Protection from Creditors
Many of you have asked me how estate planning tools can protect you and your families from the reach of creditors. One of the basic goals of estate planning is to preserve your assets for yourself and your heirs, and this article will provide you with a survey of the way estate planning can protect you.
Lifetime Gifts
When you give property to a third party, it is not subject to the grasp of your future creditors. It is, however, subject to claims of your currently known creditors. When you give a property to someone else, that property becomes liable for the debts of the recipient. For example, if you transfer an interest in real estate, it is immediately subject to any judgment liens that have been recorded against the recipient. In addition, it can be liable for future judgments or even claims of a spouse in divorce proceedings. In general, lifetime gifts offer poor protection from your creditors and your beneficiaries' creditors.
Trusts
Under California law, a trust beneficiary's interest in the trust is not subject to execution on judgments. A creditor may reach a judgment debtor's interest in the trust only by first obtaining a court order. This requires the creditor petitioning the court and having a hearing.
If the trust instrument provides that the beneficiary's income or principal is not subject to voluntary or involuntary transfer, the so-called "spendthrift" clause, the judgment debtor's beneficiary trust interest generally is not vulnerable to enforcement of a money judgment until paid to the beneficiary. As it is usually up to the trustee's discretion to determine when those payments are made, that may never happen. The exceptions to this rule are debts for child support or alimony, money owed to the federal or state government, or where the debtor is both the trust creator and a beneficiary.
The other limitation on enforcement of a judgment against a trust interest is where the beneficiary's interest in income or principal is for the beneficiary's education or support. To the extent that the trust funds are necessary for such education or support, they are not subject to enforcement of a money judgment until paid to the beneficiary. Once again, the trustee usually has discretion as to when those funds are paid.
Partnerships
Family partnerships can also offer significant protection from creditors. Individual partners do not own partnership assets, rather they only own interests in the partnership. This means that general or limited partnership assets are not liable for a money judgment rendered against a partner debtor personally. To reach a debtor's partnership interest, the judgment creditor must obtain a court order charging such interest with the amount of the judgment. As with trusts, this requires filing a motion with the court and having a hearing.
Family limited partnerships are especially effective because limited partners are forbidden by statute from managing or controlling the limited partnership. Thus it is not likely that the partner has any discretion over when payments and distributions are made. The creditor must wait to receive the distribution from the partnership (and the general partner decides when and how much).
A judgment creditor who obtains a court order is taxed on the debtor's share of partnership income, even when the income is not distributed to the judgment creditor. This means that the creditor can end up paying income taxes on partnership income that they never received.
Corporations and Limited Liability Companies
With family corporations and limited liability companies, the creditor must first apply to the court for an order charging the judgment debtor's membership interest in the limited liability company or stock in a corporation. Most of these entities have restrictions on sales to outside third parties, and so it is quite difficult for a creditor to actually realize any money from an attempted levy.
Off-Shore Trusts
Off-shore trusts do offer significant protection from the settlor's own creditors, even when the settlor retains a significant beneficial interest in the trust, such as the right to receive distributions. Such trusts are generally not effective for currently known creditors, but only those claims that arise in the future. The primary limitation with off-shore trusts is that you must rely upon the political and economic stability of the countries in which they are administered.
While none of these estate planning vehicles are totally bulletproof against creditors, they do all offer a measure of protection from claims. At a minimum, use of such devices will lead to a more favorable settlement with the creditors. In other words, more of your estate will be available for you and your beneficiaries.
