Making Tax Saving Gifts, Protecting Assets and Your Personal Rainy Day Fund

$5,000,000 Exemptions Disappearing Fast. The $5,000,000 exemptions from estate, gift and generation skipping taxes are set to expire by law on December 31, 2012. To prevent this from happening, Congress and the President have to agree to a new law before then. In the heated political debates of a Presidential election year, it looks likely that if anything is done, it will be done at the last moment and no one can predict what the new tax law will be.

Fred’s Business. Fred has a business worth $5 million and other assets such as his home and savings worth $2,000,000. Under current law, if Fred dies in 2013, the federal estate exemption will be $1,000,000.  If Fred is a DC or Maryland residence, then Fred could pay DC or Maryland state estate taxes in additional to federal taxes. This means with a $7,000,000 estate, Fred’s federal and state estate tax bill could be over $3,000,000.  The estate tax of $3,000,000 is due nine months after death in cash, unless you follow all of the technical rules to request more time to pay the tax and the Internal Revenue Service decides, in their discretion, to grant you more time to pay the tax. If you don’t pay the tax on time, there can be a 25% penalty, monthly interest and a forced sale of the assets of the estate. Basically, this means that the business has to be sold to pay the estate taxes, perhaps at fire sale prices.  The business is gone and Fred’s family loses its source of income and most of its savings.

Fear of Gifting. A lot of people are waiting on the sidelines and not planning to make large gifts this year, even though for sound tax planning, they should. The biggest fear of an older person is that they will not have enough money to live on and will be wandering the streets as a bag lady.  The US and European governments are running large deficits and many well informed observers think that this could cause high inflation, government cut backs, higher health care costs and higher prices for energy and other imported goods. A cushion of $2 million today could only have the buying power of $200,000 in ten years.  This has happened in the past and is happening today to retirees in other countries.

Tax Dilemma. In the past, to make a gift and to make sure that it was a completed gift and out of your taxable estate, you had to follow strict rules and could not retain any ability to get any of the money you gave away. If you retain too many strings, then the IRS will take the position that you never really gave the money away and it is still subject to estate taxes in your estate. Following the Fred example, if, on paper, Fred gave his business to his children but retained all of the income and control of the business, then the IRS would be likely to say the full value of the business was still part of his estate.

APT to the Rescue.  Virginia has passed a new Asset Protection Trust (APT) and about 11 states have similar provisions. If you comply with the state APT standards and the IRS rules for making a completed gift, then you can protect your assets, save estate taxes and still retain the ability to receive some of those funds in case one of the disaster scenarios actually happens. In other words, you are able to make the gift, but can get some of it back if you really need it.

First: Comply with State APT.  To accomplish this, your first have to comply with the State Asset Protection Trust requirements. See our blog on the Virginia APT requirements.

Second: Comply with Tax Requirements. In Private Letter Ruling (PLR) 200944002, the Service laid out a road map on how to set up an APT where the assets will not be part of your taxable estate, even though you could still receive distributions if you need them. This is what you should do:

(1)  Qualified Independent Trustee. You have to use a trustee, such as a trust company or a CPA that fulfills the requirements under the tax code and the Virginia APT law as a qualified and independent trustee. The trustee cannot be you or your family members.  You can use Trust Protectors to remove wayward Trustees.

(2) Rules for Distributions or Property Use. Use and distributions of trust assets must either be in the sole discretion of the Trustee or follow the tax rules for a qualified residence trust, charitable remainder trust or IRS qualified annuities.

(3) You Cannot Change the Beneficiaries if the Trust Terminates or You Die. You decide who you want to receive the money after your passing or after a set time period and the lawyer puts these rules in the trust agreement. Once the heirs are designated in the trust agreement, you can’t later change who will receive the funds after you.  

(4)  No Power to Reacquire the Property. You can’t have a right to get the property back.

(5) No Taxes Paid.  The Trustee may not use the income or assets of the trust to pay your income or estate taxes.

(6)  Your Creditors Cannot Reach Assets.  The trust has to qualify under the applicable state statute as an Asset Protection Trust. If your creditors could reach the assets in the trust, then the assets can be part of your taxable estate. This is where the APT adds a new dimension to make this whole thing work. Without the APT features, the IRS may seek to bring the assets back into your estate.

Auntie Mae.   Auntie Mae has $4,000,000 in various investments and income from social security, her deceased husband’s pension, her own retirement funds, and a paid off house. She lives on her pension income and she saves all of her investment income. Auntie Mae has always spent her money carefully and she is unable to change these lifelong habits.  Her tax advisors tell her that with a $1 million exemption from estate taxes, she will pay over $2,000,000 in estate taxes given her savings rate and life expectancy. Her advisors suggest that she could safely give away $2,000,000 this year and not pay any gift or estate taxes at this time on this gift.  She is afraid that she will need the money in the future. She decides to set up an APT that meets all of the State and tax legal requirements.  During her lifetime, she has the comfort that if she does run low on funds, her trustee (her trusted CPA) will send her money for her living expenses from the APT.  After she dies, it turns out that she never used any of the money from the $2,000,000 she put in trust for the education and future of her grandchildren. After she passes, the assets in the trust are worth $3,000,000 and there is no estate, gift or generation skipping taxes on the $3,000,000. Her grandchildren have a solid start in life with $3,000,000 of protected assets.

Don’t Try this at Home.  This type of planning requires careful professional help and an understanding that the IRS has not issued final and reliable regulations in this area.  The above PLR is a private letter ruling. This means that it cannot be used as support in your case; it can only be used by the taxpayer who obtained the ruling. However, the “tax logic” of the PLR is persuasive and largely based on other prior IRS rulings.

This blog cannot be relied upon as tax advice or to avoid penalties. Do not take any action based upon this information in this blog without consulting your own tax advisors.

Protecting Your Assets: Part II Virginia APTs; Existing Creditors.

Part II. This is part two of our summary on the new Virginia Asset Protection Trust (APT).  See Virginia’s New Asset Protection Trust.  In Part I, we discussed the basic requirements for a Virginia Asset Protection Trust under Sections 55-545.03:2 and 55-545.03:3.

There are several details which make this Virginia APT very useful:

*No Automatic Set Aside As a Fraudulent Transfer. In the past, a creditor had a powerful tool to attack an APT by arguing to the Court that the mere existence of the APT was sufficient proof that the purpose of the APT was to delay, hinder or defraud creditors. If the creditor proved that, the Court had the power to dissolve the trust as a fraudulent transfer.  Section 55-545.03:2 states that the mere creation of this APT is not enough to show such fraudulent intent.  Instead, now the creditor must be able to show more than just the transfer and the creation of the trust.  For example, the creditor would have to prove that you had no assets to pay your bills after you made the transfer to the APT.

*5 Percent Permitted. You can receive up to five percent of the value of the trust on an annual basis and that 5% does not set aside the protection features.

*Personal Residence Trust. You can protect your residence if you use a qualified personal residence trust that meets the tests of the tax code.  This trust can only be for your primary and secondary personal residences and required associated funds.

*Annuities. Certain grantor annuity interests can be protected.

*Pay Inheritance Taxes. The money in the trust can be used to pay inheritance taxes.

*Charitable Remainder Trust. You can protect assets in a charitable remainder trust.

*Pay Income Taxes.  The trust income and assets can be used to pay income taxes on income you receive from the trust.

*People Will Not Be Afraid to Help You. Planners and attorneys will be more willing to help you do this type of planning. The new law specifically states that a creditor has no claim or action against a trustee, planner or attorney for helping you set up this APT.

*Strengthens Existing Foreign APTs. The new law will strengthen in Virginia the enforcement of existing asset protections trusts formed in other states or countries. Virginia no longer has a strong public policy against these APTs which would encourage a Virginia Judge to set aside an APT from another state or country.

*Protection from Existing Creditors. You can protect assets from existing creditors. An existing creditor has five years from the date you transfer the assets to reach the assets in the trust. If the existing creditor does not sue in the five years after the transfer, even the existing creditor cannot reach the protected assets. 

Do It Now. There is a motivation in the new law to transfer as much as advisable as soon as possible to an APT.  For existing creditors, the five years begins to run the day you make the transfer to an APT. An existing creditor can only reach trust assets that have been transferred within the last five years when the creditor makes their claim.  But, any distributions out of the trust are deemed to come first from the most recent contribution.

Sally’s Trust.  In 2012, Sally sets up a qualified Virginia APT for her and her granddaughter Sandra. In 2012, Sally transfers $1,000,000 to the trust. In 2015, Sally transfers another $500,000 to the trust. In 2018, a creditor obtains a judgment against Sally for $2,000,000 for a debt that Sally owed in 2012 when she set up the APT. Even with the $2,000,000 judgment, Sally is not bankrupt. Since the creditor’s judgment was entered more than five years after Sally’s transfer of the $1,000,000 in 2012, the creditor cannot obtain the $1,000,000 Sally transferred in 2012.  The creditor requests that the Court distribute to the creditor the $500,000 transferred in 2015, less than five years from the judgment in 2018.  However, the trustee of the APT has distributed $500,000 from the APT to Sally and Sandra prior to the judgment of the creditor.   Because the $500,000 distribution is deemed to have been made from the latest transfer in 2015, there are no funds in the APT that the creditor can obtain.

Fraud & Bankruptcy. These new APTs can still be set aside if the existing creditor can show intent to defraud the creditor under Virginia law or federal bankruptcy law. Section 548(e) of the federal Bankruptcy Code allows the bankruptcy court to set aside a state APT for ten years from its establishment where there is compelling proof of an intent to defraud, hinder or delay a creditor in the set up and operation of the APT.  Therefore, in the set up and operation of these APTs, it is very important to show there was no intent to hinder, delay or defraud creditors and also to avoid bankruptcy court.  By using these APTs for other purposes, such as for estate tax planning, a personal residence trust or for charitable planning, there will be proof that there was a purpose other than to protect the assets from creditors.  There was case in the Alaska Bankruptcy Court, Battley v.Mortensen, where the bankruptcy court set aside a valid Alaska APT on the basis that there was proof of intent to delay, hinder or defraud creditors.

Bottom Line:  If you live in Virginia, you have a new powerful tool that will go a long way to providing you additional asset protection if you correctly set up and operate this trust.

Virginia's New Asset Protection Trust

Virginia’s APT.  Joining Delaware, Alaska, South Dakota and several other states, Virginia has enacted a new law that allows a Virginia resident to set up an Asset Protection Trust. Passed without any opposition, the new code Sections 55-545.03:2 and 55-545.03:3 will be effective July 1, 2012.  This is a major change in the law of trusts in general and for Virginia specifically.

Fred Loses. Fred set up an irrevocable trust in 1995 which he thought would protect his assets, prior to the new law. Fred has an auto accident in 2012 and is sued for $2,000,000 and his insurance only covers up to the maximum limit of $250,000 on his insurance policy. Fred loses all of the assets he transferred to the irrevocable trust to his auto accident creditor.

Sarah Wins. Sarah sets up an Asset Protection Trust on July 1, 2012 and transfers $1,000,000 to it. The APT meets all of the qualifications under the new law. On September 1, 2012, she has an auto accident and ends up with a judgment for $2,000,000 against her. Even with the judgment, Sarah is not bankrupt. Since Sarah’s liability from the auto accident occurred after she transferred the $1,000,000 to her APT, all of her assets in the APT are not subject to the claims of the auto accident creditor.

Qualified Self-Settled Spendthrift Trusts. The reason for this dramatic difference in results is that the new Sections 55-545.03:2 and 55-545.03:3 set aside the common law of many centuries that says that if you set up a trust and put assets in it, the assets in that trust will not be protected against the lawsuits of your creditors, now or in the future. This rule applies to a “self-settled” trust (one you set up for yourself). See the codification of this self-settled trust rule under Virginia’s version of the Uniform Trust Code, Section 55.545.05. The new law says if you meet the requirements of Sections 55-545.03:2 and 55-545.03:3, the self-settled trust rules will not apply to you and your trust and the assets in the trust will be protected from future creditors.

Old Wine Bottle, Different Taste. The APT document will be familiar in the way it looks to those who already have a trust, revocable or irrevocable. You will be able to transfer assets to the APT trust you create, get income or take out assets from this trust and have the assets protected immediately from future creditors. For any existing creditor, the existing creditor must file suit within five years of the transfer of the asset to be able to reach the assets in the trust transferred five years ago. What is different is that a trust that had this structure in the past did not protect you, but now it does.

APT Requirements: The requirements for the trust to qualify as an Asset Protection Trust under Sections 55-545.03:2 and 55-545.03:3 are:

1.  Irrevocable. The trust must be irrevocable. This means you cannot change it after you sign it. But, you will be able to decide who receives the assets after your passing as long as it is not paid to your estate or creditors of your estate. You usually do not want such a power to leave it to creditors or your estate if you are planning for grandchildren. There is substantial guidance on what is deemed revocable and not revocable.

2.  Do It While Alive. You have to create the trust while you are alive.

3.  At Least Another Beneficiary. There has to be at least one other beneficiary.

4. Discretionary Benefits Only. You can only receive principal or income in the sole discretion of an independent qualified trustee based upon “ascertainable standards”. This means the trustee can make distributions for your health, education, maintenance and support (meaning your normal living expenses).

5.  One Qualified Virginia Trustee. There has to be at least one person or company that is a qualified trustee-that is, someone who will handle trust administration in Virginia who lives or is licensed as a trust company in Virginia.

6.  Some Virginia Property. To be a qualified trustee, the qualified trustee has to have custody within Virginia of some or all of the property.

7.  Virginia law. Virginia trust law must apply.

8.  Spendthrift Trust. There has to be a provision that the trustee and you cannot pledge the assets for a loan or an annuity.

9.  No Veto. You cannot veto any distributions.

Sally’s Plan. Sally wants to set up trusts for her children and grandchildren and wants to transfer substantial dollars to these trusts. She is reluctant to do so because Sally is afraid she will have very expensive health care costs in the future and wants to make sure she will have enough to live on in the future. She sets up a Virginia APT with her Virginia accountant as the trustee and with her granddaughter Alice as a beneficiary and with Sally as a contingent beneficiary. Sally transfers $1,000,000 to the Alice trust. Sally is solvent at the time of the transfer. If Sally needs the money for her health or living expenses in the future, Sally can receive distributions. The assets are protected against most creditors of Alice and Sally and can be used for the education, health and other needs of Alice.

Contact us to see if such a trust will benefit you. Note that exiting creditors and the bankruptcy laws must be considered. Please note that state APT’s can be set aside for a ten year period if there can be proven an intent to hinder, delay or defraud creditors and you file for bankruptcy protection.

Next: See Part II as to how flexible this new Virginia APT can be for you.

Most Trusts Do Not Protect Your Assets; Asset Protection Trusts; Revocable and Irrevocable; US and Offshore

Bank Tells Her A Trust Will Protect Her. Sally called our office for an appointment to set up a trust to protect her proceeds from a new credit line to be placed on her home. She wants to protect the proceeds of the loan from her creditors and her Bank told her to set up a trust to do that. It is common for many people to think that a revocable living trust protects them from their creditors. It usually doesn’t. We told her the appointment was not a good use of her time and money. Instead, we helped Sally set up an LLC.

Self-Settled Trust. There is a legal doctrine in trust law or state statute in most states that says a self-settled trust does not protect you from past, present or future creditors. The policy behind this law is that you should not have the ability to set up a trust and remove those assets in the trust from your creditors. Otherwise, everyone would set up a trust and if they had a judgment against them, the owner of the judgment or the credit card company could not get a court order to take over the debtor's bank account. No one would have to pay their debts.

Modification of Self-Settled Trust Law. Certain states, such as Delaware, Alaska, Virginia and South Dakota have passed new statutes that alter the self-settled trust doctrine. In very general terms, these new laws allow you to set up an Asset Protection Trust (APT) and place assets in it and these assets may be not subject to what you will owe new creditors in the future. They are usually strong restrictions on what funds you can take out. Also, federal bankruptcy law overrides state law and may open up the state law APT to attack for ten years. If you are resident of a state that still has a self-settled trust law, but have an APT in Delaware, Alaska, Virginia, South Dakota or other state than allows you to set up an APT, then your local court may choose to apply the law of your state and not the law of the state of the APT and bust up your APT.

Offshore. Offshore, the story is completely different. You can set up trusts offshore where the law of the offshore country is that the assets in a self-settled trust are protected, usually after a period of three years from the date of the establishment of the trust. The assets in the offshore trust do not have to be in the country where you set up the trust. This is a complex area where you should be guided by experienced and competent counsel. This is not an opportunity for a US citizen to avoid paying taxes on investments you have outside of the country. If a US creditor attacks your offshore trust, the US court will examine what powers you have retained and whether the court can force you to bring the money back to the US and make it subject to the US court’s orders. As a general rule, if the trust and assets are offshore and the court cannot force the offshore trustee to bring the money back to the US, the ability of the US court to do anything about the money offshore will be very limited.

Trusts for Others. This self-settled trust doctrine should not be confused with trusts you set up for others. Fred dies and leaves his assets in trust for his daughter Jane for her lifetime. Jane has her CPA as a Cotrustee. Jane did not set up this trust; Fred did, so for Jane, Jane’s trust is not a self-settled trust. In routine legal cases, the Jane type of trust provides high hurdles to jump over for any past, present or future creditor of Jane. Some spouses or life partners may decide to set up such Jane trusts for each other. These can provide substantial asset protection for spouses and partners as long as the trusts are not carbon copies.

Asset Protection. There is no bullet proof asset protection vehicle and do not believe anyone who claims to have one to sell you. But, careful planning and operation of the proper type of vehicles can provide substantial protection of your hard earned assets.

Next: Virginia’s new asset protection trust law.