One popular asset protection strategy heavily advertised nowadays is the irrevocable income only trust, or IIOT. This type of trust was originally designed for Medicaid long term care planning purposes, and is no doubt effective for such planning. However, recently many practitioners have begun using this sort of trust for general asset protection. In this post, I will discuss the pros and cons of such an approach in New Jersey.
In an IIOT, the Grantor gives up all of his rights to the assets placed into the trust, which are reserved for the Grantor’s children. Normally this would be good, and wouldn’t create any of the problems with self-settled trusts outlined here. However, in an IIOT, the Grantor does retain a right to all of the income generated by the trust assets. This would normally include interest and dividends on trust investments, and rents on trust real estate.
Under the common law of trusts (which you can read about in the above link), a creditor of the Grantor can attach anything the Grantor can get his hands on. In the case of an IIOT, this means a creditor could get a right to all of the income generated by the trust. Most debtors consider this a pretty good outcome, as it will generally result in the creditor not getting very much. The trustee can always invest trust assets into vehicles that don’t generate much income, like stocks that don’t pay dividends. All of this makes the IIOT look pretty effective for asset protection purposes.
What the above analysis doesn’t consider, however, is whether due to its nature an IIOT would be pierced as a sham trust in a creditor action. Typically in an IIOT, the Grantor is also the Trustee and holds a “testamentary special power of appointment” over trust assets. [A “testamentary special power of appointment” is just a fancy way of saying the Grantor can specify in his will where the assets of the trust go after his death. The only restriction is that the Grantor can’t leave the assets to his estate or his creditors, neither of which a Grantor would likely want to do anyway.] Under a set of facts where a Grantor maintains an income interest, the right to choose investments as a Trustee, and a power of appointment, I believe it is likely a court would rule that due to the tremendous amount of influence maintained by the Grantor over trust assets that the trust is a sham.
Further, many practitioners advise clients that after they place assets into an IIOT, if they ever need to get them out the trust can simply distribute the assets to a child and the child can then give the assets back to the Grantor. While such an arrangement may work for the original Medicaid purposes for which IIOTs were invented, against a general creditor such actions even further strengthens the sham trust argument, if not crossing into conspiracy to defraud creditors.
Even putting the sham trust argument aside, in New Jersey we have a specific statute that puts a dent in the effectiveness of such trusts. When New Jersey enacted UFTA, UFTA superseded and repealed the old Uniform Fraudulent Conveyance Act (UFCA). However, it did not repeal the old Fraudulent Conveyance Act (FCA), currently codified at N.J.S.A. 25:2-1(a):
…[E]very deed of gift and every conveyance, transfer and assignment of goods, chattels or things in action, made in trust for the use of the person making the same, shall be void as against creditors.
In modern English, the FCA says that if a Grantor makes a transfer to a trust and retains use over trust assets, the transfer to trust is void as fraudulent. The key is determining what rights retained by the Grantor constitute the Grantor retaining “use” of the assets. Unfortunately there are really only two cases in New Jersey on point.
In Ward v. Marie, 73 N.J. Eq. 510 (1907), the court cited the FCA in holding that if a Grantor maintains a staggered right to withdraw principal over his lifetime and a testamentary power of appointment, the transfer to trust is void. In Pennsylvania Co. for Ins. on Lives & Granting Annuities v. Kelly, 134 N.J. Eq. 120, 122 (1943), the court briefly stated that if a Grantor maintained a lifetime income interest and testamentary power of appointment over a trust, the holding in Ward may allow creditors of the Grantor to attach assets.
Based on the FCA and the two cases interpreting it, I believe a typical IIOT may create a fraudulent transfer issue in New Jersey by its terms. We don’t know for sure what “use” is under the FCA, but Kelly at least seems to indicate that a lifetime income interest could be “use”, especially when paired with a testamentary power of appointment. This would seem to make logical sense, as a lifetime right to use property is generally considered to be functionally equivalent to a lifetime right to the income from said property.
In short, although I can’t say for sure that an IIOT won’t hold up for general asset protection, there are too many question marks for me to be comfortable with it despite its effectiveness as a Medicaid planning tool. If you are interested in learning about some other methods of asset protection which contain less ambiguity, feel free to contact me.