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Protect Your Family From Divorce and Creditors

Many good children lose their inheritance for various reasons: divorce, bankruptcy, litigation, or bad investments, just to name a few. Special provisions in a revocable trust with special protection provisions can help to protect family money. This article show how this could work, using a fictitious family of Bob and Mary and their four children, Rick, Patty, Becky and Matt.

Bob and Mary love all four of their adult children, but some of them are struggling through financial and personal difficulties. Rick is the oldest and most financially successful as a doctor. His parents know he won’t need financial support from them, but he often talks with them about other doctors who get sued by patients. Patty is the older daughter and went through a bruising divorce. Now she’s a struggling to get by, and she’s battling depression. Becky and Matt are each married, but they’ve had marital problems off-and-on.  Becky was raised to understand the importance of saving, but her husband often is between jobs and he tends to drink too much, too. Matt had a failed business, that has left him in debt but he’s working hard to get back on his feet. Each child has grandchildren who Bob and Mary adore, and except for Rick none of the other children have money to help pay for the grandchildren’s college education.

Bob and Mary want the best for their children, but they know money could be a problem for them. They worry about more divorces, and whether they could manage an inheritance. They also worry about lawsuits, from creditors or in Rick’s case from his patients. They’re also wondering how to help their grandchildren.

These are legitimate concerns. Half of all marriages end in divorce in our country. We live in a litigious society, with millions of lawsuits filed every year. And with tough economic times many people face high credit card debts, just a few months away from bankruptcy if they lose their job or have a severe illness.

Mary and and Bob also worry about their own situation. While they have a nice retirement nest egg, they wonder what would be left for themselves or their children if they need care at home or nursing home care. After dealing first with how to plan ahead for Bob and Mary’s own retirement and care needs while either is living (through long-term health care planning), their attorney asks about their children. After listening to their concerns, it’s clear that unless Bob and Mary plan ahead the children’s inheritance easily could be lost to creditors, or squandered, or paid to an ex-spouse for a divorce settlement.

What should Bob and Mary do about planning for their children’s (and grandchildren’s) inheritance?

The answer will be to add special provisions to a living trust to make it a Family Protection Trust, sometimes called a “Bloodline” or “Dynasty” trust. These trusts continue to be managed by a trustee after the parents’ death. The trust could continue for the life of the children and could, if the grantor chooses, continue for the life of grandchildren, too. The trust benefits the children and grandchildren, but it limits their direct access to the money in the trust. The trust funds can be available if needed but only if the Trustee decides.  In that way, these funds can be protected for descendants.

The very wealthy typically use similar trusts, sometimes called “spendthrift” or “generation-skipping” trusts. Spendthrift trusts protected beneficiaries from themselves, so that family fortunes wouldn’t be lost by a child who spent money foolishly or fell into the wrong crowd. Generation-skipping trusts passed funds through trust to grandchildren, to avoid having multi-million dollar taxed in the children’s estates.

Bob and Mary don’t consider themselves wealthy. But they have accumulated enough to be comfortable and they expect their assets to continue growing because they are sure to live within their means. But they can see how trust planning could help themselves and their children. They want to learn more and they find out that the Family Protect Trust can offer valuable protection, against:

  • Divorce: Because ultimate access to the trust funds depend upon the Trustee’s consent, a divorcing child won’t have to surrender part of his or her inheritance to an ex-spouse if it’s held in a Family Protection Trust. While everything is generally on the table in the event of divorce, the funds will not be considered a marital asset and there was never any risk that the inheritance was received and then co-mingled with other marital assets.
  • Creditors: The Family Protection Trusts can shield trust assets from creditors and from eventual bankruptcy.
  • Lawsuits: Like creditors, plaintiffs in lawsuits cannot attack assets held in the Family Protection Trust. Rick’s inheritance could be protected even if he gets sued by a patient for malpractice.
  • Bad judgment and Addictions: Even good children can get into trouble through bad luck, bad judgment, or drug or alcohol addictions. An independent trustee overseeing the Family Protection Trust can protect a trust beneficiary from losing everything. This can also protect the beneficiary from being pressured by a spouse or grandchild for wasteful or foolish spending. Becky’s husband can’t pressure her for extra money when her funds are in trust rather than in her own bank account.
  • Illness and Disability: If a child has an extended illness, or has a stroke or debilitating disease, large medical bills not paid by insurance could wreck their inheritance and leave them (and their family) impoverished before being able to get help through Medicaid medical assistance. Without the Family Protection Trust, the child would need to spend down assets in their own name before becoming eligible for Medicaid. The Family Protection Trust can be a cushion against losing everything and help supplement what Medicaid won’t pay for, and help the family get back on their feet.
  • Estate Taxes: With the estate tax threshold over $5,000,000 now, very few people paying estate taxes. Still, there’s no reason to pay if you don’t have to. A Family Protection Trust can keep funds out of a child’s estate so it passes to the grandchildren tax-free.

Bob and Mary wonder whether this sounds too good to be true. The like the benefits, but they wonder if there are drawbacks. Their lawyer goes over some additional considerations, before they decide to proceed, as follows:

  • Costs: Bob and Mary will have to pay legal fees to set up the trusts, but that investment is relatively small compared to the potential savings. During their lifetime, Bob and Mary will be managing their own trust, so there are no ongoing management fees until after they die. The trusts will need to be administered for the children and grandchildren after Bob and Mary have passed on. This will involve administrative costs for preparing the trust’s annual income tax return. And if there is a professional trustee, the trust will pay a management fee each year, usually about 1 percent of trust assets. There may also be administrative fees for preparing annual reports to the beneficiaries, to keep everyone informed about their own trust. Still, these administrative costs are minor compared to the potential savings.
  • Restrictions: This is the final test. By setting up the Family Protection Trust you are providing protection but limiting the trust beneficiary’s control Some beneficiaries may resent not having complete control and access to their trust funds. Which is the right decision for that? It is really a trade-off that Bob and Mary will need to decide.

After deciding to go forward with the Family Protection Trust, Bob and Mary need to make a few more decisions in consultation with their lawyer. For example, these include the following:

Who will be trustee? The toughest decision for any trust is selecting an appropriate trustee. For a Family Protection Trust the best answer is a professional trustee, such as a bank, trust company or law firm, so that the trustee is independent and not a family member. But these trustees will charge for their services, although the cost for services is justified by the trustee’s experience and judgment. The alternative would be to have another family member or family friend serves as trustee. Or each child could be trustee of his or her own trust. Each of these options other than the professional trustee brings extra risks and cautions. For example, a child serving as trustee must follow the terms of the trust. Otherwise the trust may be attacked years later as a sham. Moreover, if there is a possibility of litigation or bankruptcy, the child serving as trustee should resign hopefully years in advance of the problem and appoint an independent trustee. Bob and Mary see this choice between (a) maximum protection versus (b) giving their children more control and reducing costs, but with certain protection.

When and what assets be distributed? Mary and Bob can also set the rules for when the trustee distributes trust income and principal to their children and grandchildren. Often all trust income – interest and dividends – is distributed annually. Distributions of principal (the investments themselves) would be treated differently by letting the trustee decide when and how much to distribute. Bob and Mary could leave that decision entirely in the trustee’s discretion, or have the trustee make distributions for necessities such as health, education, support, and maintenance. Another common provision is allowing a child the absolute right to withdraw up to 5 percent of trust principal each year. The right to access some of the principal regardless of what the trustee says could make the children more comfortable with an independent trustee.

Based on what they know and wanting to do the best for themselves and their children and grandchildren, Bob and Mary set up Family Protection Trusts. Now they have peace of mind knowing that their hard-earned savings won’t be wasted or taken from their children. Bob and Mary still worry about their children and grandchildren. They plan to to continue helping their children as long as they can when it makes sense to do so; Then when Bob and Mary can’t make those decisions whether due to incapacity or death their trustee will take over that role. What a wonderful feeling. Now Bob and Mary relax a bit, and look forward to the next visit with their grandchildren…