The primary goal of estate planning has traditionally been to provide for the management and transfer of wealth at the least financial cost. In recent years, however, the rising level of the estate tax exemption ($11.4 million per individual is exempt from federal estate tax in 2019) has eliminated the need for estate tax planning for all but the uber-wealthy.

Instead, given our litigious society and the high incidence of divorce, there is an ever-increasing need for estate planning with the objective of protecting assets rather than reducing taxes. For many individuals, the biggest danger might stem from the failure to plan for the nontax consequences resulting from inadequately protecting assets from future creditors, possibly including an ex-spouse. The financial and emotional hardship posed by the possible actions of a future creditor can be largely mitigated by adopting proactive strategies with an eye toward asset protection.

The best way to protect an inheritance from such risks is to provide for lifetime trusts for your heirs rather than making outright distributions. Such trusts, referred to as spendthrift trusts, are recognized in every state and generally provide that distributions are made in the trustee’s sole discretion. As a result, beneficiaries of the trust are not able to directly access the trust principal—which means creditors, including ex-spouses, also can’t gain access.

These spendthrift trusts, however, have not traditionally provided any protection from creditors if the person transferring the assets to the trust (the settlor of grantor) is also named as a beneficiary of the trust—which means it is called a “self-settled” spendthrift trust. So how do you as an individual protect your own accumulated wealth from your creditors?

Aside from exemptions provided under state or federal law to certain types of assets (such as retirement plans, life insurance or annuities in some states), prior to 1997, the most effective strategy was the establishment of a foreign trust governed by the laws of a foreign jurisdiction that provided statutory protection for such self-settled trusts.

Since 1997, however, there has been an ongoing trend among the states to enact laws that allow you as the settlor to create a trust for your own benefit—thus making you a beneficiary—and to protect it from your future creditors. Such trusts, commonly known as “asset protection trusts,” are now recognized in 19 states.* The most recent states adopting such trust laws are Connecticut and Indiana. Generally, most of these states require, among other things, that the trust be irrevocable and that it allows for the settlor to be a discretionary beneficiary—meaning that the trustee decides when the settlor as beneficiary gets distributions—and that the trust allows the settlor to retain only certain powers. Examples of such powers: The power to “appoint the assets”—that is, the right to designate in your will the beneficiaries of the trust after your death—and veto power over distributions during your lifetime. The trust must have at least one trustee who is a resident of one of the 19 states…and the settlor must execute an affidavit of solvency attesting to the fact that the he/she will not be rendered insolvent by the transfer and does not intend to defraud a creditor.

If an individual resides in one of these 19 states and funds such a trust when there are no financial or legal clouds on the horizon, it is likely the trust assets will be bullet-proofed. However, this may not be the result for someone who does not live in one of these states because of an issue that is likely to arise in a challenge by a creditor and that has not been resolved in the courts. For example, if someone who has been ordered by a court to pay a debt resides in New York and settles a trust under Delaware law, it is not clear whether the New York court, where the judgment is likely to be enforced, will apply Delaware law or New York law against such self-settled trusts as a matter of public policy.

This uncertainty, however, does not make such trusts completely ineffective. In fact, ring-fencing—or financially segregating—a nest egg of assets in such a trust can provide significant negotiating leverage in a settlement. There are a variety of other methods to consider that can minimize a challenge. For example, if the settlor is married, the trust need not include the settlor as a beneficiary if the spouse can receive distributions from the trust while they are married. Once the spouse passes away (or if they are divorced), a third party can be given the power to add the settlor as a beneficiary. Thus, if there is a challenge to the trust while the settlor is not included as a beneficiary, the trust will be protected since it is a third-party trust.

A self-settled trust can also be an important planning tool (in addition to a prenuptial agreement) if it is settled prior to a marriage. Such a trust can help protect trust assets from claims by a divorcing spouse. Relying solely on a prenuptial agreement might not provide adequate protection since the agreement can be invalidated as a result of a change in circumstances or state law. An additional layer of protection can be obtained using an asset-protection trust in one of the 19 states. Such a trust can also prevent the commingling of marital assets, which could then be subject to division upon divorce.

An asset-protection trust is just one of several devices that individuals should consider as a means to protect their wealth. To be most effective, one should consult with competent legal counsel since these are not simply “off the shelf” commodities. The test will come when and if a trust is challenged, at which time it will be of utmost importance that the trust was created and administered with experienced counsel.

*In addition to the latest additions, Connecticut and Indiana, the states that allow the formation of asset-protection trusts are Alaska, Delaware, Hawaii, Michigan, Mississippi, Missouri, Nevada, New Hampshire, Ohio, Oklahoma, Rhode Island, South Dakota, Tennessee, Utah, Virginia, West Virginia and Wyoming.