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Reproduced from Estate Planning Magazine (Aug., Sept. and Oct. 2004)
© 2003-2004 by Mark Merric and Steven J. Oshins. All rights reserved. 1
The Effect of the UTC on the
Asset Protection of Spendthrift Trusts
by: Mark Merric & Steven J. Oshins
With the spiraling divorce rate of over fifty percent in the United States, as well as
the increasing number of lawsuits, creditor protection is often the most important
objective of our clients. An irrevocable trust set up by someone other than a beneficiary
provides the ultimate in creditor protection. As the asset protection maxim goes -- "If you
don't own it, nobody can take it away from you."1 Historically, the general rule has been
that the creator of the trust can dictate who may receive the beneficial enjoyment of the
property and the extent and circumstances under which this enjoyment may be obtained.
As a result, unless trust property is distributed to a beneficiary, it will generally be
protected from the beneficiary's creditors.
Unfortunately the Uniform Trust Code (“UTC”) may have significantly weakened
the asset protection that was formerly available for discretionary trusts in states that have
adopted it. Because of the issues surrounding the UTC, planners should consider moving
all trusts and the underlying liquid assets intended to be creditor-protected out of UTC
states.
The general rule is that through accepted legal remedies a creditor of a debtor
stands in the shoes of the debtor and may exercise any property or other right that the
debtor may exercise. So does this mean that a creditor may attach a beneficiary’s trust
interest or force the trust to make a distribution to the creditor in satisfaction of a
beneficiary’s debt? Further, could a creditor lien or attach a remainder interest? If this is
the general rule, does an estranged spouse have more rights to attach a beneficial interest
under domestic relations law than an ordinary creditor? Does a discretionary trust
provide stronger creditor protection than a support trust? This article will answer these
questions and others.
Creditor Remedies Prior to the UTC
To the extent a trust beneficiary has a “property right” certain “exception
creditors” may attach the beneficiary’s interest. These “exception creditors” are
generally the following exception creditors specifically listed in the Restatement Second
of Trusts:
(1) Alimony and child support;
(2) Necessary expenses of a beneficiary (i.e., governmental claims for medical
expenses); and
(3) Governmental claims.2
There is a fourth exception creditor listed in the Restatement Second - a creditor
for expenses incurred to preserve a beneficial interest (i.e., attorneys’ fees).3 However,
most states have not adopted this fourth exception creditor.
Exception creditors are allowed to attach the beneficial interest of a trust pursuant
to the distribution standard in the support trust (e.g., health, education, maintenance and
support). 4 Since the beneficiary has a right to force a distribution pursuant to the
distribution standard, the exception creditor also succeeds to such a right. In this respect,
the exception creditor is able to reach part or all of the assets necessary to satisfy the
creditor’s claim directly from the trust property.
Current Distribution Analysis – Non-UTC State
In general, a current distribution interest is an interest where the trustee may make
a mandatory distribution, a discretionary distribution, or a distribution based on a support
standard. Generally, if the beneficiary does not have a property interest (i.e., an
enforceable right5), a creditor has absolutely no right of recovery. The theory is that if
the beneficiary does not have a right of recovery that he may enforce, the creditor can
obtain no more rights than the beneficiary has over the trust assets. This rule that
prevents recovery by a creditor is not dependent upon spendthrift provisions. Rather, a
creditor cannot compel the trustee to pay anything because the beneficiary cannot compel
a payment.6 Therefore, so long as the governing law of the trust is not that of a state that
has adopted the UTC, absent control issues, or, in a few states, certain divorce issues, if a
beneficiary has no property interest, the analysis is generally concluded and the creditor
has no right of recovery.
However, not all state courts use a direct property analysis in determining whether
a creditor may reach a beneficial interest. Rather, some courts will examine whether the
beneficiary’s interest has an ascertainable value.7 In essence, the analysis is the same. If
the beneficiary’s interest has no value, then there is no interest or enforceable right that a
creditor may attach.
On the other hand, if the beneficiary has a property interest, then the trust must be
reviewed to determine whether it contains a spendthrift clause. Almost all trusts have
such a clause. In general, a spendthrift clause protects a beneficiary’s interest from
attachment by a creditor.
However, under the Restatement Second, there are four types of creditors that
may attach a beneficiary’s interest regardless of the spendthrift provisions. These
creditors are referred to as exception creditors. Most states have adopted three of the four
exception creditors. The exception creditor for expenses required to protect a beneficial
interest (i.e., attorney fees) has not been adopted by many states.
In addition, even if a the creditor is not an exception creditor, or even if the trust
is a discretionary trust, if the beneficiary holds too much control over the trust, a creditor
will still be able to attach to the beneficiary’s interest and reach the trust’s assets. For
example, if the beneficiary is the sole trustee and sole beneficiary of a trust, then the trust
assets may be available to a creditor.8
With respect to alimony and child support claims, a former spouse and minor
children are exception creditors, and the former spouse may attach a current beneficial
interest of a support trust on behalf of minor children. However, except for states that
have adopted the UTC or Restatement Third, a spouse generally does not have any claim
against a discretionary trust.
Remainder Interest Analysis - Non-UTC State
The remainder interest analysis varies from the current distribution analysis in a
few key areas. First, similar to a current beneficial interest, one must first determine
whether the interest is a property interest. However, the Restatement Second adopts a
different approach than that which is used in the current beneficial interest analysis. If an
interest is created for a group of persons, it is inseparable and a creditor cannot reach it.9
For example, a dynasty trust is a trust in which an interest never vests in anyone. Hence,
an interest in a dynasty trust would not be a property interest and would be “inseparable”
as defined in the Restatement Second.
The Restatement Second also provides that if an interest of a trust “is so indefinite
or contingent that it cannot be sold with fairness to both the creditors and the beneficiary,
it cannot be reached by his creditors.” 10 If this is the case, a creditor should not be able
to recover from the trust. However, if this is not the case, then the analysis shifts to
whether the trust has a spendthrift provision.
Similar to the analysis for a current distribution interest, spendthrift protection
must be analyzed within the confines of the four exception creditors. Here again, a
former spouse is an exception creditor who may attach a remainder interest for child
support or alimony.
The control issue analysis is substantially identical for a current beneficial interest
and a remainder interest. Even if a the creditor is not an exception creditor or even if the
trust is a discretionary trust, if the beneficiary holds too much control over the trust, a
creditor will still be able to attach to the beneficiary’s interest and reach the trust’s assets.
In the domestic relations area, courts have granted a former spouse greater rights
than an ordinary creditor or an exception creditor. As noted above, a spouse is an
exception creditor, but only for the purposes of alimony or child support. However, in
many states, courts have allowed a spouse to attach a remainder interest as part of a
property settlement.
Support Trusts Versus Discretionary Trusts
A trust is generally drafted as either: (1) a mandatory distribution trust, (2) a
support trust (i.e., distributions pursuant to an ascertainable standard), or (3) a
discretionary trust. Additionally, since many attorneys tend to combine the language of a
support trust with the language of a discretionary trust, a handful of states have created a
fourth type of trust called a hybrid trust.
1. Mandatory Distribution Trust
A mandatory distribution trust is a trust in which the trustee must make the
distribution required by the terms of the trust agreement. The trustee may not withhold or
accumulate a mandatory distribution. Some examples of mandatory distribution trusts
include marital deduction trusts, grantor retained annuity trusts, charitable remainder
trusts and charitable lead trusts. The trusts in these examples require mandatory
distributions in order to qualify for certain tax benefits. However, many trusts are drafted
with mandatory distributions even though there is no tax reason to do so. This often
makes some or all of the trust assets available to the beneficiary’s creditors and divorcing
spouses for no reason but that the trust scrivener was using a trust “form” which was
inadequate for planning purposes.
2. Support Trust
A support trust is created by the settlor to support one or more beneficiaries. A
support trust directs the trustee to apply the trust’s income and/or principal as is necessary
for the support, maintenance, education, and welfare (or other standard) of a
beneficiary.11 The beneficiary of a support trust can compel the trustee to make a
distribution of trust income or principal merely by demonstrating that the money is
necessary for the beneficiary’s support, maintenance, education, or welfare,12 or whatever
other standard is contained in the trust.
Following is an example of language creating a support trust:
“The Trustee shall make distributions of income or principal for the
beneficiary’s health, education, maintenance and support.”
Implicit in this support language are two components: (1) a command that the trustee
“shall” make distributions, and (2) under what standard or circumstances (i.e., health,
education, maintenance and support) distributions are to be made.
A support trust typically includes mandatory language that the trustee “shall”
make distributions.13 However, there are a few cases in which a trust has been classified
as a support trust even though the discretionary word “may” or the words “discretion,”
and even “sole discretion,” were used instead of the mandatory word “shall.” The
standard for distributions often contains words such as “health, education, maintenance
and support.” However, the standard may also include terms such as “comfort and
welfare.”14 A support trust gives the trustee discretion only with respect to the time,
manner, or size of distributions needed to achieve a certain purpose, such as support of
the beneficiary.15
For example, in McElrath v. Citizens and Southern Nat. Bank, the language “[t]he
Trustee shall use a sufficient amount of the income to provide for the grandchild’s
support, maintenance and education” [emphasis added] was held to be a support trust. 16
Similarly, in In re Carlson’s Trust, the language “[t]he trustee shall pay…[to the settlor’s]
daughters such reasonable sums as shall be needed for their care, support, maintenance,
and education” [emphasis added] was determined to be a support trust.17 Finally, in
McNiff v. Olmsted County Welfare Dept., the court decided that the language “[t]he
trustee shall administer the trust estate for the benefit of my wife and my said daughter,
or the survivor of either, and the trustee shall apply the income in such proportion
together with such amounts of principal as the trustee, it its discretion, deems advisable
for the maintenance, care, support and education of both my wife and my said daughter”
[emphasis added] created a support trust.18
3. Discretionary Trust
A discretionary trust allows the trustee complete and uncontrolled discretion to
make allocations of trust funds if and when it deems appropriate.19 Because the trustee is
given such broad powers, the beneficiary can only compel the trustee to distribute funds
if it can be shown that the trustee is abusing its discretion by failing to act, acting
dishonestly, or acting with an improper purpose in regard to the motive in denying the
beneficiary the funds sought.20
Following is an example of language creating a discretionary trust:
“The Trustee may distribute as much or more of the net income and
principal as the Trustee, in its sole and absolute discretion, deems
appropriate to or among any beneficiary or beneficiaries. The Trustee, in
its sole and absolute discretion, at any time or times, may exclude any of
the beneficiaries or may make unequal distributions among them.”
Implicit in this magical discretionary language are three components: (1) a discretionary
statement that the trustee “may” make a distribution, (2) the trustee has the “sole and
absolute” discretion to determine whether a distribution shall be made and, if so, how
much shall be distributed, and (3) the ability to exclude distributions from other
beneficiaries.
A discretionary trust generally uses permissive language such as the word “may”
instead of the word “shall.”21 However, as noted below, there are a few cases where the
courts have held that the word “shall” when combined with the words “sole and absolute”
discretion still resulted in a discretionary trust.22
The permissive word “may” is still generally further qualified by granting the
trustee unfettered discretion using words such as “sole and absolute discretion,” “absolute
and uncontrolled discretion” or “unfettered discretion.” In some cases, explicit language
that permitted the trustees to exclude or discriminate between beneficiaries when making
distributions was a major factor the court considered when determining whether a trust
was a discretionary trust.23
For example, in In re Matter of Leona Carlisle Trust, the court determined that
the language “[t]he Trustee shall expend such sums from the principal of the trust for the
benefit of [appellant]…as the trustee, in its full discretion, deems advisable,” [emphasis
added] and it “is expressly understood the trustee is under no obligation to make any
expenditures,” created a discretionary trust.24 Furthermore, the trust language provided
that the trustee shall not make any distributions for appellant’s “basic necessities as
provided or to be provided by any governmental unit,” and the trustee “shall make
distributions only to supplement and not to supplant such public assistance available for
maintenance, health care or other benefits.”25
Similarly, in Zeoli v. Commissioner of Social Services, the court found that the
language “[t]o pay or apply so much of the net income to or among either one or both of
my daughters as shall be living from time to time during the term of such trust, and in
such proportions and amounts as my trustee shall determine in his absolute and
uncontrolled discretion...” [emphasis added] created a discretionary trust. The language
in that case continued, “[m]y trustee shall not be required to distribute any net income of
such trust currently and may, in his absolute and uncontrolled discretion, accumulate any
part or all of the net income of such trust, which such accumulated net income shall be
available for distribution to the beneficiaries as aforesaid.26 [Emphasis added.]
As yet another example, in Simpson v. State Dept. of Social and Rehabilitation
Services, the trustees were required to distribute trust income and assets to any one or
more of this group of beneficiaries as the trustees “in their absolute discretion” may
determine from time to time. The instrument further provides that “the Trustees shall
have the absolute discretion, at any time and from time to time, to make unequal
payments or distributions to or among any one or more of said group and to exclude any
one or more of them from any such payment or distribution.”27 [Emphasis added.]
4. Hybrid Trust or “Discretionary Support Trust”
There are three states and possibly a fourth (Iowa, Nebraska, North Dakota, and
possibly Pennsylvania) that have taken the position that there is an additional type of trust
– a “discretionary support trust”. This type of trust includes elements of both a support
trust and a discretionary trust.28 A discretionary support trust is created when the settlor
combines the explicit discretionary language “with language that, in itself, would be
deemed to create a pure support trust.”29 Under the case law of these three or four states,
the hybrid trust covers the middle ground between a classic support trust and a classic
discretionary trust.30 If a trust is neither a traditional support trust nor a traditional
discretionary trust, these courts have followed one or the other of the following two
approaches. They have either (a) allowed extrinsic evidence to determine the
classification as either a discretionary or a support trust, or (b) required the trustee to
carry out the purposes of the trust based on a “good faith” standard and required the
trustee to make minimal distributions.
For an example of a court allowing extrinsic evidence to make the determination,
in Bohac,31 the provisions of the trust allowed the trustee to distribute principal as the
“Trustee may deem necessary” for the beneficiary’s “support, maintenance, medical
expenses, care, comfort, and general welfare.” [Emphasis added.] The court noted that
the trust provisions created a hybrid trust, but decided that extrinsic evidence must be
admitted to determine the settlor’s intent with respect to whether the trust was a support
trust or a discretionary trust. Even though the court noted that the words “comfort and
general welfare” may result in the classification of the trust as a discretionary trust, the
court held the trust was a support trust.
As another example, in Kryzsko v. Ramsey County Soc. Services,32 the trustee was
given sole discretion to invade trust principal for the “proper care, maintenance, support,
and education” of the beneficiary. The court held that the trustee did not have unfettered
discretion and must follow a standard of providing proper support. The court noted that
unlike a discretionary trust, which fixes no standard on the trustee’s absolute discretion as
to whether to pay income or principal to a beneficiary, a support trust gives the trustee
discretion only as to the time, manner, and size of the payments needed to achieve a
certain purpose such as support of a beneficiary.
As yet another example, in Lang v. Com., Dept. of Public Welfare,33 the terms of
the trust provided that “the trustee shall pay the income periodically to or for the support,
maintenance, welfare, and benefit of my son or may, in the trustee’s discretion, add part
or all of the income or principal to be invested as such.” [Emphasis added.] The trust
continued, “[t]he trustee may distribute such part of the income not necessary for the
support of my son, in equal shares to my children.” After looking at extrinsic evidence
suggesting that it was the settlor’s intent to preserve trust assets, particularly where public
benefits were available to the beneficiary, the court held that the trust was discretionary.
In contrast, in Smith v. Smith,34 the Nebraska Supreme Court held that the trustee
of a discretionary support trust can be compelled to carry out the purpose of the trust in
good faith. The trust provided that “[T]he trustee shall pay over to, or for the benefit of
one or more of the living members of a class composed of my son Richard and his issue,
so much of the net income and principal of the trust as the Trustee shall deem to be in the
best interests of each such person, from time to time. Such distributions need not be
made equally unto all members of the class. In determining the amount and frequency of
such distributions, the Trustee shall consider that the primary purpose of the trust is to
provide for the health, support, care, and maintenance of my son Richard during his life.”
[Emphasis added.] The court determined that the above language constituted a “hybrid
trust” where the trusts were not only created to support the primary beneficiary, but also
to grant the trustee greater liberty in decision-making than that of a trustee of an ordinary
support trust.
A few courts have held that the effect of a discretionary support trust is to
establish the minimal distributions a trustee must make in order to comport with the
settlor’s intent of providing basic support, while retaining broad discretionary powers in
the trustee.35 In these cases, the courts held that the minimum distribution may be
reached by a creditor.36
In Bureau of Support in Dep’t of Mental Hygiene & Correction v. Kreitzer, 37 the
Ohio Supreme Court, without using the term “hybrid trust,” found the trust language to
create neither a purely discretionary trust nor a purely support trust. Therefore, the court
held that the trust should be governed by a “reasonableness” standard that would not
permit the beneficiary to become destitute. The result was that the governmental agency
could recover against the trust assets under the exception for necessary expenses of a
beneficiary. Further, the Ohio Supreme Court seemed to lean further toward becoming a
“hybrid trust” state when it stated in a subsequent case that “[a] trust conferring upon the
trustees power to distribute income and principal in their absolute discretion, but which
provides standards by which that discretion is to be exercised with reference to the needs
of the trust beneficiary for education, care, comfort, or support is neither a purely
discretionary trust nor a strict support trust.”38
This Ohio Supreme Court ruling is particularly troubling because it used a
“reasonableness” standard. For over a hundred years, the strong majority view has been
that the appropriate standard is bad faith or abuse (i.e., the trustee acts dishonestly with an
improper motive or fails to act).39 Further, the purpose of a discretionary trust is to
prevent the courts from reviewing the “sole and absolute” discretion of the trustee. With
a discretionary trust, the settlor has chosen to put his faith in the trustee rather than the
courts. However, a support trust takes the opposite approach. With a support trust, the
settlor wants the beneficiary to have a right to enforce the ascertainable trust terms if the
trustee does not follow the standard drafted into the trust agreement.
By using a standard less than that of bad faith and closer to reasonableness, the
Ohio Supreme Court has now given the beneficiary of this hybrid type of trust the right to
sue the trustee for unreasonably not making a distribution or not distributing enough.
Furthermore, this legal right will most likely be a property right (i.e., a right enforceable
under state law) that can cause the creditor to stand in the shoes of the beneficiary.
What is a Property Interest?
Most courts first determine whether a beneficiary has a property interest under
state law. 40 Rather than using a property analysis, some courts will find that the
beneficiary’s interest has no ascertainable value. 41 In essence, the analysis is the same.
There is no interest or enforceable right that a creditor may attach because under this
analysis the beneficial interest has no value.
Assuming the property analysis approach is used, the initial step in determining
whether a creditor may recover against an interest in a trust is to determine whether the
interest is a property interest under state law.
If the beneficiary’s interest in the trust is not a property interest, then the analysis
proceeds directly to whether the beneficiary held too much control over the trust,
followed by any state nuances under domestic relations law. 42 On the other hand, if the
beneficiary holds a property interest, does the creditor stand in the shoes of the
beneficiary, and may the creditor enforce the beneficiary’s property right? The answers
to these questions depends upon whether the trust has a spendthrift provision and how
much creditor protection the spendthrift provision provides.
State law determines what constitutes a property interest. While state law may
vary, “property” is generally defined as everything that has an exchangeable value or
which goes to make up wealth or estate.43 An “equitable interest” in trust property is
regarded as a property interest of the same kind as trust res and is more than a mere chose
in action. 44 Simply, there are two methods for determining whether something
constitutes property: (1) something that may be sold or exchanged, or (2) an enforceable
right.
With regard to the first type of property, such property is freely alienable, and as
such has a fair market value that may be determined by a market price. However,
beneficial interests in trusts are generally restricted by spendthrift provisions that prevent
the transfer of any beneficiary’s interest. In this respect, there is no fair market value
because the property cannot be sold. On the other hand, under the second test, in many
situations, a beneficiary has an enforceable right (i.e., a property interest). For example,
with support trusts, a current beneficiary has a right to sue the trustee to force a
distribution pursuant to a standard in the trust. Also, if a beneficiary has a vested
remainder interest, the beneficiary will most likely receive property at some time in the
future.
Distribution Standard and the Current Beneficial Interest
Almost all courts will classify a beneficiary’s interest as being (1) a mandatory
distribution, (2) a support distribution, or (3) a discretionary distribution. However, as
previously noted, there is a problem when a scrivener conflicts the elements of a
discretionary trust with those of a support trust.
1. Mandatory Distribution Trust
When the terms of a trust require a mandatory distribution to be made, there is no
question that the beneficiary has an enforceable right to this distribution. The beneficiary
unquestionably may sue the trustee to force a distribution. Therefore, a fixed interest,
which is an interest that creates an enforceable right in the beneficiary, is a property
interest. For example, in In re Question Submitted by the United States Court of Appeals for
the Tenth Circuit, the Tenth Circuit held that a beneficiary’s future right to receive $1,000
per month was a property interest.45
With respect to a mandatory distribution right, the creditor is not attaching the
trust’s assets. Rather, the creditor is attempting to attach to the mandatory distribution
stream.46 Since this interest is a property right, the only question is whether a spendthrift
provision provides some type of protection for a mandatory distribution received from a
trust.
2. Support Trust
The common law purpose of a support trust is to provide support for a beneficiary
based on a “standard.” The most common standard used is that of health, education,
maintenance and support. Such a support standard must be definite enough for a court to
be able to determine whether a trustee is following the support standard. In this respect,
magical words such as health, education, maintenance and support have been determined
by courts to be definite. Words such as comfort and welfare may or may not be
sufficiently definite depending on state law. On the other hand, words such as joy and
happiness are not capable of interpretation on a reasonable basis, and may easily result in
a trust not being classified as a support trust.
As previously noted, if a trust is classified as a support trust, a beneficiary of a
support trust can compel the trustee to make a distribution of income or principal merely
by demonstrating that the money is necessary for the beneficiary’s support, maintenance,
education, or welfare,47 or whatever other standard is used in the trust agreement. In other
words, a beneficiary has a right to sue the trustee for failing to make a distribution from a
support trust. If a beneficiary has the right to sue the trustee, the beneficiary most likely
has a property interest under state law.48 If this is the case, does the creditor stand in the
beneficiary’s shoes and have the power to sue the trustee to force the payment of the
beneficiary’s debt? Absent spendthrift provisions, this would definitely be the case.
Therefore, whether a creditor (including an estranged spouse) may recover must be
determined under the analysis in the spendthrift portion of this article.
3. Discretionary Interest
Under the Restatement Second and almost all of the case law to date, a
discretionary beneficiary has no contractual or enforceable right to any income or
principal from the trust, and therefore the beneficiary cannot force any action by the
trustee.49 This is because a court may only review a discretionary trust for abuse and bad
faith. There is no reasonableness standard of review by a court with respect to a
discretionary trust. Further, the discretionary interest is not assignable.50 In this respect,
a discretionary beneficiary’s interest is generally not classified as a property interest.
Rather, it is nothing more than a mere expectancy.51 If a beneficiary has no right to force
a distribution from a trust, then the same rule applies to the beneficiary’s creditor. The
creditor may not force a distribution.
In this respect, whether the assets of a discretionary trust are protected does not
depend on spendthrift provisions with respect to the current beneficial interest. As
discussed in the spendthrift section of this article, the asset protection features of a
discretionary trust are much stronger than those of a support trust or a mandatory
distribution trust that must rely on spendthrift protection.
4. Hybrid Trust or “Discretionary Support Trust”
If a judge does not classify a trust with conflicting language as either a
discretionary trust or a support trust, the case law in Iowa, Nebraska, North Dakota, and
possibly Pennsylvania, has indicated that it is a hybrid trust. In general, a beneficiary of a
hybrid trust only has the right to sue the trustee for a minimal distribution.52 This being
the case, the hybrid trust does not provide the same degree of protection as a
discretionary trust. Rather, it is more similar to a support trust than a discretionary trust,
and an analysis of the spendthrift provisions must be done to determine whether the trust
assets are protected.
Remainder Interest
A remainder interest has a slightly different analysis than that of a current
beneficial interest. While divorce cases tend to use the word “property” in determining a
remainder interest,53 the rule under the Restatement Second, Section 160 requires a
determination as to whether there are “inseparable interests.” In essence, the “inseparable
interest” rule functions quite similar to the property analysis used for a current beneficial
interest. Further, the Restatement adds to the analysis an “indefinite” or “contingent”
interest analysis as another hurdle a creditor will most likely need to cross. If the
remainder interest is not a property interest, or if a creditor cannot overcome the
indefinite or contingent interest rule, then the analysis proceeds directly to whether the
debtor/beneficiary retained too much control.
According to the Restatement Second, if a beneficial trust interest is “so indefinite
or contingent that it cannot be sold with fairness to both the creditors and the beneficiary,
it cannot be reached by creditors.”54 There are two parts to this rule. First, is the
remainder interest indefinite? Second, can the remainder interest be sold with fairness to
both the creditors and the beneficiary?
1. Indefinite and Contingent Interests
A vested interest is not a contingent interest. A vested interest is one where the
debtor/beneficiary or the debtor/beneficiary’s estate will take at some point of time in the
future. The clear majority rule appears to be that a vested remainder interest may be sold
at a judicial foreclosure sale unless it cannot be sold with fairness to both the creditors
and the beneficiary, or unless the trust contains spendthrift provisions.55 These cases
follow the general property rule that a remainder interest in property may be sold even
though it is a future interest.56
Many estate planners consider a remainder interest to be a contingent interest
where either (1) one party must outlive the other party in order to take, or (2) the trust
property is subject to complete divestment due to a special power of appointment.
However, Restatement Second, Section 162, Illustration 1 indicates that the mere fact that
a child must survive a parent in order to take the trust property is not too contingent, and,
therefore, unless the remainder interest can be sold with fairness to both the creditors and
the beneficiary, absent spendthrift protection, a creditor would be able to judicially
foreclose on the remainder interest.57
2. Sold With Fairness
Would a willing buyer or willing seller pay much for an interest in trust that is
contingent on a child outliving his parent? Most likely, the interest would be highly
discounted. However, what if the interest was subject to a special power of appointment
that could divest the child of the entire remainder interest? In this case, a purchaser at a
judicial foreclosure sale would likely pay little for the interest when compared to the
amount that would ultimately be received by the remainder beneficiary.
There are very few reported cases where anyone other than a former spouse
attaches the remainder interest.58 Most creditors do not attempt to judicially foreclose on
a remainder interest because in almost all cases the “sold with fairness rule” would apply.
Even if the “sold with fairness rule” does not apply, several states have passed state
statutes preventing the forced sale of remainder interests.59
Spendthrift Provisions
A spendthrift provision is a provision in a trust agreement that provides that the
beneficiary cannot sell, pledge or encumber his beneficial interest, and a creditor cannot
attach a beneficiary’s interest. At common law, the purpose of a spendthrift trust was to
protect a beneficiary other than the settlor of the trust from his own spending habits. The
idea was to provide for someone who could not provide for himself, and to keep such
beneficiary from becoming dependent on public assistance. Therefore, if a spendthrift
clause was added to a trust, the common law developed a legal principle that a creditor
could not recover from the beneficiary’s interest.60 If the mere insertion of such a clause
could protect a beneficiary’s interest, why not include such a provision in almost all trusts?
Today, this is in fact the case.61
A beneficiary of a discretionary dynasty trust does not need to rely on a
spendthrift provision because neither the current distribution interest nor any subsequent
interest is a property interest under state law. Therefore, in a non-UTC state, neither the
beneficiary nor the creditors of the beneficiary have any right to force a distribution from
the trust. However, as a matter of course, scriveners should nearly always include
spendthrift provisions.62 This is especially true should the UTC become law.
However, the same analysis is not true for a trust that is classified as a support
trust. In this case, beneficiaries in many states may force a distribution from the trust
pursuant to the standard provided in the trust instrument. So the question becomes, can a
creditor stand in the shoes of the beneficiary and force such a distribution? The language
of a spendthrift provision on its face generally prohibits a creditor from doing so.
However, under what circumstances will courts make exceptions to spendthrift protection?
Except for certain types of creditors, a spendthrift provision protects the trust’s
assets from attachment.63 The Restatement Second, Section 157 carves out the following
four key exceptions64 to spendthrift protection, where a creditor may attach the assets of a
support trust:
1. Alimony or child support - Almost all, if not all, recent cases hold that a spouse
may reach a beneficiary’s interest for alimony or child support.65 Therefore, if a trust is
classified as a support trust, an estranged spouse may almost always reach the assets of
the trust to satisfy a maintenance or child support claim. However, this exception does
not apply to a division of marital property pursuant to a divorce.
2. Necessary services or supplies rendered to the beneficiary - Most cases in this
area arise when a federal or state institution is attempting to attach a beneficiary’s interest
for medical services rendered on behalf of the beneficiary.66 Further, in almost all of
these cases, the drafting attorney conflicted the magical words of a discretionary trust
with those of a support trust.
3. Services rendered and materials furnished that preserve or benefit the
beneficial interest in the trust - These are generally claims by attorneys for fees
incurred to either sue the trust or protect a beneficial interest. Fortunately, while the
other three exceptions of the Restatement Second are almost universally applied by the
states, this one is not. In other words, attorneys are frequently not allowed to recover
their fees from the trust.
4. A claim by the U.S. or a state to satisfy a claim against a beneficiary -
Generally, these are tax liens. The Internal Revenue Service may often reach a
beneficiary’s interest in a support trust for payment of a tax lien.67 In First Northern
Trust Co. v. Internal Revenue Service,68 the court noted that it is a well established legal
principle that the income from a spendthrift trust is not immune from federal tax liens
notwithstanding any state laws or recognized exemptions to the contrary.69
In summary, there are four exception creditors that can reach a support trust’s
assets to satisfy their claim. In a non-UTC state, these exception creditors, including the
federal government, would have no claim against the trust assets if it had been drafted as
a discretionary dynasty trust.
Conflicting Distribution Language
As noted above, with respect to the current distribution interest, a discretionary
trust generally provides the strongest asset protection features because the discretionary
distribution interest is generally not a property interest under state law. If a beneficiary
does not hold a property interest, then a creditor cannot attach it.
Unfortunately, there is a tension between the asset protection features of a
discretionary trust and who can be a trustee without possible estate tax inclusion issues.
Generally, clients wish to have a family member, such as a spouse or child, serve as the
trustee. If distributions are limited to an ascertainable standard, there are times when a
spouse/beneficiary or a child/beneficiary may serve as the sole trustee of a trust without
an estate tax inclusion issue.70 On the other hand, if the spouse or child is the sole trustee
and a beneficiary of a discretionary trust, the spouse or child will be considered to hold a
general power of appointment, thereby resulting in estate inclusion.71
Many estate planners attempt to get the best of both worlds. These planners
would like a trust that would be considered discretionary for state law purposes so that a
creditor of a beneficiary cannot attach the trust. They also would like the trust to be
deemed to have an ascertainable standard for estate and gift tax purposes, giving the
client greater selection over who can be a trustee. In an attempt to accomplish both of
these objectives, these planners draft distribution language that uses magical words from
both a support trust and a discretionary trust. For example, the trust document may read:
“The Trustee may, in his sole and absolute discretion, make distributions
of income or principal based on health, education, maintenance and
support to any beneficiary.”
The magical discretionary words “may,” and “discretion” have been conflicted with
the trust support words “health, education, maintenance and support.” Furthermore, the
discretionary language allowing the trustee to make distributions to one beneficiary and
not the others has been implied.
Naturally, the Service would like to argue that this language creates a discretionary
trust because the distribution trustee would have a general power of appointment at death
and therefore also have estate inclusion under IRC §2041.72 Conversely, the taxpayer
would like to argue that distributions are pursuant to an ascertainable standard in order to
avoid the estate inclusion issue.
Furthermore, if it is a governmental agency that is the creditor of the beneficiary
and is seeking to recover payment from the trust, the governmental agency will argue that
distributions are pursuant to an ascertainable standard and that the trust should be
classified as a support trust. The client will argue that the distributions are discretionary.
The court will almost always decide that the trust is either (1) a “support” trust (i.e.,
ascertainable standards) or (2) a discretionary trust.
As noted, almost all non-UTC courts will decide one way or the other, but not
both ways.73 By attempting to accomplish the best of both worlds, the estate planner
typically does more damage than good. The planner creates either a possible estate
inclusion issue or allows a creditor to recover from the trust assets. For this reason, the
trust scrivener should avoid conflicting trust language and should draft either a purely
discretionary trust or a support trust (i.e., distributions based on ascertainable
standards).74
Hybrid Trust
In the few states that recognize a hybrid trust,75 the hybrid trust is by definition a
conflicting language trust. The problem with this is that most of the states require the
trustee to make a minimal distribution for the beneficiaries’ needs. This being the case, a
creditor for necessary expenses of the beneficiary most likely becomes an exception
creditor.76 Further, what about child support and alimony? One could easily argue that
child support is a necessary expense. Similarly, are taxes a necessary expense of a
beneficiary? At present, the answers to these questions are unknown. However, in the
few states that recognize a hybrid trust, it seems that such a trust provides little more
protection than that of a support trust.
Remainder Interest
Absent spendthrift provisions, a beneficiary may transfer the remainder interest,
and a creditor may attach such interest. 77 This would include an estranged spouse as well
as any other creditor.78
On the other hand, if spendthrift provisions are present, ordinary creditors may
not attach a remainder interest. This is true even in bankruptcy court. The Federal
Bankruptcy Court is required to look to state law to apply property rules.79 For example,
in In Re Neuton, a California state statute provided that spendthrift provisions protected
75% of the remainder interest.80 The debtor’s ordinary creditor could not recover against
the amount protected by state law. However, if the creditor is one of the four exception
creditors and the “sold with fairness” rule does not apply, the creditor may attach and/or
judicially foreclose and sell the remainder interest. 81
Control and Dominion Issues
In the event a creditor cannot attach the trust assets under one of the
aforementioned theories of recovery, then a creditor may attempt to recover under the
theory that the debtor/beneficiary held too much control. The purpose of a spendthrift
provision is to protect the beneficiary from his own improvidence. If the sole beneficiary
is the sole trustee, he cannot protect himself from his own improvidence. Therefore, in In
re Bottom, the spendthrift provision protection was not upheld since the sole beneficiary
was the sole trustee,82 and the creditor was able to reach the assets of the trust. On the
other hand, at least two courts have held that the beneficiary/trustee did not control a trust
in which the beneficiary was a co-trustee and there were multiple beneficiaries.83
Many attorneys draft trusts with an ascertainable standard for distributions and the
primary beneficiary (i.e., the child) as the sole trustee of the trust. The trust has both the
primary beneficiary and the primary beneficiary’s children as beneficiaries. To date, the
authors of this article are only aware of one court that has directly addressed this issue,
and a second court that mentioned the issue as dicta.
In In re Schwen, the court mentioned that if one of the beneficiaries was the sole
trustee, the trustee/beneficiary’s control regarding making distributions was still limited
by a fiduciary duty to other beneficiaries. Therefore, the trustee/beneficiary would not
have too much control.84 It should be noted that in Schwen there were actually two
trustees, and the court mentioned the sole trustee situation purely as dicta. Fortunately, in
In re Coumbe, in a review of a bankruptcy case, the court provided further guidance in
this area when it held that a sole beneficiary could serve as the sole trustee so long as
there were different remainder beneficiaries.85
Nuances under State Domestic Relations Law
Until recently, in the event of divorce, almost all asset protection planners thought
that a remainder interest was free from division of marital property. Most Colorado estate
planners went into shock when the Colorado Supreme Court handed down the In re
Balanson decision.86 The Colorado Supreme Court had held that the appreciation on a
vested remainder interest subject to complete divestment was marital property eligible for
equitable division. Colorado law holds that an inheritance is exempt from the definition
of marital property, and any appreciation on inherited property is considered marital
property. Prior to this, Colorado had held that remainder interests in trusts were
indivisible.87
The disturbing facts of Balanson began when the daughter married. A few years
later, Mom and Dad create the standard estate plan that creates a marital trust and credit
shelter trust upon the death of the first spouse. Several years later, Mom dies and the
first $1 million of her assets funds the credit shelter trust, and the remainder funds the
marital trust. Dad was the sole trustee of both trusts. All income of the marital trust was
required to be distributed to Dad. However, distributions of income of the credit shelter
trust and any corpus of either trust were based on an ascertainable standard. Dad was in
good health and may easily live many more years. Further, Dad had a testamentary
general power of appointment over the marital share that would allow him to completely
extinguish the daughter’s interest should he desire by appointing all of the trust property
to his son. Several years after Mom dies, Daughter files for divorce. Son-in-law claims
that Daughter’s vested remainder interest is marital property eligible for division in the
divorce.
The daughter’s remainder interest was contingent since she must outlive her
father. Also, the daughter’s interest was subject to complete divestment because her dad
may exercise his special power of appointment solely in favor of his son. However, the
Colorado Supreme Court ruled that even if a vested remainder interest is subject to
complete divestment, such an interest is still a property interest that can be valued for
the purpose of division in a divorce. The logic behind the decision is that the Court
frequently values interests that are hard to value such as retirement plans and businesses< |