Asset Protection: LLCs vs. Irrevocable Trusts

Posted by David E. Peterson, Esq. on June 10, 2013 under Estate Planning | Be the First to Comment

We live in an economically volatile and litigious society. An unexpected lawsuit, or decline in business, can put people’s life savings at risk. Therefore, asset protection planning is of the utmost importance.

According to Massachusetts estate planning attorneys, two of the most common and effective asset protection mechanisms are the Limited Liability Company (LLC) and the Irrevocable Trust. But which one is right for you? Let’s take a look.

Limited Liability Company

Limited Liability Companies are creatures of statutory law. Think of them as Frankenstein’s Monster, patched together with elements of corporate, partnership, and tax law. Only Frankenstein is not a mad scientist, he’s your state’s legislature.

An LLC is an entity that is specifically authorized to provide a liability shield to its owners. So long as the event creating the liability occurs within the LLC, a judgment creditor will be unable to reach the personal (non-LLC) assets of the owner. For example, if you own a vacation home in an LLC, and someone is injured on the premises, then their recovery on the lawsuit would be limited to the assets of the LLC. They couldn’t recover against your bank account, or primary residence, because they’re outside of the LLC.

Furthermore, if the LLC owner is sued due to an event occurring outside of the LLC, then the judgment creditor cannot seize the LLC. For example, if you own a small business inside of an LLC, and you hit someone with your car, they can sue you, but they won’t be able to take your business away if they win.

Because of this protection against inside and outside liability, LLCs are best suited to protect assets that could potential be the source of a lawsuit. Specifically, they are great for holding investment real estate and operating businesses.

Irrevocable Trust

Until recently LLCs have been creatures of common law. That means that they’ve evolved through the decisions of courts in England and the United States over several hundred years. Now however, states often supplement trust law with statutory schemes. For example, the Massachusetts Uniform Trust Code creates a framework for trust law in the Bay State. But to the extent that it is not all encompassing, the common law remains.

When a Grantor puts assets into a trust, they are no longer the owner. Instead, the Trustee becomes the legal owner, and he or she must manage the assets according to the terms of the trust. The terms of the trust typically designate beneficiaries, who are the beneficial owners of the trust.

The asset protection mechanism of an irrevocable trust is a function of control. It works like this: if the Grantor cannot take complete control of the assets in trust, then neither can their creditors. Revocable trusts provide no asset protection to the Grantor, because the Grantor can revoke the trust and take back the assets. However, the Grantor cannot take back the assets in an irrevocable trust, because it is irrevocable, so they are protected.

But what if the Grantor wants to control the trust assets?

The terms of the trust can reserve certain rights to the Grantor. Sometimes the Grantor can also serve as the Trustee. There are many types of irrevocable trusts, but it is usually possible for the Grantor to retain a moderate to high degree of control.

But what if the Grantor wants to benefit from the assets in the trust?

This depends on the distinction between principal and income. The primary assets owned by the trust are the principal, but the income that they generate is the income. For example, a bank account is principal, but the interest that it generates is income. Shares of stock are principal, but dividends are income. Real estate is principal, but the rent paid by tenants is income.

The golden rule of asset protection is that if you can get it, your creditors can too. Therefore, irrevocable asset protection trusts prohibit the Grantor from accessing the trust’s principal. Fortunately, a Grantor can retain the right to income, and creditors will still be unable to reach the underlying assets. In this scenario, the Trustee could reallocate the principal into assets designed to appreciate in value, rather than generate income. Then they could reallocate into income generating property once the asset protection threat has passed.

For these reasons, irrevocable trusts work well for income generating property, or primary residences for older clients.

Why not use both?

A sophisticated estate planner may recommend using both LLCs and irrevocable trusts. You could have an LLC for your business, and a trust for your investments; or an LLC for your vacation home, and a trust for your primary residence. Or, if you want to get really savvy, you could have a trust own an LLC, or an LLC serve as trustee of a trust, or both!

Whether your looking for some simple protection, or you want to create a veritable lasagna (multiple layers, get it?) of LLCs and trusts, the first step is to seek the advice of an attorney that specializes in this type of planning.

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