Designing a Trust if Asset Protection is Your Goal
Most estate planning documents that create trusts contain a spendthrift provision. A spendthrift provision prohibits trust beneficiaries from selling, giving away, or otherwise transferring their interest in the trust’s assets. Additionally, it prevents a beneficiary’s creditors from reaching the beneficiary’s interest in the trust.
But spendthrift protection is not absolute. Depending on the trust’s provisions and how the Trustee administers it, creditors may be able to reach into the trust. So how is it possible to shore up a trust’s asset protection? The following are a few strategies that may help.
An Independent Trustee
Trust assets are less protected when the trustee of a spendthrift trust is the beneficiary, a family member, or a friend. That’s because a beneficiary’s creditor could argue that the trust is a sham and that the trustee is manipulating trust distributions for the benefit of the beneficiary. Having an independent trustee removes the suspicion of impropriety.
A Discretionary Distribution Standard
Many trusts contain language requiring a trustee to make distributions to the beneficiary. For example, the trust may provide that the trustee “shall make distributions of income and principal to provide for the beneficiary’s health, education, maintenance, or support.”
However, a mandatory distribution standard can make the trust assets vulnerable. Essentially, if a beneficiary has an enforceable right to distributions, creditors will be able to reach it.
Alternatively, trusts that give an independent trustee broad discretionary authority to make distributions can increase the odds that the trust assets will be protected. Instead of providing that a Trustee “shall make distributions”, the trust could provide “the Independent Trustee may distribute so much of the income and principal as the Independent Trustee, in its sole discretion, advises for any purpose.” Courts have found that such language makes the beneficiary’s interest speculative and not subject to a creditor’s claims, especially if historical distributions are inconsistent and variable.
Does this mean a beneficiary should never serve as trustee of his or her trust? Not necessarily. However, if a beneficiary is serving as a trustee, distributions should be limited to health, education, maintenance, and support. This so-called HEMS standard keeps the trust assets outside the beneficiary’s estate and reduces exposure of the assets to distributions necessary for the beneficiary’s support.
For added protection, the trust can provide that when an independent trustee is serving, distributions will be discretionary, and require that a beneficiary serving as trustee resign and appoint an independent trustee in the event of a lawsuit or if a divorce is pending.
An Open Class of Beneficiaries
A support trust that has just one beneficiary is more vulnerable than a discretionary trust that benefits multiple people. For example, rather than simply naming your children as beneficiaries of a trust, you can name your children and their descendants as concurrent beneficiaries, but direct your Trustee to give primary consideration your children’s needs.
If the class of permissible beneficiaries includes multiple people over current and future generations, then the number of potential beneficiaries is indeterminable. In such trusts, a beneficiary’s interest may not be as vulnerable to creditors’ claims.
A Trust That Endures Indefinitely
Trusts with terminating distributions are popular. Many trusts include provisions that give the beneficiaries the right to withdraw trust assets in stages; for example, half at age 25 and the remainder at age 30.
Although such trusts serve to protect trust assets for young beneficiaries and are useful when trust assets are relatively modest, they do not provide long-term asset protection. Essentially, once the trustee makes the distribution, the protective benefits of the trust cease. There is no protection available for assets the trustee distributes to the beneficiary just because they were once trust assets.
Therefore, if lifelong asset protection is a goal, creating a discretionary trust that endures for a beneficiary’s lifetime will offer the highest degree of protection.
It is important to note that some states have statutory exceptions to spendthrift protections. For example, in both Texas and North Carolina, a court can order a distribution of assets from a support trust to satisfy a judgment or court order against the beneficiary for support or maintenance of the beneficiary’s child. In Texas, a court can order a Trustee of a purely discretionary trust to make child support payments from income, not principal.
Additionally, how a trust is administered can make it more vulnerable to claims. For example, if trust distributions of a specific amount are regularly deposited into a joint marital bank account that the couple used to pay household expenses, private school tuition, or home renovations, a trust may be exposed in a divorce proceeding.
If asset protection is your goal, an attorney can help you design a trust using these strategies to help minimize the risk that trust assets your beneficiaries inherit will be vulnerable to creditors’ claims.