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Creditors' Rights in Trusts: Spendthrift, Discretionary Interest and Other Trust Terms Affecting Creditors' Rights Under Restatement (Third) of Trusts

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Creditors' Rights in Trusts: Spendthrift, Discretionary Interest and Other Trust Terms Affecting Creditors' Rights Under Restatement (Third) of Trusts Creditors' Rights in Trusts: Spendthrift, Discretionary Interest and Other Trust Terms Affecting Creditors' Rights Under Restatement (Third) of Trusts Estate Planning Retreat June 8-10, 2006 Vail, Colorado By: Stanley C. Kent I. Syllabus: A. Use of trusts in estate planning has expanded exponentially. Revocable trusts are commonlyused today as will substitutes. Irrevocable trusts are created frequently for reducing death taxes, making protectedgifis and providing supplemental care while preserving entitlement to governmental benefits. It is not surprising that creditors' issues are arising more often in the context of trust administration. What are the rights of a deceased settlor's creditors? When can creditors attach beneficial interests? What rights do creditors have after they have attached beneficial interests? Can creditors compel exercise of trustee discretion? Colorado has few laws governing creditors' rights in these contexts. What are the Colorado rules? What are the Restatement rules and why should Colorado lawyers be familiar with them? How do the Uniform Trust Code rules compare? This program will examine creditors' rights in trusts through common fact patterns and endeavor to identify the rules applicable in Colorado. n. Fundamental Principles: A. Beneficial Interests Are Property: A beneficial interest in a trust may be a present or future interest; it may be subject to conditions with respect to the recipients or the extent ofthe interest. A beneficial interest may be subject to the discretionary decisions ofa trustee or of another, or it may be subject to a power of appointment or a power of revocation or amendment. There is practically no limit to the. variety of interests a settlor may create. Restatement (Third) ofTrusts, section 49 cmt b. Is a beneficial trust interest a property interest of the beneficiary or is it merely a chose in action against the trustee? This question is important in the context of creditor claims. Ifa beneficial interest is property it will be exposed to the claims of the beneficiary's creditors. 1 The prevailing view in the United States and England is that a beneficiary of a trust has a property interest in the subject matter of the trust and not a mere chose in action. II William F. Fratcher, Scott on Trusts, section 130 (14th ed. 1987). In discussing whether a beneficiary has a property interest, the Scott treatise notes "....It must be remembered, however, that the chancellors at the beginning gave him [the beneficiaxy] no more than a claim against the trustee, and only gradually gave him proprietary rights. The growth of the trust has been a process of evolution. ....The principle that a beneficiary of a trust has a proprietary interest in the subject matter ofthe trust has been accepted by the Supreme Court ofthe United States." See Senior v. Brader, 295 U.S. 422, 55 S.Ct 800, 79 L. Ed. 1520 (1935) and Blair v. Comm 'rof Internal Revenue, 300 U.S. 5, 57 S.Ct. 330, 81 L.Ed. 465 (1937). Restatement (Third) ofTrusts, section 49 and Rptr's Notes of section 49. This fundamental principle has been recognized by the Colorado Supreme Court in In re Marriage qfJones, 812 P.2d 1 152 (Colo. 1991) ("a beneficiary has an equitable interest in the subject matter of the trust"). B. Attachment By Creditors: Except as limited by spendthrift and other restrictions imposed by the terms of the trust of resulting from the nature ofthe beneficial interest itself, creditors can attach a beneficiary's trust interest in satisfaction of the creditor's claim. Restatement (Second) ofTrusts, sections 147-149 and 162; II William F. Fratcher, Scott on Trusts, sections 147-147.3, 148, 149, and 162 (4th ed. 1 987); Restatement (Third) ofTrusts, section 56. ID. Scope of Discussion: The property interest of a trust beneficiary is subject to "attack" in many contexts. A. Creditor Claims: When can a beneficiary's general creditors attach his or her beneficial interest? After a beneficial interest has been attached, what rights do creditors have to satisfy their claims out of the beneficiary interest? B. Divorce: When is a beneficial trust interest sufficiently unlimited so that it can be treated as "property" for purposes of division of "marital property" in a divorce proceeding? r*\ 2 C. Disqualification for Government Benefits: When is a beneficial trust interest sufficiently "available" to the beneficiary to be treated as a "countable resource" in disqualifying the beneficiary for Medicaid and other government welfare benefits? All of these questions are important. However, this discussion will be limited to creditors' rights. IV. Trusts and Asset Protection: Moreover, this discussion will focus on traditional trust law principles having a direct bearing on creditor rights. Issues involving domestic asset protection trusts under the laws of Alaska, Delaware, Rhode Island, Nevada, Utah and South Dakota and involving "off shore" asset protection trusts are beyond the scope of this discussion. The asset protection attributes ofother techniques and devices (e.g. IRA accounts, life insurance policies, section 529 plans, business entities, etc.) are also beyond the scope of this discussion. The law of fraudulent transfer, while always having bearing on self-settled asset protection planning, will not be considered either. What are the traditional common law principles that protect beneficial interests from creditor claims? A. Spendthrift: A provision that prohibits both voluntary (i.e. assignment) and involuntary (i.e. attachment) alienation of a beneficial interest generally provides direct protection against the claims of the beneficiary's creditors. B. Discretion: Whether or not a trust contains a valid spendthrift provision, creditors who are able to attach the beneficial interest generally are not able to force exercise of discretion. C. Forfeiture: A trust may provide for termination of a beneficial interest or for a protective transformation of a beneficial interest if there is an attempt to attach it by the beneficiary's creditors. D. There are important common law exceptions to these rules. 3 V. Colorado Law: As suggested in the syllabus, this discussion will focus on applicable Colorado law with respect to creditors' rights. Unfortunately, Colorado law in this area is quite thin. The few notable Colorado decisions concerning creditors' rights in beneficial interests are included in your materials. This discussion will also consider the Restatement (Third) ofTrusts. What is a.Restatement! Why should Colorado lawyers be concerned about Restatements generally and Restatement (Third) ofTrusts specifically when considering rights of creditors? A. Restatements'. Restatements are written by the American Law Institute (ALI). Generally, a Restatement is a document that collects and summarizes in one place the common law on a particular subject. Where court decisions are in conflict, a Restatement strives to delineate the better rule. Restatements also fill in gaps in the law and thus promote the rule that a court should apply when encountering an issue for the first time. The hope is that state courts, by relying on Restatements as a primary guide for decisions, will over time adopt uniform rules of decision. By comparison, uniform laws are written by the National Conference of Commissioners on Uniform State Laws (NCCUSL). Uniform laws are written for enactment by the states with the goal of creating uniform statutory rules on a particular subject. While Restatements attempt to summarize the common law on a particular subject and point out the better rule when the common law is in conflict, courts are free to ignore the Restatement position. On the other hand, once a state enacts a uniform law, courts must follow the statutory rules. B. Restatements and Colorado Court Decisions: Because of the gaps in Colorado trust law, when an issue arises for the first time in Colorado, our courts have had little to guide them in making decisions. Colorado appellate courts have routinely resorted to and relied upon the Restatement position in such circumstances. In fact, as of November 2004, the Supreme Court and Colorado Court of Appeals had cited and followed the Restatement position in 59 cases where there had been no Colorado trust law on the issue before the court. See Kevin Millard, The Uniform Trust Code, Appendix C, November 2004, summarizing these 59 decisions. It is reasonable to infer from Mr. Millard's analysis that Colorado 4 courts will continue to follow the Restatement position where there is no Colorado statute or decision on point. This is especially true with respect to the rights ofa trust beneficiary's creditors. We must therefore be very familiar with the Restatement rules. VI. Policies Underpinning the Restatement Rules: A. Self-Settled Spendthrift Trusts: Common law has traditionally disfavored self-settled spendthrift trusts. Irwin N. Griswold, Spendthrift Trusts, sections 474 and 475 (2nd ed. 1947); Restatement. (Second) ofTrusts, section 156(1); Restatement (Third) ofTrusts, section 58(2); and Uniform Trust Code, section 505(a)(2). Accordingly, under the Restatement a restraint on the voluntary and involuntary alienation of a beneficial interest retained by the settlor is invalid. Restatement (Third) ofTrusts, section 58(2). B. Functional Equivalents: The Restatement emphasizes substance over form and treats functional equivalents the same. rs 1. Revocable Trusts and Wills: Under the Restatement, revocable trusts are recognized as valid will substitutes. Accordingly, such trusts and their settlors and beneficiaries are treated in like manner as wills and their testators and beneficiaries both during the life and after the death of the settlor and testator. Wills and revocable trusts are functional equivalents. This is especially relevant in the context ofcreditor claims. Property ofa revocable trust is treated as ifit were owned by the settlor. Restatement (Third) ofTrusts, section 25 cmt. a. 2. Power of Revocation and of Withdrawal: A power of revocation and a reserved power of withdrawal are treated the same with respect to the power holder's creditors.
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