Our previous blog covered the different ideas of Family Wealth Preservation and the ways children can lose the inheritance they are given. This blog discusses how a trust can be used to protect the inheritance for the children.
Instead of passing the inheritance to the child outright, the parents’ estate documents can create a trust for the child. But there are many different provisions that affect how the trust operates. There are three specific provisions that are important to how strongly or weakly a trust protects the inheritance.
Provision 1 – When does the trust terminate?
The trust can only protect the inheritance if the inheritance stays in the trust. Many trusts have mandatory termination provisions when the child reaches a certain age. Sometimes the provisions spread the termination out over several ages. It is very common to see termination provisions that force the inheritance out of the trust in one-third portions – for example, a third at age 25, a third at age 30, and the last third at age 35. Once the inheritance comes out of the trust, all the protection the trust provided is gone. To protect the inheritance, the trust should last for the child’s lifetime. There should be no mandatory distributions just because the child reaches a certain age.
Provision 2 – When do distributions of income come out of the trust?
Continuing the theme from above, the inheritance can only be protected if it is in the trust. Some trusts have provisions that mandate that the trust income must be distributed to the child in periodic installments. If the trust has an investment that earns 5%, then that income would have to be distributed out of the trust to the child. Often the payments of income are made monthly or quarterly. To protect the inheritance, there should be only discretionary distributions.
Discretionary distributions are made by the trustee under certain criteria. Usually, the distribution criteria is very broad and includes expenses related to health, education, maintenance, and support. To protect the inheritance, the trust should have no mandatory distributions of income. Only discretionary distributions should be allowed.
Provision 3 – Spendthrift Clause/Creditor Protection
A trust can contain a provision that prohibits a trustee from making any distribution to a child’s creditor. If a child owes a debt, even if the lender has a judgment against the child, this spendthrift provision prevents a creditor from forcing any of the child’s inheritance out of the trust to pay off the debt. These provisions often also prevent a child from “trading” his/her position as a beneficiary of the trust to pay off a debt.
Now that we have seen how a trust can protect the child’s inheritance and the particular provisions that can make this possible, let’s apply them to specific situations.
1. Protecting Inheritance from a Child’s Divorce.
Inherited assets are not normally subject to a divorce as long as the child keeps the assets separate from the spouse. Once the inherited assets are commingled with the spouse, they become marital assets subject to the divorce. By keeping the inheritance in the trust, it will be difficult for the spouse to argue that the inheritance was commingled and transformed into marital assets. Also, mandatory distributions of trust income could show that the child has greater cash flow and resources. This could hurt the child in dividing the marital assets and the calculation of martial support. The spouse’s argument could be that because of the mandatory flow of money from the trust:
- 1. The child needs less of the marital assets, giving more to the spouse; and
- 2. The child has more cash flow and needs less support from the spouse, or can afford to pay the spouse more support.
Having discretionary distributions makes the flow of cash uncertain and difficult to include in a divorce analysis.
2. Protecting from a Child’s Spouse.
It would be great if children only married wonderful people, but that is not always the case. Using a trust to hold the inheritance keeps control of the wealth with the child and the family. The real issue is who is the trustee. Many clients opt to have co-trustees. One is the child and the other is another family member or independent advisor. With this combination, the child, as a co-trustee, has a voice in how the inheritance is managed and utilized. But, because a second co-trustee exists, there is always someone else serving to make sure the inheritance is used only for the child and the child’s descendants – not the spouse. This prevents the inheritance from being used by the spouse and his/her children from a prior marriage.
3. Protecting from a Child’s Creditors.
It is easy for a parent to protect the inheritance from a child’s creditors by using a trust. If the trust is drafted properly, Tennessee, like most other states, has specific laws that prevent a child’s creditors from reaching into a trust created by a parent (or anyone other than the child) for assets to pay a debt. Even if the child declares personal bankruptcy, a properly designed trust can prevent the child’s creditors from reaching the inheritance.
But, if the inheritance comes to a child outright, then it is much more difficult, maybe impossible, for the child to protect the inheritance from his/her creditors. So long as the inheritance is kept in the trust, it should be protected from a child’s creditors.
Don’t Leave Your Child’s Trust At Risk
Based on the above, we recommend to almost all of our clients to hold the child’s inheritance in a trust, and not give them the inheritance outright.
If you have any questions or comments about this topic, please do not hesitate to contact the estate planning lawyers at MHPS.