Inherited IRAs Are Not Exempt From Creditors

When an IRA account owner dies, his or her designated beneficiary can choose to withdraw the account or maintain the IRA as an “Inherited IRA.”  Numerous beneficiaries of Inherited IRAs have declared bankruptcy and claimed that the Inherited IRA was exempt from attachment by the creditors.  Some Circuit Courts of Appeal had held that inherited IRAs are exempt funds in a bankruptcy setting.  Other Circuits had ruled to the contrary. 

The Supreme Court has resolved the conflict by ruling that inherited IRAs are not exempt for bankruptcy purposes.  The court’s rationale was that the purpose of the bankruptcy exemption for retirement funds is to protect the money for the person who earned the money.  The exemption was not meant to protect heirs of the person who earned the money.

Some states have exempted Inherited IRAs from bankruptcy.  Depending on where the beneficiary of the Inherited IRA lives, he or she may be able to use the state exemption and not be affected by the Supreme Court ruling. 

The practical effect of the ruling for debtors living in the wrong states is to make Inherited IRAs the same as any other account owned in the debtor’s name.  The account will not be protected if the debtor declares bankruptcy. 

In light of this ruling, surviving spouses should consider segregating an IRA that they inherit from their spouse in a separate account.  The law allows you to combine your spouse’s IRA with your own IRA; however, that may bring into question the creditor protection benefits of your own IRA.  Further, if you maintain separate accounts, you should make withdrawals from the Inherited IRA rather than your own IRA.

When designating the beneficiary of your own IRA, you should consider establishing a trust as the beneficiary.  A properly drafted trust will give your beneficiary the flexibility to withdraw the funds over several years without exposing the funds to the beneficiary’s creditors.

Despite the Supreme Court’s ruling, you can still achieve creditor protection for the portion of your IRA that you pass on to your beneficiaries.  However, the process to obtain the creditor protection has become more complicated.  

Tennessee Approves Tenants by the Entirety Trusts

On April 14, 2014, the Tennessee Legislature approved a new type of trust known as a Tenants by the Entirety Trust (“TBET”).

A TBET is a joint trust for a married couple that provides the same protection from the claims of the separate creditors of the husband and wife as would exist if the husband and wife owned the trust assets directly as tenants by the entirety. 

Being able to transfer tenants by the entirety property to a TBET without sacrificing creditor protection will make it more feasible for couples to use revocable trusts for their various benefits, including incapacity management, probate avoidance, and privacy.

A TBET only provides creditor protection for property that was held by the spouses as tenants by the entirety property prior to the conveyance of the property to the trust.  The additional requirements of a TBET include: (1) the husband and wife must remain married; (2) the property must continue to be held in trust by the trustee(s) or their successors in trust; (3) while both the husband and wife are living, the trust must be revocable by either spouse or by both of them acting together; (4) both spouses must be beneficiaries of the trust; and (5) the trust instrument, deed, or other instrument of conveyance must specify that the provisions of the new statute apply to the property. 

Traditional tenants by the entirety property automatically passes to the survivor upon the death of the first spouse.  A TBET is more flexible.  For example, the TBET could convert to an irrevocable trust for the benefit of the survivor, with the remainder to pass to children after the survivor’s death.  This structure would provide better asset protection for the survivor as well as better protection to the children if the survivor remarries.

After the death of the first spouse to die, the property will continue to be exempt from the claims of the decedent’s separate creditors.  To the extent the survivor may withdraw the trust assets, the property will be subject to the claims of the survivor’s separate creditors.

Creditor protection may be waived as to any specific creditor or any specifically described trust property, but only if expressly permitted by the trust instrument, deed, or other instrument of conveyance or if the husband and wife both give their written consent.  This provision allows a house subject to a mortgage to be transferred to a TBET.

TBETs may be created on or after July 1, 2014. 

Comparison of Asset Protection Trust Statutes

Dave Shaftel has prepared a detailed comparison of the various Domestic Asset Protection Trust statutes. He analyzes 33 different aspects of the statutes. Tennessee’s laws stack up very well in terms of protection from creditors.

You can see from the enclosed map that Tennessee is the only southeastern state that allows Asset Protection Trusts. Advisors in neighboring states are beginning to recommend Tennessee as the state in which to establish an Asset Protection Trust. 

Delaware is the leading provider of Asset Protection Trusts because they have done the best job of advertising. Unlike Tennessee, Delaware allows certain tort claimants to assert claims against Asset Protection Trusts. Except for this significant difference in Tennessee’s favor, the Delaware and Tennessee statutes are very similar.

Premarital Residence Divided Equally Between Spouses in Divorce

In the Liner divorce case, the court awarded 1/2 of the equity in the husband’s premarital residence to the wife. As a general rule, assets owned by one spouse prior to the marriage are treated as separate property and are not divided in the divorce. There are some exceptions, including the division of appreciation of the property if the non-owner contributes to the appreciation. This case did not involve appreciation. Rather, the wife was awarded 1/2 of the house primarily because she made non-financial contributions to the ongoing maintenance and management of the residence.

This case demonstrates the importance of entering into a prenuptial agreement or an asset protection trust prior to marriage. Assets that you transfer into an asset protection trust prior to the marriage will belong to the trust and will not be subject to division in the event of a divorce.


 

Trust Saves the Day for Cancer-Stricken Beneficiary With Creditor Problems

I just talked with the daughter of a deceased client regarding a trust established a few years ago. When I worked with her father on his estate planning a few years ago, his three children were all happily married and doing well financially. I encouraged him to leave each child’s inheritance in a trust just in case one of the children had marital difficulties and/or creditor difficulties.

My client was somewhat unsure of my recommendation, but agreed to establish separate trusts for his three children, with each child being the Trustee of their own trust. Each child has discretion to make distributions to the child and descendants of the child for their health, education, maintenance, and support. The child also has a testamentary limited power of appointment which gives them the power to decide how the trust will be distributed following their death.

The daughter has had a bad run of luck. The business owned by the daughter and her husband has done poorly due to the economy. Furthermore, her husband had a stroke and she has been recently diagnosed with cancer. They have serious creditor problems and are most likely headed for bankruptcy.

The good news is that the trust is protected from their creditors. The daughter will be able to live comfortably for the rest of her life. Furthermore, she has the ability to provide for her husband in the event that she predeceases him. If the father had not had the foresight to leave the daughter’s inheritance in a trust, it would all belong to creditors. This is exactly what the father wanted to avoid.

Asset Protection Trust Also Provides Same Benefits as a Revocable Trust

Several of my clients established Asset Protection Trusts ("APTs") in July of 2007. That is the  month when they first became legal in Tennessee. Unfortunately, one of my first clients to establish a Tennessee APT died recently. She never experienced creditor problems and never needed the asset protection benefits afforded by the trust.

When she became very ill earlier this year, she transferred her remaining assets to the APT. She also exercised her testamentary limited power of appointment over the APT to make some specific bequests to friends and to take advantage of the absence of federal estate taxes in 2010. The document for making this exercise was analogous to an amendment to a revocable trust.

During the last few weeks of her life, the Trustee managed the trust assets for her benefit. Upon her death, the APT became a Will substitute. My client had a “pourover” will, but it will not be needed. Currently, the Trustee is administering the APT in the same manner that a revocable trust would be administered.

If you are going to employ a funded revocable trust as part of your estate plan, you should consider utilizing an APT. An APT gives you the same benefits as a revocable trust and provides asset protection during your lifetime.

Hawaii Joins States That Allow Self-Settled Asset Protection Trusts

Hawaii has become the 13th state to allow an individual to set up a trust for his or her benefit which is protected from the individual’s creditors. Unlike Tennessee, Hawaii’s law has limits on how much you can transfer to the trust and what kind of assets you can place in the trust. In addition to these restrictions, anyone who establishes such a trust must pay a tax to the state equal to 1% of the assets transferred to the trust. Hawaii is the only state that charges a tax to establish such a trust.

Because of this tax, it is unlikely that anyone other than a resident of Hawaii would use a Hawaii trust rather than a trust in one of the other 12 states. Tennessee’s asset protection trust law compares very favorably to the other asset protection trust states. The Tennessee legislature made several improvements to our law this spring in order to keep our law at the forefront. Tennessee is still the only Southeastern state that permits self-settled asset protection trusts. See the enclosed map for the other states.
 

Inter Vivos Marital Trusts Provide Creditor Protection for Both Spouses

A recent article discussed the use of Inter Vivos Marital Trusts to reduce estate taxes. These trusts can also be used to provide asset protection from future creditors. When the objective is asset protection, the trust is designed differently.

One spouse transfers property to a trust for the benefit of the other spouse. If the donee spouse predeceases the donor spouse, the donor spouse becomes the beneficiary of the trust. The donor spouse’s retention of a successor beneficial interest in the trust represents the key distinction of a marital trust that is used for asset protection rather than reducing estate taxes.

This type of trust has always been exempt from future creditors during the donee spouse’s lifetime because it is a third party created spendthrift trust. When the donor spouse becomes the beneficiary, the trust has traditionally been available to all creditors of the donor spouse since the transfer was made to a trust of which the donor is a beneficiary.

A new Tennessee law will make these trusts exempt from the donor spouse’s future creditors after July 1, 2010. This means that one spouse can transfer substantially all of his or her assets to a trust and protect the assets from future creditors of both spouses.

Inter Vivos Marital Trusts may not be used to avoid the donor’s obligations to creditors that already exist at the time of the transfer to the trust. If the donor spouse does not retain sufficient assets to pay existing creditors, the preexisting creditors can attack the trust as a fraudulent conveyance.

Another potential benefit of an Inter Vivos Marital Trust is to make sure that the donee spouse has sufficient assets to utilize his or her federal estate tax exemption and Tennessee inheritance tax exemption. This will reduce estate taxes upon the surviving spouse’s death. No gift taxes will be payable if the donor spouse files timely federal and Tennessee gift tax returns which make a QTIP election.

For federal income tax purposes, the donor spouse will be taxed on all of the taxable income of the trust, including capital gains, during his or her lifetime. The donee spouse will be taxable on the ordinary income of the trust following the death of the donor spouse and may be taxed on some or all of the capital gains of the trust.
 

Tennessee Improves Its Trust Laws Yet Again

The past decade has seen a vast improvement in Tennessee's trust laws, making it one of the leading states for establishing a trust. Major laws that have been enacted include the Uniform Principal and Income Act (2000), the Tennessee Uniform Prudent Investor Act of 2002, the Tennessee Uniform Trust Code (2004), the Tennessee Investment Services Act of 2007, and the Tennessee Community Property Trust Act of 2010.

On April 9, 2010, the Governor signed another law that makes numerous improvements to the trust laws. The new law includes provisions providing enhanced creditor protection for various trusts, including special needs trusts and inter vivos marital trusts, and contains a provision allowing a Trustee to convert a mandatory income trust to a “unitrust” with an annual payment of between three percent (3%) and five percent (5%). I will be writing additional articles to provide more details about these changes.
 

Exemption Application for LLCs and Limited Partnerships

A lot of my clients recently received a Franchise and Excise Tax Annual Exemption Renewal Form from the Tennessee Department of Revenue. This form applies to Limited Liability Companies and Limited Partnerships that claim an exemption from Tennessee Franchise and Excise Taxes.

The three most common exemptions that apply to my clients are the obligated member entity (“OME”) exemption, the family-owned non-corporate entity (“FONCE”) exemption, and the farm exemption. If your company qualifies for one of these exemptions, you need to fill out the renewal form with the help of your CPA and send it to the Department of Revenue no later than April 15, 2010. If your company qualifies for an exemption and you have not received the form, you can get the form at http://tennessee.gov/revenue/forms/fae/fae183.pdf, or you can call the Department of Revenue at (615) 253-0600.

If you do not file the form by April 15, 2010, you will lose your exemption for 2009. The Department has the discretion to allow a late filing. If they allow a late filing, they will charge you a $1,000 penalty.
 

Notice from Tennessee Department of Revenue Regarding New Obligated Member Entities

Tennessee imposes Franchise and Excise Tax on limited partnerships and limited liability companies unless they qualify for an exemption. Due to a law change enacted earlier this year, numerous entities converted from the family owned non-corporate entity (“FONCE”) exemption to the obligated member entity (“OME”) exemption.

The OME exemption requires the entity’s owners to assume personal responsibility for liabilities of the entity. Most entities that switched to the OME exemption own commercial real estate.

In order to qualify for the OME exemption for 2009, appropriate documentation had to be filed with the Tennessee Secretary of State by October 1, 2009. On November 10, 2009, the Department of Revenue imposed an additional requirement to qualify for the OME exemption for 2009.

Each entity that switched to the OME exemption must file a new Application for Exemption with the Department of Revenue on or before November 30, 2009. If the entity does not file an Application for Exemption by November 30, 2009, it will not be exempt for 2009.

The Department of Revenue has discretion to allow a late filing of the application. However, if they permit the late filing, they must charge a $1,000 penalty.

If the entity failed to convert to an OME prior to October 1, 2009, it has the option of converting to an OME prior to December 31, 2009 if the entity wants to be exempt from franchise and excise taxes for 2010 and future years.

If you are an owner of an OME and are concerned about your potential exposure to liabilities of the entity, you should consider transferring a portion of your assets to an asset protection trust.
 

Making Gifts to Your Granddaughter's Future Ex-Husband

Wealthy grandparents often make gifts to their grandchildren. A grandparent can give $13,000 per year to each grandchild without incurring gift tax. If gifts are made over several years, estate taxes upon the death of the grandparents can be substantially reduced.

There is a hidden trap in making gifts. The danger is that your grandchild may get divorced in the future. Some states consider all property owned by either spouse to be marital property which is subject to a 50/50 division upon divorce.

The problem is illustrated by a family that I now represent. The grandmother made gifts of stock of the family business to her granddaughter in the 80s and 90s. The grandmother died in 1997. Two years later, her granddaughter married a man the grandmother never met.

I did not know the grandmother, but have represented the grandmother’s daughter for the last several years. The daughter continued her mother’s pattern of making annual exclusion gifts to her daughter. Rather than direct gifts, the gifts were made to a Cristofani Trust (pdf) that benefits the daughter’s husband and all of her children and grandchildren.

The granddaughter recently obtained a divorce in a state that treats all property owned by either spouse as marital property. In accordance with state law, the judge awarded one-half of the granddaughter's stock in the family business to the granddaughter’s husband.  The net result is that when the grandmother made gifts to her granddaughter, she was also making a gift to her granddaughter’s future ex-husband.

The stock awarded to the ex-husband was subject to a Shareholder’s Agreement, which allowed the company to purchase the stock from the ex-husband. As you might imagine, the family was upset about having to buy back the stock.

The laws of the states where the grandmother and granddaughter lived at the time of the gifts would not have included the gifts in the marital estate if the granddaughter had obtained a divorce in either one of those states. However, division of property is determined by the state in which the couple resides at the time of the divorce.

Fortunately, because the gifts by the daughter were made to a trust, these gifts were protected in the divorce. The moral of this story is to consider making gifts to a properly designed trust in order to reduce the chance that the donee will lose part of the gift if they subsequently obtain a divorce in the wrong state.
 

Pre-Marital Asset Protection Trust Enhances Divorce Protection

More than 50% of marriages end in divorce. When one spouse enters the marriage with significant assets, they often leave with less than they started with.

The traditional method for protecting your assets is to enter into a prenuptial agreement before you get married. I recommend this to all of my clients who are getting married.

In lieu of or in addition to a prenuptial agreement, Tennessee residents can protect their assets by transferring them to an asset protection trust {pdf} before they get married. Even if they do not have a prenuptial agreement, their spouse will not be entitled to any of the trust assets upon divorce. Furthermore, their spouse will not be able to claim any portion of the trust assets upon death. This latter point is especially important for later-in-life marriages when one or both spouses have children from prior marriages.

I have mostly used pre-marital asset protection trusts for young adults who have received substantial gifts and/or inheritances from their parents and grandparents. As a general rule, these young adults have relied solely upon the protection afforded by the trust because they were not willing to discuss a prenuptial agreement with their future spouse.

 

Receiving Your Inheritance in Trust

If one of your parents is alive, you should consider asking your parent to give you any inheritance that you will receive in a beneficiary-controlled trust.

A properly designed beneficiary-controlled trust can provide protection from creditors, including divorced spouses, and from estate taxes upon your death. When discussing this matter with your parents, blame your attorney for raising the issue.

At my suggestion, one of my clients persuaded his mother to amend her Will to leave his future inheritance in a trust controlled by my client. The amendment did not affect the bequests to my client’s siblings. His mother died last year and the trust has been funded with approximately $800,000. My client is currently distributing cash from the trust to his son, who recently lost his job. This is not a taxable gift by my client. My client's son is in a low income tax bracket, which significantly reduces the income taxes payable with respect to the trust’s income.

The ability to divert income to a child without losing control of the assets is one of the many benefits from receiving your inheritance in a trust.