Asset Protection and Living Trusts

Asset protection and living trusts are so important as the following story illustrates.  The courtroom was packed. People were standing in the isles. There was no question: the man was guilty, and the citizens wanted justice. Many millions of dollars had been siphoned out of the little town, and unless the money was recovered, a lot of businesses were going to go under. The state attorney general was poised. The defense counsel was calmly waiting.

Over a five year period, the man on trial, Mr. Smart, had built a large business with a huge cash flow. He also was smart enough to take care of his asset protection and living trusts.  All of the businesses in town had grown to rely on Mr. Smart’s business. Although he had always paid his bills and was a good man, he couldn’t handle success; and he changed. He just kept expanding his business. It became huge. His company made millions and millions in profits in its third and fourth years.

In the fifth year everything came apart. The company hired too many employees. It bought a huge new building, and the Gulf War hit America. Overnight, Americans changed their spending patterns. For a brief period, they became preoccupied by the media’s high tech coverage of the war, and they became very conservative buyers.

Company sales went from $10,000,000 a month to under $1,000,000, but the overhead kept right on coming. All of the businessmen in town who supplied parts for the product, printed the advertising, mailed the products, fixed the computers, and supplied all of the company’s needs didn’t know how bad things were getting for Smart. Because they knew Smart was loaded with money, the businessmen in town all extended credit for 30, 60, 90, 120 days. Because Smart was their biggest customer, they had to either extend credit or start laying off people and cutting way back.

The company and Smart tried everything they could. They introduced several new products. They advertised, and they sold the new products. But, sales didn’t pick up fast enough. The company was too far in debt, and its overhead was way too high. Sales of the new products had actually gone well, but the buyers began to complain to the company and the state agencies. The new products were late in delivery. The new products were never delivered. Smart had done something dumb. He had sold products that never existed. The new products didn’t exist – except in the minds of Mr. Smart and his executives.

“All rise!” ordered the bailiff. The judge in his flowing rob entered and took his position behind the bench. Court was in session. After opening statements, the defense attorney stood and asked the judge to dismiss Mrs. Smart from the suit. She had been named on the suit, but as the defense attorney clearly pointed out, there were no allegations in the complaint of her ever doing anything wrong. The attorney general had to agree.  The asset protection and living trusts Mr Smart has formed were the reason.

The judge demanded, “Do you have any charges against Mrs. Smart?”

“She has all of the money. It’s all in her trust,” the attorney general stated.

“Has the money been illegally transferred to the trust?”


“Was it transferred when the company owed all of its current bills?”


Since the money had been taken out of the company in the third and fourth year, over a year earlier while things were going well, its removal from the company couldn’t be considered and attempt to defraud the company’s creditors.  The asset protection and living trusts Mr Smart had put in place were working.

Because the money has been removed and gifted by Mr. Smart to his wife years earlier, it was well outside of the bankruptcy statutes of limitation. As soon as she got the money, it was put in her individual trust where Mr. Smart had no interest in it. Even if Mr. Smart declared personal bankruptcy, the money was well beyond the reach of his creditors.

In spite of the attorney general’s pleading with the judge, there was no legal reason to maintain the case against Mrs. Smart. Within twenty minutes the case against Mrs. Smart was dismissed with prejudice, meaning it could not be reopened against her. The attorney general was helpless in her fight for the money that was in the trust. Asset protection and living trusts had worked.

Several years later, we came upon Mr. Smart while strolling down the beach on Kauai. We sat on the beach and talked in the shadow of his penthouse condominium. During the conversation, he stated that he had been wiped out. He was flat broke. He was a kept man – a well kept man.

Two Trusts

Whether your estate has big time tax problems or is a small estate, psychologically you are very attached to what you “own.” Most couples feel that they are in a common enterprise, the family, and that their assets are all in “one pot.”

Asset protection and living trusts are used in estate planning primarily to avoid probate. Some of them work, but most of them don’t work to avoid probate, but that’s another story. The trusts come in two basic flavors, joint trusts and two separate trusts. The joint trust, where all assets are held in one trust until the death of one of the spouses, works well because it preserves the “one pot” way of life the couple is used to having. The two trust system, however, appears to be cleaner for asset protection planning.

In the two trust system, two separate trust documents are actually created – one for each spouse. Both trusts are living revocable trusts. They have been funded and managed as separate trusts. The property in the trusts avoids probate, and a full exemption equivalent can be sheltered from estate tax at the death of the first spouse with no actual tax being paid, just as it can be sheltered in the joint living revocable trust.

In establishing the two trusts, the husband creates one trust acting as grantor and is named as trustee and beneficiary. The wife creates the other trust acting as grantor and is named trustee and beneficiary. The property in each trust, of course, is owned by the trust and controlled by the trustee to be used for the benefit of the beneficiaries named in the trust. The husband is usually named to receive the benefit of the wife’s trust after she dies and vice versa. Other than the benefit that arises after the death of the grantor, each spouse has no legal interest in the other’s trust.

Upon the death of the husband or wife, the trust he or she created becomes irrevocable. The property in the trust will be taxed at the grantor’s death – unless the property is transferred to the surviving spouse or the surviving spouse’s trust. The trust papers are written to retain up to the exemption equivalent amount in the deceased spouse’s trust. Thus, the maximum exemption equivalent amount is protected, and the surviving spouse’s trust goes on as a revocable trust.

As long as the wife is alive, her husband has no legal interest in her trust. That means the property in her trust is, in theory, protected from his legal problems. Can you see the power in what that means?

Double Protection

In asset protection and living trusts planning you should use two individual trusts – one trust for you and one for your spouse. The two trusts can be created using the two trust system or using a joint trust which established separate trust divisions for you and your spouse. Divide the wealth evenly or stack the wealth with the spouse (the spouse’s trust) that is least likely to be exposed to legal attack. A spouse that is a professional or runs a business is especially open to attack, so plan on stacking the wealth in favor of the other spouse. Before you stack all of the family’s wealth in one spouse’s trust, you need to make sure you aren’t running afoul of the estate tax laws.

If one spouse is attacked by someone through a lawsuit, the other spouse’s trust is beyond the reach of the suit as long as the other spouse cannot be drawn into the lawsuit.

Dividing the estate into two trusts is not a total protection if one spouse gets sued, but it can certainly help protect half of the estate. It is a step which is easy to take. It can be a futile effort in some cases, but in many other cases, it can save a family’s financial future. If you are in a community property state, the separation between husband and wife is harder, if not impossible, to establish, so beware.

Lee R. Phillips and his wife, Kristy S. Phillips, are co-authors of the book Protecting Your Financial Future. It discusses revocable trusts in detail and shows you how to use them for estate planning and asset protection.