Odds and Ends

Did the Texas Legislature Create a Back Door for the Creation of a Self-Settled Asset Protection Trust?

by Rania Combs

Trusts with spendthrift provisions protect assets from claims of creditors. The inclusion of a spendthrift provision in a trust provides the beneficiary with asset protection because it prevents the beneficiary or any other creditor from forcing a trustee to turn over trust assets to satisfy a judgment or a claim.

Some states and foreign countries allow people to create asset protection trusts for their own benefit, but in Texas, the general rule is that person creating the trust (the “settlor”) can not get spendthrift protection if the settlor creates the trust for his own benefit.

The rationale for the rule is obvious: Texas does not want
bad actors to escape their creditors’ claims by creating asset protection
trusts for themselves.

However, amendments the Texas Legislature made to the spendthrift statute in 2013 may have created a back door to creating a self-settled asset protection trust.

Spendthrift Protection for Trust Property Appointed Back to Settlor

Section 112.035 (d)(2) of the Texas Property Code was added to the statute in 2013. This section summarizes the general rule that asset protection does not apply to the settlor if he is the beneficiary of a trust he creates; however, it includes an exception to the general rule.

Specifically, if the settlor becomes a beneficiary of the trust solely by virtue of the exercise of a power of appointment by a third party, then his interest in the trust will be protected from creditors.

A power of appointment is essentially a power to decide how to dispose of property in the trust. It allows the power holder to direct who should receive the trust assets. A settlor can grant someone a limited or general power of appointment. A limited power of appointment limits the class of potential recipients to whom the power holder can appoint the property, while a general power of appointment does not. Additionally, settlors can specify whether the power can be exercised during the power holder’s life, or only at the power holder’s death.

For example, suppose a settlor creates a trust for the benefit of his brother, and grants his brother a power of appointment. The settlor can limit the power of appointment, requiring that his brother exercise it in favor of the settlor or the settlor’s descendants. If his brother exercises the power of appointment and directs that the trust assets be funneled into an asset protection trust for the settlor, the resulting trust created for the settlor by virtue of the brother’s exercise of the power of appointment would be protected from creditors even though the settlor created the original trust.

Spendthift Trust Protection for Irrevocable Trusts Created for a Spouse

Remember the general rule is that a settlor cannot create an asset protection trust for his own benefit. But section 112.035(g), which was added in 2013, provides that a person will not be deemed to be a settlor in certain situations.

Specifically, sections 112.035(g)(1)-(2) of the statute, provide that a person is not deemed to be a settlor of an  irrevocable trust created for the settlor’s spouse when the settlor becomes the beneficiary of the trust after the spouse’s death.

So for example, this section would allow a husband to create an irrevocable asset protection trust during his life for the benefit of his wife. The trust could provide that if the wife predeceases him, all assets in the trust would pass to the husband in an asset protection trust. During his wife’s life, assets in the trust would be protected from creditors (and the husband would indirectly benefit from any distributions to her.) If his wife predeceases him, assets that pass to him in trust after her death would be protected from creditor claims even though the husband initially created the trust for his wife.

Spendthrift Protection for Reciprocal Spousal Trusts and General Power of Appointment Trusts

Additionally, Section 112.035(g)(3)(A) says that for purposes of the spendthrift trust statute, a beneficiary of a asset protection trust created by a spouse will not be deemed to be the settlor of the trust even if the beneficiary has also created a trust for the other spouse.

In other words, the statute seems to suggest that spouses could partition their property such that each spouse owns 50 percent of the property as his or her separate property, and could then each a create asset protection trust for each other’s benefit, thereby shielding all their assets.

Doing this is not advisable in situations where estate taxes are a concern because the IRS will disregard reciprocal trusts for transfer tax purposes. But for couples who don’t have estate tax concerns, this may provide a means of achieving asset protection in Texas.

Spendthrift Protection for General Power of Appointment Trusts

Finally, Section 112.035(g)(3)(B) provides that for purposes of the spendthrift trust statute, a person would not be considered a settlor to the extent that the property of the trust was subject to a general power of appointment in another person.

This suggests that a settlor can create a trust for a beneficiary, even someone who is not his spouse, and grant a third party a general power of appointment. If the third party exercises the power of appointment in favor of an asset protection trust for the settlor, the resulting trust for the settlor would be protected from creditors’ claims even through the settlor created the original trust.

Some caveats…

A trust for the benefit of a spouse must be funded with separate property assets. This means, spouses would need to partition community property. Doing this should not be taken lightly. Fifty percent of first marriages end in divorce, and the divorce rate for subsequent marriages is higher. When you partition assets and transfer those assets to an irrevocable trust for the benefit of your spouse, you can’t take those assets back.

The same goes for irrevocable trusts created for any other
beneficiary. When you transfer assets to an irrevocable trust, they are no
longer yours. You should not give away assets you might need in the future for
your own support.

Giving someone a general power of appointment is risky. It gives the power holder enormous power to dispose of the assets as they wish. Additionally, assets subject to a general power of appointment are included in the power holder’s estate when he or she dies, which means someone granted a general power of appointment must be willing to use some of his or her estate tax exemption to help the settlor achieve his asset protection goals.

Transferring assets to an irrevocable trust should not be used as a means to avoid the claims of creditors. Irrevocable trusts will not be effective to shield a settlor’s assets from persons or other entities who currently have a claim against the settlor.

Texas law already provides a good deal of asset protection for certain types of assets even without going through the trouble of creating a trust. For more information read: What Assets Are Protected From Creditors In Texas? For additional protection, it is always wise to ensure you have adequate automobile and home insurance, as well as an umbrella policy. Creating an LLC and observing corporate formalities will protect your personal assets from business liabilities.

And finally, this is a relatively new statute. I could not find any case law elaborating on it. I discussed it with a colleague who reviewed the legislative history on the bill and found that there was no explanation or discussion of subsection (g) in the record that is of note. So while it seems to be a create a back door to a self-settled asset protection trust, we currently have no guidance on how it will develop.

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