Lots of legal changes are coming for Californians. These changes may have profound impact on our tax liability, as well as in estate, business, and asset protection planning. Federal tax reform is getting the most news these days in popular media, but other legal reforms are also taking shape– in asset protection, property tax, retirement planning, and more. This article explores some of the more pertinent changes in asset protection planning, and discusses a few strategies to consider today.
1. Changes in Asset Protection Law
At the Law Offices of John C. Martin in Menlo Park, California, our attorneys have consistently advised clients to think twice about leaving an inheritance to children (or others) outright and free of trust. Granted, an outright inheritance is the simplest and the least expensive (in terms of initial administrative cost) way to gift assets to beneficiaries at death. Yet, as with all estate planning decisions, the goals of simplicity and low cost may be outweighed by other goals, including the desire to provide asset protection or third party management.
In California, the facts demonstrate the compelling case for asset protected trusts: (1) We live in the most litigious state in the nation; (2) rates of divorce are above 50%; and (3) during our lifetimes, we will most likely not see the end of the economic cycles of boom and bust. As such, whether to asset protect an inheritance is not solely a question of confidence in the capabilities of a child (or spouse, for that matter.) Rather, the facts of litigation, divorce, and general brokenness in our society also need to be considered.
Many who have left an inheritance to a child in trust may now feel confidence that creditors will not be able to reach the trust assets. Usually, such trusts provide that a third party trustee may make distributions for a beneficiary’s proper “health, education, maintenance, or support.”
However, two recently cases demonstrate the assault on trusts with such language in California: Carmack v. Reynolds, a 2017 California Supreme Court case, and a 2016 9th Circuit case, United States v. Harris. Both cases call into question the limits of statutory protections afforded to beneficiaries of discretionary trusts. Before these cases, it was assumed that a creditor could only claim 25% of a mandatory distribution under a trust (since that was how the law appeared to read). Now, these cases establish that a creditor can seize 25% of anticipated future mandatory distributions from the trust as well, which effectively expands the ability to collect beyond 25% of a mandatory distribution. Indeed, after these cases, it is difficult to determine what a creditor can’t reach.
As a result, we need to reconsider the drafting of third party discretionary trusts. Some potential solutions are: (1) including a third party trustee with absolute discretion over distributions, such that no distributions are deemed to be “mandatory”; (2) including a “decanting” provision to permit the trust to be re-sitused in a jurisdiction which is more debtor friendly, such as Nevada; (3) including trust protector provisions enabling the trust to be revised, transferred, or otherwise safeguarded in the event of changed circumstances; or (4) Funding a private retirement plan. This last strategy is discussed in more detail, below. Keep in mind, however, that these “fixes” have important limitations that make asset protection law increasingly challenging in California.
2. Private Retirement Plans
Recent court decisions like Carmack and Harris might make it appear that California is the most creditor-friendly state in the Union at the moment. That may be a fair statement. However, there still exists an often ignored asset protection strategy that is available in California: the use of private retirement plans to shield assets from creditors, including during bankruptcy. Indeed, bankruptcy law practitioners would likely be committing malpractice if they did not inform their clients of this important asset protection tool.
In California, it is possible when filing for bankruptcy to elect as between the applicability of Federal or California exemption statutes. If an asset is exempt under the chosen statute, it is generally not available to satisfy claims out of the bankruptcy estate. One asset class which is exempt under the California statute are assets held in a retirement plan. This includes ERISA qualified and non-qualified plans, which in turn includes private retirement plans.
When used properly, substantial wealth can be transferred into a private retirement plan in order to asset protect an estate, with significant benefits. Such benefits include the following:
– The private retirement plan can be drafted as a grantor trust. As a grantor trust, the grantor of the trust (generally the client) is taxed on all of the income in the trust. As such, there are no income tax consequences upon transfer of assets to the plan. Moreover, there will be a step-up in basis for assets in the plan at the time of the client’s death.
– Any assets can conceivably be transferred to a private retirement plan, provided that the purpose of the transfer is for the transferor’s retirement. Cases analyzing the propriety of private retirement plans (as well as the transfers thereto) look closely at the facts surrounding the purpose of the plan and the nature of the underlying transfer of assets. Were the assets retirement assets? Was there evidence that the transfer was primarily intended to fund the transferor’s retirement? If so, a secondary purpose to avoid claims of one’s creditors may be acceptable to the courts. Even the equity in a home (through a process called “equity stripping”) could conceivably be transferred to a private retirement plan and asset-protected, provided that the facts indicate that the primary intent was to provide for the transferor in their retirement. [Albeit, caution should still be exercised in that a court may not agree that the primary purpose of equity stripping a home was to fund the client’s retirement].
– There is no limit to the amount of contributions that can be made to the plan. Essentially, all of a client’s assets can be asset protected provided that the requirements are met.
Would a transfer to the Private Retirement Plan be a voidable transaction under California’s new Uniform Voidable transaction Act (UVTA)? This is always something that can arise, particularly in California, and the inquiry is fact specific. However, at least one case in California upheld a transfer into a private retirement plan the day before the defendant filed for bankruptcy. The court reasoned that since the private retirement plan was clearly intended to support the debtor in his retirement, the state’s policy to get these retirees off the government doll, so to speak, outweighed the interests of creditors in reaching the policy. That’s at least some good news for debtors.
3. Conclusion: Stay Tuned
As always, everyone’s life circumstances are unique. The law also may not go the direction we predict in this article. That’s why it’s always important to consult with an attorney before acting on the contents of this article. If you take anything away, let it be that there are no guarantees when it comes to asset protection planning. It’s better to think of asset protection planning in terms of “enhancing” the protections afforded to our beneficiaries through trusts and other legal strategies. To help anticipate these and the other changes that are sure to come down the road, consult with a certified specialist in estate planning, trust, and probate law, as well as competent financial and tax advisors.