California Asset Protection Trusts

California Asset Protection Trusts are intended to take advantage of California laws which provide generous exemptions for assets such as retirement savings. Assets which are exposed to potential claims can be protected if California trust law and asset protection cases are closely followed.

 California Trusts

The legal arrangement known as a trust has three distinct parties. A Trustor creates the trust by transferring property to a Trustee. The Trustee agrees to hold the property for the benefit of one or more Beneficiaries according to terms specified in a trust agreement. The legal impact of a trust is to split legal and beneficial ownership of property. The Trustee holds legal title for the benefit of the designated beneficiaries and is legally responsible for carrying out the terms of the trust agreement according to the highest legal standard as a fiduciary.  

Trusts in California are a valuable asset protection tool because of this division of ownership into legal and beneficial interests. A Trustee’s interest in a property is not subject to the claim of a judgment creditor because the Trustee has no beneficial interest in trust property. A creditor of the Trustor is not permitted to reach trust property beyond any residual interest retained by the Trustor. California also protects trust property from claims against a Beneficiary as long as the Beneficiary’s rights to the property are legally restricted.

If the purpose of a trust established in California is to accomplish asset protection goals of a Trustor, the powers and interests reserved to the Trustor must be carefully drawn. A power to revoke a trust and regain the enjoyment and use of trust property is the equivalent of full beneficial ownership. Accordingly, property held in trust subject to a right to revoke is fully reachable by a creditor of the Trustor. (California Probate Code Section 18200)

Asset Protection with Living Trusts

A living trust is the foundation of most estate plans and is a good example of this rule.. A living trust provides valuable estate planning benefits by passing property directly and efficiently to family members without a costly and time consuming court supervised probate. However,  because the Trustor usually reserves the power to revoke or amend the trust , it generally has limited value for asset protection.

One exception is that property in a living trust is exempt from claims of the State for a reimbursement of MediCal benefits. This is a significant feature because prior to 2017 California was entitled to collect from the estate of individuals any amounts  provided as MediCal benefits, such as treatment or nursing facility costs. The 2017 law   provides that property of the decedent which is held  in a living trust is not subject to reimbursement claims. Depending on the circumstances   this asset protection feature together with estate planning benefits, make a living trust a valuable component of most estate planning and asset protection plans.

 Trusts for Protecting Assets

In contrast to a living trust, trusts  which are dedicated to provide for a beneficiary will not be reachable by a judgment creditor unless the Trustor retains impermissible beneficial rights over the property.

For example, if you set up a trust to hold savings for your child’s college education, this is a classic example of a trust which accomplishes basic asset protection goals. As long as you do not retain the power to revoke the trust and regain all  or a portion of the funds, the money saved in the trust is protected from any judgment against you. It’s good to know that money for the child’s education will be protected from any liability risks you may have.

Self- Settled  Spendthrift Trusts

But if you set up a trust for your child and provide that the trustee can or must also distribute funds to you for living expenses or other purposes, then you will be considered a beneficiary of the trust. As such, a creditor can reach the maximum amount which could be distributed to you. (California Probate Code Section 15304)

The law in California generally does not permit you to transfer assets to a trust, use the income or principal for your benefit while protecting the assets from bankruptcy or creditor claims. Such a trust is known as a Self- Settled Spendthrift Trust. This type of trust is a valid legal agreement but creditors will have the right to access trust property. The exceptions to this general rule are discussed below.

Domestic Asset Protection Trusts

Other states do allow you to set up a Self Settled Spendthrift Trust. In Delaware and Nevada and 17 states in total, a Trustor is permitted to retain distribution rights and still have the property protected from claims if certain state requirements are met. Read More

The laws in these states were modeled on those in various offshore havens. Trusts established in countries such as the Cook Islands or Nevis, have for many years permitted Self Settled Spendthrift Trusts permitting the Trustor to be a beneficiary of the trust with the assets of the trust protected against claims. Read More

Domestic asset protection trusts are generally effective for residents of the state where the trust is established. If residents of another state wish to set up a trust in an asset protection jurisdiction the law has not yet been fully tested.  For example, we don’t know what degree of protection is available for a California resident who sets up an asset protection trust in Nevada.

Because of this uncertainty, those who wish to be a direct beneficiary of a trust while maintaining  enjoyment over the property  must work with California Asset Protection Trusts which meet California rules.  Alternatively, offshore asset protection trusts can be effective particularly when trust property is located outside the jurisdiction of U.S. courts.

California Private Retirement Plan

A significant exception to California’s rule against Self Settled Spendthrift Trusts is the complete exemption of amounts in Private Retirement Plans from judgment or bankruptcy. ( California Code of Civil Procedure Section 704.115,  See also In re Cheng, [943 F.2d 1114] (9th Cir. 1991)

While California law differs from the asset protection states and the Cook Islands, it does offer advanced protection for retirement savings. California encourages residents to save for retirement by providing complete protection for savings in private retirement plans. This protection is accomplished by exempting any amount of savings in private retirement plans from creditor claims and bankruptcy. And the protection applies while the funds are in the trust and after they are distributed.

Protection for Non-Qualified Plans

it is important to note that the unique feature of California law on retirement savings extends to both IRS qualified plans and non-qualified plans. Other states and federal law protect most qualified retirement plans. California extends this exemption to non-qualified plans as well.  Even if you already have a 401(k) or other qualified plan, you are still permitted to form a non-qualified private retirement plan to hold savings.

There are many benefits to the California law on private retirement plans. While qualified plans have strict contribution limits there are no limitations on the amount which can be transferred into a non-qualified plan.  In addition there are no matching requirements for employee coverage and no annual filings with the IRS.

An example of how the Private Retirement Plans work is a recent case we had with OB/GYN physician. Her malpractice liability extends for up to 18 years after retirement since the statute of limitations is suspended until the patient reaches age 18. The client wished to build and protect a retirement savings fund which would be free of liability risk. We set up for her a private retirement plan  which involved a contribution of current savings plus future surplus she might generate from her practice. As noted, California law protects retirement plan assets while in the plan and when later distributed.  As a result, all of the funds and future retirement distributions would not be subject to judgments or bankruptcy.

Amounts contributed to non -qualified private retirement plans are not deductible on your tax returns and are not taxable when funds are distributed.  For tax purposes the plan is neutral and money going in or out is not subject to tax. The plan can make any type of investments from savings accounts to purchasing real estate and investing in companies.  Since the plan is not subject to the IRS qualification rules, the prohibited transaction and self- dealing restrictions  will not apply.

California case law on Private Retirement Plans lays out a roadmap for how these plans should be drawn and administered. The exemption from judgments will apply only to plans  which are intended to save money for retirement. Although you can make investments from the plan, taking early withdrawals for personal living expenses will likely void the asset protection features. Making a contribution and then borrowing back the funds may also jeopardize these benefits. The funds in the plan should be held   according to a retirement trust agreement   which specifies the rules of the plan, the retirement benefits, the contribution formula and the obligations of the plan sponsor and participant.

Asset Protection Trusts Restricting Trustor’s Rights

A broad variety of trusts will also fit within California asset protection laws if the trust is drawn to avoid the prohibition on Self Settled   Spendthrift Trusts. That is, trusts can be created with asset protection features   if   the interest retained by the Trustor cannot be reached or has little value to a judgment creditor. A trust which effectively converts full ownership of property  into a limited or restricted right will achieve asset protection benefits to the extent of those restrictions.

Personal Residence Trust

California homestead protection provides only modest protection for equity in the family home. The basic homestead amount starts at $75,000 which is substantially lower than many other states. As a result, trusts intended to protect the family residence are a common feature in California asset protection planning.

Most often, the type of trust used for asset protection is a Personal Residence Trust with provisions specifically  restricting the trust for California law. These provisions typically limit the Trustor’s rights into a right to occupy the residence for a term of years.

Family Savings Trusts

The term Family Savings Trust is a broad descriptive term for a trust intended to hold and protect assets against lawsuits and business risks. In California, a Family Savings Trust can be extremely flexible in form and  often incorporates provisions which combine the features of domestic and even offshore arrangements within the language of the plan documents. Family Savings Trusts are often structured as term trusts which restrict the Trustor’s rights over the property for a designated term of years, during which the property is shielded from claims. In this manner the Family Savings Trust may function similar to a Private Retirement Plan. Assets other than the family home can be held within the Family Savings Trust and are governed by special terms appropriate for that asset under California law.

Separate Property Trusts

In California,   property acquired during marriage is presumed to be community property. As such all community property is available for creditors of either spouse. It is also subject to equal division in the event of a divorce. Further, separate property of one spouse which is co-mingled or used for the benefit of the community risks characterization as community property.

Spouses who wish to hold property separately from the community, protected from claims of a spouse or a judgment creditor, often create a Separate Property Trust to insulate the assets.

Also parents making gifts or providing inheritances for children often use a Separate Property Trust.  This is done to insure that the property transferred to their child is protected from claims arising from the child’s spouse.  In addition, a Separate Property Trust can insulate property passing to the child from any personal or business liability and lawsuit risk that the child might have, independently of his or her spouse. A Separate Property Trust is a popular asset protection vehicle in California for insulating family wealth from liability risks

Life Insurance Trusts

The cash value of life insurance policies and annuities are protected in California only to the extent of $9,700 ($19,400 for married couple). Other states provide complete exemptions for the cash value of life and annuity policies but these are largely exposed in California. Many of our clients purchase these policies because they provide substantial tax benefits in the form of a tax-free buildup of cash value. These funds can then be “borrowed” back at a low rate to provide an untaxed  source of cash at or before retirement.

Death benefits from life policies and annuity policy payments also have a limited exemption.  Proceeds are only protected from claims to the extent reasonably necessary for the support of the debtor, a spouse and dependents. This is the same standard that is applied to IRA’s under California law. This “reasonable support ” standard is not a fixed amount but is generally determined in court so it is difficult to predict the outcome in advance. It is safe to say that in most cases, a substantial portion of policy proceeds will be exposed to claims of a judgment or bankruptcy creditor.

For those who have cash value policies which exceed the $9,700 exemption or who wish to protect policy death benefits a Life Insurance Trust can be designed to protect the value in a policy. If the cash value is intended solely for retirement purposes a Private Retirement Plan may be an effective vehicle. Policy death benefits can be payable to a Family Savings Trust which provides asset protection for policy proceeds. In large estates (Over $10 million) subject to estate tax, the Trustor’s rights over the policy must be carefully limited to avoid estate taxation of the proceeds.

Profit Shifting Trusts

California income taxes rank among the highest of any state. In addition, capital gains are taxed as ordinary income and do not receive the favorable tax treatment accorded under federal law. Trusts which are intended to limit exposure to California taxes are usually created under the law of a favorable low or no tax state. Delaware and Nevada trusts can be designed to provide legal tax advantages over California trusts in a variety of circumstances.