Asset Protection Planning Using Special Needs Trusts

A client in financial distress is often searching for any possible opportunity for protecting assets from her creditors. Having been advised of the applicability of the Fraudulent Transfer Act, the client understands that gifts to family members or sales at below market prices are likely to be challenged as fraudulent transfers. In general, a fraudulent transfer is one made with the intent to hinder, delay or defraud a creditor. However, intent can be also be found where the debtor transfers assets without receiving reasonably equivalent value and intends to incur debts beyond her ability to pay. In addition, a transfer is fraudulent if the debtor transfers assets without receiving reasonably equivalent value and is insolvent at the time or becomes insolvent as a result of the transfer. If a transfer is found to be fraudulent, the creditor has a number of remedies including avoidance of the transfer or attaching the transferred property.

Many traditional asset protection planning opportunities available to persons not in financial distress cannot be used by distressed debtors because of the Fraudulent Transfer Act. Sometimes, however, a family’s unique situation can justify a transfer that otherwise might have been considered fraudulent. We occasionally encounter distressed debtors with children or are suffering from chronic physical or mental disabilities…autism, cystic fibrosis, muscular dystrophy and so forth. It is not unusual for a parent or grandparent, as part of his or her estate planning, to set up a Special Needs Trust for such child. This type of trust can be funded at death or inter vivos (during life). This author submits that if a distressed debtor funds a Special Needs Trust with the intent to further the interests of the child and to insure adequate funds exist for such child’s needs beyond those provided by governmental benefits, and not with the intent to hinder, delay or defraud creditors, such transfer may be permissible.

The establishment and funding of the Trust cannot be a mere subterfuge for what would otherwise be a fraudulent transfer. There must be evidence that the client is satisfying an independent and significant goal (providing for the wellbeing of the child) which is unrelated to the client’s financial condition. If this condition is satisfied and it can be demonstrated that the client did not intend to defraud her creditors, the next condition is that the client was not insolvent or the transfer did not render her insolvent. If debts exceed the value of the debtor’s property, the debtor is deemed to be insolvent under the Act. If the debtor is not generally paying her debts as the debts become due, she will also be considered insolvent.

From a practical perspective, a creditor is faced with a tough hurdle in challenging the transfer to a Special Needs Trust. Not only does the creditor have to prove intent (which can be actual or constructive) or show that the insolvency test was violated, but the creditor must also fight the natural inclination of a jury to want to permit a transfer to a Special Needs Trust especially when all of the testimony is presented about the affected child and his future problems.