benefit the interest of the ,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 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 , ¶ 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 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 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. should be concerned about the doc- tions. Upon the death of the first (continued on page 7)

10. Scheffel v. Krueger, 782 A.2d 410 (2001). 11. Kyle Krueger would not reach age 50 until 2016. 12. For another view on this case, see Steven J. Oshins and Christopher M. Riser, Scheffel v. Krueger: The Effectiveness of Statutory Spendthrift Trusts, 140 Tr. & Est. 10, 12 (Oct. 2001). 13 See George Gleason Bogert, George Taylor Bogert, and Amy Morris Hess,The Law of Trusts and , §§ 129 and 1003 (rev. 2d ed., West 1992 and Supp. 2001); Mark L. Ascher, Austin Wakeman Scott, William Franklin Fratcher, Scott on Trusts, § 341.1 (4th ed., Little, Brown & Co. 1987); Larry D. Scheafer, Trusts: Merger of Legal and Equitable Estates Where Sole Trustees Are Sole Beneficiaries, 7 A.L.R.4th 621 (1979). 14. See also Stephen E. Greer, “The Alaska Dynasty Trust,” 18 Alaska L. Rev. 253, 272 (2001). 15. The required income distribution causes the sub-trust to be classified as a simple trust under Internal Revenue Code § 651. See Byrle Abbin, Income Taxation of Fiduciaries and Beneficiaries, § 403 (Aspen 2002). 16. Treas. Reg. § 1.661(a)-2(a) (2001); See also Byrle Abbin, supra n. 15, at §404. 17. Restatement (Second), supra n. 4, at § 152, cmt. j.

PAGE 6 NAELA QUARTERLY / FALL 2004 eficiary has over a trust,21 giving the Drafting Trusts for Maximum Asset fer his interest,23 not because of any surviving spouse a “five-and-five Protection from Creditors prohibition against alienation, but (continued from page 6) power” over the should because the beneficiary (and thus, be strongly reconsidered. While a Mandatory principal distribu- his creditors) cannot compel distri- five-and-five power gives the surviv- tions. Under the Restatement (Sec- butions from the trustee other than ing spouse added comfort that she ond), a spendthrift provision is valid for the restricted purpose set forth in will be able to invade the trust princi- for a beneficiary who is entitled to the .24 pal during her lifetime, it also enables have the principal conveyed to him at Language that creates a support 18 creditors to reach the trust principal a future time. Most states follow trust is typically mandatory. A sup- on a recurring basis. this rule, but a minority of states find port trust usually includes language For instance, suppose a bypass restraints on a beneficiary’s right to specifying that the trustee “shall” trust provides the surviving spouse receive the principal of a trust to be make distributions.25 In addition to with a five-and-five power and is invalid. If the “beneficiary is entitled mandatory language of distribution, funded with $1 million at the first to have the principal conveyed to him the trustee is given a standard for spouse’s death. Such a trust would immediately, a spendthrift provision making such distributions, which may 19 permit the surviving spouse’s credi- would be invalid,” but a minority of be reviewed by a court for reason- states hold that, the trust principal is tors to access $50,000 (disregarding ableness. Typically, the drafter pro- not reachable by creditors until the growth or loss in the trust assets) vides for support distributions for beneficiary has received it. Although each year that the surviving spouse the beneficiary’s “health, mainte- the weight of authority is that no remains alive, regardless of whether nance, support and education.” How- spendthrift protection is available if the surviving spouse actually exer- ever, on occasion, the drafting attor- the beneficiary is entitled to an imme- cised the five-and-five power. There- ney includes the terms “welfare and/ diate distribution of principal, a mi- fore, if a decedent has died leaving or comfort.”26 As one can see by the nority of states have recognized the surviving spouse with a five-and- type of language used, the discretion spendthrift provisions where the ben- five power over the bypass trust, the given a trustee of a support trust for eficiary can elect whether to take the surviving spouse should consider a making distributions relates only to principal or leave it in trust for his qualified disclaimer of such power if 20 the time, manner, or size of the distri- benefit. there is concern regarding future As the Scheffel case illustrated, butions—not to whether to make the creditors of the surviving spouse (as- the payment of principal at a specified distributions to the beneficiary.27 suming the surviving spouse has no age or series of ages (e.g., one-third of When drafting a support trust, creditors pursuing her at the time of the trust at age 25, one-half of the the attorney should include a spend- the first spouse’s death). remaining trust at age 30, and the thrift clause. Without such a clause, remainder at age 35) will, in a majority any surplus income not necessary for of states, protect the trust assets from Support Trusts the beneficiary’s support could be a beneficiary’s creditors until the ben- A support trust is “[a] trust subject to seizure by the beneficiary’s eficiary attains the designated age or which empowers the trustee to pay to creditors. This provision has been ages. Upon reaching the designated the beneficiary only so much of the statutorily mandated in certain states. age, however, any principal distrib- trust’s income [and principal] as is For instance, New York law provides uted to the beneficiary would then be necessary for the beneficiary’s sup- that where no valid direction for the attachable by his creditors. port, education and maintenance.”22 income is given in the trust docu- The Restatement (Second) provides ment, the beneficiary’s creditors can Five-and-Five Powers that the creditors of a beneficiary of a reach income in excess of what is Because a creditor may also exer- support trust cannot reach his inter- necessary for support and educa- cise any a ben- est and such beneficiary cannot trans- (continued on page 8)

18. Restatement (Second), supra n. 4, at § 153(1). 19. Id. at § 153(2). 20. Id. at § 153, cmt. c. See also Peter Spero, Asset Protection: Legal Planning, Strategies and Forms, ¶ 6.09[4] (Warren, Gorham & Lamont 2002); Bogert, supra n. 13, at § 228; Scott, supra n. 13, at § 153; In re Arney, 35 B.R. 668 (Ill. 1983); Ober v. Dodge, 231 N.W. 444 (1930); Darling v. Dodge, 206 N.W. 266 (1925); Davis v. Harrison, 240 F. 97 (9th Cir. 1917); Cashman v. Bangs, 86 N.E. 932 (1909). 21. Engel, supra n. 1, at ¶ 915.03; Rothschild, “Protecting the Estate from In-Laws and Other Predators,” 35 U. Miami Heckerling Inst. on Est. Plan., at ¶¶ 1707.13-1707.14 (2001). 22. Black’s Law Dictionary, supra n. 3, at 1513. 23. Restatement (Second), supra n. 4, at § 154. 24. Id. at §154, cmt. b.; Greer, supra n. 14, at 269; Bogert, supra n. 13, at § 229; Scott, supra n. 13, at § 154; Spero, supra n. 20, at ¶ 6.04; Rothschild, supra n. 21, at ¶ 1706. 25. Lineback ex rel. Hutchens v. Stout, 339 S.E.2d 103 (1986). 26. The terms “welfare” and “comfort” are not an ascertainable standard for purposes of Internal Revenue Code § 2041, and will result in estate tax inclusion. See Treas. Reg. § 20.2041- 1(c)(2) (2001). 27. Eckes v. Richland County Social Servs., 621 N.W.2d 851(2001).

NAELA QUARTERLY / FALL 2004 PAGE 7 Drafting Trusts for Maximum Asset all of the trust assets at a given age.34 has discretion “as to whether and Protection from Creditors A support trust is a good draft- when distributions may be made to (continued from page 7) ing alternative either (1) in a jurisdic- beneficiaries.”38 This protection, tion.28 California law also provides tion that does not recognize spend- which is much greater than the pro- that income or principal payable to a thrift trust provisions, or (2) where tection of a spendthrift trust, comes beneficiary, in excess of the amount the settlor is not comfortable with the at the price of leaving the beneficiary needed for support and education, more expansive power given the at the mercy of the trustee’s judgment can be used to satisfy judgments trustee of a fully to withhold or distribute trust income against the beneficiary.29 (see discussion below). and principal. It is the very nature of In defining support, courts tend this type of trust and the fact that the to give deference to the settlor’s in- Other Types of Trusts beneficiary cannot compel a trust dis- tent. Consequently, the trust should Spray Trusts. A spray trust, also tribution that provides the asset pro- 39 be drafted to define support as broadly sometimes referred to as a blend, sprin- tection. The protection is so great as possible, after taking into account kling or protective trust, is a trust that in most jurisdictions it cannot be the goals of the settlor. If the settlor’s where “the trustee has the discretion undermined to pay claims for taxes or 40 intent is undefined in the document, to either distribute or accumulate the child support. A discretionary trust jurisdictions vary tremendously as to ... income [and principal] of the trust is most appropriate if the beneficia- how they define support. Some juris- and distribute it among the trust’s ... ries are subject to a high degree of risk dictions define support by looking at beneficiaries in varying magni- and the settlor is comfortable that the the beneficiary’s lifestyle prior to the tudes.”35 This type of trust provides trustee will act in accordance with the creation of the trust (“station in life” asset protection for the beneficiaries settlor’s wishes. standard).30 Other jurisdictions re- because no one beneficiary can claim Generally, a discretionary trust view the beneficiary’s circumstances a portion of the trust. The trustee has is drafted with permissive language. without regard to lifestyle.31 Still other discretion to make distributions to The trustee “may” (as opposed to 41 states examine the beneficiary’s cur- some or all of the beneficiaries, and to “shall”) make distributions. Never- rent lifestyle without reference to any exclude anyone in the class of benefi- theless, some courts have held that a prior lifestyle, and some jurisdictions ciaries.36 Arguably, because a ben- mandatory distribution requirement have not resolved the matter.32 eficiary cannot compel a distribution combined with “sole and absolute The beneficiary of a support trust from the trustee of a discretionary discretion” of the trustee resulted in 42 cannot assign his interest, and a spray trust, a spray trust also pro- the creation of a discretionary trust. trustee cannot be compelled to honor vides protection from claims of the Other courts have found that the ex- a purported assignment by the ben- Internal Revenue Service and other plicit language permitting the trustee eficiary, even if the trustee is aware of taxing authorities for taxes owed by a to exclude or discriminate among ben- it.33 Absent a spendthrift clause, beneficiary.37 eficiaries was a major factor in con- though, it may be possible for the Discretionary trusts. Discretion- cluding that a trust was a discretion- 43 beneficiary to assign a vested inter- ary trusts offer the greatest asset ary trust. est in the principal of a support trust, protection of any planning strategy Depending on the jurisdiction, a such as where the trust provides that under a revocable trust. A discretion- discretionary trust subject to a distri- the beneficiary is to receive some or ary trust is one in which the trustee (continued on page 9)

28. N.Y. EPTL § 7-3.4 (2003). 29. Cal. Prob. Code § 15307 (2003). 30. California adopted this standard at Cal. Prob. Code § 15307 (2003) (comment by California Law Revision Commission). 31. N.Y. CPLR §§5226 and 5226.2 (2003). 32. Spero, supra n. 20, at ¶ 6.04; C. R. McCorkle, Surplus Income of Trust in Excess of Amount Required for Support and Education of Beneficiary; as Subject to Claims of Creditors, 36 A.L.R.2d 1215 §4 (1954). 33. Restatement (Second), supra n. 4, at § 154, cmt.c; Bogert, supra n. 13, at § 229; Scott, supra n. 13, at § 155; Spero, supra n. 20, at ¶ 6.04; Rothschild, supra n. 21, at ¶ 1706.1. 34. In re McLoughlin, 507 F.2d 177 (1975); Seattle First Nat’l Bank v. Crosby, 254 P.2d 732 (1953); Epstein v. Corning, 22 A.2d 410 (1941). 35. Black’s Law Dictionary, supra n. 3, at 1513. 36. Restatement (Second), supra n. 4, at §§ 161, 162 cmt. a; Bogert, supra n. 13, at § 230; Spero, supra n. 20, at ¶¶ 6.05, 6.10(6)(b); Rothschild, supra n. 21, at ¶ 1707.3. 37. Magavern v.U.S., 550 F.2d 797 (1977), 39 A.F.T.R.2d 77-968, 77-1 USTC ¶ 9249. 38. Black’s Law Dictionary, supra n. 3, at 1510. 39. Restatement (Second), supra n. 4, at §155 cmt. b; Bogert, supra n. 13, at § 228; Scott, supra n. 13, at § 155; Spero, supra n. 20, at ¶ 6.03(1); Rothschild, supra n. 21, at ¶ 1705.1. 40. Spero, supra n. 20, at ¶6.03(1). 41. State ex rel. Secretary of Social and Rehabilitative Servs., v. Jackson, 822 P.2d 1033 (1991). 42. Myers v. Kansas Dept. of Social and Rehabilitative Servs., 866 P.2d 1052 (Kan. App. 1994). 43. McNiff v. Olhstead County Welfare Dept., 176 N.W.2d 888 (Minn. App. 1970).

PAGE 8 NAELA QUARTERLY / FALL 2004 Drafting Trusts for Maximum Asset a trustee has not complied with a For example, in McDonald v. Protection from Creditors standard of distribution or has abused Evatt, 53 the court found that a trust (continued from page 8) his discretion: (1) a distribution may was not discretionary because the bution standard may or may not pro- be ordered by the court to satisfy a trustee could pay something or noth- ing, so the trustee’s discretion re- vide protection from the beneficiary’s judgment or court order against the beneficiary for support or mainte- lated merely to the time of payment. creditors. In some jurisdictions, the nance of the beneficiary’s child, The in question inclusion of a standard is fatal. For spouse, or former spouse; and (2) the provided that the trustees could pay instance, in Martin v. Martin,44 the court shall direct the trustee to pay from net income “such sums of money court held that a trustee could be the child, spouse, or former spouse as they may deem best fit and proper,” compelled to make distributions that such amount as is equitable under the if in their opinion it was fit and proper were subject to the beneficiary’s credi- circumstances but not more than the to do so. Similarly, in In re Nicholson’s tors’ claims. The trust instrument in 54 amount the trustee would have been Estate, the court held that language Martin required that the trustee exer- required to distribute to or for the keeping all moneys and other things cise his discretion after taking into benefit of the beneficiary had the of value in trust for two boys, to be account the beneficiary’s needs for trustee complied with the standard or distributed at the trustee’s discre- 45 education, care, and support. Simi- not abused the discretion.”50 tion, afforded discretion only as to 46 larly, in Taylor, the court noted that Thus, the general rule under the the time and manner of payment. Fi- 55 the trust instrument stated that the UTC is that a creditor cannot compel nally, in Kammholtz v. Allen and In 56 trustee “shall pay” so much of the the trustee to distribute from a discre- re Neumeister’s Estate, the courts trust income as the trustees deem tionary trust, even if the trustee has found differences between (1) a dis- necessary for the health care, mainte- failed to comply with the distribution cretionary trust in which the trustee has unlimited discretion as to whether nance, and support of the benefi- standard or has abused his discre- the beneficiary should receive any- ciary. The court ruled that this provi- tion. The one exception is for support thing, and (2) a trust in which distribu- sion showed the settlor’s intent for claims of a child, spouse, or ex- tions to beneficiaries by the trustee mandatory distributions, and the trust spouse. Otherwise, the power to force were conditioned merely upon the was held not to be a discretionary a distribution lies solely with the ben- occurrence of an event. trust.47 eficiary.51 Shifting trusts. To give the ben- There is a trend toward eliminat- The asset protection of a discre- eficiary greater flexibility, it is some- ing the distinction among support tionary trust is not available “where times possible to draft a trust to allow trusts, discretionary trusts, and dis- the trustee has discretion merely as to a shift in its purpose, terms, and ben- cretionary trusts with distribution the time [and manner] of payment, eficiaries. Whether a shifting provi- 48 standards. The UTC provides that and where the beneficiary is ultimately sion in a trust prevents attachment by “whether or not a trust contains a entitled to the whole or to a part of the a beneficiary’s creditors depends on 52 spendthrift provision, a creditor of a trust property.” Accordingly, to the nature of the creditor’s claim and beneficiary may not compel a distri- achieve maximum protection from a the interest, if any, that the benefi- bution that is subject to a trustee’s discretionary trust, the trust should ciary retains after the shift occurs. discretion, even if: (1) the discretion provide that the trust assets can be The higher the priority of the claim, is expressed in the form of a standard held in trust indefinitely, and the trust the less interest in the trust property of distribution; or (2) the trustee has should contain a spendthrift provi- the beneficiary can retain if absolute abused the discretion.49 To the extent sion. (continued on page 10)

44. Martin v. Martin, 374 N.E.2d 1384 (Oh. App. 1978). 45. Cf. Lineback, supra n. 25; Chenot v. Bordeleau, 561 A.2d 891 (1989); Myers, supra n. 42 (where language referencing a distribution standard was not found to cause the trust to be classified other than as a discretionary trust). 46. U.S. v. Taylor, 254 F.Supp 752 (1966), 18 A.F.T.R.2d 5179, 66-2 USTC ¶ 9522. 47. See also TAM 200017665. Cf. First of America Trust Co., 72 AFTR 2d 93-5296, 93-2 USTC ¶ 50507. 48. Greer, supra n. 14, at p. 263. 49. UTC, supra n. 4, at §504(b); Restatement (Third), supra n. 4, at §60. If the settlor’s purpose in establishing the trust is to provide for a beneficiary’s needs, and if it is acceptable social policy that the beneficiary should not be left without support, then the trustee is subject to a standard of reasonableness in determining whether a distribution should be made to a beneficiary. See Greer, supra n. 14, at p. 263; Clifton B. Kruse, Jr., Third Party and Self Created Trusts: Planning for the Elderly and Disabled Client, at 61, and fn. 112 at 98-99 (3rd ed., ABA Real Property, and Section 2002). 50. UTC, supra n. 4, at § 504(c). 51. Id. at §504(d); cmt. to §504. See also UTC, supra n. 4, at §814(a). 52. Restatement (Second), supra n. 4, at §155(c); Bogert, supra n. 13, at §228; Spero, supra n. 20, at ¶6.03(1)(b); Rothschild, supra n. 21, at ¶ 1705.2. 53. McDonald v. Evatt, 62 N.E.2d 164 (1945). 54. In re Nicholson’s Estate, 50 A.2d 283 (1947). 55. Kammholtz v. Allen, 256 F.2d 437 (Cal. App. 1958), 155 F.Supp 511 (1957). 56. In re Neumeister’s Estate, 304 P.2d 67 (Cal. App. 1957).

NAELA QUARTERLY / FALL 2004 PAGE 9 Drafting Trusts for Maximum Asset achieve protection from creditors.62 tax, perspective is to draft the trust to Protection from Creditors For example, the trust could pro- provide for an independent trust pro- (continued from page 9) vide that distributions could be sus- tector who can remove and replace protection of trust property is desired. pended in the event that the trustee the trustee with a new independent trustee.66 A shifting trust that terminates a determines that such distributions While an independent trustee beneficiary’s interest on the occur- would not benefit the beneficiary— provides the greatest assurance of rence of a specified event gives the such as when the beneficiary has asset protection, such a trustee is greatest assurance for asset protec- separated from his spouse or is going often not acceptable if the settlor tion from a beneficiary’s creditors.57 through a divorce, is afflicted with a wants the surviving spouse or the The basis for this rule lies not in pro- drug, alcohol or gambling addiction, remainder beneficiary to participate tecting the beneficiary—but rather in has a proven inability to manage his in the administration and distribution implementing the settlor’s intent and finances, or is subject to the undue decisions of the trust created for the protecting the settlor’s right to choose influence of others. This type of broad spouse or remainderman. In that case, the objects of his bounty.58 discretion would thwart a public the spouse or beneficiary can serve Although the termination of a policy argument that the suspension as co-trustee with another trustee beneficiary’s interest offers the great- of benefits provision is being mis- who has fiduciary duties to other est protection from a beneficiary’s used to allow a beneficiary to avoid 63 beneficiaries of the trust.67 creditors, a shifting trust that does not his creditors. A third alternative is to appoint completely terminate the beneficiary’s the spouse or beneficiary as trustee interest is effective against creditors Drafting a Revocable Living Trust of the trust created for his or her in many jurisdictions. The retained for Maximum Asset Protection benefit, and name an independent interest must be such that the benefi- It is important that a revocable trustee as the successor trustee. If ciary cannot force a distribution from trust that provides for a continuing the beneficiary-trustee anticipates a 59 Miller v. trust for the surviving spouse or de- the trust. For instance, in challenge by a creditor, he or she 60 scendants and other beneficiaries in- Miller, the court upheld a trust in could resign as trustee, and the inde- clude a spendthrift clause. which the beneficiary’s interest— pendent trustee would assume the upon his filing for bankruptcy—shifted The next consideration in draft- administrative duties over the trust. so that distributions were solely at the ing a revocable trust for maximum However, if the creditor attached the 61 discretion of the trustee. asset protection is to avoid the appli- beneficiary-trustee’s interest before Suspension of distributions to cation of (1) the doctrine of merger or the beneficiary-trustee’s resignation, beneficiary. As an alternative to ter- (2) section 60(g) of the Restatement the beneficiary’s interest may be minating or changing the character of (Third) (dealing with a beneficiary- reached to the same extent as if the a beneficiary’s interest, some drafters trustee). This can be done in several beneficiary had remained as trustee. have suspended the right of a benefi- ways. The first is to have an indepen- The doctrine of merger can also ciary to receive distributions upon the dent third party serve as trustee over be avoided by drafting the beneficial occurrence of a specified event(s); the beneficiary’s trust. Creditor pro- interest as a fully discretionary spray the beneficiary’s interest is reinstated tection for the beneficiary is not sac- trust that allows the trustee to distrib- after the disqualifying event has rificed by giving the beneficiary the ute income and/or principal among a passed or has been resolved. This right to remove and replace the inde- class of beneficiaries—such as the suspension protects against creditors’ pendent trustee with another inde- surviving spouse and descendants 64 claims, if the trustee’s power to sus- pendent trustee. A beneficiary’s of the deceased spouse or a child of pend distributions is absolute and not power to remove and replace the the settlor and that child’s descen- just a condition limiting the time or trustee should be limited to “reason- dants.68 This type of trust contains 65 manner of payment. The breadth of able cause.” A better strategy from no provisions for distributions for the trustee’s discretion is critical to an asset protection, as well as estate (continued on page 11)

57. Spero, supra n. 20, at ¶¶ 6.07-6.07(2)(a); Rothschild, supra n. 21, at ¶ 1707.11; Annot., Validity of Provisions of Instrument Creating Legal Estate Attempting to Exempt It From Claims of Creditors, 80 A.L.R. 1000 (ALI, 1932); In re Fitzsimmons, 896 F.2d 373 (Cal. App. 1990); Security-First Nat’l Bank v. Rogers, 330 P.2d 811 (1958); Meade v. Rowe’s Executor and Trustee, 182 S.W.2d 30 (1944); Nichols v. Aton, 91 U.S. 716 (1875); Cf. Bank One Trust Co., N.A., 77 A.F.T.R.2d 96-1579, 80 F.3d 173 (Oh. App. 1996), 96-1 USTC ¶ 50188. 58. Am. Jur.2d Trusts §126 (Lawyers Cooperative Publishing 1995); In re Reuss’ Estate, 91 N.Y.S2d 479 (1949); Miller v. Miller, 31 S.E.2d 844 (W.Va. App. 1944). 59. Spero, supra n. 20, at ¶ 6.07(2); Rothschild, supra n. 21, at ¶ 1707.12. 60. Miller v. Miller, 31 S.E.2d 844 (W.Va. App. 1944). 61. See also Industrial Nat’l Bank v. Budlong, 264 A.2d 18 (1970); Jones v. Coon, 295 N.W. 162 (1940). Cf. Riggs Nat’l Bank, 636 F.Supp 172 (1986), 57 A.F.T.R.2d 86-1358, 86-1 USTC ¶ 9398. 62. Spero, supra n. 20, at ¶¶ 6.03(1)(b), 6.07(2)(b); Rothschild, supra n. 21, at ¶ 1707.16. 63. Spero, supra n. 20, at ¶ 6.07(2)(b). See also Domo v. McCarthy, 580 N.E.2d 788 (Oh. App. 1989); Landmark First Nat’l Bank v. Haves, 467 S.2d 839 (Fla. App. 1985); Roorda v. Roorda, 300 N.W. 294 (1941); Okla. Dept. of Human Services v. Tr. Co. of Okla., 825 P.2d 1295 (1991) cert. den.; McGrath v. Ward, 91 F.Supp 636 (1950).64. Rev. Rul. 95-58, 1995-2 CB 191, and P.L.R. 9746007; but Cf. P.L.Rs 200031008, 200020010, and 200024011. 64. Rev. Rul. 95-58, 1995-2 CB 191, and P.L.R. 9746007; but Cf. P.L.Rs 200031008, 200020010, and 200024011. 65. See P.L.R. 9303018 for a discussion of “reasonable cause.” 66. Greer, supra n. 14, at p. 268. 67. Restatement (Third), supra n. 4, at §60, cmt. g; Greer, supra n. 14, at 273-274; Spero, supra n. 20, at ¶ 6.09. 68. Spero, supra n. 20, at ¶ 6.05.

PAGE 10 NAELA QUARTERLY / FALL 2004 Drafting Trusts for Maximum Asset tribution-by-contribution or ongoing tate tax inclusion period (ETIP) pre- Protection from Creditors basis—to exclude a Crummey vents the allocation of generation- (continued from page 10) powerholder from receiving a with- skipping transfer (GST) tax exemption drawal power over a current, as well as upon the execution of the trust, thereby support or for health, education, main- future, contributions to the ILIT.71 The precluding the leveraging that is avail- tenance, and support. In addition to result is that if a Crummey powerholder able with other planning strategies. avoiding the doctrine of merger, a has creditors who may attach his with- Instead, the planner should consider fully discretionary spray trust should drawal right or the amount withdrawn using continuing trusts for beneficia- bar a claim for spousal support and when the Crummey powerholder exer- ries after the expiration of the settlor’s alimony, as well as claims from state cises his withdrawal right, such term interest in a split-interest trust. and federal taxing authorities. powerholder can be excluded from the These continuing trusts can be struc- If asset protection for a benefi- tured with the same provisions dis- ciary is an issue, a trust should never beneficiaries eligible to make with- drawals from current and/or future cussed above for revocable trusts, be drafted to provide for outright which will protect the trust assets distribution of income or principal to contributions to the ILIT. Supplemental needs trusts. “Dis- from the beneficiaries’ creditors. The a beneficiary. Instead, the income continuing trusts can also be struc- should be accumulated and added to cretionary supplemental care trusts providing for the needs of beneficia- tured to include a testamentary gen- principal, and held in trust for the eral power of appointment over non- lifetime of the beneficiary. If protec- ries not supplied by way of public benefit programs, created by non-ben- GST tax-exempt assets in order to avoid tion of the deceased spouse’s assets imposition of GST tax. from the creditors (or new paramour) eficiary [trustors], appear to be legal, appropriate and encouraged by both Furthermore, in states that do not of the surviving spouse is desired, a have strong bankruptcy protection QTIP marital trust, which provides state and statutes. These trusts are sensitive responses by car- for the home, a QPRT may offer sub- for the distribution of income only, stantial asset protection for the ing family members or others to make should be used instead of a general settlor’s residence.73 Upon transfer available to the chronically ill and dis- power of appointment marital trust. If of the house to a QPRT, the settlor abled community the extra needs, be- distributions of only income would converts his interest in the residence yond basic support, that such benefi- prove inadequate for the support of from a fee simple to a right to occupy ciaries reasonably require or from the surviving spouse, discretionary the property for a term of years. Even which greater comfort can be support distributions can be added, if a creditor of the settlor could force achieved.”72 A supplemental needs although this would subject a por- the sale of the residence within the trust is simply a variation of a discre- tion of the principal in the QTIP trust trust, the creditor would be able to tionary trust. Its purpose is to set to potential attachment by the sur- attach only an income stream—be- aside assets, which, at the trustee’s viving spouse’s creditors. cause the sale of the residence in a discretion, can be used to pay for the properly drafted QPRT would con- Specific Drafting Issues “supplemental” needs of the benefi- vert the trust to a GRAT for the bal- Irrevocable life insurance trusts ciary not covered by governmental ance of the QPRT term.74 and intentionally defective grantor assistance programs (such as Medic- trusts. Considerations in drafting an aid or SSI), while at the same time not Conclusion irrevocable (ILIT) causing the beneficiary to be disquali- Many drafting techniques will or an intentionally defective grantor fied for valuable government aid. A increase the asset protection avail- trust (IDGT) for maximum asset pro- can be cre- able to trust beneficiaries. A prudent tection are much the same as the ated either as a sub-trust of a revo- estate planner should be knowledge- considerations applicable to a revo- cable trust or as a stand-alone trust. able about these techniques, and take cable trust. With regard to an ILIT, Split-interest trusts. Many es- though, there is the added problem of tate planners have drafted split-inter- advantage of them when drafting a Crummey69 powerholders, who have est trusts (such as qualified personal trust for a client who is concerned a general power of appointment sub- residence trusts (QPRTs), grantor re- about creditors, a divorcing spouse ject to attachment by their creditors.70 tained annuity trusts (GRATs), grantor of a child or descendant, or others To deal with this, a properly retained unitrusts (GRUTs)) to dis- who might attempt to reach the trust drafted ILIT should include a provi- tribute assets outright to children. The interests of a surviving spouse or sion allowing the settlor—on a con- reason is that the existence of an es- descendant.

69. See Crummey v. C.I.R. , 397 F.2d 82 (1968), 22 A.F.T.R.2d 6023, 68-2 USTC ¶ 12541. 70. But see UTC, supra n. 4, at §505(b)(2), and Tex. R.S. §112.035(e), which appear to limit the ability of a creditor of a Crummey powerholder to attach the powerholder’s withdrawal rights. 71. See Rothschild, supra n. 21, at ¶ 1707.14. 72. Kruse, supra n. 49, at 82. 73. Rothschild, supra n. 21, at ¶ 1703.3. 74. Treas. Reg. § 25.2702-5(c)(8)(i)(B) (2003).

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