Arizona Living Trusts, Testamentary Trusts, & Asset Protection
June 14, 2011
An Arizona living trust is an arrangement in which a person, called a settlor, transfers his/her assets to a revocable trust for the benefit of others upon the settlor's death. Living trusts are commonly used as an alternative to wills in order to direct the distribution of a person's assets after his/her death and to avoid probate. In contrast, an Arizona testamentary trust is created by a decedent's will upon his/her death. Unlike living trusts, testamentary trusts are not created to avoid probate.
Asset protection is the process of structuring ownership of a person's assets to preserve maximum value for the owner and family, etc. in the event of creditor problems.
Although neither Arizona living trusts nor Arizona testamentary trusts provide asset protection for trust settlors (the people who create trusts), in many states that have enacted a variant of the Uniform Trust Code (including Arizona), both living trusts & testamentary trusts can provide asset protection for trust beneficiaries, even if the beneficiaries are also trustees, if such trusts include "spendthrift" provisions.
Often, a beneficiary who is also a trustee possesses two different interests in a trust: 1) interest in income and 2) interest in principle. Although neither the Uniform Trust Code (a model from which many states derive their trust laws) nor the Arizona Trust Code (Arizona's actual trust laws) make such a distinction, the Internal Revenue Code does, and this distinction can result in substantial federal tax consequences.
1) Interest in Income
Both the Uniform Trust Code and Arizona Trust Code provide that interests in income are protected from the trustee/beneficiary's creditors as long distributions of income are limited to ascertainable standards, e.g. health, educations, maintenance, & support, and the trustee/beneficiary is not also the trust settlor.
The relevant portion of the Uniform Trust Code provides:
If the trustee’s or cotrustee’s discretion to make distributions for the trustee’s or cotrustee’s own benefit is limited by an ascertainable standard, a creditor may not reach or compel distribution of the beneficial interest except to the extent the interest would be subject to the creditor’s claim were the beneficiary not acting as trustee or cotrustee.
In addition, the Arizona Trust Code also provides that creditors are not permitted to compel distributions even if "the trustee's discretion to make distributions for the trustee's own benefit is purely discretionary." A.R.S. § 14-10504(E).
As mentioned previously, however, in situations where the trust aims to qualify for the unlimited marital deduction under Internal Revenue Code § 2056, a trust will not provide asset protection because § 2056 requires that the beneficiary, surviving spouse must receive all the income from the trust as a mandatory distribution.
2) Interest in Principle
The relevant provisions of both the Uniform Trust Code and the Arizona Trust Code regarding trust principle are the same as those regarding trust income. As such, distributions of principle that are limited to an ascertainable standard are protected from creditors to the same extent as distributions of income under the Uniform Trust Code & Arizona Trust Code.
Unlike distributions of income, however, Internal Revenue Code § 2056 does not require trust beneficiaries to receive trust principle in mandatory distributions to qualify for the unlimited marital deduction. Because of this, distributions of principle from the marital trust that are not limited by an ascertainable standard, i.e. purely discretionary, are also protected from creditors under the Arizona Trust Code.
This brief overview of some important considerations associated with Arizona asset protection through Arizona living trusts and Arizona testamentary trusts is by no means comprehensive. Always seek the advice of a competent professional when making important financial and legal decisions.