Trusts and the Rights of Beneficiary Creditors

Trusts have evolved as an instrument to not only give the settlor greater control over the disposition of his assets at death and to lower estate taxes, but also as a method to protect the trust income or principal from the creditors of the trust's beneficiaries. A creditor always has the right to attach income or property once it is transferred to the beneficiary and a creditor can get a court order that requires the trustee to pay the creditor instead of the beneficiary whenever a distribution is made to the beneficiary until the debt is paid. But whether the creditor can demand a distribution from the trust for payment of the beneficiary's debt depends on the terms of the trust.

If the beneficiary can demand a payment from a trust, then creditors of the beneficiary can also demand payment. For this reason, if the beneficiary of the trust is also the settlor of the trust, then creditors can reach the assets of the trust, since the settlor usually retains all rights to the trust's assets. It is also against public policy to allow the settlor to shield his own assets from creditors, while still benefiting from those assets, by putting them in a trust. ^{Uniform Trust Code (UTC) §505}

A mandatory trust is required to pay a set amount to its beneficiaries according to a formula specified in the trust document. With this type of distribution, the creditor can take the place of the beneficiary and receive the payment instead of the beneficiary until the debt is satisfied. However, ERISA, a federal law covering pension funds, does not allow claims against pension funds by creditors.

A discretionary trust allows the trustee the discretion of how to distribute the trust assets and to whom. A beneficiary of a discretionary trust has no property rights in the trust, so the beneficiary cannot demand payment from a discretionary trust unless the trustee has abused her discretion. Since a creditor of the beneficiary has no more rights to trust property than the beneficiary has, neither can the creditor demand payment.

Spendthrift and Support Trusts

Unless the trust document provides otherwise, a beneficiary can generally transfer his interest in a trust. If the beneficiary can voluntarily transfer his interest, then a creditor, through a court order, can force the beneficiary to transfer his interest to the creditor.

If the trust document has a spendthrift clause that prevents the beneficiary from transferring his interest in the trust to another—both voluntarily and involuntarily—then creditors cannot force a transfer of the beneficiary's interest to them. A trust cannot allow voluntary transfers but not involuntary transfers because it is against public policy, so, to be legally effective the spendthrift clause must prevent both voluntary and involuntary transfers. A spendthrift clause also has no legal effect to a mandatory trust, so a spendthrift trust is, by legal necessity, a discretionary trust. ^{UTC §506}

A spendthrift clause can apply to trust income or principal or both and it may only apply to particular beneficiaries.

Under bankruptcy, the bankruptcy trustee gains no more rights than the beneficiary. Hence, a spendthrift clause protects the trust's assets from being included in the bankruptcy estate. ^{11 U.S.C. § 541(c)(2)}

A support trust is a special type of spendthrift trust in that the trust pays the beneficiary only enough, according to a formula in the trust document, for the support and the education of the beneficiary and nothing more; otherwise, a trust that pays more than necessary for support will not satisfy the legal requirements of a support trust and creditors will be able to reach it. However, creditors that provide basic support for the beneficiary can attach the beneficiary's interest in the trust.

Because a support trust is for the support of the beneficiary, the interest in the trust cannot be transferred, even if it is not explicitly stated in the trust document. Otherwise, how can the trust provide support?

While spendthrift and support clauses are effective against most creditors, the states and the courts, as a matter of public policy, have granted exceptions to priority creditors:

• judgment creditors for child support and alimony;
• claims for taxes by the state and federal governments;
• judgment creditors who have provided services to protect the beneficiary's interest in the trust.
• creditors who have provided basic support for the beneficiary.

Self-Settled Asset Protection Trusts

As already stated, a settlor cannot protect his assets from creditors by transferring his assets to a trust where he is also a beneficiary. However, a few jurisdictions, including Alaska, Delaware, and Missouri, and some off-shore jurisdictions, have allowed self-settled trusts as a means of attracting money to their jurisdictions. It seems almost a certainty that other states will also adopt self-settled asset protection trusts, since anyone can form these trusts in the states where they are allowed even if the settlors are not domiciled there.

However, there are some general requirements, at least with self-settled trusts in the United States:

• the trust must be discretionary;
• the trust must be irrevocable;
• the settlor must not have defaulted on child support payments;
• and the trust was not created to defraud creditors—in other words, the trust existed before there were any creditor's claims or any actions that would give rise to creditor's claims.
• Naturally, the trust must benefit the state that allows self-settled protection trusts, which explains the following additional requirements concerning the trust's state of creation:
  • at least some of the trust assets must be located and administered in the state;
  • at least 1 of the trustees must be a state resident or if the trustee is a business, such as a bank or a trust company, its principle place of business must be in the state;
    • all of the trustees for a Delaware trust must be Delaware residents.

Any transfers of assets to self-settled trusts that were made to defraud creditors can be reversed as a fraudulent transfer under the Uniform Fraudulent Transfer Act. Note, also, that self-settled asset protection trusts have not been extensively tested against legal challenges, so it is questionable how effective they will be.

Medicaid Eligibility for Trust Beneficiaries

Sometimes trusts are used to support an individual in such a way so that they qualify for Medicaid—a federal program administered by the states that provides medical care for people who cannot afford it. Generally, eligibility for Medicaid will include trust income and principal to the extent that the beneficiary can access those funds. For instance, if the beneficiary is also the settlor, then all of the trust funds that are available to the settlor-beneficiary will be included as resources available to the Medicaid applicant.

If the beneficiary is not the settlor, then all the trust income and principal that the beneficiary should receive or could demand will be considered as part of resources available for her use. Hence, mandatory trusts that must pay a certain amount will be included in the beneficiary's income as well as income that must be paid out by a support trust for the support of the beneficiary. However, if the trust is irrevocable, then only those funds that are available to the beneficiary will be included in the beneficiary's assets, unless it is a testamentary trust created by the spouse's will or if the trust was created for a disabled person and the trust document specifies that the government will be paid for all unreimbursed medical expenses after the beneficiary dies.

Because the government is providing basic support for the individual, spendthrift clauses in discretionary trusts do not apply, and so could demand payment from the trust to the same extent that the beneficiary could. However, there is an exception for a supplemental needs trust that exists to provide support for medical services that the government does not cover.