Generally, when you retain an interest in a trust you create, the trust is subject to your creditors’ claims to the extent of the interest you have retained, and perhaps to the full extent of trust assets. Also, because creditors have access to the trust assets, transfers you make to a trust in which you retain an interest -- even if the trust is irrevocable -- are not completed gifts for estate tax purposes and will be included in your estate at death.

The most reliable way to protect assets from future creditors and keep them out of your estate at death is to not retain any rights to the trust assets or income, including any right to control who receives trust assets. You may not, however, be inclined to give it all away with no strings attached or interests retained. Thus, you may have considered establishing trusts in certain foreign jurisdictions that provide for creditor protection even if the grantor holds a retained interest.

The New Domestic Alternative

Recognizing that trust asset protection is a sound and legitimate financial planning tool, some state legislatures have begun enacting statues that provide similar protection onshore. The Alaska Trust Act and the Delaware Trust Act were changed in 1997 to allow a grantor to create a trust that is protected from his or her future creditors even though the grantor has retained the right to receive discretionary distributions of income or principal.

This is because Alaska and Delaware trusts may prohibit a grantor who holds a beneficial interest in the trust from assigning, either voluntarily or involuntarily, his or her interest in the trust prior to the distribution of the interest to the grantor. This prohibition may also apply to the grantor’s current creditors as long as the transfer into the trust is not a fraudulent conveyance.

How the Trusts Work

Joe transfers $500,000 to a trust he has created outside of Alaska or Delaware. The trustee has the discretion to make distributions of income from the trust to Joe during his life. On Joe’s death, the trust assets will be distributed to Joe’s daughter.

If Joe then incurs a debt he is obligated to pay, the creditor can reach trust assets to the extent of Joe’s income interest. On Joe’s death, the entire value of the trust will be includable in his estate for estate tax purposes.

This would not be the result if the trust were now formed in Alaska or Delaware. Under these states’ statutes, the trust assets would not be available to Joe’s creditors, even though he has retained the right to receive trust income.

In addition, some would say that the trust assets should not be included in Joe’s estate at his death. Why? Because, they would argue, if the trust was formed in a state where the trust assets could not be reached by a grantor’s creditors, the transfers into the trust should be deemed completed gifts and, therefore, not includable in Joe’s estate.

Can Creditors Reach the Assets?

Although Alaska and Delaware offer greater creditor protection than most states, creditors may still be able to reach these trusts. The U.S. Constitution requires any state to enforce the judgments of any other state. Thus, a creditor can obtain judgment against the grantor outside Alaska or Delaware. Enforcement of the judgment, however, would also have to involve an Alaska or Delaware court, making it a lengthy process. Additionally, U.S. bankruptcy law extends to virtually all persons in the United States, so if bankruptcy law could void the transfer to the trust, Alaska or Delaware laws would not protect the assets.

Also, keep in mind that these new laws will not protect the trust assets if any transfer into the trust was intended to defraud creditors or avoid a judgment order for child support.

Weigh the Advantages of Domestic vs. Foreign Trusts