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Drafting Trusts for Maximum Asset Protection from Creditors

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Drafting Trusts for Maximum Asset Protection from Creditors benefit the interest of the beneficiary,6 and (4) claims against the beneficiary by the United States or a state.7 Many states have adopted some or all of these exceptions. One example of judicial erosion of spendthrift protection is In re Mar- riage of Gorman,8 which involved a marital dissolution proceeding for Edward and Cynthia Gorman. Drafting Trusts for Maximum Asset Edward’s father had died a number of years earlier, leaving assets in trust Protection from Creditors for his wife (income and discretionary By Dennis M. Sandoval, CELA principal distributions), with the re- mainder to go to Edward and his sib- lings. The trust contained a spend- In the past, it was quite common sion that prevents the beneficiary thrift provision. Edward’s mother, age to draft estate plans so as to distrib- from assigning his trust interest. 86, also had a revocable trust with ute assets outright to beneficiaries at spendthrift provisions and similar dis- the decedent’s death. However, the Spendthrift Trusts tributions to Edward and his siblings at her death. Cynthia contended that increase in marital separation and dis- A spendthrift trust is defined as the marital property subject to divi- solution, combined with a judicial a “trust created to provide a fund for sion in their divorce proceeding in- system that has allowed ever-expand- the maintenance of a beneficiary and 1 cluded the appreciation in the assets ing theories of liability and skyrock- at the same time to secure the fund of Edward’s parents’ trusts. eting jury awards, calls into doubt the against his improvidence or incapac- prudence of this type of planning. ity.”3 Today, the validity of spend- The trial court held that Edward’s Many aspects of a traditional estate thrift trusts is recognized to varying interests in the trusts were mere ex- plan such as wills or revocable living degrees by virtually every state. A pectancies because his mother—by trusts can provide asset protection spendthrift trust is a trust with a re- the terms of the trust—could exhaust for the surviving spouse as well as striction that prevents the beneficiary the principal in Edward’s father’s trust the remainder beneficiaries (typically from voluntarily, or involuntarily, and could revoke her own inter vivos children and grandchildren). assigning his interest. trust. On appeal, the Colorado Court Some legislatures and courts have of Appeals reversed, finding that Ed- Drafting Revocable Living Trusts eroded the asset protection of spend- ward had a vested property right both and Testamentary Trusts thrift provisions over time, although in his father’s trust (subject to pos- State law generally provides that other states’ legislatures and courts sible exhaustion by mother’s with- a creditor “steps into the shoes” of have maintained, and even enhanced, drawals of principal) and in his the judgment debtor. As a result, a the protections afforded by spend- mother’s trust (subject to her revoca- creditor may—after obtaining a court thrift trusts. The Restatement of tion of the trust). The court of appeals order—generally exercise any right Trusts and the Uniform Trust Code ruled that, despite each trust’s spend- or power that the beneficiary has to (UTC) provide the following excep- thrift provision, a portion of Edward’s demand income or principal from a tions to a spendthrift provision: (1) interest in the trusts constituted mari- trust for the benefit of that benefi- child support and alimony,4 (2) nec- tal property subject to division in the ciary.2 Therefore, a revocable trust essaries,5 (3) services rendered and divorce proceeding.9 should contain a spendthrift provi- material furnished which preserve or (continued on page 6) 1. Barry S. Engel, David L. Lockwood, and Mark Merric, Asset Protection Planning Guide: A State-of-the-Art Approach to Integrated Estate Planning, ¶ 135.01 (CCH, Inc. 2000). 2. Engel, supra n. 1, at ¶ 915.02. 3. Black’s Law Dictionary 1400 (6th ed., West 1990). 4. Restatement (Second) of Trusts §157(a) (2000); Restatement (Third) of Trusts (2nd tent. draft 2003) § 59(a); Uniform Trust Code (UTC) § 503(a) (2002). 5. Restatement (Second), supra n. 4, at § 157(b); Restatement (Third), supra n. 4, at § 59(2). 6. Restatement (Second), supra n. 4, at § 157(b); Restatement (Third), supra n. 4, at § 59(c); UTC, supra n. 4, at § 503(b). 7. Restatement (Second), supra n. 4, at §157(c); Restatement (Third), supra n. 4, at § 59(c); UTC, supra n. 4, at § 503(c). 8 In re Marriage of Gorman, 36 P.3d 211 (Co. App. 2001). 9. The holding in Gorman was subsequently overruled by an amendment of C.R.S. § 14-10-113 (2001) by the Colorado legislature in S.B. 02-160. For another case in which the spendthrift provision of a trust created by a third party was ignored in a divorce proceeding of a beneficiary of such trust, see Dwight v. Dwight, 774 N.E.2d 1149 (Mass. App. Ct. 2002). NAELA QUARTERLY / FALL 2004 PAGE 5 Drafting Trusts for Maximum Asset trine of merger. Section 341(1) of the spouse to die, it is common for a Protection from Creditors Restatement (Second) of Trusts (Re- revocable trust to split into a bypass (continued from page 5) statement (Second)) provides that (or credit shelter) trust and a marital “[e]xcept as stated in Subsection (2), trust. Upon the death of the surviving Contrast Gorman with Scheffel if the legal title to the trust property spouse, many estate-planning docu- v. Krueger.10 In 1985, Grandmother and the entire beneficial interest be- ments provide for continuing trusts Krueger established an irrevocable come united in one person who is not for children or other beneficiaries. spendthrift trust for her grandson, under an incapacity, the trust termi- The terms of these sub-trusts often Kyle Krueger. The trust provided that nates.” Subsection (2) provides an provide for mandatory distributions Krueger was to receive all the net exception when a beneficiary having of income at least annually. Of course, income and discretionary principal the entire beneficial interest in the in the case of a marital trust designed distributions for maintenance, sup- assets of a spendthrift trust becomes to qualify for QTIP treatment under port, and education until Krueger at- the sole trustee without his consent. IRC Section 2056(b) (7), distribution tained age 50,11 at which time the trust In that case, the beneficiary can pro- of all the net income to the surviving assets would be distributed to him. In cure the appointment of a new trustee spouse at least annually is a prereq- 2001, Krueger was convicted of sexu- and have the trust reconstituted. uisite for obtaining the marital deduc- ally molesting a minor child, and the However, if a creditor of the benefi- tion. child’s mother, Mrs. Scheffel, sued ciary were to attach the trust assets For the other types of sub-trusts, for damages on behalf of her minor before the beneficiary appointed a a common reason for providing man- daughter. The court entered a default new trustee and reconstituted the datory distributions is to minimize judgment for $551,286 in damages, trust, those assets would not have income tax. A mandatory distribution and Mrs. Scheffel sought to attach spendthrift protection in most states.13 of income from a trust is taxed at the Krueger’s beneficial interest in his The rights of a creditor under beneficiary’s marginal tax rate15 rather grandmother’s trust. section 60 of the Restatement of Trusts than the potentially higher marginal The trial court ruled that the (Third) (Tentative Draft No. 2) (Re- income tax rate of the trust. However, spendthrift provisions of the trust statement (Third)) are dramatically a discretionary distribution of income barred attachment. Mrs. Scheffel ap- different when it comes to a benefi- to a beneficiary is also taxed at the pealed, arguing that the state (New 16 ciary acting as trustee. The creditor is beneficiary’s marginal rate, as op- Hampshire) spendthrift statute was able to reach the maximum amount posed to the trust’s rate—but discre- not intended to bar a claim for a tort of the trustee-beneficiary can properly tionary distributions offer more flex- the beneficiary, especially one for take. The trustee-beneficiary’s rights ibility as well as greater asset protec- which the beneficiary had been crimi- and authority represent a limited form tion possibilities. nally convicted. The New Hampshire of ownership equivalence analogous The Restatement (Second) states Supreme Court affirmed, interpreting to certain general powers under sec- that “[a]fter the income of a spend- the spendthrift statute very strictly. tion 56, Comment b, of the Restate- thrift trust has been paid to the ben- The Supreme Court held that the eficiary it can be transferred by him ment (Third)—which essentially dis- legislature’s intent in affording pro- and can be reached by his creditors;” regards the trustee-beneficiary’s fi- tection under the statute was clear, this rule is followed by the vast major- duciary position and treats the ben- and the court was unable to create a ity of states. 17 The approach of pay- eficiary as if he were the settlor of the public policy exception—even for ing all income to the beneficiaries of trust and disregards any remainder acts as egregious as Krueger’s.12 the sub-trust should be rethought if beneficiaries.14 one reason for creating the trust is to Doctrine of Merger protect the trust income from the credi- In drafting a trust for spendthrift Mandatory Distributions tors of the surviving spouse or the protection, a prudent estate planner Mandatory income distribu- remainder beneficiaries.
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