CAN A TRUST PROTECT YOUR CHILD’S INHERITANCE?

A living trust is a common estate planning tool for transferring assets at death to children and other loved ones. One of the primary reasons trusts are used is to avoid the necessity of having assets tied up in Probate Court (a common misconception is that a Will avoids probate – it does not). Another reason might be to minimize the amount of estate taxes owed upon death, although under current tax laws, estate tax is reserved for the very wealthy. However, one of the most important benefits of a trust is the ability to protect your assets from your children and from their creditors.

Note, this article is not about protecting your assets from your own creditors. While there are asset-protection trusts and other techniques for doing that, a revocable living trust does not accomplish that goal. However, it can be a valuable asset-protection tool for your children if properly drafted.

A common estate plan might provide that upon your death (or upon the death of the last to die of you and your spouse), your assets will be distributed outright to your children. While that has the benefit of being simple, there can be risks with such a plan:

The child may be immature or irresponsible with finances. In many cases, a child who receives a sizable inheritance will view it as a windfall. Rather than save the money for the future, he or she may not be able to resist the temptation of spending it on items or services that he or she ordinarily would not have purchased, such as expensive cars, luxury items, and lavish vacations.
The child may have creditors. If a child owes money to a creditor (whether as a result of a loan, a civil judgment, or otherwise), and defaults on that debt, that child’s assets are subject to being seized or attached by his or her creditors. To the extent a child receives an inheritance outright, it becomes fair game to his or her creditors.
The child may get divorced. In a divorce, a couple’s marital assets are typically divided equally between the former spouses. While inheritance is considered a “separate” asset under most states’ laws, and not marital property, it can easily be reclassified as marital property if the child commingles it with other marital property. An example of this would be using that money to help purchase a marital home, or depositing it into a joint bank account.

A properly drafted trust can reduce those risks by limiting or delaying the distribution of assets to your children and putting control of distribution decisions in the hands of a qualified trustee. In most cases, a trust will give the trustee some degree of discretion concerning distributions of income or principal to the trust’s beneficiaries.

An important component is the existence of a “spendthrift” clause in the trust, which is a statutory protection in most (if not all) states. Such a clause prevents a beneficiary from transferring (voluntarily or involuntarily) his or her interest in the trust, and prevents most creditors of the beneficiary from reaching the trust income or principal before it is distributed to the beneficiary. Of course, once trust assets are distributed to the beneficiary, those assets become his or her property, and thus are subject to creditors’ claims. But until that occurs, a spendthrift clause provides very good protection. It is important to note, however, that a spendthrift clause generally will be unenforceable with regard to claims against the beneficiary by a state or federal governmental entity (such as claims for unpaid taxes). And in most states, if there is a judgment against the beneficiary for the payment of child support or spousal maintenance (i.e. alimony), a spendthrift clause does not prevent the child, spouse, or former spouse from obtaining a court order attaching trust income or principal that would otherwise be distributable to the beneficiary (although in some states, such as Missouri, this is limited to trust income).

A trust can also help protect your assets from being given to your child’s spouse in the event of a divorce. The reason is that the assets of a properly drafted trust remain segregated from your child’s assets, and out of his or her control – at least to the extent the trust assets have not been distributed to your child (and even then, depending on state law, for purposes of divorce they may still remain separate property as long as they are not commingled with marital property). Similarly, in the event your child dies and is survived by a spouse and/or children, with a trust, you can control the extent to which the assets are distributed to (or held for the benefit of) the surviving spouse and/or your grandchildren.

In conclusion, making a trust part of your estate plan, combined with the designation of a capable and qualified trustee and a spendthrift clause, can help ensure that after you are gone, your assets will be preserved and protected from your children, their creditors and their ex-spouses.

CAN A TRUST PROTECT YOUR CHILD’S INHERITANCE?

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Bill O’Leary, Esq.

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