More than just for spoiled rich kids – how trusts can protect your assets in case of divorce

You may think of a trust as something only for the extremely wealthy. Or you may picture spoiled rich kids living the high life on money their parents or grandparents worked for years to acquire and placed in trust for them.

But trusts can do much more than simply pass on family wealth. If properly chosen and constructed, a trust can actually help insure that your money will pass on to your children and grandchildren by protecting it in the event of divorce – whether yours or your child’s.

What is a trust?

A trust is a legal document created to hold any type of property. A trust must have a minimum of three parties:

  • Grantor. Also sometimes referred to as the trustor, the grantor is the person who places assets into the trust.
  • Trustee. The person responsible for enforcing the terms of the trust and making distributions of trust assets. The trustee can be one or more individuals, or it a corporation, such as a bank or trust company that specializes in managing trusts. In some cases it is acceptable for the grantor to also serve as a trustee, but when the goal is asset protection in the event of divorce, it is best that the grantor appoint a third-party.
  • Beneficiary. The beneficiary is the person (or persons) entitled to receive distributions under the trust.

The trust language dictates how its assets should be distributed. Distributions can be either mandatory or discretionary. With mandatory distributions, a certain amount – whether a fixed dollar amount or a percentage of the trust’s assets – must be distributed at the time and manner specified in the trust. With discretionary distributions, the trustee can the amount and timing of any distributions, even if that means making no distributions at all.

Types of trusts

There are several different types of trusts. It is important to note that once assets are placed in a trust, they are owned by the trust, and not the person who transferred them in to trust.

  • Revocable Trust. Often referred to as a living trust, a revocable trust is a trust where the grantor, beneficiary and trustee is almost always the same person. The purpose of a revocable trust is to avoid the grantor’s family have to administer probate at his death, and to have provisions in place for the grantor’s care should he become mentally or physically incapacitated and unable to care for himself. During his lifetime the grantor can take out as much of the trust’s assets as he wishes, and may revoke the trust at any time and have all of its assets transferred back into his name.
  • Irrevocable Self-Settled Trust. A self-settled trust is similar to a revocable trust in that it is funded by the grantor with his own assets. What makes it different is that the grantor does not serve as trustee – that position is granted to an independent third party – and distributions are entirely discretionary.
  • Third-Party Trust. In this type of trust, the grantor creates and funds the trust for the benefit of a third-party. Typically, these are the trusts that parents create for their children, and can be funded either during the parents’ lifetime or at the parents’ death. Distributions are almost always discretionary, although some trusts provide for lump sum payments to be made as the beneficiary reaches certain ages, while others keep the money in trust until the child’s death.

How trusts provide asset protection

Of the three trusts described above, only the self-settled and third-party options have the potential to protect trust assets in the event of divorce. Because the grantor can withdraw assets from the revocable trust as in whatever amounts and as often as he wishes, it provides no asset protection whatsoever in the event of divorce.

Irrevocable Self-Settled Trust

An irrevocable self-settled trust has the potential to protect the grantor’s assets from being eligible for division as marital property in the event of divorce. Because the grantor is only a discretionary beneficiary of the trust and has no control over whether and when distributions are made to him, they will likely not be considered part of the marital estate in the event of a divorce, and thus not eligible for division.

However, it is extremely important to note that the trust could be included as part of the marital estate if its creation violated the fraudulent transfer rule. Under this rule, any transfer to a third-party, including a trust, is considered fraudulent and therefore invalid if it was made to hinder or avoid creditors. If the trust was created shortly before you filed for divorce, for example, your spouse could successfully argue that the transfer was made with the specific intent of keeping the assets from being subject to division during the divorce.

Third-Party Trust

A parent who wants to make sure his child’s inheritance is not subject to division in case of divorce should create a third-party discretionary trust, and name somebody other than the child to serve as trustee. Courts have ruled that because the beneficiary-spouse is only entitled to distributions at the trustee’s discretion, the assets of a third-party trust are not considered part of the marital estate, and are therefore not eligible for division between the spouses in the event of a divorce. This, coupled with the fact that the trust will provide the same protection whether created before or after marriage, makes the creation of a third party trust a smart choice for parents wanting to protect a child’s inheritance in the event of divorce.

It is important to note, however, that in the case of both the self-settled and third-party trusts, any actual distributions made to the beneficiary will be considered marital property and therefore subject to division in the event of divorce, unless the beneficiary places them in an account that is entirely separate from his spouse. Once any distribution is deposited into a shared account, it becomes marital property.

Final Thoughts

Because trusts can be flexibly designed to meet your goals, they are an attractive option to consider when working with your attorney to protect your or your child’s assets in the event of divorce. There may sometimes be tax consequences to creating and funding a trust, so be sure to talk to your attorney about whether any of these options are right for you.

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