Asset Protection Trusts – The Nominal Settlor Controls?

Take-Away: We normally think of self-settled asset protection trusts, like the Michigan Qualified Distributions in Trust Act, as the only way for a trust to protect assets that are transferred to it by a beneficiary. But we need to remember that there are other ways in which an irrevocable trust can be used to protect assets that the beneficiary transfers to it- by sale. But what may work to protect assets from creditors may not work if the goal is to remove the transferred asset from the transferor’s estate for estate tax calculation purposes.

Recent Case: A unique asset protection trust was discussed in a recent federal Bankruptcy Appellate Panel decision released on May 3, 2018. Church Joint Venture, L.P. v. Earl Benard Blasingame and the Blasingame Family Residence Generation Skipping Trust, Nos. 17-8009/8011, appeal from the United States Bankruptcy Court, for the Western District of Tennessee.

Facts: Blasingame owed $4.0 million to a bank secured by a mortgage against his home (and about 28 adjacent acres) and other assets owned by him. This was back in 1993. The bank announced its intent to foreclose on the home mortgage that it held. To prevent her son from losing his home, Mr. Blasingame’s mother directly paid the bank $490,000 in return for which the bank released its mortgage lien on the home. At the same time her son and his wife transferred the title to their home by warranty deed to a spendthrift trust that was simultaneously created by his mother. The son and his wife were named as co-trustees of the irrevocable trust. The son, his wife, and their children, were named as current trust beneficiaries and other named individuals were named as contingent trust beneficiaries. The trust’s duration was for as long as the rule against perpetuities allowed, i.e. 21 years after lives in being, such that it was intended to last for several generations. The trust instrument expressly provided that the home ‘shall be the residence’ for the son and his wife for their lifetimes. The trust instrument gave the right to four other individuals to reside in the home after the deaths of the son and his wife. Acting as co-trustees, the son and his wife at the same time gave to the son’s mother, the trust’s settlor, a promissory note in the face amount of $460,000. This promissory note was later forgiven by son’s mother in installments over several years. The son and his wife were still living in the home, owned by the trust, when they filed for Chapter 7 in bankruptcy in 2016.
Creditor’s Claim: A creditor sued the couple in the name of the bankruptcy trustee. The creditor claimed that the debtors’ interest in the home was actually a transferrable legal life estate, which would require the debtors to turn over their life estates in the home to the bankruptcy trustee so that the life estate interests could be liquidated and the net sales proceeds applied to pay their creditors. All parties agreed, however, that the title to the home was formally held in the name of the trust, where it had been for the past 2 decades.
Narrow Issue: Simply stated, the issue in dispute was whether the debtors held an equitable joint life estates in the real property, or joint legal life estates in the real property.
Court Decision: The appellate panel referred to several provisions in the trust instrument to find that the debtors held only an equitable (not legal) joint life estate in the home. What was stressed by the panel was that several provisions in the trust instrument ensured to the debtors and their children that they would have the right to live in the home and that they could not lose that right of occupancy. The panel focused on the presence of a spendthrift provision in the trust which the panel found ‘expressed the mother’s intent that the debtors not have a legal title which they could dispose of to their, or their children’s, detriment.’ Thus, the spendthrift clause was found to be the basis for the settlor’s intention that the debtors were not allowed to transfer, assign or encumber their interests in the real property- that the trust only granted to the debtors the right to do nothing other than reside in the trust’s principal residence. In addition the panel concluded that the debtors could not rent the real property to someone else, nor could they collect income from the real property. As a result, the panel found that the debtors had no obligation to turn over the title to the home they occupied, rent-free, to the bankruptcy trustee because the trust instrument only created an inalienable equitable (not legal) life estate for them, which the bankruptcy trustee could never use, sell or lease. Some relevant conclusions reached by the bankruptcy panel included the following:
Trusts are designed for the purpose of one person or entity holding the legal interest on behalf of another, the beneficiary. Accordingly, when interpreting a trust document, it will be assumed that the settlor intended to convey an ‘equitable’ interest unless otherwise clearly stated in the trust instrument.
The creditor argued that the trust was a ‘dry’ trust because it did not impose any affirmative duties on the co-trustees; the co-trusts merely held ‘passive’ title to the home and adjacent acreage. The panel rejected this argument, finding that the trust was ‘active’ in light of the multiple fiduciary duties imposed on the co-trustees to distribute and apply income and principal of the trust, or to hold and manage trust assets.
The panel found that while the debtors were both co-trustees and beneficiaries of the trust, their children were also beneficiaries along with the other named contingent beneficiaries. Consequently, the debtors, as co-trustees, had duties and obligations beyond merely holding legal title for their own benefit.

Observations:

Sale v. Gift?: The key fact that drove this panel’s decision was that the mother, not her son, was the settlor of the trust. But the facts surrounding how the title to the home got transferred into the trust were a bit confusing; while the mother was the named settlor of the trust, she did not purchase the home from her son and daughter-in-law and then transfer title to the home to the trust that she created. Rather, her son and daughter-in-law directly transferred title to the home directly to the trust of which they were trust beneficiaries (self-settled?), and then acting as co-trustees, they gave a promissory note to the mother for $460,000 [not the $490,000 amount that the mother had paid to the bank to release its mortgage lien from the real estate owned by the son and daughter-in-law.]
Revocable Trust: If the son (and his spouse) had been the settlor(s) of a revocable trust, the assets transferred to the trust would have become part of their Chapter 7 bankruptcy estate. If the trust had been revocable, no matter how long the title to the real estate had been held in the name of that revocable trust, the real estate would have been included in their bankruptcy estate. MCL 700.7506(1)(a) provided: During the lifetime of the settlor, the property of a revocable trust is subject to claims of the settlor’s creditors. See also In re Hertsberg Inter Vivos Trust, 457 Mich 439, 578 NW2d 289 (1998).
Irrevocable Trust: If the son had been the settlor of an irrevocable trust, the assets he transferred to that trust might have passed muster and would not be included in his bankruptcy estate. That is because if the trust had been created by him and title to his real estate transferred to the trust long enough in the past, it would not have been classified as a fraudulent or voidable transfer under the Michigan Voidable Transfer Act, where a transfer to a trust can be set aside if the transfer was made to hinder, delay or defraud creditors- too much time would have passed between the transfer of title to the trust and the time that transfer came into question.
Asset Protection Trust: At common law, a trust settlor in Michigan cannot create a self-settled spendthrift trust and avoid his/her creditors. See Kohut v. Lewiston Living Trust (In re Lewiston) 532 BR 36 (2015) where the bankruptcy court observed: “the Michigan Trust Code neither authorizes self-settled spendthrift trusts nor abrogates Michigan common law and public policy regarding self-settled spendthrift trusts.” That, of course, changed in 2016 with the Michigan Qualified Dispositions in Trust Act if the settlor is willing to comply with all of the Act’s specific requirements when forming the trust and the settlor adheres to the specified the ‘retained’ rights permitted by that Act. The Blasingame Family Residence Trust was obviously not a self-settled trust. But what assets did the settlor actually transfer to the trust? Was she the settlor in name only?
Transfer for Fair Value?: Not clear from the reported facts is how the title to the real property came to rest in the irrevocable trust in an arm’s-length transaction. The facts were treated by the panel as if the mother had purchased the home from her son and daughter-in-law for its fair value, and she then transferred the title by warranty deed to the co-trustees. But the actual steps involved did not support that conclusion.
Step #1: Recall that the mother directly paid-off the bank transferring to it $490,000, to induce the bank to release its mortgage lien against the home. [An indirect gift from mother to son and daughter-in-law because she directly paid their loan?]
Step #2: The son and his wife then transferred title by warranty deed to the home to themselves as co-trustees of the irrevocable trust that the son’s mother had created for their benefit. [A gratuitous transfer of title to a valuable asset by them? Under income tax rules, the son and daughter-in-law would be treated as grantors of the trust for income tax reporting purposes- they transferred assets to a trust of which they were beneficiaries with the right to use the real estate they just transferred.]
Step #3: The co-trustees did not then give the promissory note to the son and his wife as a sale/exchange for the title just received; rather, they gave a $460,000 promissory note directly to the son’s mother, who arguably transferred nothing into the trust in exchange for the note. [An indirect gift by the co-trustees to the mother, as no consideration was received from her by the trustees?] If the note had been given to son and his wife by the co-trustees, and they as the note holders then subsequently assigned the note to the son’s mother for her in repayment of the their mortgage obligation release she enabled, those steps would then have been much more in alignment with the outcome where the conclusion was that the mother transferred ‘her’ real property to ‘her’ irrevocable trust established for the benefit of ‘her’ son, daughter-n-law and his children, all in exchange for the promissory note- not a self-settled trust.

I wonder how forgiving other courts would be when they encountered facts based on what actually occurred. One other key point is that no one challenged the assumption that the $460,000 note given by the co-trustees was equal to the fair value of the home that was simultaneously transferred to the trust in 1993.

Conclusion: The bankruptcy panel treated the trust as being created and funded by the mother, not her son and daughter-n-law, even though the home that they lived in became one of the assets of the trust over which he and his wife were lifetime beneficiaries. As a result, the real property transferred to the trust was not included in the son’s bankruptcy estate, even though from a distance it looks very much like a self-settled trust that was created and funded by the trust beneficiaries. While not part of the son and his wife’s bankruptcy estate, upon the son and his wife’s deaths, it would not surprise me if their children nonetheless claimed that the value of the home should be included in their taxable estate for federal estate tax calculation purposes, in order to claim a basis adjustment under IRC 1014- since this was a transfer to an irrevocable trust under which the transferors retaining the enjoyment of the lifetime use of the transferred asset. The bankruptcy court panel seemed content to rely on the form of the transaction, meaning the sole fact that the mother was the named settlor of the irrevocable trust. We know only too well that the IRS is much more willing to apply a substance over form doctrine and it may have come up with an entirely different conclusion- that the son and daughter retained an interest in the real estate they transferred to an irrevocable trust.