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How Does an Asset Protection Trust Work?

Rebecca Lake
An attorney reviews the draft of a trust with his client

Trusts can be a useful addition to your estate plan if you want to create a financial legacy for your loved ones or minimize estate taxes. An asset protection trust is a type of trust that has a specific purpose – protecting your assets from creditors. Establishing this type of trust may be necessary if you’re concerned about your assets being attached as part of a lawsuit settlement or court judgment. If you’re considering an asset protection trust, it’s important to understand how it works and how to legally create one.

Asset Protection Trust, Explained

Asset protection trusts differ from other types of trusts in that they have a specific function: shielding assets against creditors. If you were creating a trust to pass on assets to your spouse, children or other beneficiaries, you might set up a revocable living trust. This way, you’d still have the ability to add or remove assets within the trust and direct the trustee on how to manage those assets on behalf of your beneficiaries.

An asset protection trust is irrevocable, meaning that any transfer of assets into the trust is permanent. In other words, the trust would own the assets in question and they would be managed by the trustee. By removing those assets from your ownership, you can protect them against creditor lawsuits.

For example, say that you’re having remodeling work done on your home and one of your contractors gets injured on your property. Your homeowner’s insurance only covers up to a certain amount of medical expenses so the contractor sues you to recoup the remaining costs. If you have an asset protection trust in place, they would only be able to attach assets you personally own to satisfy any court judgment they might win.

Types of Asset Protection Trusts

There are two kinds of asset protection trusts you can set up, depending on your needs and where you live. Domestic asset protection trusts can only be established in states that have laws which allow them. A foreign asset protection trust is essentially an offshore trust you can set up in jurisdictions outside the U.S.

Domestic asset protection trusts can be set up for a singular purpose, such as asset protection for Medicaid planning or asset protection for a special needs beneficiary. If Medicaid is necessary to help pay for long-term care, this kind of trust may be necessary to be Medicaid-eligible. A special needs asset protection trust could also make it easier to qualify for government benefits.

A foreign asset protection trust would be governed by the laws of whichever jurisdiction you’ve established it in, rather than U.S. law. The advantage is that if a creditor wins a lawsuit against you in a U.S. court, that judgment may not be enforceable according to the laws of the jurisdiction where your trust is held. Foreign asset protection trusts can also offer enhanced privacy protections when it comes to not disclosing which assets are held in the trust to third parties.

Pros and Cons of Asset Protection Trusts

An attorney discusses a trust with her clients

The biggest advantage of creating this kind of trust is being able to protect assets from creditors and lawsuits. Even if you’re not expecting to be sued by someone, having this type of trust in place could be helpful in the event that you end up facing a lawsuit.

An asset protection trust is something you might consider if you run a business, for example. You would have protection against personal injury claims as well as creditor lawsuits if you end up defaulting on business loans or lines of credit for any reason. You may also consider this kind of trust if you have a higher net worth and you simply want to ensure that your assets are safeguarded against creditors for your beneficiaries.

In general, trusts also make it possible for your heirs to skip the probate process once you pass away. Probate is a legal process in which an executor collects your assets, pays off any lingering debts and then distributes remaining assets to your heirs according to the terms of your will or state inheritance laws should you die intestate. Probate can be lengthy and costly but an asset protection trust would allow your heirs to avoid it for the assets included in the trust.

The main drawback of an asset protection trust is that it’s irrevocable. Once assets are transferred to the trust, you can’t change your mind and take them back out again. That could complicate estate planning if you have a change of heart about which assets you want to include.

Finally, setting up an asset protection trust can be time-consuming, not to mention expensive in terms of the attorney fees involved. You also have to factor in the ongoing fee which is paid to the trustee for performing his or her duties.

How to Establish an Asset Protection Trust

Asset protection trusts are more complex than other types of trusts and for that reason, it may be helpful to work with an estate planning attorney in creating one. Generally, there are two basic steps involved: creating the trust document and funding the trust.

When creating an asset protection trust document, you’d include the same things as you would with any other type of irrevocable trust. That means you’d need to choose a trustee and name the trust beneficiaries. You would also need to specify how you want the trustee to manage the assets held in the trust on behalf of your beneficiaries.

Funding an asset protection trust is where things can get a bit more complicated. Depending on the type of assets you plan to transfer to the trust, it may be necessary to establish a limited liability company prior to funding. You would also need to consider any potential tax implications of adding assets to this type of trust.

The Bottom Line

"Trusts" on a keyboard

An asset protection trust is a highly specialized type of irrevocable trust that can insulate your assets from creditor actions, including lawsuits. This type of trust can help you preserve wealth for future generations while also avoiding probate, though it may not be right for everyone. Talking with an estate planning attorney can help you decide whether one belongs in your estate plan.

Tips for Investing

  • Consider talking to a financial advisor about which assets you may want to include in an asset protection trust. If you don’t have a financial advisor yet, finding one doesn’t have to be complicated. SmartAsset’s financial advisor matching tool can match you with up to three local financial advisors, and you can choose the one who is best for you. If you’re ready, get started now.
  • Trusts are just one element you may need to include in your estate plan. A last will and testament is the most basic estate planning tool you can use to specify who will inherit your assets. You may also want to include a durable power of attorney or advance health care directive to round out your plan.

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