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Inheritance Protection Trusts

It is usual for parents to leave an inheritance by making an outright distribution to a child or other individual beneficiary. Sometimes, the parent may include a provision to delay distribution if the child has not reached a certain age (or ages) before the outright distribution(s) is made.

Once the child receives the inheritance, however, the assets become the child's property. The inheritance is subject to all of the same risks that any owner faces. Primarily these include  claims made by judgment creditors or other third parties. If the child has a set-back, the inheritance can be lost to the creditor and the parent's desire to provide a "nest-egg" will be thwarted.

In addition, the inheritance can be treated as marital property unless state law provides exceptions for inherited property. Even where an inheritance is not generally treated as marital property, state law also provides ways that the child could cause the assets to become marital property. One situation often faced is the child's failure to maintain the inheritance as his or her separate property by commingling the inheritance with other marital assets.

Further, the inheritance will be included as part of the child's estate and can be distributed to individuals who are not part of the parent's family. For example, the child may decide to leave everything to a spouse who can thereafter leave those assets to a new husband or to her own family. Additionally, even if the child chooses to leave the inheritance to his or her children, a surviving spouse has the right to elect to receive a statutory share of the deceased child's estate regardless of how the child decided to distribute the assets.

In each situation, the inheritance the parents wanted to remain "in the family" can pass to strangers.

There is a better way to pass an inheritance to a child by using an "Inheritance Trust" rather than an outright distribution. With an Inheritance Trust, the parents can set the 'rules' for when and how the property is made available to the child. A properly drafted Inheritance Trust containing a "spendthrift clause" will isolate the inheritance from the child's own property and will therefore be exempt from claims by creditors or soon to be ex-spouses. Such a trust can also be structured to last for the child's lifetime and thereafter direct how the remaining assets will pass at the child's death. With a "Dynasty Trust" the assets can remain in the family for several generations.

The usual complaint about using an Inheritance Trust is that the child doesn't really 'get' his or her inheritance and has to "beg the bank for money". However, the Inheritance Trust can be designed as a "Beneficiary Controlled Inheritance Trust" where the child can serve as a trustee and have the right to control the trust assets and make distributions when the child-trustee believes appropriate.

There is a balance that needs to be established when the Beneficiary Controlled Inheritance Trust is drafted. The greatest degree of protection from third parties and soon to be ex-spouses exists where there is only a third party trustee and the child does not serve as trustee. When the child serves as a co-trustee with an independent third party the trust can provide protection that is only slightly less. If the child serves as the sole trustee, it is very possible that a court would chose to ignore the existence of the trust and treat the assets as being owned by the child-trustee. One additional option that should be reviewed is having the child serve as a co-trustee with an independent trustee who can be removed and replaced by the child.

An Inheritance Trust is always preferable to an outright distribution. A Beneficiary Controlled Inheritance Trust can provide most of the benefits of an outright distribution while providing a layer of protection not otherwise available.