Planning Notes

Life Insurance & Creditor Protection in Arizona

Thu, 26 Jan 2012 14:25:42 -0700

Arizona life insurance beneficiaries who are deemed to have “insurable interests” in the lives of another, other than those effecting the insurance or their legal representatives, are “entitled to [life insurance] proceeds against the creditors and representatives of the person effecting the insurance.” A.R.S. § 20-1131(A).

Eligible Beneficiaries

Not everyone is entitled to be a beneficiary of a life insurance policy on the life of another. In fact, only the following parties are permitted to have an “insurable interest” in the life of another:

1. In the case of individuals related closely by blood or by law, a substantial interest engendered by love and affection.

2. In the case of other persons, a lawful and substantial economic interest in having the life, health or bodily safety of the individual insured continue, as distinguished from an interest which would arise only by, or would be enhanced in value by, the death, disablement or injury of the individual insured.

3. An individual party to a contract or option for the purchase or sale of an interest in a business partnership or firm, or of shares of stock of a closed corporation or of an interest in the shares, has an insurable interest in the life of each individual party to the contract and for the purposes of the contract only, in addition to any insurable interest which may otherwise exist as to the life of the individual.

4. A charitable organization as provided in section 43-1201, paragraph 4, which has a policy ownership interest has an insurable interest in the life of each proposed insured who joins with the charitable organization in applying for a life insurance policy naming the charitable organization as owner and irrevocable beneficiary.

A.R.S. § 20-1104.

Cash Surrender Value Beneficiaries

In addition to proceeds that are payable at death, many life insurance policies also have a cash surrender value, however, the class of beneficiaries that may receive such proceeds against the creditors of the insured is significantly smaller than the class that receives proceeds payable at death against the creditors of the insured.

In particular, if a person was continuously insured for a period of two years by an unexpired life insurance policy and that life insurance policy names the insured’s “surviving spouse, child, parent, bother, sister or any other dependent family member” as beneficiary, the cash surrender value of such policy is “exempt from claims and demands of all creditors, other than a creditor to whom the policy has been pledged or assigned, and except that, subject to the statute of limitations, the amount of any premiums which are recoverable or avoidable by a creditor pursuant to title 44, chapter 8, article 1, with interest, shall inure to their benefit from the cash surrender value.” A.R.S. § 20-1131(D).

This brief overview of some important considerations associated with life insurance and protection from creditors under Arizona law is by no means comprehensive. Always seek the advice of a competent professional when making important financial and legal decisions.

Qualified Personal Residence Trust (QPRT)

Wed, 07 Dec 2011 11:21:29 -0700

A qualified personal residence trust, or QPRT, can reduce the federal estate tax associated with transfers of real property to heirs, reduce the federal gift tax associated with such transfers, and, provide asset protection.

Federal Estate & Gift Tax

A trust settlor (sometimes called a grantor or truster) must transfer his/her ownership of a residence to an irrevocable grantor trust while retaining the right to use the residence for a term of years. The IRS characterizes the transfer of the remainder interest, i.e. the interest in the residence after the term of years has expired, as a completed gift to the trust beneficiaries and the settlor must file a gift tax return for the present value of the remainder. Note that a such a gift is not eligible for the federal gift tax annual exclusion, because it is a future interest.

The key to minimizing the present value of the remainder interest in the residence, is to choose the longest reasonable term of years possible because the longer the term of the trust, the lower the present value of the remainder interest, which results in a smaller gift. Although the calculations involved in determining the value of the remainder interest are complex (IRC § 2701), a trust with a term of twenty (20) years, for example, will allow a much lower valuation of the remainder interest than a trust with a term of one (1) year.

Choosing the longest reasonable term of years is complicated by the fact that if the settlor is not alive at the expiration of the term of years, the value of the residence will be included in the settlor's estate. As such, the settlor must balance his/her desire to reduce the gift tax with the reality of his/her life expectancy in order to reduce the federal estate tax.

Federal Estate Tax Uncertainty

During 2011 & 2012, the effective unified federal estate and lifetime gift tax exemption is $5 million dollars per person or $10 million per legally married couple. This means that people can transfer their assets to heirs, while alive or dead, without being subject to federal estate or gift tax if the value of the decedent's estate and the lifetime gifts not subject to the annual gift tax exemption, does not exceed the effective unified federal estate and gift tax exemption.

This current effective unified federal estate and gift tax exemption, i.e. $5 or $10 million, is likely more than sufficient to cover the entire estate for most Americans. However, in 2013 the exemption is set to drop to $1 million per person or $2 million per married couple if Congress does not act and would result increase the number of people subject to the federal estate and gift taxes.

Federal Capital Gains Tax

Because a residence owned by a QPRT will not be included in the gross estate of the settlor, unless the settlor does not outlive the QPRT term, the beneficiaries of the trust will not receive the step-up in basis, which they would have received if the residence was included in the gross estate of the settlor. Without a step-up in basis, and if the property has appreciated substantially since acquired, the beneficiaries will be liable for capital gains based upon the settlor's cost basis as opposed to the fair market value of the property at the settlor's death, i.e. stepped-up basis. However, if the beneficiaries make the residence their primary residence, the personal residence exclusion may cover all or part of that appreciation if the residence is later sold.

Asset Protection

Because a QPRT is irrevocable, it is not legally owned by the trust settlor and cannot be used to satisfy creditors' claims unless it was fraudulently transferred to the trust, used to guarantee a debt, or similar action.

This brief overview of some important considerations associated with a qualified personal residence trust (QPRT) is by no means comprehensive. Always seek the advice of a competent professional when making important financial and legal decisions.

Bankruptcy Discharge of Federal Income Taxes

Fri, 11 Nov 2011 11:04:51 -0700

The United States Bankruptcy Code ("Code") provides for the discharge of federal income tax obligations in certain, limited situations. While there are numerous restrictions on bankruptcy discharge of such taxes, one is of particluar importance: timing.

Individual Bankruptcy

Individuals are generally permitted to file for discharge through bankruptcy under two chapters of the Code: Chapters 7 & 13. Chapter 7 provides for discharge of debts through liquidation while Chapter 13 provides for discharge pursuant to a repayment plan through which some debts are repaid and the others are discharged.

Federal Income Tax Obligations

Although both Chapters 7 & 13 provide for the discharge of qualifying federal income tax obligations, Chapter 13 requires repayment of such obligations. However, Chapter 13 does avoid the accrual of future penalties and interest.

Timing Requirements

The Code permits discharge of certain older federal income tax debts while it does not permit the discharge of newer federal income tax debts. Federal income taxes are generally not eligible for discharge through liquidation under Chapter 7 or through repayment under Chapter 13 unless the following timing requirements are met:

The debtor's federal income tax return was due, including all extensions, more than three years before the bankruptcy petition filing.
The IRS assessed the tax more than 240 days before the bankruptcy petition filing.
The debtor's federal income tax return was filed more than two years before the bankruptcy petition filing.

11 USC §§ 507(a)(8) & 523(a)(1)(B).

Prior to Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA), Chapter 13 provided for a "super-discharge" of tax debts for which the debtor did not actually file a tax return, however, that exception has been eliminated and timing requirements are now ostensibly the same as under Chapter 7.

This brief overview of some important considerations associated with bankruptcy and taxes is by no means comprehensive. Always seek the advice of a competent professional when making important financial and legal decisions.

Arizona's Property Tax Exemption & Deferral

Thu, 06 Oct 2011 12:56:35 -0600

Arizona law permits the reduction, or elimination, of property tax obligations for qualified real property owners and also permits qualified real property owners to defer payment of property taxes until the real property is sold or the real property owner dies. A.R.S. §§ 42-11111 & 42-17302.

Property Tax Exemption

The State of Arizona calculates real property taxes on owner-occupied residences based upon Assessed Value. The Assessed Value is 10% of the Full Cash Value, not 10% of the fair market value.

If the person meets the requirements set forth in A.R.S. § 42-11111, the amount of the current exemption is then subtracted from the Assessed Value. The property tax is then calculated based upon the modified Assessed Value.

Qualification

The exemption is available to individuals in a number of different cirumstances including qualifying widows, widowers, and disabled persons whose income does not exceed particular amounts and whose house does not exceed a particular Assessed Value, which is set forth in A.R.S. § 42-11111.

Property Tax Calculation

For example, a woman who meets the requirements set forth in A.R.S. § 42-11111 resides in and owns a home with an Assessed Value of $15,0000. In 2011, the exemption amount is $3,488. After substracting the exemption from the Assessed Value, her property tax will be caclulated based upon an Assessed Value of $11,512 ($15,000 - $3,488).

Property Tax Deferral

Arizona law permits a qualified individual to elect to defer the payment of property taxes on that individual's qualifying residence for a particular year.

Qualification

In order to be qualified, the individual must meet the following requirements:

1. The individual shall be at least seventy years of age on the date the deferral claim form is filed.

2. The individual, either individually or with another individual who resides in the residence, shall own the residence or be purchasing the residence under a recorded instrument of sale or shall hold the property under the terms of a real estate trust.

3. The individual must either:

(a) Have lived in the current residence for at least six years immediately preceding the date the deferral claim form is filed.

(b) Have lived in this state for at least ten years immediately preceding the date the deferral claim form is filed.

4. The individual may not own or have any legal, equitable, beneficial or security interest in any other residence or other real property, wherever it may be located, except indirectly through an investment security, such as a mutual fund, that includes real property among its assets.

A.R.S. § 14-17302(B)(1)-(B)(4)

In addition, "the total taxable income of all persons residing in the residence for the taxable year immediately preceding the current year may not exceed ten thousand dollars." A.R.S. § 14-17302(D).

Property tax deferals are also available to married couples who meet the requirements for individuals and who "[c]onsent to the deferral of taxes, regardless of whether both spouses have an ownership interest in the residence." A.R.S. § 42-17302(C).

Payment

The deferred property taxes, plus interest, must be paid upon the occurrence of one of the following events as set forth by statute:

1. The individual who claimed the deferral dies without a surviving spouse who qualifies under section 42-17302.

2. The tax deferred residence is sold or becomes subject to a fully executed, binding contract of sale or title to the residence is otherwise transferred to persons other than the individual or the individual's spouse who qualifies under section 42-17302. A tax deferred residence may not be transferred or conveyed unless the deferred property taxes, interest and costs are paid in full.

3. The residence is no longer the residence of the individual and, in the case of a married individual, the individual's spouse who qualifies under section 42-17302, unless the individual or spouse is required to be absent from the residence due to illness.

4. The residence becomes income producing property.

A.R.S. § 42-17311(A)(1)-(A)(4)

This brief overview of some important considerations associated with Arizona property tax exemption and deferral is by no means comprehensive. Always seek the advice of a competent professional when making important financial and legal decisions.

Inherited IRA: Distributions, Beneficiaries & Trusts

Fri, 23 Sep 2011 15:48:42 -0600

The Internal Revenue Code (IRC) allows that after the death of the account owner, the proceeds from an Individual Retirement Account (IRA) may be distributed to a single beneficiary, multiple beneficiaries, multiple trusts (each having one beneficiary), and multiple trusts (each having multiple beneficiaries). In the case of a trust with multiple beneficiaries, however, the length of the distribution period may not exceed the life expectancy of a single designated beneficiary.

Required Minimum Distribution Beginning Date

The federal law, IRC §401(a)(9)(A)(i) & (ii), governing IRA distributions requires that distributions to the account owner begin by a certain date.

In the case of a non-spouse designated beneficiary, distributions must begin by the end of the year following the account owner's death. If the designated beneficiary was the decedent's spouse, however, the designated beneficiary may delay such distributions until he/she is 70 1/2.

Distribution Period: Actual Life & Life Expectancy

Section 401(a)(9)(A)(ii) requires that the entire interest of the account owner be distributed over the actual life of the account owner and a designated beneficiary or "over a period not extending beyond the life expectancy of such [account owner] or the life expectancy of such [account owner] and a designated beneficiary."

Whose Life Expectancy? (Multiple Trust Beneficiaries)

In cases of multiple trust beneficiaries, and after the death of the account owner, distributions may not continue beyond the life or the life expectancy of the oldest beneficiary (designated beneficiary).

Section 1.401(a)(9)-8 of the Treasury Regulations sets forth "separate account" rules for separate IRAs that the permit distributions from each account without reference to the lives or life expectancies of any other beneficiaries. However, §1.401(a)(9)-5 states "the separate account rules under A-2 of §1.401(a)(9)-8 are not available to multiple beneficiaries of a trust with respect to the trust's interest in the employee's benefit."

Separate Account Rules & Trusts

Although §1.401(a)(9)-4 requires that only individuals, not trusts, may be designated beneficiaries for purposes of determining the timing of required distributions, neither the IRS nor the Treasury Regulations prohibit the posthumous splitting of an IRA into two accounts. In such cases, however, distributions may not continue longer than the life expectancy of the eldest surviving beneficiary.

This brief overview of some important considerations associated with posthumous IRS distribution timing is by no means comprehensive. Always seek the advice of a competent professional when making important financial and/or legal decisions.

Built-In Gain & S-Corporations

Tue, 30 Aug 2011 09:13:57 -0600

Built-in gain, or BIG, is a term used by the IRS to describe gain that must be recognized by a corporation in addition to its shareholders. IRC § 1374. Built-in gain applies to 1) corporations previously taxed under Subchapter C (C-Corporations) of the Internal Revenue Code (IRC) that elect taxation under Subchapter S (S-Corporations) and whose assets appreciated before the election was made or 2) corporations that acquire assets with carry-over basis from a predecessor C-Corporation.

Entity-Level (Corporate) Taxation

Under Subchapter C, a corporation must recognize gain on the sale of assets in addition to other events. A shareholder must also recognize any increase in his/her share values associated with such gain when the shareholder either sells his/her shares in the corporation, the shareholder receives a distribution during the liquidation of the corporation, the corporation redeems a shareholder's stock, and other similar transactions. For a C-Corporation and its shareholders, the sale of an asset can impose two distinct taxes, however, the timing of the two taxes permits some opportunity for tax arbitrage depending upon when the shares are sold, if ever.

Pass-Through Taxation

Under Subchapter S, gain is passed through to shareholders and the corporation is not taxed on gain on the sale of assets. The shareholders recognize gain on the sale regardless of whether a distribution is made. For an S-Corporation, the sale of an asset triggers a single tax.

Calculating Built-In Gain

The calculation of BIG tax is a two-step process. First, a C-Corporation must calculate unrealized BIG when the corporation elects to be taxed under Subchapter S by subtracting the corporation's adjusted basis in a particular asset from the fair market value of the asset at that time. Second, if the corporation sells assets having unrealized BIG during "the recognition period", the corporation must pay a BIG tax based upon the lesser of the corporation's net recognized BIG or the corporation's taxable income. IRC § 1374(d)(2) & 1375(b)(1)(B).

Built-In Gain Recognition Period

For a C-Corporation that elects to be taxed under Subchapter S, the IRC imposes a period, usually 10 years - but 7 years in 2009 & 2010 and 5 years in 2011, during which the corporation must recognize gain on the sale of assets that appreciated before the election was made. The applicable recognition period is that which is in effect at the time of the sale, not the period in effect at the time the election was made.

For example, a C-Corporation elects taxation under Subchapter S during 2011 in which the IRC requires the recognition of BIG for 5 years from that date of the election. If the corporation sells an asset in 2017 that appreciated before the election was made and Congress does not change the current law, i.e. the holding period in 2017 is 10 years, the corporation will be liable for tax on BIG associated with the sale of the asset regardless of the 5-year period that was in effect at the time of the election in 2011.

This brief overview of some important considerations associated with built-in gains is by no means comprehensive. Always seek the advice of a competent professional when making important financial and legal decisions.

Business Succession Planning & Life Insurance

Fri, 05 Aug 2011 16:24:29 -0600

Business succession planning aims to address what will occur when a business' ownership* changes. Such planning can address, for example, what transpires when business owners die, sell ownership interests, transfer ownership to new generations, etc. Life insurance often plays a substantial role in business succession plans, e.g. allowing the decedent's family to retain the business by using life insurance proceeds to pay any estate taxes associated with an owner's death. The following post specifically discusses the transfer of business ownership caused by death using life insurance proceeds to enable substantial continuity of ownership for the other business owners and financially provide for the decedent's family with respect to the decedent's share of the business' value.

Many businesses do not possess sufficient liquidity to purchase the ownership interests of a deceased business owner outright. However, there is a common means of providing such liquidity upon the death of a business owner: life insurance.

Two of the common ways in which businesses structure life insurance polices are: 1) cross-purchase agreements & 2) entity-purchase agreements.

1) Cross-Purchase Agreements

When a cross-purchase agreement is used, each owner purchases a life insurance policy on each of the other owners. If one of the owners dies, each living owner will receive a life insurance payment that he/she will use to purchase the decedent's ownership interest from his/her beneficiaries. However, if the business has more than two or three owners, using a cross-purchase agreement often becomes impractical due to the number of life insurance policies involved and the associated underwriting costs for each policy.

2) Entity-Purchase (Redemption) Agreements

When an entity-purchase (redemption) agreement is used, the business purchases life insurance policies on the various owners so that it can redeem, i.e. repurchase or buy back, the shares of the decedent. Because entity-purchase agreements are often substantially more complicated than cross-purchase agreements, they can be less practical for businesses with fewer than two or three owners.

Some assert that entity-purchase agreements are fairer than cross-purchase agreement if there is a substantial disparity in the ages of a business' owners because the business bears the burden of paying for the premiums (although the premium payments are still not deductible). However, others believe that cross-purchase agreements are fairer because, although the premiums they pay are higher, younger owners are more likely to see a return on their insurance investment, as there is a greater likelihood that the older owners will die while the policy is in force.

Life Insurance Taxation

Life insurance proceeds are generally not subject to federal income tax under § 101(a) of the Internal Revenue Code (IRC). However, entity-purchase agreements implemented by entities taxed under Subchapter C of the IRC, e.g. c-corporations and some LLCs, must meet the requirements of IRC § 302(b) or § 303 for redemptions to qualify as sales of shares, for which a decedent's estate recognizes no gain as opposed to recognizing a dividend.

In either case, however, premium payments used to fund life insurance policies are not deductible for purposes of federal income taxes under IRC § 264(a)(1).

This brief overview of some important considerations associated with business succession planning and life insurance is by no means comprehensive. Always seek the advice of a competent professional when making important financial and legal decisions.

* Though we use the term ownership for the purpose of simplicity throughout this post, it includes those business interests that are not generally described as ownership interests, e.g. partnership or LLC memberships interests.

Real Estate LLC & Asset Protection

Mon, 25 Jul 2011 14:18:20 -0600

Real estate can be the source of substantial liabilities. Under certain circumstances, however, many of those liabilities can be eliminated by properly structuring ownership of real estate in a limited liability entity like a limited liability company (LLC).

Contract Liability

The significant cost of acquiring real estate often requires owners to borrow money purchase real estate. Because of the significant fluctuations in real estate values over the past decade, especially here in Arizona, many property owners now owe more money on loans associated with their real estate than the real estate is worth.

Although Arizona law generally prohibits lenders from suing homeowners to collect deficiencies associated with the disposition of primary residences, lenders can obtain deficiency judgments against real estate owners in other circumstances. However, if the real estate is owned by an LLC as opposed to a person, and the owner of the LLC (called an LLC member) has not personally guaranteed the loan or acted wrongfully, the lender cannot seek recourse against the LLC member for a deficiency, only the LLC itself.

Tort Liability

In the United States, people are required to act reasonably (non-negligently) relative to their age and capacity. If a person does not act reasonably, he/she can be liable for damages associated with his/her breach of that duty. However, a person who owns real estate can, in certain situations, protect his/her personal assets from negligence claims arising from the ownership of the real estate. This is done by titling ownership of real estate in the name of an LLC or other limited liability entity.

For example, if a tenant of rental property slips and falls in a pool of standing water at the rental property because a sprinkler was not properly installed, that owner of the rental property might be liable for those injuries. If the property is owned by a person, then the tenant can pursue the personal assets of the owner. If an LLC owns the property, however, only the LLC will be liable for damages (unless an LLC member personally created the danger through an act of negligence like incorrectly installing the sprinkler head that caused the pool standing of water), but the tenant would not be able to pursue the LLC member's assets to satisfy a judgment entered against the LLC.

Limited Liability Company (LLC)

During the past 30 years, the LLC has risen from realtive obscurity in Wyoming to wide-spread acceptance and usage in every state as an entity of choice for many businesses and for many asset protection plans. This is in large part because of the flexibility and lack of formational and operational formalities required by LLC statutes as compared to corporation statutes. There is, however, another possibly more important reason: charging order protection for LLC members.

Charging Orders

In contrast to corporations, which generally permit judgment creditors of a shareholder, except in Nevada, to foreclose upon a judgment debtor's property interest in a corporation, which is represented by shares, and exercise the rights associated with those shares, creditors of LLCs in many states, e.g. Arizona, are expressly prohibited from seeking foreclose of an LLC member's property interest in the LLC and are not permitted to exercise management or control over the LLC. Courts in some states, however, have permitted a foreclosure-like remedy, i.e. Florida (Olmstead) & Colorado, by disregarding single-member LLCs and imposing personal liability upon an LLC member in situations where the member was utilizing the LLC for unlawful purposes. However, Florida's legislature recently enacted a statute that only allows creditors to pursue charging orders against multiple-member LLC interests.

This brief overview of some important considerations associated with real estate LLCs and asset protection is by no means comprehensive. Always seek the advice of a competent professional when making important financial and/or legal decisions.

Arizona Living Wills & Health Care Powers of Attorney

Mon, 27 Jun 2011 14:46:14 -0600

Arizona living wills and health care powers of attorney are legal documents that allow people to articulate their wishes. Although these two directives may seem mutually exclusive, they can actually work in tandem.

Health Care Power of Attorney

An Arizona health care power of attorney can be the broadest health care directive permitted under Arizona law. It can allow an adult to absolutely designate one or more other adult individuals to independently make health care decisions on that adult's behalf or to provide funeral and disposition arrangements in the event of the person's death or it can give specific instructions. Moreover, this includes not only treatment decisions, but decisions about the medical personnel and medical facilities at which a person should be treated.

Arizona law requires that a health care power of attorney be: 1) written, 2) dated, 3) signed, and 4) notarized or witnessed by at least one adult who affirms that the notary or witness was present when the person dated and signed or marked the health care power of attorney and that the person appeared to be of sound mind and free from duress at the time of execution of the health care power of attorney. ARS § 36-3221.

The notary or witness shall not be any of the following: 1) A person designated to make medical decisions on the principal's behalf, 2) A person directly involved with the provision of health care to the principal at the time the health care power of attorney is executed. If a health care power of attorney is witnessed by only one person, that person may not be related to the principal by blood, marriage or adoption and may not be entitled to any part of the principal's estate by will or by operation of law at the time that the power of attorney is executed. ARS § 36-3221.

Living Will

An Arizona living will can either exist by itself or as part of a health care power of attorney. It specifies those end-of-life actions a person would and would not like taken on his/her behalf. The situations and actions listed in a living will may range from very general to very specific.

If a living will is part of a health care power of attorney, it need only be in writing and need not comply with additional execution formalities. If it is not part of a health care power of attorney, however, its execution must satisfy the same execution requirements as a health care power of attorney. ARS § 36-3261.

The Arizona statutes are somewhat unclear as to whether a health care provider can act independently under a living will that only exists as part of a health care power of attorney, or whether the attorney-in-fact must issue the directives set forth therein. Therefore, to avoid this possible limitation, we suggest that a living will be executed as a separate document, even if its terms are contained in a health care power of attorney.

Out of State Validity

A health care directive prepared before September 30, 1992, or prepared in another state, district or territory of the United States is valid in Ariozna if it was valid in the place where and at the time when it was adopted and only to the extent that it does not conflict with the criminal laws of Arizona. ARS § 36-3208.

Controlling Directive

If there are conflicts among the provisions of valid health care directives, the most recent directive is deemed to represent the wishes of the patient. ARS § 36-3209.

This brief overview of some important considerations associated with living wills and healthcare powers of attorney is by no means comprehensive. Always seek the advice of a competent professional when making important financial and legal decisions.

Arizona Living Trusts, Testamentary Trusts, & Asset Protection

Tue, 14 Jun 2011 15:39:05 -0600

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.

Trust Interests

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.