RE: Asset Protection Plan
Revocable vs. Irrevocable Trusts

Dear John and Jane:

When we met last week, you asked for additional information regarding the difference between using a revocable trust and an irrevocable trust. Hopefully this letter will help you understand these two trusts better. First, let's look at two fundamental concepts in asset protection and estate planning.

Ownership of property has traditionally been described as being composed of a bundle of sticks. Each individual stick is not ownership of the whole, and any individual stick may have an attribute of ownership that is beneficial or not beneficial. Estate planning and asset protection is the act of deciding which sticks we keep, and which we get rid of.

Another fundamental concept is control. Controlling an asset is often more important than owning an asset. Judgments always attach to property you own, they often do not attach to property you control. Let's assume you are the controlling member of an LLC. The LLC has $1,000,000 in assets. If you personally get hit with a lawsuit, the $1,000,000 in assets cannot be used to satisfy the judgment because you do not own the assets, the LLC is the owner. However, since you control the LLC, you can give to yourself a loan, lend yourself the LLC employees and equipment, and have the LLC guarantee a bank loan to you. You have full use of the $1,000,000 because you control the assets, but do not own them.

A trust is a method by which we exercise the above concepts of giving away sticks and maintaining control.

Technically, a trust is a legal relationship in which the trustors (also known as grantors) transfer property to a trustee who holds and manages the property for the benefit of the beneficiaries. One set of sticks has been given to the trustee, and
another set of sticks has been given to the beneficiaries. You control the property by the way you set up the trust on paper.

Trusts can be used for many uses and purposes. They can supply one or more qualifications for dealing with the trust assets that the trust beneficiaries lack or that the grantors think they lack. It may be lack of prudence, maturity, management or investment skill and experience, physical capacity, mental competence, lack of interest or simply lack of time.

In addition, there may be other uses and purposes such as insulating trust assets from the claims of creditors of a business, accumulating funds for special purposes, or serving as a parental substitute in financial matters.

Superimposed on these purposes there may be, and often are, tax saving purposes, income or estate tax savings, or both, and, for many, there will be a purpose and desire to avoid probate.

The most significant difference between a revocable trust and an irrevocable trust is the amount of control that you can exercise over the trusts. With a revocable trust, you always have absolute control over the actions of the trustee, the use of the assets, and the beneficiaries. With an irrevocable trust, you give up certain measures of control depending on what advantage you are seeking to maintain and what advantage you are willing to forego. For example, if all you want to do is to protect your children's life insurance policy from business creditors, the primary requirement is that you give ownership of the policies to a third person. However, if you also want to be sure that income from the trust is not included in your income taxes, you have to also take the following step: that third person must not be your spouse, child, or any other person or entity over whom you have control, unless that person has an interest in the income adverse to your use.

Giving ownership of your insurance policy to a third person also generates an additional concern: liability for gift taxes. If you give any person more than $10,000 per year, the federal government can collect a gift tax from you (or, if necessary, from the beneficiary). You have, currently, a lifetime gift credit of $1,000,000 (this credit will grow from year to year until 2010 when it reaches $3,000,000). So, in many cases, giving more than $10,000 to a person in any one year does not actually result in the payment of a tax. Moreover, it is usually better to pay a small tax on an appreciating asset instead of a large tax on the same asset in 10 or 20 years. This is especially true with regard to life insurance policies.
You currently own a life insurance policy with a death benefit of $200,000. The cash surrender value is probably not more than $20,000. Since you have three children who would benefit from the life insurance trust, you could contribute the entire life insurance policy to the trust, and not have to pay any gift tax. In addition, upon your death, there would not be any estate taxes due. If, instead, you held the policy outside of a trust, upon your death the entire $200,000 would be included in your estate tax. Internal Revenue Code, section 2037, brings the money back into your estate for purposes of computing the estate tax due. It does not bring the money back into the estate for any other purpose (except if necessary to collect the taxes due).

As you can see, there are many issues that affect any single transaction, and there are many issues that are effected by that transaction. Unfortunately, some of the issues conflict with each other. It is, therefore, necessary to determine what our primary, secondary, tertiary and quaternary goals are. We then have to recognize that we may have to give up our third goal in order to achieve our first and second goals. We may have to decide which particular aspect of ownership we definitely need, and which aspect of ownership we are willing to give up.

A couple of other quick distinctions between revocable trusts and irrevocable trusts follow. Remember, the primary distinction is in the amount of control you retain.

REVOCABLE LIVING TRUST
A revocable living trust can provide the following benefits:

1.Avoids the publicity, the expenses and the delays of probate.
2.Avoids the interruption of income for family members on the death of the
settlor or on his becoming disabled or incompetent.
3. Permits the grantor to see the trust in operation and to make changes as
experience and changed circumstances suggest.
4. Serves as a receptacle for estate assets and death benefits from qualified
employee benefit plans and insurance on the life of the grantor, both of which
need not be included in the estate.
5. Brings together scattered assets in two or more states or jurisdictions,
placing title in the trustee, thereby avoiding administration of the individual's
estate in different places.
6. Enables a going business to continue without interruption.
7. Relieves the grantor of the burdens of investment management.
8. May authorize the trustee to advance funds to the grantor's executor for
certain purposes or to buy assets from the executor at a fixed price, and so
help avoid the forced sale of estate assets at depressed prices.
9. May be less vulnerable to attack on the ground of the grantor's capacity, fraud
and duress than a will or will-created trust would be.

A revocable living trust has these additional attributes:

1. It does not provide any income tax savings.
2. It can provide some limited estate tax savings. If the beneficiaries are given merely a life interest in the trust, with a limited right to withdraw principal (subject to an ascertainable standard), there would not be any estate tax upon their death.
3. It is not subject to any gift tax liability either at the time it is set up or when assets are contributed to it.

IRREVOCABLE LIVING TRUST
The irrevocable living trust can save income taxes for the family, help build an estate, protect its assets and its beneficiaries, save estate taxes, and avoid probate. These benefits, however, come with a steep price: you must make an irrevocable transfer of property to the trust, and, generally, pursue a hands-off position forever more.

A irrevocable trust can save on income taxes unless: You retain the right to control the beneficial enjoyment of the trust property of its income; possess certain administrative powers; if the trust income is or may be payable to or for the benefit of the settlor or his spouse, accumulated for them, or applied to the payment of premiums on insurance on the settlor's life; or the trust income is used for the support of a legal dependent of the settlor.

An irrevocable trust can avoid estate taxes if: You do not retain a life interest in the property or control its enjoyment; possess a reversionary interest worth more than 5% of the value of the property at the time of your death; possess the power to alter, terminate, or revoke the trust; possess a general power of appointment; possess an incident of ownership in any insurance policy on your life naming the trust as a beneficiary; and, the trust is not be set up within three years of your death.

An irrevocable trust can incur gift tax liability: When set up, or when assets are contributed to it. However, it is probably better to get assets out of your estate now, before they appreciate and the tax becomes greater. Moreover, working with the asset during your lifetime (instead of after your death) it is possible to structure the transfer or the asset in such a way as to reduce the taxable value of the asset. Remember, too, that you and your spouse now have a life-time gift tax credit of $2,000,000 in addition to the yearly credit.

With the above information in mind, I am going to recommend that you do set up two trusts. An irrevocable trust that you can use for your life insurance and other appreciating property, and a revocable trust for your other assets. The irrevocable trust would have the power to lend you and your spouse money at favorable rates (and the power to forgive debt), so you could continue to use the assets placed in the trust. More importantly, the irrevocable trust will provide for what appears to be your primary concern: your children's well-being. The assets placed in the irrevocable trust can never be taken away from your kids. As you can see from the enclosed price list, the document preparation fee for the irrevocable trust is only an additional $295.

Sincerely,

LUIS MICHAEL BUSTILLOS