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Asset Protection: What You Really Need to Know

By Helena S. Mock

What do we mean when we talk about “asset protection?” In some cases we are talking about protecting assets from our own creditors or from future estate taxes. In other cases we are talking about protecting our own assets from the high costs of home health and long-term care. And, in some cases we are talking about protecting assets we leave to our children from their creditors, from their spouses, and from their spouse’s creditors. The key in all cases is that the person you want to protect cannot have unlimited access to the assets you want to protect because if you can get to the assets, so can your creditors.

In this article, we will focus on protecting your own assets from your creditors for either estate tax or long-term care purposes. The best vehicle for doing this is the Asset Protection Trust. Virginia law does allow a settlor (also referred to as a “grantor”) to create a self-settled spendthrift trust which is shielded from the reach of creditors. In order for the assets to be protected, the trust must be a “qualified self-settled spendthrift trust” as defined under Virginia law. The law requires that: (1) the trust is irrevocable; (2) the trust is created during the settlor’s lifetime; (3) there is, at all times when distributions could be made to the settlor, at least one beneficiary other than the settler to whom income and/or principal may be distributed; (4) the trust has at all times at least one qualified trustee; (5) the trust instrument expressly incorporates the laws of the Commonwealth of Virginia to govern the validity, construction, and administration of the trust; (6) the trust instrument includes a spendthrift provision that restrains both voluntary and involuntary transfer of the settlor’s qualified interest; and (7) the settlor does not have the right to disapprove distributions from the trust.

Asset protection plans can only protect against potential future liability, not liabilities that have already been incurred. This is not only true from an ethical standpoint, but also from a legal one, because the law provides that any transfers made once a liability has been incurred will be deemed to be fraudulent. Further, for Medicaid purposes, there is a five-year look-back period. Any transfers made to a trust or otherwise within five (5) years of applying for Medicaid are deemed to be fraudulently made for the purpose of qualifying for Medicaid. Therefore, pre-planning is essential. If you wait until there is a need for long-term care, it’s too late.

The Asset Protection Trust is a self-settled irrevocable trust that is created to hold certain assets and, as a result, you are no longer deemed to own those assets. You must give up control over the assets in the trust. You can, however, name someone who would have access to the trust assets for the benefit of your children or whomever you choose to name as beneficiary(ies). Additionally, in some cases you can give that person the discretionary authority to make gifts to you of the principal of the trust. For this to work, however, that person cannot be a close relative (i.e. spouse, sibling, child) but could be an in-law, cousin, or more distant relative.

You may choose to retain an income interest in the trust such that you and/or your spouse would receive all of the income generated by the assets in the trust on a regular basis. And you may elect to characterize the trust as a “grantor trust” for income tax purposes, which means that all of the taxable income generated by the trust would be taxed to you even if not entirely distributed. Certain types of income such as capital gains are generally not distributed. Thus, if a property valued at $100,000 was placed in the trust and then later sold for $150,000. The additional $50,000 generated by the sale would not be considered income for trust accounting purposes and would not be distributed to you. Instead it would remain in the trust but still be taxed to you as a capital gain on your personal income tax return.

You could also elect not to treat the trust as a grantor trust. In this case, any transfer of assets into the trust would be considered a taxable gift for gift tax purposes, but the income generated by the trust would not be taxed to you. If using the trust as a Medicaid planning vehicle, you may not wish to retain an income interest and instead allow the income to be distributed to your children or to simply accumulate in the trust. Note, however, that income that accumulates in the trust will be taxed to the trust at the trust’s higher tax rate.

As the funding of any irrevocable trust essentially requires you to give up the benefit and control of the assets in the trust, it is important that we first discuss issues such as your cash flow needs, which requires an analysis of your monthly income and expenses, and your comfort level with giving up control of your assets and how much you trust your children. You may choose to keep some of your assets outside of the trust for liquidity purposes.

Virginia law does permit the termination of an irrevocable trust where the grantor and all beneficiaries agree. It is also possible to grant an independent person (someone unrelated to you) the power to terminate the trust under certain circumstances or simply in that person’s discretion. This person is commonly referred to as the Trust Protector. Because these trusts are irrevocable, they completely disappear from your financial statement since the assets owned by the trust no longer belong to you. For financing purposes, this may make it difficult to obtain additional loans because you can no longer show the property as an asset. However, for asset protection purposes, the fact that the assets no longer belong to you completely removes them from the sight of any potential creditor.