Advisors promote trusts as an indispensable component of the estate plan. We tout the importance of trusts for credit shelter and generation-skipping transfer (GST) tax planning. We proclaim that trusts protect assets from creditors, including insatiable divorce creditors. Meanwhile, many of our clients are worried that inheritances will get tied up in trust, complicating beneficiaries' lives. In the past, there was a solution: the beneficiary-controlled trust that gave beneficiaries a fair amount of control, yet still provided crucial tax and creditor protection.
The beneficiary-controlled trust proliferated dramatically in recent years — and no wonder. In it, the current beneficiary is named as the sole trustee; has the power, in his sole discretion, to make distributions of income and/or principal to himself under the health, education, support and maintenance (HESM) standard of Internal Revenue Code Section 2041 and Treasury Regulations rules,1 and has a limited power to appoint trust assets to anyone other than the beneficiary.2
The beneficiary's control of such a trust is powerful. Perhaps too powerful? Does the beneficiary exercise such control that the trust no longer qualifies as a “discretionary trust” or “spendthrift trust,” thereby exposing it to creditors? Has the practitioner's focus on estate tax inclusion issues in drafting trust instruments put trust assets at risk of creditor attachment?
In fact, we believe that the use of the standard beneficiary-controlled trust should be reconsidered. When protection of trust assets is an overarching concern and one of the main reasons for using a trust, the current beneficiary should not be named as the sole trustee and should be prohibited from participating in the decision as to whether and when to make distributions to himself. All flexibility is not lost, as the beneficiary can be given a limited power to appoint trust assets to anyone other than the beneficiary; to act as a co-trustee; to name the additional co-trustee of his trust; and to act as the sole investment advisor of his separate trust. In addition, the beneficiary could be given the power to remove and replace the appointed co-trustee, as long as the replacement trustee is not a related or subordinate party to the beneficiary.
We reach these conclusions because the power — and asset protection value — of beneficiary-controlled trusts has been eroded in recent years by the Restatement (Third) of Trusts and other sources of law.
Little has been written about the asset protection of beneficiary-controlled trusts. Yet it is important to consider. With the prospect of significantly increased estate-tax exemption levels and lower estate-tax rates, trust asset protection may take center stage in the coming years.
Protection of trust assets stems from three sources: (1) qualification as a discretionary trust, (2) trust spendthrift provisions, and (3) state trust law.
Qualification as a Discretionary Trust — A trust is generally labeled as a mandatory distribution trust, a support trust or a discretionary trust.3 Case law in at least four jurisdictions has developed yet another trust, often referred to as a hybrid trust.4 The beneficiary-controlled trust is designed to qualify as a discretionary trust.
The beneficiary of a discretionary trust has no right to distributions. The trustee is vested with the sole discretion about whether and when to make distributions. As a result, the beneficiary has no property interest in a discretionary trust and no interest that a creditor may attach. Traditionally, this is where the creditor protection analysis of discretionary trusts ended. But the Restatement in 1999 changed this analysis.
The Restatement now calls for an examination of the level of the beneficiary's control over trust assets.5 Comment g to Section 60 begins by noting that the “material in this Comment had no counterpart in prior trust restatements, but coverage of these situations is now required as a result of modern planning practices” (that is to say, the proliferation of beneficiary-controlled trusts). The comment acknowledges the general power of appointment rules of IRC Sections 2041 and 2514, but notes, “Given the different policies and considerations involved in creditors' rights situations, the tax statutes, regulations, and cases are of limited relevance and certainly cannot be viewed here as controlling.” That is, the fact that trust assets would not be included in the gross estate of a beneficiary does not automatically mean protection of trust assets from a beneficiary's creditors.
While recognizing that this new commentary had no counterpart in previous Restatements and only a few cases to date address the subject of Comment g, the Restatement attempts to garner support for its position from historical trust treatises. The Comment cites Section 422 of Dean Erwin N. Griswold's 1947 treatise, Spendthrift Trusts, as providing that if “‘the discretion is given to a beneficiary, that is, if the trustee must make payments to the beneficiary at the latter's will, the trust is not … regarded as a discretionary trust’” and notes that George G. Bogert and George T. Bogert's The Law of Trusts and Trustees provides similar discussion.
Comment g then outlines the few cases that have addressed the comment's subject. But these generally focus on the effectiveness of trust spendthrift provisions, not on whether a trust fails to qualify as a discretionary trust. So we'll examine these cases in our spendthrift discussion. The point, however, is that if the current beneficiary is serving as the sole trustee, the trust may no longer qualify as a discretionary trust. The result? The analysis proceeds to examine the effectiveness of trust spendthrift provisions and state trust laws.
Spendthrift Protection — If a trust fails to qualify as a discretionary trust, the effectiveness of trust spendthrift provisions take center stage. In fact, in bankruptcy proceedings, spendthrift provisions may serve as the sole protection of trust assets. State spendthrift laws are not uniform, but a majority of states recognize the validity of spendthrift trusts.6 Most states lack a statutory definition of a spendthrift trust, leaving case law to define its boundaries.7
There are two main formulations of the spendthrift qualification test. Illinois and Florida law serve as examples of these different formulations. The U.S. Court of Appeals for the Seventh Circuit in In re Perkins held the following to be characteristics of spendthrift trusts under Illinois law: “(1) whether the trust restricts the beneficiary's ability to alienate and the beneficiary's creditors' ability to attach the trust corpus; (2) whether the beneficiary settled and retained the right to revoke the trust, and (3) whether the beneficiary has exclusive and effective dominion and control over the trust corpus, distribution of the trust corpus and termination of the trust.”8
The Seventh Circuit noted that the “degree of control which a beneficiary exercises over the trust corpus is the principal consideration under Illinois law.”9 Illinois courts have not fashioned a bright line test to determine when a beneficiary's control over a trust renders it non-spendthrift.10 But Illinois bankruptcy courts have held that “the beneficiary cannot control [the trust]” and that “[p]roperty which a debtor in bankruptcy has the unfettered ability to possess and own is not protected by the exclusionary language of Section 541(c)(2),”11 that “‘the beneficiary must not have any control over or right to a distribution from the trust.”12 Even more dramatic is the statement of the bankruptcy court in In re Groves, in which the court stated: “In a true spendthrift trust there is no possible voluntary action a beneficiary can take which would initiate an early termination of the trust or invasion of the corpus.”13 Should the power granted the current beneficiary in the beneficiary-controlled trust concern practitioners in the context of these pronouncements?
Florida law provides an example of the other main formulation of the test to qualify as a spendthrift trust. Unlike Illinois, Florida has not set forth a strict multi-part test. Spendthrift trusts are generally defined under Florida law as “those trusts that are created with a view of providing a fund for the maintenance of another, and at the same time securing it against his own improvidence or incapacity for self-protection.”14 There is no specific language that must be used to create a spendthrift trust under Florida law. Rather, the courts simply focus on the extent to which assets have been retained in trust for the benefit of another person and the extent to which they are secured from the beneficiary's own self-protection.15 The new Florida Trust Code (FTC), effective July 2007, provides statutory reinforcement for the validity of spendthrift trusts,16 but fails to address whether spendthrift provisions in the beneficiary-controlled trust are valid. We have recommended to one of the principal authors of the FTC that the code be revised to specifically address these issues.
Courts in many jurisdictions, particularly jurisdictions whose trust law is not fully developed statutorily, rely on the Restatement Comment b to Section 58, which provides that if the beneficiary has the “equivalence of ownership” of trust assets, the trust does not qualify as a spendthrift trust.17 The comment also notes that prior versions of the Restatement have stated that “if the beneficiary is entitled to have the principal conveyed to him immediately, a restraint on the voluntary or involuntary transfer of his interest in the principal is invalid,”18 and that “if a beneficiary is entitled to have the principal paid or conveyed to him immediately or at any time he may call for it, a restraint on alienation of his interest is invalid.” Comment b goes on to cite In re McCoy, an Illinois bankruptcy case that made use of the “ownership equivalence” basis for invalidating a trust's spendthrift provisions.19 The issue then becomes whether the beneficiary-controlled trust provides the current beneficiary with “ownership equivalence.”
American Jurisprudence 2d also addresses this issue, providing that the test of spendthrift validity in some jurisdictions requires a determination be made as to “whether the beneficiary has exclusive and effective dominion and control over the trust corpus, distribution of the trust corpus, and termination of the trust.”20 The treatise also notes that “the degree of control which a beneficiary exercises over the trust corpus has been viewed as being the principal consideration.”21 Section 103 addresses dominion and control of the beneficiary over the trust corpus. American Jurisprudence notes that the “very basis of a spendthrift trust-provision of maintenance and support to someone in a manner that protects the assets from the beneficiary's improvidence fails when the settlor has given the beneficiary the ability to exercise dominion and control over the corpus form.”22 Section 103 concludes with the following statement:
“Implicit in the term spendthrift is the notion that the distribution of the trust is controlled by someone other than the beneficiary of the trust. To qualify as a spendthrift trust, a beneficiary must show that he does not possess exclusive and effective control over the termination or distribution of the trust. Otherwise, when the beneficiary exercises absolute dominion over the property of a spendthrift trust, such trust fails.”23
In support of these conclusions, American Jurisprudence cites two Illinois cases, including In re Lyons and In re McCoy. Also citing a Tennessee case on point, American Jurisprudence notes that a “beneficiary of a spendthrift trust is not allowed to have control of the trust property; the rationale apparently is that control of the property while it is in the trust would be essentially the same as ownership, as if there were no trust.”24 This statement seems to reflect the sentiment in Section 58 of the Restatement and its ownership equivalence test.
A look at In re McCoy is instructive.25 Under the terms of Judith McCoy's will, a family trust was created for the benefit of her husband, George McCoy, and their children. George was named as the sole trustee. The terms of the family trust called for all income to be distributed to the husband during his lifetime.26 The principal was to be distributed as follows: “The trustee may in its discretion pay to my spouse, or for his benefit, so much or all of the principal of the Family Trust as the trustee from time to time determines to be required or desirable for his health, maintenance and support. The Trustee need not consider the interests of any other beneficiary in making distributions to my spouse or for his benefit. Although my primary concern is for my spouse's health, maintenance and support, the trustee may in its discretion during the life of my spouse pay to, or use for the benefit of, one or more of my descendants to the exclusion of one or more of them so much of the principal of the Family Trust as the trustee from time to time determines to be required for their health, education, maintenance and support.”27
George eventually filed for bankruptcy and the bankruptcy trustee argued that the trust assets should be included in his bankruptcy estate, claiming the trust did not qualify as a spendthrift trust. The bankruptcy court held in favor of the bankruptcy trustee, and George appealed to the district court.
The district court highlighted that the focus under Illinois law is on the extent of the beneficiary's control over trust corpus and proceeded to examine whether George possessed excessive control over the trust assets. The district court first addressed George's argument that distributions to himself were limited by an ascertainable standard and thus limited his dominion and control.28 The court questioned what amount of control was left after George had made his determination, free from review, as to what was “desirable” for his HESM.29
George's next argument was that the word “desirable” in the trust was limited to what is reasonably related to payments for his HESM. The district court was unconvinced. It held that George failed to establish that his determination of what is ‘desirable’ for his HESM was somehow limited, stating: “[T]here is nothing in the Family Trust to prevent [McCoy], as trustee of the Family Trust, from making a determination that any particular sumptuous luxury or indulgence is required or desirable for his [HESM] and thereby withdraw from the corpus of the Family Trust accordingly.”30
McCoy countered by referring to HESM-related distributions for maintaining himself in the station of life to which he had become accustomed.31 The court noted, however, that the family trust was silent as to what encompassed HESM.32 Instead, the family trust left it to George himself to determine not only what was required or desirable for HESM, but also what encompassed HESM.33
Finally, George argued that his fiduciary duty to the other beneficiaries of the trust restricted his control over the trust.34 The court disagreed, noting that the language of the family trust belies this argument. It said, “The Trustee need not consider the interests of any other beneficiary in making distributions to my spouse for his benefit.”35 The court upheld the bankruptcy court's decision, ruling that because the debtor had “unbridled access to the corpus of the Trust” the property was part of the bankruptcy estate.36
In re Bottom addresses these issues as well.37 On Aug. 9, 1993, Wayne D. Bottom filed for bankruptcy and within 180 days from that time, his father died, leaving assets to Wayne in trust.38 There is little discussion of the specific terms of the trust, other than that “75% of the residuary estate be held in trust for [Wayne], to be paid to him in the Trustee's discretion for the ‘support, care, comfort, and maintenance’” of Wayne,39 who was named as sole trustee.40 The bankruptcy trustee argued that the trust assets should be included in Wayne's bankruptcy estate.41 The facts do not indicate whether the trust had a spendthrift provision, but the bankruptcy court's analysis leads us to assume that it did.
Wayne argued that the trust assets should be excluded from his bankruptcy estate under the provisions of Section 541(c)(2) of the bankruptcy code.42 The bankruptcy court noted that “Florida courts have indicated that ‘a spendthrift trust is defined to be those trusts that are created with a view of providing a fund for the maintenance of another, and at the same time securing his own improvidence or incapacity for self-protection.’”43 The court then provided that this policy is not served in this case.44 “Because [Wayne] is named as the sole Trustee of his own trust, the only one that can guard [Wayne] from his own improvidence is [Wayne] himself.”45 The court concluded this discussion by noting that “[i]t is for this reason that the trustee and the sole beneficiary cannot be one in the same under Florida law.”46 As a result, the trust did not qualify as a spendthrift trust under Florida law, and the trust became part of Wayne's bankruptcy estate.
State Laws — A number of states have statutes that appear to trump Comment g to Section 60 of the Restatement, which eroded traditional creditor protection afforded to discretionary trusts. But these laws fail to provide the same protection to trust assets in bankruptcy proceedings.
For example, Illinois' 735 ILCS 5/2-1403 provides the general rule that property held in trust cannot be attached to satisfy a creditor's claim if the trust was created by a person other than the debtor. The only exception (at least on the face of the statute) is for unpaid child support payments. The Illinois statute therefore offers a high degree of asset protection to beneficiary-controlled trusts, at least pre-bankruptcy. It is important to note, however, that the statute does not prevent a trust beneficiary from alienating his interest in the trust and therefore the statute does not brand all Illinois trusts as spendthrift trusts. The Illinois statute, however, does trump the erosion of the traditional discretionary trust analysis set forth by the Restatement.
The UTC, as originally promulgated, failed to address the issue raised in Comment g to Section 60 of the Restatement. After practi—tioners voiced their concerns, Article 5 was revised to address this issue. The FTC has adopted this provision. Subsection 736.504(2) of the FTC provides that “[i]f the trustee's discretion to make distributions for the trustee's own benefit is limited by an ascertainable standard, a creditor may not reach or compel distribution of the beneficial interest except to the extent the interest would be subject to the creditor's claim were the beneficiary not acting as trustee.” This section therefore affords the beneficiary-controlled trust the same degree of asset protection as a discretionary trust with a trustee other than the beneficiary. The Comment to Section 504 of the UTC, the genesis of subsection 736.504(2) of the FTC, notes that trusts are commonly drafted when the trustee is given the power to make discretionary distributions of income and/or principal to the trustee himself. But to prevent estate-tax inclusion, distributions are typically limited by an ascertainable standard. The drafting committee's position was that “adoption of the Restatement rule would unduly disrupt standard estate planning and should be limited.”
Traditional sources of trust asset protection are slowly being eroded. Sections 58 and 60 of the Restatement in particular cast doubt on whether a beneficiary-controlled trust will protect trust assets from a beneficiary's creditors, both pre-bankruptcy and in bankruptcy proceedings. Case law in a number of jurisdictions also spark concern. The result is that beneficiary-controlled trusts may not offer a sufficient level of asset protection in many situations.
A number of state statutes attempt to address this issue. The statutes, however, only address qualification of the beneficiary-controlled trust as a discretionary trust and fail also to address whether spendthrift provisions of the beneficiary-controlled trust are valid. The result is that while these statutes offer creditor protection to the beneficiary-controlled trust pre-bankruptcy, this protection may not carry over to bankruptcy proceedings, where the focus of the bankruptcy courts is on the effectiveness of trust spendthrift provisions.
An additional concern is the beneficiary, who is acting as sole trustee, might violate the HESM standard. Subsection 736.504(2) of the FTC provides that the beneficiary-controlled trust qualifies as a discretionary trust as long as distributions are limited to HESM. But what if the beneficiary makes distributions to himself in violation of the ascertainable standard? A creditor would likely argue that the beneficiary, as sole trustee, is violating and not respecting the standard and that therefore the court should also not respect the standard as a limitation on the beneficiary's power to make distributions to himself. The result may very well be that even with statutes like subsection 736.504(2) of the FTC, trust assets remain subject to creditor attachment.
One issue is whether the presence of remainder beneficiaries serves as a sufficient limitation on the beneficiary's ability to make distributions to themselves. The Restatement did not address this issue in Sections 58 or 60. In addition, in the McCoy case there were additional current beneficiaries and the trust assets still were included in McCoy's bankruptcy estate. The language of the trust instrument in that case explicitly waived any such fiduciary duty argument. Trust instruments often include such language as a means of allowing trusts to be terminated by distributing the remaining trust assets to current beneficiaries. The fear is apparently that corporate trustees would be hesitant to make such terminating distributions to current beneficiaries without this language, recognizing their duties to remainder beneficiaries. This language, however, eliminates any argument that the current beneficiary, as sole trustee, is somehow limited by a fiduciary duty to remaindermen. The Bottom case simply never addressed this issue, as that court pointedly held that when the beneficiary is the sole trustee, the trust does not qualify as a spendthrift trust.
Please note that we are not advocating the position that beneficiary-controlled trusts should be shelved and never used. There may be situations in which the size of the trust and administrative costs simply do not justify mandating the appointment of an additional co-trustee. But ask yourself whether in these cases, a trust really is the vehicle of choice.
- Limiting distributions to oneself pursuant to this ascertainable standard prevents the trust assets from being included in the beneficiary's gross estate for federal estate tax purposes.
- The permissible appointees are any person or entity, other than the beneficiary, the beneficiary's estate, creditors of the beneficiary or creditors of the beneficiary's estate.
- See Steven J. Oshins, “Asset Protection Other Than Self-Settled Trusts: Beneficiary Controlled Trusts, FLPs, LLCs, Retirement Plans and Other Creditor Protection Strategies,” 39 Heckerling Institute on Estate Planning, Chapter 3, at Section 304 (2005); Gideon Rothschild, “Protecting the Estate From In-laws and Other Predators,” 35 Heckerling Institute on Estate Planning, at para. 1706.1 (2001), citing Black's Law Dictionary 1513 (6th ed. 1990).
- See Oshins, supra at note 3, at Section 304.
- One issue is whether the assets of a true discretionary trust should be included in the bankruptcy estate, given that a beneficiary has no property interest in a discretionary trust. The bankruptcy courts do not appear to focus on this issue. Instead, bankruptcy courts move directly to examining trust spendthrift provisions, because this is the focus of Bankruptcy Code Section 541(c)(2). See, for example, In re McCoy, 2002 WL 1611588 (N.D. Ill. 2002), and In re Bottom, 176 B.R. 950 (Bankr. N.D. Fla. 1994). The general bankruptcy inclusionary rule is that all legal and equitable interest in property are included in the debtor's bankruptcy estate and thus appears to include discretionary trusts. At least one bankruptcy court, however, held that a true discretionary trust, while it did not qualify as a spendthrift trust, was excludible from a debtor's bankruptcy estate pursuant to Bankruptcy Code Section 541(c)(2). See In re Pechanec, 59 B.R. 899 (Bankr. D. Kan. 1986).
- Philip M. Linquist, “If the Beneficiary is the Sole Trustee, Do You Have a Spendthrift Trust? Texas v. Restatement Third,” Trusts, available at www.hughesluce.com/files/tbl_s47Details%5CFileUpload265% 5C115%5CCAIL.pdf.
- See, for example, In re Groves, 120 B.R. 956, 960 (Bankr. N.D. Ill. 1990).
- In re Perkins, 902 F.2d 1254, 1257 n. 2, citing In re Silldorff, 96 B.R. 859, 864 (C.D. Ill. 1989).
- In re Balay, 113 B.R. 429, 437 (Bankr. N.D. Ill. 1990).
- In re Rolfe, 34 B.R. 159, 161 (Bankr. N.D. Ill. 1983).
- In re Kazi, 125 B.R. 981, 987 (Bankr. S.D. Ill. 1991), citing In re Balay, 113 B.R. at 437; In re Perkins, 902 F.2d at 1257 n.2d; In re Silldorff, 96 B.R. at 864; In re Dagnall, 78 B.R. at 534.
- In re Groves, 120 B.R. 956, 960-61 (Bankr. N.D. Ill. 1990).
- Croom v. Ocala Plumbing & Electric Co., 57 So. 243, 244 (Fla. 1911); see also In re Bottom, 176 B.R. 950, 952 (Bankr. N.D. Fla. 1994).
- For example, in one case a Florida bankruptcy court held that even though a trust failed to include a traditional spendthrift provision, the fact that it qualified as a discretionary trust transformed the trust into a spendthrift trust, excludible from the bankruptcy estate under Bankruptcy Code Section 541(c)(2). See In re Esterson, 150 B.R. 72 (Bankr. M.D. Fla. 1993).
- Florida Trust Code Section 736.502.
- Ibid., at Section 58, Comment b.;
- See Oshins, supra at note 4, Section 324, citing Restatement (Second) of Trusts, Sections 153(2) and 153, Comment c.
- 76 Am. Jur. 2d, “Trusts,” Section 95 (2005).
- Ibid., citing In re Green, 115 B.R. 1001 (Bankr. W.D. Mo. 1990), order aff'd, 123 B.R. 327 (W.D. Mo. 1990), rev'd on other grounds, 967 F.2d 1216 (8th Cir. 1992)).
- Ibid, citations omitted.
- Ibid, citing In re Cassada, 86 B.R. 541 (Bankr. E.D. Tenn. 1988).
- In re McCoy, 2002 WL 1611588 (N.D. Ill. 2002).
- Ibid., at *6.
- See McCoy, supra, at n.25.
- Ibid., at *6.
- See McCoy, supra, at n.25.
- See ibid., at *6-7.
- Ibid., at *6.
- Ibid., at *7.
- In re Bottom, 176 B.R. 950, 951 (Bankr. N.D. Fla. 1994).
- Ibid. This raises the question of whether Wayne D. Bottom could have sustained an argument that he was limited by an ascertainable standard, given the use of “comfort” in the distributional standard.
- Ibid., at 952.
- Ibid. Another Florida bankruptcy court noted that in construing Bankruptcy Code Section 541(c)(2), “courts have generally taken the position that if the beneficiary has any current right to reach the corpus of the trust, the trust will not be re—cognized as an exception to Section 541 and the debtor's interest in the trust would be considered property of the estate.” In re Esterson, 150 B.R. 72, 73 (Bankr. M.D. Fla. 1993).
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