What is an asset protection trust (APT)?
Trusts are often used to pass down wealth from one generation to the next. But a specific type of trust — an asset protection trust — offers protection from creditors while you’re still alive.
In this article, we’ll explore the different kinds of asset protection trusts, how they work and what you should know before setting one up.
What is an asset protection trust (APT)?
An asset protection trust is an estate planning tool that shields a person’s assets from creditors and lawsuits. These complex financial and legal structures often require a lawyer to create.
It’s an irrevocable trust, which means you relinquish control over assets placed inside the trust to a third-party trustee, such as a bank, accountant or lawyer. Once established, it’s nearly impossible to alter the terms of the trust.
By signing over ownership of assets to the trust, these assets technically belong to a different entity instead of you. This generally puts your assets out of reach of creditors, liens and other judgements.
Asset protection trusts are popular with people in high-risk occupations (think doctors and real estate developers) and very wealthy individuals looking to shield their net worth from creditors. They may also be used in lieu of a prenuptial agreement.
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Types of asset protection trusts
There are three types of asset protection trusts. Each functions differently, and each comes with its own unique set of advantages and disadvantages.
Domestic APTs
Domestic asset protection trusts are a legal way to safeguard wealth from creditors and potential lawsuits. Domestic APTs are relatively quick and easy to establish in the 20 states that permit them:
- Alabama
- Alaska
- Connecticut
- Delaware
- Hawaii
- Indiana
- Michigan
- Mississippi
- Missouri
- Nevada
- New Hampshire
- Ohio
- Oklahoma
- Rhode Island
- South Dakota
- Tennessee
- Utah
- Virginia
- West Virginia
- Wyoming
While domestic APTs are irrevocable, you as the creator still retain some control over the trust. How much control varies by state, but in general, you retain the ability to:
- Receive trust income
- Direct (but not consent to or veto) your trustee’s investment decisions and distribution decisions
- Remove and appoint new trustees and trust advisors
Some states permit the trust creator even broader powers. However, in many states, if the person who sets up the trust can also benefit from it, creditors may still be able to make a claim against the trust’s assets.
Depending on the state, domestic asset protection trusts can be used to avoid or lower state income taxes. So long as the trust is established in a state with no state income tax (such as Alaska or Wyoming), the assets inside the trust aren’t subject to state taxes.
But domestic APTs aren’t bulletproof. Nearly all states, except Nevada, have carve-outs that allow certain creditors to make claims on trust assets, such as in divorce settlements or child support disputes.
A domestic APT is more of a proactive move than a short-term strategy: There’s a period of limitations before asset protection kicks in, and it can’t protect you from an outstanding claim already taken out against you. The number of years required to achieve asset protection within the trust varies from state to state.
Foreign APTs
A foreign asset protection trust, also known as an offshore trust, is a legal structure set up outside the United States to shield the owner from creditors. Foreign APTs are more expensive to create than domestic APTs.
To establish a properly structured foreign APT, you’ll need an estate planning attorney who is well-versed in the selected country’s laws and regulations.
In certain places, like the Cook Islands, the creator of the trust can still have some control over it. The creator can change its terms, manage the property inside it, choose or remove the trustee and be a named beneficiary. If an asset transfer to the trust is found to be fraudulent, it doesn’t mean the entire trust is void — only the part that was transferred dishonestly can be used to pay back the creditor.
Wealthy business owners may establish a foreign APT as part of a larger strategy to dodge creditors, along with the use of insurance, offshore LLCs and offshore bank accounts.
Foreign APTs are not intended to avoid income or estate taxes. In fact, the IRS prohibits it.
While some promoters of foreign APTs claim that the transfer of U.S.-based assets (such as a home) protect the creator from owing income or estate taxes, the IRS disagrees.
“If the taxpayer continues to reside in his home and control his assets, those assets may be seized and sold in satisfaction of his liabilities,” according to an IRS tax publication.
So beware of any foreign APTs marketed as part of a package to avoid federal income or employment taxes because “the courts can ignore such trusts and order the taxpayer’s property sold to satisfy the outstanding liabilities.”
Medicaid APTs
A Medicaid asset protection trust is an estate planning tool used to shield assets from Medicaid in order to qualify for benefits. It’s most often used by older individuals who are trying to qualify for Medicaid long-term care services.
Medicaid considers a person’s total assets and income when determining eligibility. Each state sets its own asset limits, but generally, it’s $2,000 or less. While certain assets aren’t counted toward that total — such as an applicant’s primary residence — many people exceed the asset limit while still struggling to afford long-term care.
Placing things like a second home or a retirement account inside an asset protection trust prevents these items from being counted against you during Medicaid eligibility. Without this type of trust, a Medicaid applicant would need to “spend down” nearly all of their resources in order to qualify for the program.
Another benefit of APTs is they shield a person from Medicaid estate recovery. When a Medicaid recipient dies, the state in which they received Medicaid can attempt to collect reimbursement for long-term care expenses from the deceased person’s estate. However, the state can’t come after those assets if they’re placed in an asset protection trust.
One of the biggest drawbacks about Medicaid APTs is that they are not a viable short-term solution. Medicaid checks to ensure no assets were gifted or sold in the five years prior to applying for the program, a practice known as the “look back” period. If Medicaid finds out that assets were transferred to a trust less than five years before applying for the program, it can deny the application.
Advantages and disadvantages of APTs
Each type of asset protection trust comes with its own unique advantages and disadvantages. For example, domestic APTs are relatively quick to establish, while foreign APTs are much more complex and require a deep understanding of the other country’s tax laws.
Here are some pros and cons shared by all APTs.
Pros
- Wealth protection: Assets held in the trust are shielded from creditors, providing a level of financial security.
- Tax efficiency: Domestic protection trusts established in states without state income tax may avoid state taxation. However, no asset protection trust is intended to shield the creator from federal income tax or estate tax.
- Privacy: Trusts provide a level of confidentiality because they are not public documents, unlike wills.
Cons
- Complex to set up: You’ll need to hire an experienced attorney to create an asset protection trust. It can take months to get everything drafted and finalized.
- Expensive: Creating a domestic APT can cost $2,000 to $5,000 and up, while foreign APTs generally start at $20,000 and up.
- Limited protection: Generally, an APT must be created before any claims are brought against you. For domestic APTs, it can also take several years after the trust is established before assets are fully protected from creditors.
Establishing an asset protection trust
Are you considering creating an asset protection trust? Here are the general steps you’ll need to follow:
- Speak with a lawyer: Setting up an asset protection trust requires working with an experienced estate planning attorney.
- Choose the right jurisdiction: Your attorney will help you identify the best state or country to establish the trust. If you’re establishing a domestic APT, states like Alaska, Delaware and Nevada are popular choices, though regulations around them change frequently.
- Draft the trust agreement: Your attorney will create a comprehensive trust agreement, which will outline the trust’s terms, conditions, trustee and other details.
- Select a trustee: Pick a third-party individual or institution to manage the trust. They’ll oversee the assets and ensure they’re distributed according to the trust’s terms.
- Transfer your assets: Move your chosen assets into the trust. This could include real estate, investments, business holdings and other property, like boats. Keep detailed records of these transfers.
Bottom line
An asset protection trust is a complex financial planning tool designed to protect the property of high-net worth people from creditors. While APTs offer valuable benefits like wealth protection, tax efficiency and privacy, they can be complex and expensive to set up, requiring careful planning and legal expertise. If you’re considering establishing an APT, consulting with an experienced attorney and a financial advisor is essential.
