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Many estate planning trusts also possess significant asset protection features. A qualified personal residence trust (“QPRT”) results when an interest in real property, which could be attached by a creditor, is converted into a mere right to reside in the residence for a term of years. The sale of an asset to a “defective” grantor trust in exchange for a promissory note converts the asset into an instrument which may be unattractive to a creditor if it provides only for interest payments.
Since these trusts are ubiquitous in estate planning, they are less likely to be vulnerable to a claim that they were formed with an intent to hinder, delay or defraud creditors. Less commonly, trusts are called upon to achieve purely asset protection objectives. Their effectiveness in this role appears to militate in favor of their greater use.
Asset protection features of an asset protection trust (“APT”) may arise by virtue of a discretionary distribution provision in the trust. The trust may provide that the Trustees “in their sole and absolute discretion may pay or apply the whole, any portion, or none of the net income for the benefit of the beneficiaries.” Alternatively, the Trustees’ discretion may be limited by a broadly defined standard, i.e., “so much of the net income as the Trustees deem advisable to provide for the support, maintenance and health of the beneficiary.”
The effect of a discretionary distribution provision on the rights of a creditor are profound. If the trust provides that (i) the beneficiary cannot compel the trustee to make distributions, and assuming that (ii) the rights of a creditor can be no greater than those of the beneficiary, it follows that (iii) a creditor cannot compel the trustee to make distributions. Therefore, properly limiting the beneficiary’s right to income from the trust may well determine the extent to which trusts assets are protected from the claims of creditors.
Failure to properly limit the beneficiary’s right to income from an APT can have deleterious tax consequences if the creditor is the IRS. TAM 0017665 stated that where the taxpayer had a right to so much of the net income of the trust as the trustee determined was necessary for the taxpayer’s health, maintenance, support and education, the taxpayer had an identifiable property interest in the trust which was subject to a federal tax lien. Since the discretion of the trustee was broadly defined, and subject to an “ascertainable standard” rather than being absolute, the asset protection feature of the trust was diminished.
If asset protection is a major objective, it would be inadvisable to draft a trust in which the trustee’s obligation to distribute income is subject to an ascertainable standard, rather than within the trustee’s absolute discretion. However, that is not enough: Even if the trustee’s discretion is absolute, a court may review the trustee’s discretion. Fortunately, courts have generally been disinclined to substitute their judgment for that of the trustee, even where the trustee’s discretion is absolute. The Uniform Trust Code is in accord, providing that a creditor of a beneficiary may not compel a distribution even where the trustee has abused his discretion.
A beneficiary should not be named sole trustee of his own discretionary APT, since the interest of a beneficiary who has discretion to determine his own distributions may be attached by a creditor. On the other hand, if the sole trustee — even a beneficiary — has no discretion with respect to distributions made to himself, his interest in the trust would not likely be subject to attachment by a creditor. However, amounts actually distributed could be reached.
II. Spendthrift Trusts
Even if the trustee’s discretion is absolute, the APT should also contain a valid spendthrift clause, since it is not enough for asset protection purposes that a creditor be unable to compel a distribution. The creditor must also be unable to attach the beneficiary’s interest in the trust. A spendthrift provision prevents the beneficiary from voluntarily or involuntarily alienating his interest in the trust. The Supreme Court, in Nichols v. Eaton, 91 U.S. 716 (1875), recognized the validity of a spendthrift trust, holding that an individual should be able to transfer property subject to certain limiting conditions.
A spendthrift trust will thus protect a beneficiary from (i) his own profligacy or bankruptcy; (ii) his torts; and (iii) many of his creditors, (including his spouse). No specific language is necessary to create a spendthrift trust, and a spendthrift limitation may even be inferred from the intent of the settlor. Still, it is preferable as well as customary to include spendthrift language in a trust. A spendthrift provision may also provide that required trust distributions become discretionary upon the occurrence of an event or contingency specified in the trust. Thus, a trust providing for regular distributions to beneficiaries might also provide that such distributions would be suspended in the event a creditor threat appears.
A few exceptions could reduce the effectiveness of a spendthrift trust. As indicated above, if a beneficiary is also the sole trustee of a discretionary spendthrift trust, the trust will be ineffective as against creditors’ claims. Other exceptions are in the nature of public policy exceptions. Thus, assets in a spendthrift trust may be reached to enforce a claim against the beneficiary for support of a child. Courts might also invalidate a spendthrift trust to satisfy a judgment arising from an intentional tort. Furthermore, a spendthrift trust would likely be ineffective against claims made by the government relating to taxes, since the strong public policy in favor of the government collecting taxes may be deemed to outweigh the public policy of enforcing spendthrift trusts.
III. “Self-Settled” Spendthrift Trusts
A “self-settled” trust is one which the beneficiary creates for his own protection. Here, the settler is either one of the beneficiaries or the sole beneficiary of the trust. A self-settled trust may also be spendthrift. Prior to 1997, neither the common law nor the statutory law of any state permitted a self-settled trust to be endowed with spendthrift trust protection.
However, since 1997, five states, including Delaware and Alaska, have enacted legislation which expressly authorizes the use of self-settled spendthrift trusts. A self-settled spendthrift trust, if established in one of these five states, may effectively allow an individual to put assets beyond the reach of creditors while retaining some control over and access to trust assets. These states now compete with jurisdictions such as the Cayman Islands and Bermuda, which for many years have been a haven for those seeking the protection of a self-settled spendthrift trust.
Most states, including New York, continue to abhor self-settled spendthrift trusts. This is true even if another person is named as trustee and even the trust is not created with an intent to defraud existing creditors. New York’s strong public policy against self-settled spendthrift trusts is evidenced in EPTL §7-3.1, which provides that “[a] disposition in trust for the use of the creator is void as against the existing or subsequent creditors of the creator.” Still, there appears to be no reason why a New York resident could not transfer assets to the trustee of a self-settled spendthrift trust situated in Delaware or in another state which now permits such trusts.
Trust arrangements nominally not self-settled spendthrift trusts, but which seek to achieve that status by indirect means, will likely fail in that desired objective. Thus, a “reciprocal” or “crossed” trust arrangement, in which the settlor of one trust is the beneficiary of another, would likely offer little or no asset protection. (In fact, the “reciprocal trust doctrine” has often been invoked by the IRS to defeat attempts by taxpayers to shift assets out of their estates.)
Important estate planning objectives may be furthered by establishing an APT. However, normal estate tax rules must be considered. For example, the estate of a settler who retains the right to receive trust distributions will be required to include trust assets in the estate under IRC § 2036. This problem will not be avoided even if the “right” to receive income is within the discretion of the Trustees, since it is the retained right which causes inclusion. However, by utilizing a domestic APT in which the settler retains no right whatsoever to income, inclusion under IRC § 2036 should be avoided.