The goal of all asset protection planning is to insulate assets from claims of creditors without concealment or tax evasion. It is usually impossible to completely and absolutely protect assets, and the focus is on making assets more difficult and more expensive to reach.
All asset protection planning is based on the following two premises: (1) creditors can generally reach any asset owned by a debtor;[1] and (2) creditors cannot reach those assets that the debtor does not own.[2]
When working within the context of the first premise, the goal is to make it more difficult and more expensive for a creditor to reach the debtor’s assets. This may include encumbering assets, converting assets from non-exempt to exempt, substituting assets or transferring ownership to legal entities. Working within the second premise, the goal is to fit within its parameters, but without any detriment to the client-debtor. Generally, this means that as the end-result of the planning the debtor should not own any assets, but should retain their beneficial enjoyment and some degree of control.
Continuing with the second premise, debtors strive to achieve two incompatible goals – (i) they want to possess the beneficial enjoyment or control of their assets, whether through direct ownership or otherwise, and (ii) they also want to distance themselves from the ownership and control over the assets, to make such assets inaccessible to creditors.
In this obvious dichotomy, trusts come to the rescue by splitting the beneficial enjoyment of trust assets from their legal ownership.
The beneficiaries of a trust are the beneficial owners of the assets holding equitable interests, but they do not hold legal title to the assets. The legal title is vested in the trustee of the trust. The trustee of a trust thus stands in the position of a fiduciary to the beneficiaries.[3] The trustee holds title to the trust assets for the benefit of the beneficiaries and has to administer the trust for the benefit of the beneficiaries and no one else.[4]
A creditor’s ability to satisfy a judgment against a beneficiary’s interest in a trust is limited to the beneficiary’s interest in such trust.[5] Consequently, the common goal of asset protection trusts is to limit the interests of beneficiaries in such a way so as to preclude creditors from collecting against trust assets.
Trusts are widely used in asset protection. Not all types of trusts are effective asset protection devices, but a properly drafted and structured trust may be an almost impregnable form of asset protection.
The most commonly drafted trust is the revocable inter-vivos trust (the so-called “living trust”). Living trusts protect beneficiaries from claims of creditors to the same extent as irrevocable trusts. However, if the debtor is a settlor of the trust, the living trust will not provide the settlor-debtor with any measurable degree of asset protection, because and to the extent of the settlor’s power to revoke.[6]
The protective benefits of an irrevocable trust were
addressed in a recent
Consequently, any trust created to protect the assets of a settlor must be irrevocable.
Practice Pointer: A living trust may have a very limited asset
protection use. A living trust that has
a generic name (i.e., instead of the
The qualified personal residence trust (“QPRT”) is an irrevocable trust very frequently used for both estate planning and asset protection. QPRTs are used to transfer a settlor’s residence out of the settlor’s estate at a low gift tax value. Once the trust is funded with the settlor’s residence, the residence and any future appreciation of the residence is excluded from settlor’s estate.
The QPRT is a split-interest trust, with the settlor retaining a term-of-years right to live in the residence rent-free, with the remainder interest going to the remainder beneficiaries. The gift of the remainder interest is a completed transfer, and the settlor no longer owns that interest and it is not reachable by the creditors of the settlor.
To the extent the settlor retains an interest in the QPRT, the QPRT will be deemed self-settled (discussed below), and the protective benefits of the trust will not apply. However, even though a settlor’s creditor has the legal ability to reach the retained interest, in practice that is rarely, if ever, attempted. The retained interest has very little value to a creditor because such an interest would be difficult to sell at a foreclosure sale.
Consequently, creditors either do not pursue residence
interests held in QPRTs, or are more willing to
negotiate on favorable terms with the settlor-debtor.
A spendthrift trust is a type of trust that either limits or altogether prevents a beneficiary from being able to transfer or assign his interest in the income or the principal of the trust.[9] Spendthrift trusts have traditionally been used to provide for beneficiaries who are incompetent or are simply unable to take care of their own financial affairs. Today, almost every trust incorporates a spendthrift clause.
Example: Mr.
Howell is worried that his wife will spend her entire inheritance on a shopping
spree in
If a trust incorporates a spendthrift clause and the beneficiary is therefore precluded from transferring his interest in either income or principal, then the beneficiary’s creditor will not be able to reach the beneficiary’s interest in the trust.[10]
The protection of the spendthrift trust extends solely to the property that is in the trust. Once the property has been distributed to the beneficiary that property can be reached by a creditor, except to the extent the distributed property is used to support the beneficiary.[11] If a trust calls for a distribution to the beneficiary, but the beneficiary refuses such distribution and elects to retain property in the trust, the spendthrift protection of the trust ceases with respect to that distribution and the beneficiary’s creditors can now reach trust assets.[12]
There are three notable exceptions to the protection afforded to a beneficiary of a spendthrift trust.
If the settlor of a trust is also a beneficiary of a trust, then the assets that the settlor has retained a benefit in will not be protected by the trust’s spendthrift clause.[13] This is known as a prohibition against “self-settled” trusts.
The settlor does not need to be either the sole settlor or the only beneficiary of the trust. As long as the settlor is a beneficiary of the trust to any extent, to that extent the trust will be deemed self-settled.
Example: Husband and wife establish a trust for their own benefit, and contribute their community property. The trust will be self-settled as to each spouse.
Example:
If a trust is self-settled that means only that the interest
of the settlor-beneficiary is not protected from creditors. It does not mean that the trust is invalid,
that other beneficiaries are unprotected or that the trust does not offer other
benefits. In the above example, the
trust is self-settled only as to
The prohibition against self-settled trusts in
The court held that only “the income and the additional corpus required for her support and obtainable by her from the trustee” is subject to creditor claims.[15] The rest of the corpus, including the remainder interest were not for the benefit of the settlor-beneficiary, and thus not self-settled (and therefore not reachable by the settlor’s creditors).
If the trustee of a self-settled trust has any discretion in making distributions, then the creditors of the settlor may reach the maximum amount that the trustee may distribute in his discretion to the settlor-beneficiary.[16]
Consequently, when a trust is self-settled, to obtain any asset protection for the settlor, discretionary powers should be avoided in favor of a clearly ascertainable standard.
While
When a debtor is the sole beneficiary and the sole trustee of a trust, the trust’s protective benefits are lost because the trust is deemed terminated and the beneficiary holds trust assets free of trust.[17] This happens because of the doctrine of merger – the debtor now holds all the equitable interests in the trust in his capacity as the beneficiary, and all the legal interests in his capacity as the trustee. When the equitable and legal interests are vested in one person, there is no longer a trust relationship and that person can fully dispose of the property as any other person.
Because the
A beneficiary of a trust includes any person who has a
present or future interest in the trust, vested or contingent.[20] In Ammco Ornamental Iron
a creditor of a beneficiary, who was also the sole trustee, attempted to
challenge the spendthrift clause of an irrevocable trust by arguing that under
the doctrine of merger the trust terminated.
The debtor-beneficiary held a life estate, and on his death the trust
corpus was to be distributed to the beneficiary’s children pursuant to a
testamentary power of appointment held by the beneficiary. The court held that when the remainder
beneficiary is in existence and ascertained and the remainderman’s
interest is not subject to a condition precedent, the remainder interest is
vested in such beneficiary.[21] The fact that the interest of the remainder
beneficiary was subject to a complete divestment (due to lifetime distributions
to the current beneficiary), did not change the remainder beneficiary’s status
as a beneficiary of the trust.[22] Consequently, the children of the
debtor-beneficiary also qualified as the beneficiaries of the trust, and the
doctrine of merger was inapplicable.
Even if an irrevocable trust has a spendthrift clause, a court may order the trustee to satisfy a beneficiary’s support obligation to a former spouse or minor child out of any distributions that the trustee has decided, in his discretion, to make to the beneficiary.[23]
This is an example of two conflicting public policy rationales. Spendthrift clauses have been enforceable, historically, because our society places a great deal of importance on private property rights. Consequently, creditors cannot generally reach a beneficiary’s interest in a spendthrift trust. However, our society places an even greater importance on satisfying support obligations, and even a spendthrift trust will not shield a beneficiary from such obligations.
A trust is called “discretionary” when the trustee has discretion (as to the timing, amount and the identity of the beneficiary) in making distributions.[24] There must not be any trust provisions that mandate a distribution, but there may be provisions that set standards for distributions.[25] Because the trustee is not required to make any distribution to any specific beneficiary, or may choose when and how much to distribute, a beneficiary of a discretionary trust may have such a tenuous interest in the trust so as not to constitute a property right at all. If the beneficiary has no property right, there is nothing for a creditor to pursue. The statutes follow this line of reasoning by providing that a trustee cannot be compelled to pay a beneficiary’s creditor if the trustee has discretion in making distributions of income and principal.[26]
Practice Pointer:
When drafting a trust that allows the trustee to exercise discretion in making
distributions subject to a standard (including an ascertainable standard), the
discretion clause should be carefully worded.
Practitioners should always favor using permissive phrases such as
“trustee may pay to the beneficiary” instead of mandatory phrases such as “trustee
shall pay to the beneficiary.” In U.S. v. Taylor,[27]
the trust provided that the trustee “shall pay” to the beneficiary so much of
the income from the trust as the trustee deemed necessary for the support of
the beneficiary. The court interpreted that
language to mean that the trustee was mandated to make distributions, and his
discretion was limited only to determining the amount “necessary.”[28]
Even if a trust is truly discretionary it should have a spendthrift clause. While the trustee would not need to honor a beneficiary’s demand for a distribution, it is possible that absent the spendthrift clause a creditor would force the beneficiary to assign his interest in the trust (whatever it may be) to the creditor. If that happens, then some day when the trustee does make a distribution, it will be made to the creditor. Also, most trusts are never fully discretionary and it makes sense to obtain the protection of the spendthrift clause.
Once the beneficiary receives a distribution from the trust, even if it is discretionary, the protective benefits of the trust cease. The distributed assets are treated as any other assets of the beneficiary-debtor, and there is no statutory protection available for such assets simply because the assets used to be held in a trust.
In a case of first impression, a
The court’s analysis is suspect. The intent of the Probate Code is irrelevant if the debtor-beneficiary has no property right in the trust because of a trustee’s unfettered discretion.
A properly drafted discretionary trust is an almost impregnable form of asset protection. But if the trust is discretionary, it means that there are no mandated distributions and no demand rights granted to the beneficiary. This potentially leaves the beneficiary at the mercy of the trustee.
To some extent beneficiaries are protected from the trustee by statutes. Trustees must always exercise their discretion reasonably, and even if the trustee is granted “sole and absolute” discretion, the discretion must not be exercised “arbitrarily” and must be exercised in accordance with fiduciary principles.[31]
The statutes are not sufficient to ensure that the beneficiary will receive either regular or demanded distributions when not threatened by creditors, and it is up to the practitioner to carefully draft the trust to achieve that goal while maintaining the asset protection benefits of the trust.
The protection of a discretionary trust is not diminished by setting forth a distribution standard for the trustee.[32] This allows the drafter to build into the trust some protection for the beneficiary, from the trustee, by including some broadly defined standards. Including distribution standards in an asset protection trust is not always advisable, as in a case of a foreign asset protection trust. Because foreign trusts are usually established for debtors facing greater creditor exposure, protecting beneficiaries from creditors is more important that protecting them from the trustee. In these cases, distribution standards are usually sacrificed in favor of unfettered discretion.
When a distribution standard is desired, the following sample standard may be used:
The trustee may, in its discretion, pay to or apply for the benefit of the beneficiary, so much of the income or principal of the trust as the trustee deems advisable to provide for the beneficiary’s health, education, support, comfort, maintenance, education, professional or vocational courses, and to otherwise enable the beneficiary to maintain his accustomed standard of living. The trustee may also pay to or apply for the benefit of the beneficiary so much of the income or principal of the trust as the trustee deems advisable to allow the beneficiary to purchase a residence, a business or to make investments.
It is also advisable to set forth in the trust the settlor’s intent for the trust. The courts in
Striking the right balance between surrendering the ownership of trust’s assets and retaining some control over and benefit from such assets is a difficult task. From control perspective, the debtor-beneficiary wants to be either a trustee of the trust, or wants to impose mandates and standards on the third-party trustee. From an asset protection perspective, the debtor-beneficiary needs a spendthrift trust with the maximum possible discretion conferred on the trustee.
When the debtor-beneficiary is the sole trustee of a discretionary trust, he has unfettered access to the assets of the trust. As discussed above, if the debtor is the sole beneficiary of the trust and also the sole trustee, then under the doctrine of merger the trust, regardless of its form, will not provide the debtor with any protection. Consequently, it may be advisable to add a co-trustee, or to add remainder beneficiaries.
In practice, some practitioners appoint the sole beneficiary as the sole-trustee of a discretionary, spendthrift trust, and provide for an automatic removal of the beneficiary as a trustee if and when he becomes a debtor. The hope is to accomplish the best of both worlds, give the beneficiary complete control over trust assets when there are no creditors pursuing the beneficiary, and to promptly remove the beneficiary as a trustee and achieve asset protection when the creditors appear. If the beneficiary is truly the sole beneficiary of the trust (i.e., there are no remainder or contingent beneficiaries) at any time, then under the doctrine of merger the trust terminates. It is not clear what happens when a new trustee is substituted or a co-trustee is added as there is no trust in existence at that time. Similar to the advice above, practitioners should consider adding a friendly co-trustee (possibly with limited powers) or remainder beneficiaries at the outset.
No matter what distribution standards are drafted into the trust or how much control is given to the beneficiary, some settlors may want mandatory distributions. A mandatory distribution provision in a trust does not take into account the discretion of the trustee. The trustee simply must make the distribution in the manner and at the time prescribed in the trust (an example of a mandatory distribution includes a QTIP trust where income must be paid to the surviving spouse on a quarterly basis). Mandatory distributions present a problem because sometimes the trustee may be required to make a distribution when a beneficiary is being pursued by a creditor.
If a trust calls for mandatory distributions and the protection of the beneficiary is desirable, it may be advisable to include in the trust a clause prohibiting any and all distributions to a beneficiary while that beneficiary is being pursued by a creditor.[34] It is important to make clear the settlor’s intent that such clause should override all other trust provisions.
[1] Code of Civil Procedure § 695.010(a).
[2]
[3] See, generally, Probate Code §§ 16000-16015.
[4] Probate Code § 16002(a).
[5] Garcia v.
[6] Probate
Code § 18200.
[7] (2006) Cal.App.4th (slip opinion).
[8] Slip. Opn. page 9.
[9] County Nat. Bank etc.
[10] Code of Civil Procedure § 695.030(a) and Probate Code §§ 15300 and 15301(a).
[11] Probate
Code §§ 15300, 15301(a), 15306.5(c); Frazier
v. Wasserman (1968) 263
[12] Probate Code § 15301(b).
[13] Probate Code § 15304(a).
[14] (1965) 237 Cal.App.2d 254.
[15]
[16] Probate Code § 15304(b).
[17] Hill v. Conover (1961) 191 Cal.App.2d
171, 180; Ammco Ornamental Iron, Inc. v. Wing (1994) 26
Cal.App.4th 409, 417; Rest. 2d Trusts § 99, subd. (5),
com. e., pp. 228-229.
[18] Probate Code § 15209(a).
[19] Mead v.
[20] Probate Code § 24(c).
[21] Ammco Ornamental Iron at 418.
[22]
[23] Probate Code § 15305(c).
[24] 11 Witkin, Summary of
[25] Probate Code § 15303(c).
[26] Probate Code § 15303(a).
[27] (N.D.
[28]
[29]
[30]
[31] Probate Code §§ 16080 and 16081(a).
[32] Probate Code § 15303(c).
[33] Brock v. Hall (1949) 33 Cal.2d 885, 889.
[34] N.B. This may be inadvisable in a QTIP trust, because it will then fail to qualify for the unlimited marital deduction.