary is the trustee, even if the doctrine of
merger does not apply. For example, Restatement (Third) of Trusts 60, comment g, advances
the proposition that discretionary interests of a trustee/beneficiary are subject to claims of the
trustee/beneficiarys creditors, no matter how limited the trustee/beneficiarys discretion to make
distributions to himself or herself.25 To help guard against this risk, a spendthrift trust might
include a provision similar to the following:
If the Trustees determine that the exercise of any discretion or power granted by this Trust
Agreement would result in the assets of the Trust being subject to the claims of a beneficiarys
creditors, then the exercise of such discretion or power shall be postponed until the Trustees
determine the assets of the Trust are no longer so threatened. The Trustees may, at any time,
appoint a consenting independent co-Trustee by written notice to the appointed co22

UTC 504(e).
2041(b)(1)(A); Treas. Reg. 20.2041-1(c)(2).
For example, Restatement (Third) of Trusts 60, G, which was approved the American Law Institute in 1999,
provides that the beneficial interest of a beneficiary/trustee may be reached by the beneficiary/trustees
creditors.
In support of this view the Restatement cites In re Baldwin, 142 B.R. 210 (Bankr.S.D.Ohio 1992); Morrison v.
Doyle, 570 N.W.2d 692 (Minn.App.1997), rev'd, 582 N.W.2d 237 (Minn.1998); In re Lichstrahl, 750 F.2d 1488
(11th Cir. 1985); In re McCoy, 274 B.R. 751 (Bankr.N.D.Ill.2002), aff'd, 2002 WL 1611588 and L.W.K. v.
E.R.C., 432 Mass. 438, 448, 735 N.E.2d 359, 368 (2000).
23

24

25

Trustee and the current income beneficiaries. Furthermore, an independent Trustee shall be
Page 35 of 36

appointed by a court having jurisdiction over this Trust if necessary to ensure that trust assets
will not be subject to creditor claims.
Irrevocable Life Insurance Trusts
For tax planning purposes, many individuals choose to give life insurance policies on their life to
their heirs. If the policy is given more than three years before the grantors death, and the
grantor does not retain an incident of ownership with respect to the insurance policy, then the
policy proceeds are not within the decedents taxable estate upon the grantors death.26
Alternatively, the life insurance policy can be purchased and owned by an irrevocable life
insurance trust (ILIT).
As mentioned in Part I of this Article, amounts given by a grantor to an irrevocable trust can be
insulated from the grantors creditors, provided the gift did not constitute a fraudulent
conveyance. If these gifts are invested in life insurance, the insurance contract will be similarly
protected. Furthermore, if the trust continues after the insureds death, and the trust agreement is
drafted in a manner that affords spendthrift protection under applicable state law, the insurance
proceeds paid to the ILIT can also be protected from the beneficiarys creditors.
Conclusion
A properly drafted trust agreement can provide a high level of asset protection for the recipients
of gifts and bequests without materially affecting the beneficiarys ability to enjoy his or her
inheritance. In many states, the fact that the trustee has the discretion to distribute both income
and principal to a beneficiary for health, education, support and maintenance in an accustomed
standard of living does not, in and of itself, cause the trust assets to be reachable by creditors.
Furthermore, the trust can invest in business activities a beneficiary wants to pursue and
purchase assets such as a home for a beneficiarys use and enjoyment, all without jeopardizing
the asset protection attributes of the trust. Better still, if the trust agreement is carefully drafted,
it may be possible for the beneficiary to serve as trustee and still not subject the trust assets to
creditor claims.

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