Trusts and Bankruptcy: Using the Right Tools

If you have a living trust, you may be confident that your assets are protected no matter what may befall your estate. The truth is that your property and money might still be vulnerable to your creditors, the IRS and bankruptcy court.

What is a Living Trust? It is a legal written statement of how you want your estate divided after your death or in case you become incapacitated. In a living trust, also called a revocable trust, you retain ownership of all your assets. You are called the grantor or settlor. Even though the trusts contains your assets, you can still run your corporation, make business decisions and use funds for your expenses. You still pay income tax on the earnings of the assets in the trust during your life, but you reduce the gift and estate taxes for your heirs. You also can name the successor to your business, meaning that if you become incapacitated, your corporation will be able to function directed by someone you trust. That same privilege of naming someone you trust can designate the guardian of minor children. Trusts also keep assets out of costly and time-consuming probate and can shelter them from creditors. The trust is examined annually to make certain it still meets your goals for it and that it protects any new assets. Upon your death, the living trust becomes irrevocable.

What is the difference between revocable and irrevocable trusts? In an irrevocable trust, you give up all claim to the assets placed into the trust. This type of trust is more secure in bankruptcy with one exception. If you transferred your assets to the trust when you began considering bankruptcy, your creditors may be able to prove your “intent to defraud,” and a court may still allow them access to the trust.

No matter how large or small your estate is, your estate planning should involve setting up your trust and making a will. The process of creating the trust involves deciding which assets will be placed in it and what your purpose is for the trust. Ordinarily, things like insurance policies, retirement funds and other financial assets with named beneficiaries do not have to be included because they transfer to the person designated on them upon death of the grantor. Some of these, like retirement funds, have built-in tax benefits. Other property or assets that will not be included in the trust should be listed in a will. One specific type of will, the “pour over,” allows assets to be put into the trust if the grantor dies unexpectedly. Wills and trusts work together to protect your assets.

If your intent is not to protect your assets from bankruptcy, but to protect income for your spouse, you might create a credit shelter trust. This trust becomes your beneficiary, named in your will. You can bequeath funds up to the legal limit of estate tax exemptions. Then, the remainder of your estate goes to your spouse free of tax encumbrance. The credit shelter, or bypass, trust allows the assets to grow without tax liability, so your spouse can invest the money. You can also build trusts that benefit your grandchildren. These are called generation-skipping trusts, and allow your children to administer them. Another type of trust protects your home, especially if it is appreciating in value. The assets and earnings in some trusts are taxable, while others are not. Some trusts allow your spouse to get income from the trust and, after her death, the remainder goes to the people you specified. That is useful if there has been a divorce, and you want to ensure your children inherit.

Trusts can be built to do many things, including protecting your estate from bankruptcies or lawsuits. They are financial tools and, when built by people who understand their implications, they can allow you to pass on your hard-earned financial legacy to the people for whom you want to provide. Please contact us with any questions about how a trust can affect your tax situation.

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