Prepared by Jeffrey Zaluda and Shannon B. Miloch
Most states, including Illinois, have laws dating back to the Carpetbagger Era that insulate one spouse from the individual creditors of the other spouse for non-family expenses or obligations. For a married person, this is one of the most important opportunities available in asset protection planning since it allows a potential debtor spouse to place assets into the hands of the less-risk oriented spouse and enjoy protection of those assets from the future creditors of the transferor spouse. Down, dirty, and generally effective.
- And, typically, spouses can transfer title back and forth between themselves with no income or transfer tax consequences.
- In several states, a presumption exists that a simple transfer of title between spouses will not remove the marital property or community property aspect of an asset. To overcome the presumption, there must be clear and convincing evidence that the transfer is meant as an irrevocable gift or an agreement which explicitly transmutes community or marital property into the separate property of an individual spouse. This presumption has the benefit of allowing transfers for creditor protection purposes while still preserving an argument in divorce court that the transferred property did not cease to be a marital asset.
- An inter vivos qualified terminable interest property trust (QTIP) can be effective as long as the donor does not view divorce as a realistic risk, since the transfer will be irrevocable once made. The advantage of using a QTIP is that only the income of the QTIP is at risk, and then only with respect to the donee spouse’s creditor.
- Spousal Lifetime Access Trusts (SLAT) are common tools used by estate planners for asset protection for married couples. Generally, each spouse will create their own irrevocable SLAT for the benefit of the other spouse and Grantor and the Grantor’s spouse’s descendants. SLATs may be funded by any assets, gifted by the Grantor to the trust using the Grantor’s gift tax exemption. The assets gifted to the SLAT appreciate outside of the Grantor’s estate, free of gift and estate tax. While SLATs are standard practice for many estate planners, it is important to remember the technicalities of these trusts for effective asset protection, including the reciprocal trust doctrine, grantor trust status, gift splitting, valuation timing, communicating risks in the event of divorce. and so on.
- Pre- and post-nuptial agreements can also be effective tools for asset protection by defining which assets belong to which spouse, which liabilities are the responsibility of which spouse, and in the event of asset transfers between spouses, which assets retain their character as marital or non-marital property.
- Since these are bilateral agreements with bargained-for consideration, they ought to be effective as to the rights of third party creditors, as well.
- These agreements also implicitly acknowledge what we all know: a spouse is generally speaking a married person’s greatest creditor (though most of us – including me, honey, I swear! – have no resentment or problem with that!).
One sure fire way for a plan to fail in providing effective protection is for the client to fail to follow corporate and other formalities governed by federal and state law and the terms of the documents. This means that the planner must, at a minimum:
- Provide the client with a written road map of “dos and don’ts” with respect to the entities involved and then regularly chat with the client to ensure he is following instructions.
- Ensure that the CPA is on board and comfortable with the reporting requirements, and that returns are filed in a timely manner. One important step is to determine whether a trust is to be treated as a foreign trust under IRC Section 7701. Offshore trusts and accounts are required to file one or more of a number of returns that many CPAs do not normally come across in their day-to day practices. Just to provide a sample of the IRS’s penchant for sadism: Forms 3520 (for transactions with foreign trusts), 3520-A (for foreign trusts with U.S. owner), 8938 (for taxpayers with foreign financial assets with aggregated value over $50,000), 926 (for transfers to foreign corporations), 56 (notice regarding fiduciary relationships), 1040NR (for non-residents), 5471 (for certain U.S. owners of foreign corporations), 8858 (for foreign disregarded entities), 8865 (for foreign partnerships), 8621 (for a shareholder of PFIC or QEF), 1120-F (for a foreign corporation), and 4970 (for accumulation distributions), among others. So, working as a team, especially in the first couple of years, is highly advisable.
- Ensure that investment advisors are placing title to the accounts with the proper entities, that the proper taxpayer ID is being used for each account, and that only the proper parties are given direction over investments or distributions with respect to the accounts.
- Make sure that all trust or LLC distributions are properly documented. For example, if an LLC holds investments and the LLC is owned by an asset protection trust with a third party trustee, and the trust beneficiary is asking for a distribution, the written record should ideally show a written approval of the distribution by the trustee based on the specified circumstances, a request by the trustee to the LLC manager for a distribution, written approval by the manager, and the distribution flowing first from the LLC to the trust, and then out to the beneficiary. And, of course, all of that must be in compliance with the specific terms of the governing documents, which will differ from case to case.
Your reputation is worth far more than any professional fee, no matter what. If you don’t feel good about a matter, then don’t take it on. Easy to say, but hard to implement, particularly if you are dealing with a long-term client. Nonetheless, in the long run you are not doing your client any favors and you are certainly not doing yourself any favors by taking on questionable matters.
Part of the fun, and risk, of asset protection planning is that it requires the lawyer or other planning professional to have multiple skill sets. In addition to the normal arsenal of estate planning tools, such as trusts, an asset protection planner needs to deal with real estate law, business and corporate law, income tax planning and its consequences (on state, federal, and foreign levels), international law, divorce law, environmental law, the differences in different states’ laws (nuanced or otherwise), ERISA, debtor/creditor law, myriad reporting requirements, geography (you ought to be able to at least identify Sioux Falls, South Dakota or Luxembourg on a map!), financial statement and tax return analysis, etc. Only a planner comfortable working with a palette of that nature, or at least having access to resources that can assist the planner in those areas, should be advising the client on asset protection strategies.
Clients commonly ask about the protection afforded to their 529 Plans. Illinois legislates that accounts invested in the Illinois College Savings Pool are exempt from the claims of creditors of the participant (i.e., the person who can direct investments, withdrawals, etc.), donor, or designated beneficiary of the account. The protection is limited to the estimated cost of tuition, fees, and room and board for 5 undergraduate years of education, which for 2024 was estimated at $350,000. The protection is further limited to amounts contributed up to the gift tax annual exclusion limits. Section 529 plans are similarly exempt under the Bankruptcy Code to the extent of amounts necessary to provide for the beneficiary’s education expenses (with certain exceptions for contributions made within 2 years of filing).
No court in the U.S. would deny a client that right.
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