Protect Your Family From Divorce and Creditors

Mary and John have four adult children, all with varying degrees of financial and personal success. Dennis, the oldest and most successful financially, has no need for financial support from his parents. Judy, next in line, unfortunately has been through a bruising divorce and is struggling to raise her son on her own. Jennifer and Jack are both married, but their marriages have had their ups and downs. Jennifer's husband has been known to sink their limited resources into failed get-rich-quick schemes. And Jack has just borrowed a lot of money to start his own dentistry practice.

Parents never stop worrying about their children, and Mary and John are no different. They are worried about any of their children being divorced, about whether Judy will have enough money, whether Jack's business will flourish, or whether he may be sued by a patient. They're worried about there being enough money for their grandchildren.

These concerns are not without basis. Nationally, half of marriages end in divorce. In our litigious society, 16 million lawsuits are filed every year in the United States. With health insurance tied to employment, the loss of a job can mean the loss of health insurance and then bankruptcy can result from a devastating illness or injury. Mary and John can help their children as needed while they're alive. But whatever they leave their children in their estate can go up in smoke if bad luck or bad decisions strike. This is even the case with money left to Dennis. While he may have sufficient funds to weather any bad luck, he's likely to have a taxable estate. Money left to him could be subject to a hefty estate tax before it passes on to the grandchildren.

So what can Mary and John do to make sure that what they leave actually helps their children and grandchildren?

The answer is a Family Protection Trust, also sometimes called a Bloodline or Dynasty trust. These are trusts that continue after the parents' death through the life of the children and, if the grantor chooses, during the life of the grandchildren as well. The funds are left for the benefit of the children and grandchildren, but limits are placed on their access to the trust funds. The funds are there if needed, but cannot be spent down at whim. This restriction provides the necessary protection.

The wealthy have always used similar trusts, often called "spendthrift" or "generation-skipping" trusts. Spendthrift trusts were designed to protect beneficiaries from themselves. The landed gentry could leave funds for the neer-do-well sons, knowing it wouldn't all be quickly lost at the casinos in Monte Carlo. Generation-skipping trusts were designed to prevent estates from being taxed twice, both when the parents die and when their children die.

But don't those with less money have an even greater need to make sure it is protected?

Here are some of the benefits of a family protection trust:

Creditors. The funds in family protection trusts are protected from creditors and in the event of bankruptcy.

Litigation. Like creditors, plaintiffs in lawsuits cannot invade family protection trusts. Funds left to Jack will not be subject to claim if he is ever sued for alleged dental malpractice.

Divorce. While everything is generally on the table in the event of divorce, a family protection trust will be treated differently from property in the name of a divorcing spouse. It will not be considered a marital asset.

Bad judgement. An independent trustee can protect a trust beneficiary from bad choices, whether that be risky investments or spending that is foolhardy. And the bad judgement may not be one's children but their spouses may prevail upon them to take risks with funds that should be there for their retirement or for their children's education. Jennifer will have a lot easier time saying no to her husband if her funds are in trust and not in their joint bank account.

Bad luck. While parents can't protect their children from bad luck, they can create a cushion for them if it occurs. If a child becomes disabled or loses insurance and incurs a large medical bills, he or she can qualify for Medicaid coverage without having to spend down all the funds in a family protection trust, as would be necessary for funds in the child's name.

Taxes. While fewer and fewer people are paying estate taxes with the increase in the threshold, which will be $11.58 million (federally) in 2020, there's no reason to pay if you don't have to. A family protection trust can keep funds out of a child's estate so it passes to the grandchildren tax free.

So, with all of these benefits of family protection trusts, what are the drawbacks?

Cost. Mary and John will have to pay their attorney a fee to set up the trusts, but it will be quite minimal compared to the potential savings. In addition, there will be continuing administrative costs after they die. These will include the preparation of an annual income tax returns for the trusts and, if there is a professional trustee, a management fee, usually about 1 percent of trust assets a year. Again, these are quite small compared to the potential savings.

Restrictions. Some trust beneficiaries will object to not having complete control and access to their trust funds. This is a trade off. Do the benefits outweigh this disadvantage? Mary and John will have to decide.

There are some other trade-offs and choices Mary and John will have to decide on. These include the following:

Choice of trustee. The hardest decision in any trust is choosing the appropriate trustee. The best answer for a family protection trust is an independent professional trustee, such as a bank, a trust company or a law firm. But this has a cost to it and may increase a child's disgruntlement about not having complete access to the trust funds. The child may feel more comfortable if another family member or family friend acts as trustee. Or each child can be trustee of his or her own trust. However, this means more risk and less certain protection. The child must follow the terms of the trust. If he doesn't, the trust might be attacked at a later date as a sham. If the child sees the possibility of litigation or bankruptcy, he should resign at the earliest possible date and appoint an independent trustee. Again, another trade off for Mary and John to decide on, ironclad protection versus somewhat less certain protection but less cost and more control for their children.

Distribution rules. Next, Mary and John need to decide the rules for distributing trust income and principal to their children. It's typical, though not necessary, to have all trust income interest and dividends distributed annually. They can leave principal distributions to the discretion of the trustee or limit it to necessities for their children, such as food, clothing, health and education. They can also give their children the unfettered right to withdraw up to 5 percent of trust principal each year. This may make the children more comfortable with an independent trustee.

So, Mary and John set up family protection trusts for their four children and can rest assured that what they've worked long and hard to accumulate will be there for their children for the long-term. But do they stop worrying about them? Not necessarily. That's just what parents do. But at least they'll know that they did everything they could for their children and grandchildren.

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