Does a Revocable Trust Protect Your Assets From Lawsuits and Creditors?

One of the most common misconceptions we hear about revocable living trusts is that placing a home, bank account, or investment property into a trust protects the asset from lawsuits and creditors.

Unfortunately, that is generally not the case.

A revocable living trust is an extremely valuable estate planning tool. It can help your family avoid probate, provide for the management of your assets if you become incapacitated, and direct how your property will pass after your death. But during your lifetime, it ordinarily does not create a liability shield around your assets.

Understanding what a revocable trust does, and does not do, can help you build a more complete plan that addresses both estate planning and asset protection.

Why a Revocable Trust Does Not Protect the Grantor

The person who establishes a trust is often called the grantor or settlor. With a typical revocable living trust, the grantor usually:

Serves as the initial trustee;
Retains complete control over the trust property;
Can buy, sell, invest, or spend the assets;
Can change the beneficiaries and other trust terms; and
Can amend or revoke the trust at any time.

That flexibility is one of the trust’s greatest benefits. It is also why the trust does not provide lifetime creditor protection for the trust Grantor.

California Probate Code section 18200 states that when a settlor retains the power to revoke a trust, the trust property is subject to the settlor’s creditors to the extent of that power during the settlor’s lifetime. Put simply, if you can take the property back whenever you wish, a creditor can generally reach it too.

Changing the title of an asset from “Jane Smith” to “Jane Smith, Trustee of the Jane Smith Revocable Trust” does not make the asset unavailable to Jane’s creditors. For liability purposes, Jane has not truly given up ownership or control.

What About a Lawsuit?

If you are sued and a judgment is entered against you, assets held in your revocable trust generally remain exposed just as they would if they were held in your individual name. The revocable trust itself is not a substitute for liability insurance, an appropriate business entity, or a carefully designed asset-protection strategy.

This does not mean a revocable trust has failed. It simply means the trust was designed primarily for probate avoidance, incapacity planning, privacy, and the orderly transfer of property upon death, not to protect the person who created it from personal liabilities.

Practical Ways Californians May Reduce Risk

Asset protection is rarely accomplished with a single document. More often, it involves several layers of protection selected for the person’s assets, occupation, family circumstances, and level of risk.

1. Homeowners Insurance and Umbrella Liability Coverage

Insurance is often one of the most practical first lines of defense. Homeowners, automobile, landlord, professional, and business policies may cover risks associated with particular activities or property.

A personal umbrella policy can also provide additional liability coverage above the limits of underlying homeowners and automobile policies. For many families, increasing liability coverage is considerably simpler and less expensive than creating a sophisticated irrevocable trust.

Coverage is never automatic for every claim. Policy limits, exclusions, covered people and properties, and minimum underlying coverage requirements should be reviewed regularly with a qualified insurance professional.

2. California’s Homestead Exemption Declaration

California law provides a homestead exemption that may protect a portion of the equity in a person’s principal residence from certain judgment creditors. The statutory amount is based on the applicable countywide median sale price, subject to an annual inflation-adjusted increase (with cap of $743,459). See California Code of Civil Procedure – CCP §704.730.

Homestead Declaration protection can also benefit a qualifying spouse and family members who reside in the home. Recording a declaration is generally a relatively affordable legal step, but the document must be properly prepared, signed, notarized, and recorded in the county where the property is located.

It is important to understand the limits. A homestead declaration does not make a home lawsuit-proof, protect unlimited equity, double the exemption, or eliminate mortgages, tax liens, mechanics’ liens, or other obligations that may fall outside the exemption. It also does not prevent every creditor from forcing a sale; instead, it generally preserves the homeowner’s exempt share of the equity when the law applies.

Because the exemption amounts are adjusted and the rules contain important exceptions, homeowners should obtain current legal advice about whether recording a homestead declaration would provide a meaningful benefit in their particular circumstances.

3. Limited Liability Companies for Rental Properties

An LLC may be appropriate for rental or investment real estate. When properly established, funded, insured, and maintained, it can help separate liabilities arising from a rental property from an owner’s other personal assets.

For example, if a tenant or visitor is injured at a rental property, ownership through an LLC may help contain a claim to the LLC and the property it owns. California law generally treats the debts and liabilities of an LLC as belonging to the company rather than its members.

However, an LLC is not an impenetrable shield. It generally will not protect an owner from the owner’s own negligence, personal guarantees, improper commingling of funds, or other personal liability. The LLC must also be operated as a real, separate entity, with appropriate records, accounts, contracts, and insurance. Tax consequences, lender requirements, property-tax issues, and California filing and annual tax obligations should be reviewed before transferring real estate.

An LLC interest can often be assigned to a revocable trust for probate-avoidance purposes. In that arrangement, the LLC may provide the liability compartment while the revocable trust provides the estate-planning structure. The documents must be coordinated correctly.

What About Domestic Asset Protection Trusts?

Domestic Asset Protection Trusts, commonly called DAPTs, are irrevocable trusts authorized by a limited number of states. Under the law of those states, a person may transfer assets to a trust, remain as a discretionary beneficiary, and potentially obtain protection from certain future creditors after applicable requirements and waiting periods are satisfied.

California does not generally provide the same protection for a self-settled trust created for the settlor’s own benefit. A California resident’s attempt to use a DAPT established under another state’s law can involve complex questions about which state’s law applies, where the settlor lives, where the assets and trustees are located, and whether a California court will respect the intended protection.

DAPTs also involve costs, some loss of control, specialized administration, tax considerations, exceptions for certain creditors, and the risk that a transfer will be challenged. They are generally considered only in more sophisticated planning, often for high-net-worth individuals with substantial exposure. They are not the typical answer for the average family seeking ordinary liability protection.

Most importantly, no asset-protection trust should be created or funded after a claim has arisen, or when a lawsuit is threatened, with the expectation that assets can simply be moved beyond a creditor’s reach. California law permits creditors to challenge transfers made with the intent to hinder, delay, or defraud them. Effective planning must be completed well before a problem appears.

A Revocable Trust Can Protect an Inheritance After Your Death

Although your revocable trust does not ordinarily protect your assets from your creditors during your lifetime, it can be designed to protect assets inherited by your beneficiaries after your death.

This is an important distinction.

Many basic trusts direct the trustee to distribute a child’s inheritance outright at a particular age. Once distributed, the inheritance belongs to the child personally and may become exposed to the child’s creditors, lawsuits, financial mistakes, or a divorcing spouse, particularly if inherited assets are commingled with a spouse or otherwise handled improperly.

Instead, the trust can provide that a beneficiary’s inheritance remains in a continuing trust. Depending on how it is drafted and administered, a continuing trust may provide meaningful protection while still allowing the assets to be used for the beneficiary’s health, education, support, housing, and other needs.

Protective features may include:

A spendthrift provision;
No unrestricted right for the beneficiary to demand distributions;
Discretionary distribution standards;
An independent trustee or independent distribution trustee when appropriate;
Careful rules governing if and when a beneficiary may serve as trustee; and
A trust protector with authority to respond to changing circumstances.

For example, if an adult child is facing a lawsuit or divorce when a parent dies, an independent trustee may be able to retain the inheritance in trust rather than distributing it directly into the beneficiary’s hands. The result depends on the trust language, the beneficiary’s control, how distributions are made, and the applicable law, so careful drafting and administration matter.

Estate Planning and Asset Protection Should Work Together

A revocable living trust remains the foundation of many excellent California estate plans. The mistake is expecting it to perform a job it was not designed to do.

A well-coordinated plan may use:

A revocable trust for probate avoidance and incapacity planning:
LLCs for appropriate rental or business assets;
Adequate property and liability insurance, including umbrella coverage;
Available homestead and statutory exemptions; and
Continuing trusts to protect a beneficiary’s inheritance after the grantor’s death.

The best strategy will depend on the nature and value of your assets, your potential liability risks, your family goals, and how much control and complexity you are willing to accept.

If you have assumed that transferring assets into your revocable trust made them lawsuit-proof, now is a good time to review your plan. We can help you identify what your trust already accomplishes, where exposure may remain, and which practical protections may be appropriate for you and your family.

If you, a friend, or a loved one would like to discuss estate planning and/or creditor protection strategies, contact our Intake Department at 760-448-2220 or visit us online at www.geigerlawoffice.com/contact.cfm. We proudly serve families throughout California from our offices in Carlsbad and Laguna Niguel.