Definition

Whole life insurance is called permanent protection, meaning the coverage (and possibly the premiums) lasts for your entire (whole) life, as long as the premiums are paid. The death benefit is a guaranteed amount, and your premium is fixed. When you pay the premiums on a whole life policy, part of the money accumulates in a cash value account. Guarantees are based on the claims-paying ability of the issuing insurance company.

Prerequisites

You have a long-term need for insurance

You want insurance protection coupled with a cash value component

Key Strengths

Premiums are fixed

Policy pays minimum guaranteed death benefit (unpaid policy loans may reduce the death benefit below the guaranteed minimum)

Cash values grow tax deferred at guaranteed rate (cash values are held in the general account of the insurer and are subject to claims by creditors if the insurer faces insolvency)

Cash values are accessible during lifetime

Key Tradeoffs

Policy surrender in early years of policy can be costly

Because insurance company controls investment of cash value, you don't get the potential for higher returns that accompanies other types of investments

Guarantees are subject to the claims-paying ability of the issuing insurance company

Variations from State to State

No federal regulatory agency--insurance companies are regulated in each state by the department of insurance (or its local equivalent)

State laws govern ability of creditors to access cash values

How Is It Implemented?

Policy application may require physical exam

Can be difficult to compare policy features and benefits

Tax issues relating to policy loans and surrenders can be complex

Whole Life

What is it?

Permanent (cash value) life insurance

Whole life insurance is called permanent protection, meaning the coverage (and possibly the premiums) lasts for your entire (whole) life, as long as the premiums are paid. The death benefit is a guaranteed amount, and your premium is fixed. When you pay the premiums on a whole life policy, part of the money accumulates in a cash value account.

When can it be used?

You have a long-range insurance need

The purpose of whole life insurance is to protect against long-range or permanent needs. The coverage extends over your entire lifetime (generally up to age 95 or 100), protecting you even after you stop working. You can lock in a premium schedule, so you won't have to worry about the rising cost of insurance as you get older or your health deteriorates.

Strengths

Provides benefits common to all cash value insurance

Like all other permanent (cash value) policies, a whole life policy contains the following features:

Cash value grows tax deferred

Cash value can be borrowed against (however, unpaid policy loans will reduce the death benefit available to your survivors)

Caution: With a whole life insurance policy, you may be allowed to access your cash value by surrendering (canceling) the policy (you may be subject to surrender charges). However, once you cancel the policy, you will no longer have insurance protection. See Tradeoffs for more information.

Policy provides guaranteed minimum death benefit

Your whole life policy provides a minimum death benefit, which is usually equal to the face amount of the policy. This death benefit is guaranteed as long as you pay your premiums when due and your policy remains in force. See Tax Considerations for more information.

Caution: Unpaid policy loans will reduce your death benefit below the guaranteed minimum. See Tradeoffs.

Policy cash value receives guaranteed rate and predictable growth

With a whole life insurance policy, the insurance company manages your cash value and guarantees the return you will receive. The cash value that is part of your whole life policy is held in the general account of the insurance company. Even if the insurance company's investments perform poorly, you still receive the same rate of interest on your cash value. However, you should keep in mind that if the insurer faces insolvency, funds in the general account could be subject to claims by creditors of the insurer, including all other policyholders.

Your premiums are a fixed amount

When you buy a whole life policy, your premium payments are a set, level amount, making budgeting for your payments easy because the premium can't be increased. Even if the insurance company's general account (through which death benefits are paid) performs poorly or your health declines, you can never be required to pay a higher premium to maintain the guaranteed minimum death benefit.

Tip: If your policy pays dividends, you may choose to have the dividends applied toward your premium payment, reducing your out-of-pocket expense.

Choice of premium payment periods available

While whole life insurance coverage lasts your entire lifetime, your premium payments don't necessarily have to. Whole life insurance may offer a variety of premium payment options. For instance, if you want to pay a smaller premium over your lifetime, you may want to consider ordinary level premium whole life. Or, if you want to pay larger premiums for a shorter amount of time, you may want to consider limited pay whole life.

Can be cost-effective form of permanent insurance protection

If you expect your insurance need to last your entire life without diminishing, a whole life policy can be a cost-effective way to buy insurance protection. In the short term, whole life (or any type of permanent (cash value) life insurance, for that matter) is more expensive than term insurance. In the long term, however, whole life may be less expensive. With term insurance, you can count on your premiums increasing with each renewal. When you buy a whole life policy, however, your premiums are level and will not increase over time, an advantage if you keep the policy for many years.

Tradeoffs

Policy surrender in early years of policy can be costly

If you want all your cash value from a whole life policy but don't want to take a policy loan, you must surrender (cancel) your policy, and you may be subject to surrender charges. In addition, policy fees and expenses are usually charged against the policy in the first few years. As a result, policy surrenders during the first few years of the policy may provide little cash value.

Guarantees are subject to the claims-paying ability of the issuer

Guarantees relating to the policy are subject to the claims-paying ability of the issuing insurance company.

How to do it

Determine your life insurance need and overall financial goals

Before you buy life insurance, you need to know how much insurance you need. Insurance need is based on numerous factors, including your current age and income, marital status, number of incomes in the household, number of dependents, long-term financial goals, level of outstanding debt, and existing insurance and other assets. Your overall financial, estate, and tax planning goals and your planning time horizon should be considered as part of your insurance need evaluation.

Tip: Consult your financial advisor concerning your need for insurance. Some of the analysis can be complicated.

Complete the insurance application and name your beneficiary

Before the insurance company can issue your policy, it must receive a completed application form. The application includes general health questions, and the process may include a physical examination, which is usually paid for by the insurance company. A critical part of the application is the beneficiary designation--the naming of the person or persons to receive the policy proceeds when you die. You must name a primary beneficiary (this can be your estate) to receive the proceeds of your insurance policy. Your beneficiary may be a person, corporation, or other legal entity. You may name multiple beneficiaries and specify what percentage of the net death benefit each is to receive. If you name your minor child as beneficiary, be sure to designate an adult as the child's guardian in your will.

Generally, you can change your beneficiary at any time. Changing your beneficiary usually requires nothing more than signing a new designation form and sending it to your insurance company. If you have named someone as an irrevocable (permanent) beneficiary, however, you will need that person's permission to adjust any of the policy's provisions.

Caution: Naming your estate as beneficiary will subject the policy proceeds to claims by creditors of the estate.

Buy the policy and pay your premium

Once your life insurance application has been approved and you pay your initial premium, you'll be issued a policy. However, because an insurance policy is a legal contract, make sure you thoroughly understand all of its provisions before signing it or paying your premiums. Ask an insurance agent or financial professional for help, if necessary.

Review your insurance need periodically

The amount of life insurance you need may change over time, so you should periodically review your life insurance coverage. It's especially important to review your coverage when a major life event occurs (such as the purchase of a home, birth or adoption of a child, or change in marital status).

Tax considerations

Income Tax

Premium payments not deductible

Life insurance premium payments are generally not tax-deductible expenses.

Policy loan proceeds generally not taxable

When you take out a loan against your life insurance policy (except a policy classified as a modified endowment contract (MEC)), the amount you receive is not considered taxable income. This rule applies even when the loan is larger than the amount of premiums you have paid in (except in the case of a policy classified as a MEC).

Example(s): You own a life insurance policy (non-MEC) with a cash value of $20,000. Your basis in the policy is $14,000. You decide to take a policy loan to pay your daughter's college tuition. Under the terms of your policy, you are allowed to take a loan for an amount up to 90 percent of the policy cash value--in this case, $18,000 ($20,000 x 0.90). You are not currently subject to tax on the amount of the loan, even though the loan is larger than your basis in the policy.

Caution: If you cancel your policy while there is a loan balance outstanding, you may be subject to income tax on the amount of the loan.

Policy loan interest not deductible

Interest you pay on a policy loan is not a tax-deductible expense when the loan is for purposes other than business or investments (plus any accrued but unpaid interest).

Policy cancellation may be taxable

If you cancel (surrender) your policy for cash, the gain on the policy is subject to federal income tax. The gain on a canceled policy is the difference between the net cash value and loan forgiveness amounts and your policy basis.

Caution: You may be subject to surrender charges. Check your policy.

Caution: Policy fees and expenses are usually charged against the policy in the first few years. As a result, policy surrenders during the first few years of the policy may provide little cash value.

Caution: If you surrender your policy while there is a loan balance outstanding, you could be subject to income tax on the amount of the loan (plus any accrued but unpaid interest).

Policy lapse may be taxable

If you allow your policy to lapse, you could be subject to income tax even if you don't receive any cash from the policy. A policy lapse can occur when you stop paying premiums and don't have cash values available that can be used to pay the premiums. If you have an outstanding policy loan, it is possible you could be subject to tax on the amount of the loan plus any accrued but unpaid interest.

Death benefits generally not subject to federal income tax

Policy death benefits are generally not subject to federal income tax. One notable exception is when the policy has been sold or otherwise transferred for valuable consideration by one policy owner to another, subjecting it to the transfer-for-value rule.

Gift and Estate Tax

Policy proceeds not considered gift to beneficiary

When the proceeds of your life insurance policy are paid to a beneficiary, they are not treated as a gift for federal gift and estate tax purposes.

Policy premium payments generally not subject to federal gift and estate tax

When you are the owner of a policy on your own life, with another party as the beneficiary, premium payments made by you are not considered a gift to the beneficiary for federal gift and estate tax purposes. If, however, someone else pays the premiums on a policy you own, the premium payments are considered a gift to you and may be subject to the tax. Policy premiums paid by another on your behalf generally qualify for the annual gift tax exclusion.

Policy proceeds included in estate value in some cases

The proceeds of a life insurance policy are included in the value of your estate if you held any incidents of ownership at any time during the three years before your death or if the proceeds are payable to you or your estate or executor. Incidents of ownership include (among other things) the right to change the beneficiary, take out policy loans, or surrender the policy for cash.

Policy proceeds often exempt from state inheritance tax

In many states, life insurance proceeds are exempt from state inheritance taxes. For more information, please contact me at 502.271.8452

Tax Planning Tips: Life Insurance    

Understanding the importance of life insurance is one thing. Understanding the tax rules is quite another. As insurance products have evolved and become more sophisticated, the line separating insurance vehicles from investment vehicles has grown blurry. To differentiate between the two, a mix of complex rules and exceptions now governs the taxation of insurance products. If you have neither the time nor the inclination to decipher the IRS regulations, here are some life insurance tax tips and background information to help you make sense of it all.   

Life insurance contracts must meet IRS requirements 

For federal income tax purposes, an insurance contract cannot be considered a life insurance contract--and qualify for favorable tax treatment--unless it meets state law requirements and satisfies the IRS's statutory definitions of what is or is not a life insurance policy. The IRS considers the type of policy, date of issue, amount of the death benefit, and premiums paid. The IRS definitions are essentially tests to ensure that an insurance policy isn't really an investment vehicle. The insurance company must

comply with these rules and enforce the provisions.       

Keep in mind that you can't deduct your premiums on your federal income tax return  

Because life insurance is considered a personal expense, you can't deduct the premiums you pay for life insurance coverage.              

Employer-paid life insurance may have a tax cost               

The premium cost for the first $50,000 of life insurance coverage provided under an employer-provided group term life insurance plan does not have to be reported as income and is not taxed to you. However, amounts in excess of $50,000 paid for by your employer will trigger a taxable income for the "economic value" of the coverage provided to you. 

You should determine whether your premiums were paid with pre- or after-tax dollars                  

The taxation of life insurance proceeds depends on several factors, including whether you paid your insurance premiums with pre- or after-tax dollars. If you buy a life insurance policy on your own or through your employer, your premiums are probably paid with after-tax dollars. Different rules may apply if your company offers the option       to purchase life insurance through a qualified retirement plan and you make pretax contributions. Although pretax contributions offer certain income tax advantages, one tradeoff is that you'll be required to pay a small tax on the economic value of the "pure life insurance" in the policy (i.e., the difference between the cash value and the death benefit) each year. Also, at death, the amount of the policy cash value that is paid as part of the death benefit is taxable income. These days, however, not many companies offer their employees the option to purchase life insurance through their qualified retirement plan.                  

Your life insurance beneficiary probably won't have to pay income tax on death benefit received                  

Whoever receives the death benefit from your insurance policy usually does not have to pay federal or state income tax on those proceeds. So, if you die owning a life insurance policy with a $500,000 death benefit, your beneficiary under the policy will generally not have to pay income tax on the receipt of the $500,000. This is generally true regardless of whether you paid all of the premiums yourself, or whether your employer subsidized part or all of the premiums under a group term insurance plan. Different income tax rules may apply if the death benefit is paid in installments instead of as a lump sum. The interest portion (if any) of each installment is generally treated as taxable to the beneficiary at ordinary income rates, while the principal portion is tax free.

In some cases, insurance proceeds may be included in your taxable estate

If you hold any incidents of ownership in an insurance policy at the time of your death, the proceeds from that insurance policy will be included in your taxable estate. Incidents of ownership include the right to change the beneficiary, the right to take out policy loans, and the right to surrender the policy for cash. Furthermore, if you gift away an insurance policy within three years of your death, then the proceeds from that policy     will be pulled back into your taxable estate. To avoid having the policy included in your taxable estate, someone other than you (e.g., a beneficiary or a trust) should be the owner.

Note: If the owner, the insured, and the beneficiary are three different people, the payment of death benefit proceeds from a life insurance policy to the beneficiary may result in an unintended taxable gift from the owner to the beneficiary.

If your policy has a cash value component, that part will accumulate tax deferred

Unlike term life insurance policies, some life insurance policies (e.g., permanent life) have a cash value component. As the cash value grows, you may ultimately have more money in cash value than you paid in premiums. Generally, you are allowed to defer income taxes on those gains as long as you don't sell, withdraw from, or surrender the policy. If you do sell, surrender, or withdraw from the policy, the difference between what you get back and what you paid in is taxed as ordinary income.      

You usually aren't taxed on dividends paid                  

Some policies, known as participating policies, pay dividends. An insurance dividend is the amount of your premium that is paid back to you if your insurance company achieves lower mortality and expense costs than it expected. Dividends are paid out of the insurer's surplus earnings for the year. Regardless of whether you take them in cash, keep them on deposit with the insurer, or buy additional life insurance within the policy, they are considered a return of premiums. As long as you don't get back more than you paid in, you are merely recouping your costs, and no tax is due. However, if you leave these dividends on deposit with your insurance company and they earn interest, the interest you receive should be included as taxable interest income.        

Watch out for cash withdrawals in excess of basis--they're taxable            

If you withdraw cash from a cash value life insurance policy, the amount of withdrawals up to your basis in the policy will be tax free. Generally, your basis is the amount of premiums you have paid into the policy less any dividends or withdrawals you have previously taken. Any withdrawals in excess of your basis (gain) will be taxed as ordinary income. However, if the policy is classified as a modified endowment contract (MEC) (a            situation that occurs when you put in more premiums than the threshold allows), then the gain must be withdrawn first and taxed. Keep in mind that if you withdraw part of your cash value, the death benefit available to your survivors will be reduced.

You probably won't have to pay taxes on loans taken against your policy               

If you take out a loan against the cash value of your insurance policy, the amount of the loan is not taxable (except in the case of an MEC). This result is the case even if the loan is larger than the amount of the premiums you have paid in. Such a loan is not taxed as long as the policy is in force. If you take out a loan against your policy, the death benefit and cash value of the policy will be reduced.

You can't deduct interest you've paid on policy loans                 

The interest you pay on any loans taken out against the cash value of your life insurance is not tax deductible. Certain loans on business-owned policies are an exception to this rule.                  

The surrender of your policy may result in taxable gain               

If you surrender your cash value life insurance policy, any gain on the policy will be subject to federal (and possibly state) income tax. The gain on the surrender of a cash value policy is the difference between the gross cash value paid out (plus any loans outstanding) and your basis in the policy. Your basis is the total premiums that you paid in cash, minus any policy dividends and tax-free withdrawals that you made.      

You may be able to exchange one policy for another    without triggering tax liability         

The tax code allows you to exchange one life insurance policy for another (or a life insurance policy for an annuity) without triggering current tax liability. This is known as a Section 1035 exchange. However, you must follow the IRS's rules when making the exchange.

On June 28, 2012, the U.S. Supreme Court ruled, in a landmark decision, that the Patient Protection and Affordable Care Act (ACA), including the provision that most Americans carry health insurance or pay a penalty, is constitutional.

The ACA, signed into law in 2010, made sweeping reforms to health-care coverage in the United States. Many provisions of the law have already taken effect. A number of other provisions are scheduled to take effect in subsequent years, including the requirement that most Americans and legal residents have qualifying health insurance (exceptions apply) or pay a penalty in the form of a tax. Here's a summary of some of the important provisions that are already in place, and those that are on their way by 2014.

In effect now

Children can no longer be denied insurance coverage because of pre-existing conditions

Payment of $250 rebate to Medicare Part D beneficiaries subject to the coverage gap (beginning January 1, 2010) and gradually reducing the beneficiary coinsurance rate in the coverage gap from 100% to 25% by 2020

Insurers will not be able to impose lifetime caps on insurance coverage

All plans offering dependent coverage will be required to allow children to remain under their parents' plan until age 26

Insurers cannot cancel or deny coverage if you are sick except in cases of fraud

Adults with pre-existing conditions will be able to buy coverage from temporary high-risk pools until 2014, when coverage cannot otherwise be denied for pre-existing conditions

Key provisions effective on or before January 1, 2014

Increasing the medical expense income tax deduction threshold to 10% of adjusted gross income, up from the current 7.5% (January 1, 2013)

Increasing the Medicare Part A tax rate by 0.9% on wages over $200,000 for individuals ($250,000 for married couples), and assessing a new 3.8% tax on some or all of the net investment income for these higher-income individuals (January 1, 2013)

All Americans must carry health insurance or face a penalty (in the form of a tax) of up to 2.5% of household income on individuals, with exceptions for economic hardship, religious beliefs, and other situations (January 1, 2014)

Adults with pre-existing conditions cannot be denied coverage or have their insurance cancelled due to pre-existing conditions (January 1, 2014)

A requirement that states establish an American Health Benefit Exchange that facilitates the purchase of qualified health plans and includes an Exchange for small businesses (January 1, 2014)

Tax credits will be available to qualifying families to offset the cost of health insurance premiums (January 1, 2014)

Employers with more than 50 employees must offer health insurance for their employees or be fined per employee (January 1, 2014)

Imposing taxes or fees on health insurance providers and drug companies, while doctors and hospitals will receive less compensation from government sources (January 1, 2014)

So is this it?

While the Supreme Court has ruled the ACA constitutional, it may still face challenges as Congress may seek to repeal the law. The ultimate fate of the health-care reform law may be determined by the outcome of the November elections.

CASE:

There are five estate planning documents you may need, regardless of your age, health, or wealth:

1. Durable power of attorney
2. Advanced medical directives
3. Will
4. Letter of instruction
5. Living trust

The last document, a living trust, isn't always necessary, but it's included here because it's a vital component of many estate plans.

Durable power of attorney

A durable power of attorney (DPOA) can help protect your property in the event you become physically unable or mentally incompetent to handle financial matters. If no one is ready to look after your financial affairs when you can't, your property may be wasted, abused, or lost.

A DPOA allows you to authorize someone else to act on your behalf, so he or she can do things like pay everyday expenses, collect benefits, watch over your investments, and file taxes.

There are two types of DPOAs: (1) a standby DPOA, which is effective immediately (this is appropriate if you face a serious operation or illness), and (2) a springing DPOA, which is not effective unless you have become incapacitated.

Advanced medical directives

Advanced medical directives let others know what medical treatment you would want, or allows someone to make medical decisions for you, in the event you can't express your wishes yourself. If you don't have an advanced medical directive, medical care providers must prolong your life using artificial means, if necessary. With today's technology, physicians can sustain you for days and weeks (if not months or even years).

There are three types of advanced medical directives. Each state allows only a certain type (or types). You may find that one, two, or all three types are necessary to carry out all of your wishes for medical treatment. (Just make sure all documents are consistent.)

First, a living will allows you to approve or decline certain types of medical care, even if you will die as a result of that choice. In most states, living wills take effect only under certain circumstances, such as terminal injury or illness. Generally, one can be used only to decline medical treatment that "serves only to postpone the moment of death." In those states that do not allow living wills, you may still want to have one to serve as evidence of your wishes.

Second, a durable power of attorney for health care (known as a health-care proxy in some states) allows you to appoint a representative to make medical decisions for you. You decide how much power your representative will or won't have.

Finally, a Do Not Resuscitate order (DNR) is a doctor's order that tells medical personnel not to perform CPR if you go into cardiac arrest. There are two types of DNRs. One is effective only while you are hospitalized. The other is used while you are outside the hospital.

Will

A will is often said to be the cornerstone of any estate plan. The main purpose of a will is to disburse property to heirs after your death. If you don't leave a will, disbursements will be made according to state law, which might not be what you would want.

There are two other equally important aspects of a will:

1. You can name the person (executor) who will manage and settle your estate. If you do not name someone, the court will appoint an administrator, who might not be someone you would choose.
2. You can name a legal guardian for minor children or dependents with special needs. If you don't appoint a guardian, the state will appoint one for you.

Keep in mind that a will is a legal document, and the courts are very reluctant to overturn any provisions within it. Therefore, it's crucial that your will be well written and articulated, and properly executed under your state's laws. It's also important to keep your will up-to-date.

Letter of instruction

A letter of instruction (also called a testamentary letter or side letter) is an informal, nonlegal document that generally accompanies your will and is used to express your personal thoughts and directions regarding what is in the will (or about other things, such as your burial wishes or where to locate other documents). This can be the most helpful document you leave for your family members and your executor.

Unlike your will, a letter of instruction remains private. Therefore, it is an opportunity to say the things you would rather not make public.

A letter of instruction is not a substitute for a will. Any directions you include in the letter are only suggestions and are not binding. The people to whom you address the letter may follow or disregard any instructions.

Living trust

A living trust (also known as a revocable or inter vivos trust) is a separate legal entity you create to own property, such as your home or investments. The trust is called a living trust because it's meant to function while you're alive. You control the property in the trust, and, whenever you wish, you can change the trust terms, transfer property in and out of the trust, or end the trust altogether.

Not everyone needs a living trust, but it can be used to accomplish various purposes. The primary function is typically to avoid probate. This is possible because property in a living trust is not included in the probate estate.

Depending on your situation and your state's laws, the probate process can be simple, easy, and inexpensive, or it can be relatively complex, resulting in delay and expense. This may be the case, for instance, if you own property in more than one state or in a foreign country, or have heirs that live overseas.

Further, probate takes time, and your property generally won't be distributed until the process is completed. A small family allowance is sometimes paid, but it may be insufficient to provide for a family's ongoing needs. Transferring property through a living trust provides for a quicker, almost immediate transfer of property to those who need it.

Probate can also interfere with the management of property like a closely held business or stock portfolio. Although your executor is responsible for managing the property until probate is completed, he or she may not have the expertise or authority to make significant management decisions, and the property may lose value. Transferring the property with a living trust can result in a smoother transition in management.

Finally, avoiding probate may be desirable if you're concerned about privacy. Probated documents (e.g., will, inventory) become a matter of public record. Generally, a trust document does not.

Note:  This is intended only as a discussion of this trust.  It is not intended to render legal advice in anyway.  Please contact an attorney for a legal opinion or please contact my office and I can refer one to you.  Dwayne K Dowell, CPA

Summary:

What is a domestic self-settled spendthrift trust?

A self-settled trust is a trust where the grantor (i.e., the creator, settlor, or donor) is one of the beneficiaries, or the sole beneficiary, of the trust. A spendthrift trustis a trust that prevents trust beneficiaries from transferring their interests in the trust to other parties (e.g., creditors). Prior to April of 1997, a self-settled trust could not be a spendthrift trust under the laws in all 50 states, and U.S. citizens were forced to create such trusts in offshore or foreign jurisdictions.

In April of 1997, Alaska passed the first legislative act authorizing the use of self-settled spendthrift trusts (also called domestic asset protection trusts). In the same year, Delaware enacted similar legislation (hence this type of trust is often referred to as an Alaska/Delaware trust). A handful of states have since followed suit.

How does a domestic self-settled spendthrift trust work?

In general

With a spendthrift trust, the trustee is given discretion to make or not make distributions to beneficiaries. Because distributions are discretionary, beneficiaries are prevented from voluntarily or involuntarily transferring current or future rights in the trust. In other words, beneficiaries can't give away trust income or principal in advance of receiving it. One effect of such alienation language in a trust is that creditors of a trust beneficiary cannot claim that trust assets are assets of the beneficiary. Therefore, creditors cannot stake a claim against trust assets, but can only collect money that is actually distributed to the beneficiary.

Requirements

Though the states that allow this type of trust have their own requirements and exceptions, there are elements that are common to all domestic self-settled spendthrift trusts:

• The trust must be irrevocable
• The trust document must expressly state that the laws of the state in which the trust is located govern the trust
• The trust document must include a spendthrift provision
• Some trust assets must actually be held within the state
• The trustee must be a resident of the state (though the state may allow an out-of-state co-trustee)

Retained interests

Typically, grantors retain the following interests, although other rights may be permitted, depending on the state:

• Discretionary distributions of income and/or principal
• Veto power over distributions
• Special (or limited) testamentary power of appointment (i.e., the power to name or change the ultimate beneficiaries, excluding the grantor, grantor's creditors, grantor's estate, and creditors of the grantor's estate)

Limitations on claims

Each state limits the time in which creditors can make claims against the assets in the trust. For example, a state may provide that creditors whose claims arise after the trust has been created (i.e., future creditors) have only 4 years from the date the grantor transfers the assets to the trust to make such claims, and existing creditors have the later of 4 years from the date of transfer or one year after the creditor discovers (or should have discovered) the existence of the trust.

Generally, creditors' claims are barred after the statute of limitations period expires.

Fraudulent transfers

Creditors who make claims within the allowable time period must prove that transfers to the trust were fraudulent (i.e., made when the creditor's claims were already foreseen by the grantor). If the creditor is successful, the creditor can recover its debt and any costs allowed by the court.

Exempt creditors

Generally, spouses, children, and existing tort claimants are exempt from the statute of limitations and fraudulent transfer rules as explained above.

Tax considerations

Income Tax

Generally, domestic self-settled spendthrift trusts are grantor-type trusts--income earned by and expenses incurred by trust assets flow through to the grantor on his or her personal income tax return. However, the trust may be deemed a separate taxpayer if an adverse party must approve distributions to the grantor.

Gift Tax

Generally, transfers to a domestic self-settled spendthrift trust are subject to gift tax unless the grantor retains a power of appointment.

Estate Tax

Whether assets remaining in a domestic self-settled spendthrift trust at the grantor's death are subject to estate tax depends on the degree of control retained by the grantor. Generally, a discretionary income interest is not considered a retained interest, whereas other retained interests could result in estate taxation.

Suitable clients

• Professionals (e.g., doctors, lawyers, engineers)
• Business owners
• Officers, directors, and fiduciaries
• Real estate owners who may be vulnerable to environmental claims
• Other individuals who are exposed to liability or contractual claims

Example

Larry buys a large tract of land that he plans to develop into an upscale residential community of single-family homes and condominium units, as well as health and recreation facilities, and commercial spaces for conveniences such as a small grocery or dry cleaning business. The project will take several years to complete. Currently, the land is not fenced in and is abutted by other residential neighborhoods. Larry lives with his family in a $1.5 million home that is titled in his wife's name. Larry and his wife live in a state that protects their retirement plans, life insurance, and annuities from creditor claims. But, Larry is the sole owner of an investment portfolio valued at close to $4 million, and he wants to protect those assets in the event of a large lawsuit in connection with the land.

Larry lives in State A, which is adjacent to State B, which allows self-settled spendthrift trusts. Larry creates such a trust in State B, naming a trust company in State B as trustee, and he and his spouse as sole beneficiaries during their lives, and their children as the ultimate beneficiaries. The trustee is given complete discretion to make or not make distributions to Larry and his spouse. Larry transfers his entire investment portfolio to the trust.

Over the next 2 years, the trust company administers the trust and manages the investment portfolio according to Larry's advice. One year later, with about two-thirds of the project completed, a serious accident occurred on Larry's land. The resulting lawsuits produced judgments against Larry far in excess of Larry's liability insurance limits, but the claimants were unable to reach Larry's investment portfolio to satisfy the judgments.

Advantages

Permits grantor to be beneficiary of spendthrift trust

Grantors can form a trust for their own benefit that protects them against creditors, something that is expressly prohibited by the majority of states. Generally, the states that allow self-settled spendthrift trusts have laws that shorten the time period for a creditor to challenge transfers, and make it more difficult for creditors to prove transfers were fraudulent.

Familiar jurisdiction to grantors

Some grantors will feel more comfortable with a trust located within the United States as opposed to an offshore jurisdiction.

Simpler and less costly than offshore trust

Generally, creating and maintaining an offshore trust is more complex and more expensive than a domestic trust.

Disadvantages

Fraudulent conveyance issues

Grantors must take care not to trigger fraudulent transfer laws, which might subject them to very severe penalties including hefty fines and jail time. Grantors must NOT:

• Create the trust to avoid known creditor claims, spousal support, or child support
• Make themselves insolvent by transferring too many assets to the trust
• Act as the independent trustee

Full faith and supremacy clause issues

Should a creditor be successful in a non self-settled spendthrift trust state, the state in which the trust is located is obligated to enforce the judgment under the Full Faith and Credit clause of the U.S. Constitution. Similarly, under the supremacy clause of the U.S. Constitution, federal law will preempt state law.

May not offer as much protection as an offshore trust

An offshore trust may be less likely than a domestic trust to be attacked by creditors as they generally present more hurdles that must be overcome by the creditor, including the psychological barrier of dealing with foreign persons and systems.

Untested law

The validity of self-settled spendthrift trusts has yet to be tested in the United States Supreme Court. Until the law is firmly established, care should be taken to create and fund such trusts under appropriate circumstances.