If you make enough money in your life, there is a good chance you’ll be on the receiving end of a frivolous lawsuit. It’s unfortunate but true that the United States is a pretty “sue-happy” country. Whether your business is being accused of a patent violation, or you bump into someone in traffic at a red light, your personal assets could be seized to satisfy a judgment. And those judgments don’t stop at your death — assets in your estate could potentially be claimed by creditors and lawsuits. While regular insurance can go a long way toward protecting you, it’s not always enough. Instead, an irrevocable life insurance trust (ILIT) can be used to hold funds and protect those funds from creditors and judgments.
How Creditors and Judgments Go After Your Estate
Even death isn’t protection from lawsuits and creditors. In fact, any interested person with a legal claim can open your estate and push it into probate to make a claim on assets you’re trying to pass on to your heirs. If your estate representative denies a creditor’s claim, then that creditor will have the option to take its case to court. A dispute in probate court can drag on for years.
In the meantime, your heirs don’t get the property or funds you’ve left to them. Instead, they will have to wait until a final decision on probate is decided. This is a long, costly process that can deplete your lifetime of savings. Even if your estate eventually wins the suit, you could lose a significant portion of those funds simply due to legal costs. After all, when your estate is pulled into probate court, your estate must cover the cost of that probate. If the creditor wins the suit, your estate is responsible for paying it. It might even be required to liquidate assets to pay out those judgments.
While most of our clients have enough to settle their debts when they pass, this is a risk that anyone could face. It’s not unusual for disgruntled relatives and former business partners to file against an estate in the hopes that the estate will pay out simply to avoid depleting its funds through legal costs. No matter how organized your estate, there’s always the risk that your heirs will face such lawsuits. The best way to avoid this is to keep funds outside of your estate in an ILIT.
How Irrevocable Trusts Protect Assets for Heirs
While trusts can protect your money from the federal government, that’s not the only purpose they serve. They can also protect your estate from creditors and lawsuits. Because irrevocable trusts remove your assets from your estate, one ideal way to protect your heirs’ inheritance is to put it in a trust. Using an ILIT offers an additional layer of insulation. This is because life insurance policies are contracts, and they are not subject to probate. They instead bypass probate and pay directly into the trust.
The trust, provided it’s created correctly, will not be part of your estate, so creditors can’t go after it to satisfy judgments. In addition, they can’t tie it up in court for years because it’s not part of your probate. The trust allows you to pass funds on to your heirs quickly, rather than having to wait through a long probate process.
One key to ensuring this trust is set up correctly is making it irrevocable. Irrevocable means that, once it’s established, you can’t alter or cancel it. You’ll no longer have any control of it. While this sounds restrictive, it’s necessary to ensure you have no “incidents of ownership.” When you have incidents of ownership, this trust could be considered part of your estate. This is the case in a revocable trust.
Having a revocable trust won’t protect your estate from creditors. While it can allow your estate to avoid probate by passing on assets directly, it could be challenged because the funds are considered part of your estate. While a revocable trust can reduce the chances of court disputes, it’s not as safe as an irrevocable one. In addition, the funds within a revocable trust will be considered part of your estate for estate taxation purposes.
The irrevocable trust is not legally owned by you because you have no power to change it. Funding the irrevocable trust with life insurance policies can add another layer of insulation to protect your estate from legal claims. Having your assets in an irrevocable trust can even act as a deterrent to frivolous lawsuits because it can limit the assets that someone arguing a legal claim can go after.
The creation of an irrevocable trust being funded with life insurance can be very effective, though somewhat complex. It requires leveraging annual gift tax exclusions and managing certain legal rights to ensure the trust stays out of your estate. Contact a Howard Kaye advisor at 800-DIE-RICH for more information on protecting your legacy through ILITs.