Disclosures: Bhatia and Mandell report no relevant financial disclosures.
January 03, 2022
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Using trusts to shield assets: What to know about these key protection tools

Disclosures: Bhatia and Mandell report no relevant financial disclosures.
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Physicians interested in estate or asset protection planning inevitably inquire about the use of trusts. Certainly, trusts can play significant roles in many physicians’ estate and/or asset protection planning.

Because a discussion of all the types of trusts and their uses would take many installments of this column to cover adequately, we will focus this article on asset protection planning — using trusts to shield a physician’s assets against future lawsuits and other types of liability risk.

Revocable trusts - no asset protection

Sanjeev Bhatia
Sanjeev Bhatia
David B. Mandell
David B. Mandell

The first thing to understand about trusts is that they can be divided into two broad categories: revocable and irrevocable. Revocable trusts, as their name indicates, can be revoked at any time, like a will, and can always be changed or superseded. While revocable trusts, like “family trusts” or “living trusts,” can be valuable for estate planning because they can be revoked or changed at any time, they provide no asset protection against lawsuits or liability risks, at least as long as the grantor (the person who created the trust) is alive.

Revocable trusts are useless for asset protection precisely because they allow the grantor to undo the trust. In other words, if you wanted to unwind a revocable trust and use the funds for yourself, you could do so. Therefore, a creditor can essentially force the grantor of the trust to do this — asking a court to “step into the shoes” of the grantor if the grantor owes money to the creditor.

Irrevocable trusts: Asset protectors

While revocable trusts offer no asset protection, irrevocable trusts are outstanding for this purpose. Once one establishes an irrevocable trust, they forever abandon the ability to undo the trust and reclaim property transferred to the trust. With an irrevocable trust, the grantor loses both control of the trust assets and ownership.

Why irrevocable trusts protect assets

Irrevocable trusts protect assets for the same reason that revocable trusts do not. As mentioned earlier, revocable living trusts do not provide asset protection because creditors can “step into the grantor’s shoes” and undo the trust. The logic here is that if an orthopedist has the power to undo the trust, so do his/her creditors.

An irrevocable trust results in the opposite. Because an established irrevocable trust cannot be altered or undone, creditors cannot “step into the shoes” of the grantor and undo the trust. Assets in an irrevocable trust are immune from creditor attack, lawsuits and other threats against the grantor (per above, the person who created the trust).

Two key clauses for irrevocable trusts

If one of the goals of establishing an irrevocable trust is to protect trust assets from potential creditors, there are two important clauses to include in the trust. These clauses are not necessarily important to protect the grantor but rather work to shield the beneficiaries, who are often family members, like a spouse or children, from their creditors. These clauses work by giving certain power to the trustee, the person or firm designated by the trust document to administer the trust.

Spendthrift clause

The spendthrift clause allows the trustee to withhold income and principal that would ordinarily be paid to the beneficiary if the trustee feels that the money could or would be wasted or seized by the beneficiary’s creditors. This clause accomplishes two goals. First, it prevents a wasteful beneficiary from spending trust funds or wasting trust assets. This is especially important to many orthopedists who set up trusts with their children as beneficiaries. The trustee can then stop payments if the child spends too quickly or unwisely.

Second, the spendthrift clause protects trust assets from creditors of the beneficiaries. Beneficiaries may be young now, but as adults they will face the same risks that everyone does: lawsuits, debt problems, divorce, failing businesses, etc. The spendthrift clause protects trust assets from your children’s creditors by granting the trustee the authority to withhold payments to a beneficiary who has an outstanding creditor. If the beneficiary and trustee are at “arm’s length,” the creditor has no power to force the trustee to pay the beneficiary. The creditor only has a right to payments actually paid by the trustee; he or she cannot force the trustee to make disbursements.

Anti-alienation clause

The anti-alienation clause also protects trust assets from the beneficiary’s creditors. Specifically, the anti-alienation clause prohibits the trustee from transferring trust assets to anyone other than the beneficiary. This, of course, includes creditors of the trust beneficiary. Thus, while the spendthrift clause allows the trustee to withhold payments if a creditor lurks, the anti-alienation clause goes one step further. It prohibits the trustee from paying trust income or principal to anyone but the named beneficiary.

Domestic asset protection trusts

For many years, a person in the United States who was interested in creating an irrevocable trust to protect assets against their potential future creditors, but also wanted access to those same assets, would need to establish a trust outside the U.S. because no state allowed this type of trust. These types of trusts were called asset protection trusts or offshore asset protection trusts. This changed in 1999, when Alaska changed its laws, becoming the first state to allow such a trust. Thus, was born the domestic asset protection trust (DAPT). As of this writing, 20 states have now adopted statutes which authorize DAPTs in their state.

As above, DAPTs are unique irrevocable trusts in that an orthopedist can be both the settlor establishing the trust and a beneficiary of the trust. When there is no lawsuit concern, the doctor can get to the trust assets as beneficiary.

However, if they ever have lawsuit concerns, the trust can be written so that the trustee cannot make distributions to the orthopedist, as they are “under duress.” In this way, a DAPT can allow both access to the trust assets when the “coast is clear” and protection when lawsuits and creditors are lurking. With these ideal features, DAPTSs can be attractive for physicians who live and practice in a state with DAPT trust legislation. Even orthopedists in non-DAPT states may be able to take advantage of a DAPT in a different state if the trust is drafted in a way that complies with their home state law, which is called a “hybrid” DAPT or HDAPT.

A partial list of states with DAPT legislation include Alaska, South Dakota, Nevada, Ohio, Missouri, Connecticut and Delaware. Please contact the authors for a complete and current list.

Conclusion

Physicians concerned about asset protection must realize that revocable trusts provide no shield while the physician is alive. Only irrevocable trusts can protect assets and the DAPT is often the most attractive type of trust, given that it allows access to trust assets without the threat of a creditor claim. DAPTs, therefore, should be considered by many physicians as part of a comprehensive asset protection plan.

References:

Wealth Planning for the Modern Physician and Wealth Management Made Simple are available free in print or by ebook download by texting HEALIO22 to 844-418-1212 or at www.ojmbookstore.com. Enter code HEALIO22 at checkout.

For more information:

Sanjeev Bhatia, MD, is an orthopedic sports medicine surgeon practicing at Northwestern Medicine in Warrenville, Illinois. He can be reached at sanjeevbhatia1@gmail.com or @DrBhatiaOrtho.

David B. Mandell, JD, MBA, is an attorney and founder of the wealth management firm OJM Group www.ojmgroup.com. You should seek professional tax and legal advice before implementing any strategy discussed herein. He can be reached at mandell@ojmgroup.com or 877-656-4362.