You should include asset protection trusts in your living trust to protect your children's inheritance.
California Asset Protection Trust
A Revocable Living Trust will help you avoid probate, but adding asset protection trust provisions will significantly protect your children's inheritance
If you are a California resident and you have assets that would go through probate, then you need a revocable living trust as the foundation to your estate plan. A well written and funded revocable living trust will allow your family to avoid the high costs and hassles of probate when you pass away.
However, is that enough? Most of our clients choose to add what we call “asset protection trusts” to their revocable living trust to better protect their children’s inheritance from divorce claims and lawsuits. An asset protection trust is a testamentary trust that is part of your revocable living trust that kicks in when you pass away.
How Will Your Children Receive Their Inheritance?
You can choose how your children will receive their inheritance. The two main choices are outright or in trust.
Young children cannot own assets until they become adults. In California, children become adults at age 18. For our clients with young children, we design their revocable living trusts to allow their children’s inheritance to be in trust, with a family member or trusted friend as trustee to manage the assets until the child is at least 18.
During our planning meeting, we will ask you what age you think your children would be capable and mature enough to manage their inheritance - what age do you think you will no longer have to protect your children from their own bad decisions? The younger your children are, the more this is a guess.
If you are optimistic, you may say age 18 or 21. If you are pessimistic, you may say age 40 or 50. Most parents say age 25 or 28, thinking that after college and a few years of working in the real world and paying bills and taxes, their children will be up to the task. Until that magic age, your child's inheritance can be held in trust with someone you trust acting as trustee.
But what happens at that chosen age? Let's say you choose age 25, we can write your revocable living trust so that when each child is 25, his or her share will be distributed outright, or remain in trust.
If outright, there will be no protection for the inheritance from a divorce or a lawsuit against your child.
Assets Remain in Trust
If your child's inheritance remains in trust, which we call a lifetime asset protection trust, the trust assets will be significantly protected from divorce claims and lawsuits.
At age 25, or the age you choose, your child can take over as trustee of her own trust. As trustee, she will have control over how to invest the assets and when to make distributions to herself. But here’s the best part: if the inherited assets remain in trust, your daughter’s divorcing spouse can’t get to them. And, if she is sued, in most cases the plaintiff can’t get to them. And if she has a solid marriage, the assets are also significantly protected from lawsuits filed against her husband.
Below are two real life examples of the benefits of asset protection trusts.
Asset Protection Trust Protects Child’s Inheritance From Divorce
Our client, Barbara, told us her daughter was having marital problems, and she feared a divorce was imminent. Barbara was worried her daughter's husband would make a claim to the inheritance she would leave her daughter. Her revocable living trust was written to give her daughter an outright inheritance.
We advised Barbara to amend her revocable living trust so that when she passed away, her daughter would receive her inheritance in an asset protection trust, rather than an outright distribution.
Here’s what happened. Barbara died a few years later, and when the trust administration was completed, Barbara’s daughter received her inheritance in an asset protection trust.
Daughter’s asset protection trust was written to name daughter as the trustee and the beneficiary. As trustee, daughter had full control of the inheritance. She had complete authority over how to invest the inheritance - mutual funds, rental property, business start-up, anything she wanted. Yet, because her inheritance was in the asset protection trust, it was significantly protected from a divorce claim.
A year later, daughter and her husband filed for the divorce. Her husband’s divorce attorney claimed that husband was entitled to half of daughter’s inheritance. The judge ruled against him. The judge said that the inheritance was off-limits to the husband because the inheritance was in the asset protection trust. Thanks to Barbara’s foresight and planning, her daughter’s inheritance was safe. Husband was very angry. Daughter was very happy.
California is a community property state. With rare exceptions, once a couple is married, assets become community property, which means each spouse has a right to half the assets. One of the exceptions to community property is an inheritance. An inheritance is the recipient’s separate property, unless it is commingled.
With an outright distribution, it is easy to commingle an inheritance. Daughter receives an inheritance check (outright distribution) and deposits it into her and her husband’s joint checking account. Whether she knew it or not, by depositing the inheritance check to the joint account, she made a gift of half to her husband. What started out as separate property just became community property.
An asset protection trust makes it much more difficult to accidentally make a separate property inheritance community property.
Asset Protection Trusts Prevents Soon-to-be Ex-Wife from Getting Inheritance
We helped Helen establish her revocable living trust with asset protection trusts for her children. Two years later, Helen died.
As we were working through the trust administration, we learned from Helen’s daughter that a month after Helen died, Helen’s son was killed in a traffic accident. We also learned that the son was embroiled in a nasty divorce, and his soon-to-be ex-wife was demanding his inheritance.
Because the son died after his mother, his inheritance was vested, and it was going to be allocated to his asset protection trust.
When we write asset protection trust provisions, we include provisions stating that if the primary beneficiary dies, his children become the beneficiaries.
In this case, when the son died, his 20 something year old daughters became the beneficiaries of his asset protection trust - not his soon-to-be ex-wife, who wasn’t the mother of his children.
If Helen had not included asset protection trust provisions in her revocable living trust, and instead used a standard outright distribution provision, her son’s soon-to-be ex-wife would have received his inheritance.
If son would have received his inheritance outright, it would have vested when Helen died. When son died soon after, his inheritance would be included in his estate. From what we were told, son had a basic will, which left everything to his wife. As a result, the wife he was divorcing, and not his daughters, would have received the inheritance from Helen.
But it gets worse. Since the inheritance would be included in son’s estate, and because son did not have a revocable living trust, his estate would have to go through probate. The only winners in this case would be his divorcing wife and the probate attorneys.
However, because Helen included asset protection trust provisions in her revocable living trust, son’s wife could not get the inheritance and the inheritance did not go through probate.
This was a very positive result in what was a very tragic family situation. Helen died, then son died, but because of the asset protection trust, the inheritance was protected for the benefit of Helen’s granddaughters.
Most of our clients choose to use lifetime protection trusts. Their reasoning is if they are going to put in the effort to set up their revocable living trust estate plan so their family won’t have to go through probate, why not design the trust to significantly protect their children’s inheritance.