Asset Protection Trust Update: Good News, But Also New Arguments

A few months back I wrote a summary about an infamous New Jersey divorce case that was getting a lot of publicity, Phanenstihl where the divorce court ordered the trustee of a third-party support trust to pay to the beneficiary’s soon-to-be ex-wife 50% of the value of the trust corpus, in spite of the presence of a spendthrift clause and also in spite of the discretion conferred on the independent trustee to make income or principal distributions to the beneficiary husband. The Supreme Court of New Jersey reversed that decision this past August finding that the beneficiary did not possess a property interest in the trust that could be awarded to the beneficiary’s spouse, and also mentioning as part of its reasoning that the beneficiary’s interest in the discretionary trust was incapable of being accurately valued for divorce division purposes. This appellate reversal is obviously a ‘win’ for those settlors who create irrevocable trusts for their children and grandchildren with the intent to provide creditor protection for those beneficiaries.

But then there is a recent trial court decision, In Re Matter of Daniel Kloiber Dynasty Trust, u/d/d 12020-2002, 2014 WL 3934309 which again acts as a reminder that irrevocable trusts are not ironclad when the trust beneficiary is in the middle of a divorce. The facts of Kloiber are complicated but a short summary will give you enough of a picture: Father creates an irrevocable Delaware dynasty trust for benefit of son, a resident of Tennessee [Delaware having favorable dynasty-type trust laws]. Relatively speaking, a nominal amount (thousands) is used by Father to fund the dynasty trust for Son’s benefit. Son later sells his start-up IT company stock to this dynasty trust in exchange for a $6.0 million Note. Two years later, the Trustee sells the start-up company stock it now holds for $240 million [yes, the stock that was sold to the Trust for $6.0 million only two years later is sold by the Trustee for $240 million. That fact alone would trigger anyone’s ‘smell test!’] Son now finds himself in a divorce now in a divorce, no doubt claiming the only marital asset is a $6.0 million promissory Note, all of which obviously explains why the divorce was hotly contested.

The co-trustees [son being the denoted investment trustee, with another acting as the distribution trustee] claim that there is a spendthrift clause that prohibits the divorce court from invading the trust corpus to satisfy creditor claims which would include wife, who Son claims is a creditor. The Co-trustees also claim that the dynasty trust is a discretionary trust and that Son has no discernible property interest in the trust. Wife responds: (i) the trust is a support trust, not a pure discretionary trust, and thus Son has a property interest that can be valued for purposes of identifying their marital estate; and (ii) wife is not actually a creditor of Son; rather she is a person to whom the trust beneficiary has a legal obligation to support under Tennessee law, so she is not a creditor per se under contract law, but a person who is entitled to be supported under state law.

The trial court never got to the point of rendering a decision in this divorce case where the spouses wrangled for several years asserting their respective positions. Instead, after years of battle [and no doubt thousands of legal fees], the husband and wife filed a settlement agreement with the trial court that will cause the third-party irrevocable dynasty trust created by husband’s father, with creditor protection features, to be severed into two parts, with the husband continuing as the beneficiary of one half of the trust corpus and his ex-wife being the beneficiary of the other one half.

While the wife was not a present or priority beneficiary of the dynasty trust, she is what the court called a floating spouse [a term I have never heard of before- I initially envisioned my wife snorkeling] where she is an eligible trust distributee if she is both (i) married to and (ii) cohabiting with, her named trust beneficiary husband. Apparently the litigating parties felt that the wife’s floating spouse role- while still married to her husband- maybe she lived with him for 24 hours?- warranted the trustee’s authority to divide the trust corpus into shares where the floating spouse becomes the lifetime beneficiary. The court’s file was sealed so many of these questions that come to mind as to how the parties legally reached this ‘split the baby’ solution remain a mystery.

Some unanswered questions and take-aways from the Kloiber case follow:

Questions:

Did the independent trustee have standing to participate in the divorce action? Did the dynasty trust formally confer standing on the independent trustee to intervene and participate in the Son’s divorce action in order to protect the trust?
Was the independent trustee empowered under the trust instrument to hire attorneys, using trust assets, to assert the independent trustee’s position in the divorce proceedings? If that provision existed, did the Son hire an attorney and use trust assets to defend the divorce, using his role as ‘co-trustee’ as a cloak.
Did the trust instrument’s ‘boilerplate’ provisions permit the independent trustee to sever the trust?
Did the independent trustee first obtain the approval of a probate court to sever the trust corpus before the parties then went to the divorce court to grant a settlement of the divorce premised upon the severance of the dynasty trust?
Did the trust instrument specify how long the floating spouse had to live with her husband, the beneficiary, in order to become eligible to receive a trust distribution, or could she meet that condition by returning to live with him for a mere 24 hours?

Take-aways:

If a settlor really wants to protect their trust’s assets from the beneficiary’s former spouse [whether viewed as a creditor or one who possesses a legal statutory right of support] it is best to use a purely discretionary trust and not a support trust. The Michigan Trust Code is pretty clear that the ‘transferee or creditor of a beneficiary of a discretionary trust provision’ has no right to any amount of trust income or principal until after it is distributed to the trust beneficiary. MCL 700.7505
Since divorce judges are pretty notorious for not following, or for that matter caring about, the fine distinctions of trust and fiduciary duty law, being limited only by what they conclude is a fair division of the marital estate, if the settlor’s goal is to insulate a trust beneficiary’s interest from future creditor claims, including former spouses, it would be wise in the ‘material purpose’ provisions of the trust instrument for the trust settlor to actually come out and say that the trust beneficiary possesses no property interest in the trust. This blunt statement is supported by MCL 700.7815(1) which clearly states: “A beneficiary of a discretionary trust provision as described in section 7505 has no property right in a trust interest that is subject to a discretionary trust provision, and has no right to any amount of trust income or principal that may be distributed only in the exercise of the trustee’s discretion.” Whether that clear statement of law will hold a heavy-handed divorce judge in check is another matter, but it would probably provide a strong appealable issue if the divorce judge simply chose to ignore the trust law as it is written.
Technically, if the trust is a discretionary trust then you do not even need the protection of a spendthrift clause. In contrast, if the trust is a support trust then it is wise to add a spendthrift provision. While the trust might be written in Michigan there is always a good chance that the trust beneficiary will be in another jurisdiction if the divorce occurs, and a divorce judge in another jurisdiction may try to impose that other state’s ‘public policy’ as a reason to not follow Michigan’s law that would normally govern the trust and its administration.
A trust’s spendthrift provision can be useful to deter creditor claims, but the Michigan Trust Code does exclude some creditors from the shield of a spendthrift prohibition. Claims of the trust beneficiary’s child or spouse, per a court order, for support are excepted. So are claims held by the state or federal government. MCL 700.7504(1) As a former divorce attorney, if I wanted to circumvent a trust’s spendthrift clause on behalf of the former spouse to assure collection remedies, I would provide in the divorce settlement documentation that the award to the non-beneficiary spouse in the divorce settlement was a ‘non-tax deductible alimony-in-gross’ award, so that the award to the former spouse is presented as a support award and thus it falls within the statutory exception to the spendthrift limitation.
If possible, the settlor should avoid naming the child-beneficiary as a co-trustee, even if their role is restricted to acting solely as an investment trustee and not a distribution trustee. Divorce judges tend to attach far more authority to the –co-trustee’s role even when the authority or responsibility is restricted solely to making trust investments. It might be better to simply give the child-beneficiary the right to remove and replace trustees, so long as the replacement trustees are neither controlled by nor subordinate to the beneficiary, and not put the child in the role of co-trustee.