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. Spendthrift provisions may be effected by any of the following methods:
- prohibiting the beneficiary from transferring his interest
- limiting distributions of income or principal for the support of the beneficiary, or even paying such support directly to the providers of that support instead of to the beneficiary himself
- forfeiting the beneficiary's interest if an attempt is made to transfer that interest
- subjecting distributions to the trustee's discretion; or
- prohibiting creditors from attaching the beneficiaries interest.
Some states prevent a creditor from attaching trust property at all, but some states restrict spendthrift provisions by:
- prohibiting or nullifying spendthrift restrictions by law, or
- allowing creditors to attach any interest not needed for support or above a certain dollar amount
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.
There are also trusts that provide support for children or adults with special needs. These trusts are usually set up to supplement means-tested government assistance programs, such as supplemental Social Security. More information about these trusts in provided in Special Needs Trust.
Domestic 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, have allowed domestic asset protection trusts (DAPTs, aka self-settled asset protection trusts) as a means of attracting money to their jurisdictions.
The advantage of Alaskan trusts is that assets are protected from all creditors, if the assets were not fraudulently conveyed. By contrast, Delaware does not protect against claims from divorced spouses. Other states that have DAPT laws include: Nevada, Oklahoma, Rhode Island, and Tennessee.
For the DAPT to be effective, the grantor should be a resident of a DAPT state; otherwise, the state in which the trust is located may, under the U.S. Constitution, have to recognize a court judgment from another state.
Self-settled trusts in the United States have some general requirements:
- 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.
Some DAPT states treat distributions to a DAPT as a completed gift, so the distribution is removed from grantor's estate. However, if the unified tax credit is used to exclude the gift to the trust, then any subsequent distributions to the grantor will be included in the estate, thus wasting the portion of the unified tax credit used offset the gift tax.
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 DAPTs have not been extensively tested against legal challenges, so it is questionable how effective they will be.
Foreign Asset Protection Trusts
A foreign trust can also be an effective means of protecting assets. Years ago, the wealthy hid much of their wealth in foreign accounts, such as Swiss bank accounts. Nowadays, United States (US) law requires that US citizens report any ownership interest in a foreign entity, if the value of the interest exceeds $50,000 by year-end or $75,000 at any time during the year. Foreign interests are reported on Form 8938, Statement of Specified Foreign Financial Assets and filed with the tax return. The tax penalty for failing to report foreign interests is steep: A $10,000 fine plus $10,000 for each additional 30 days of nondisclosure. Additionally, criminal penalties may also be assessed. A taxpayer who has a financial interest or signature authority over a foreign bank account whose value exceeds $10,000 during any time of the year must file FinCEN Form 114, Report of Foreign Bank and Financial Account, also known as an FBAR. The penalty for not filing an FBAR is particularly steep: the greater of $100,000 or 50% of the account value; even imprisonment is possible. Form 8938 may also have to be filed.
Not only must foreign assets be reported, but also there is generally no protection from attachment by courts to satisfy judgments, since most countries of the world, including Switzerland, honor US court judgments. Assets can be protected, at least to some extent, if they are held in foreign trusts located in countries that do not recognize US court jurisdiction, notably the Cayman Islands, the Cook Islands, the Isle of Man, and Nevis. Generally, these asset havens do not assess income taxes on foreign accounts and they also protect the privacy of trust beneficiaries. However, US citizens will still have to pay taxes on any income earned from those assets, assuming that they report those assets as required under US tax law.
To protect assets from creditors, the trust must be irrevocable and discretionary, and the grantor cannot serve as trustee: otherwise, the court can compel the grantor to make distributions to creditors. Usually, the trustee is a resident of the foreign country where the trust is located. Even though the grantor does not serve as trustee, the grantor will still desire some measure of control, to change situs or to remove the trustee. Thus, most of these offshore trusts also have a trust protector that is separate from the trustee, who can replace the trustee or effect other changes to the trust.
A major drawback to foreign trusts is the legal and administrative expenses for setting up and managing the trust. Additionally, there is no guarantee that creditors will not be able to attach the assets, since a judge may hold the grantor in contempt of court. Although the grantor, per the trust document, cannot compel distribution, it can be argued that the grantor did set up the trust to avoid being compelled by a court to distribute funds to a creditor.