A trust beneficiary possesses an equitable interest, but not legal ownership, in trust property. Creditors of a trust beneficiary therefore cannot generally assert claims at law against the beneficiary’s equitable interest in trust assets. However, under common law, a settlor cannot establish a trust for his own benefit thereby protecting trust assets from claims of the his own creditors. Such a trust would be a “self-settled spendthrift trust.”

New York retains the common law rule. EPTL § 3.1 provides that “[a] disposition in trust for the use of the creator is void as against existing or subsequent creditors of the creator.” However, seven states do now permit self-settled spendthrift trusts, which have also come to be known as “asset protection trusts” (APTs). Delaware’s statute, 12 Del. C. § 3570 et seq., among the most liberal, notes that it “is intended to maintain Delaware’s role as the most favored jurisdiction for the establishment of trusts.”

A Delaware trust is established when the Settlor transfers assets to a Delaware person or entity authorized to act as Trustee. Although the trust must be irrevocable, the Settlor may retain the right to (i) veto distributions; (ii) exercise special powers of appointment; (iii) receive current income distributions; and (iv) receive principal distributions if limited to an ascertainable standard (e.g., health, maintenance, etc.)

Existing creditors must assert rights against a Delaware APT within a certain time period, or will later be barred from bringing any claim. Under 12 Del. C. § 3572(b), a creditor who knows of the transfer must commence an action within 4 years from the date of the transfer, or within 1 year after the transfer was or could reasonably have been discovered, if later. A creditor whose claim arises after the transfer to the APT must commence an action within 4 years of the date of transfer, irrespective of his knowledge of the transfer.

On June 30, 2005, the law was amended to permit a trust which is being redomiciled in Delaware to include for purposes of computing the period of limitations for creditor claims the time it was located in another state. Section  3572 also now provides that if another state’s court fails to apply Delaware law, the trustee’s authority is terminated by operation of law, and a new trustee is appointed.

It appears likely that a Delaware Court would apply Delaware’s statute in a manner consistent with the settlor’s intent, even if the settlor were a nonresident. In Wilmington Trust Co., 186 A. 903 (Del. Ch. 1936), the Delaware court remarked: “Suppose a person domiciled in New York should travel by train to Delaware, carrying with him a sum of cash, and in Delaware deposit his money with a Delaware resident under a specified trust to be there held and administered, and should then return to his state of  domicil, it would seem all out of reason to say that the law of New York rather than the law of Delaware should govern the validity of the trust.”

Although the Full Faith and Credit Clause requires every state to respect the statutes and judgments of sister states, the Supreme Court, in Franchise Board of California v. Hyatt, 538 U.S. 488 (2003) held that it “does not compel a state to substitute the statutes of other states for which its own statutes dealing with a subject matter concerning which it is competent to legislate.” In Hanson v. Denckla, 357 U.S. 235 (1958), a landmark case, the Supreme Court held that Delaware was not required to give full faith and credit to a judgment of a Florida court that lacked jurisdiction over the trustee and the trust property.

By transferring assets to a Delaware APT, the settlor may be able to retain enjoyment of the trust assets while at the same time rendering those assets impervious to those creditor claims which are not timely interposed within the applicable period of limitations for commencing an action. [A Delaware trust may also continue in perpetuity. By contrast, New York retains the common law Rule Against Perpetuities, which limits trust duration to 21 years after the death of any person living at the creation of the trust. NY EPTL § 9-1.1.]

However effective trusts are at protecting against creditor claims, once trust assets are distributed to beneficiaries, the beneficiary holds legal title to the property. At that point, creditor protection may be lost. Since one cannot predict in advance a particular beneficiary’s needs, “sprinkling” provisions accord the Trustee discretion to distribute income or principal among the settlor’s descendants as the Trustee deems appropriate for their needs, taking into consideration the likelihood that a creditor might attempt to seize distributed property.

Although many settlors choose to distribute trust assets outright to children once their children reach certain predetermined ages, holding the assets in trust for longer periods may be preferable, since creditor protection can then be continued indefinitely. If the Trustee has wide discretion to make distributions of income and principal, and may even distribute all of the principal — thereby terminating the trust — flexibility is not lost even if the trust instrument provides that it will continue indefinitely.

One example which illustrates the advantages to holding assets in trust for a longer period of time involves the possibility of divorce. Assets held in an APT set up either by the spouse or by the parent stand a greater chance of being protected in the event of a divorce than assets distributed outright to the spouse even if the beneficiary-spouse does not “commingle” these distributed assets with other marital assets.

If the settlor insists on providing for a distribution of all of the principal of the trust upon the beneficiary’s reaching a certain age, e.g., 35 or 40, a “hold-back” provision allowing the Trustee to withhold distributions in the event a beneficiary is threatened by a creditor claims, could prove invaluable. To provide maximum creditor protection, the “sprinkling” power should end when a creditor appears. If the trustee has discretion to distribute in the event a creditor appears, then a court might be more willing for order the trustee to exercise discretion to make a distribution.

The settlor should not be named as trustee of an irrevocable trust since a settlor’s power to determine beneficial enjoyment would cause estate tax inclusion under IRC §§ 2036 and 2038. However, the settlor will not be deemed to have retained control for estate tax purposes merely because the trustee is related to the settlor. Therefore, the settlor’s spouse or children be named as trustees. Also, the settlor may be named the trustee of certain nongrantor trusts provided the settlor’s powers are circumscribed to avoid estate tax inclusion. However, even here it is preferable not to name the settlor as trustee.

To avoid estate tax problems for the beneficiary herself, the powers granted to the beneficiary must be circumscribed. A beneficiary’s power to make discretionary distributions to herself without an ascertainable standard limitation would constitute a general power of appointment under Code Sec. 2041 and would result in inclusion of trust assets in the beneficiary’s estate. To avoid this problem, an independent trustee should be appointed to exercise the power to make decisions regarding distributions to that beneficiary.

Planning to divest New York of jurisdiction to impose fiduciary income tax on undistributed trust assets can produce large tax savings. NY Tax. Law. §605(b)(3) taxes trusts created by New York settlors. However, a resident trust is not subject to tax if (i) all trustees are domiciled in a state other than New York; (ii) all property, both real and intangible, is located outside of New York; and (iii) all income and gains of the trust are derived from sources outside of New York. Therefore, New York will not tax a trust that has no New York trustees and no New York assets or income.

To illustrate, a trust created by a New York resident and administered in New York must pay $76,992 of New York State tax on a capital gain of $1 million. However, if the trust were domiciled (or redomiciled) in Delaware, this tax would be avoided, as Delaware imposes no income tax on capital gains incurred on an irrevocable nongrantor trust provided that no remainder beneficiary lives in Delaware. Del. Code Ann., §§ 1101-1243.