Discretionary Trusts: The Fault-line in Administration

Take-Away: While a wholly discretionary trust in Michigan provides excellent creditor protection, much of that protection can be lost in how the trust is administered. Setting the discretionary trust on ‘cruise-control’ is an invitation to a court to find that the beneficiary possesses certain rights in the trust.

Background: We have covered at length in several prior missives how strong Michigan’s law is to protect a discretionary trust from the beneficiary’s creditor claims. [MCL 700.7103(d).]

Statutory Creditor Protection: The creditor of the beneficiary of a discretionary trust does not have a right to any amount of trust income or principal that may be distributed only in the exercise of the trustee’s discretion. As a result, trust property is not subject to the enforcement of a judgment against the trust beneficiary until income or principal, or both, is distributed directly to the trust beneficiary. [MCL 700.7505.]
No Exception Creditors: Unlike a support trust, or a spendthrift trust under the Michigan Trust Code, no ‘exception creditors’, e.g. federal or state governments, spousal support awards, etc., may reach the assets held in a discretionary [See MCL 700.7504 where ‘exception creditors’ are defined.]
Not a Property Interest: The key to this protection against a beneficiary’s creditor claims is that the beneficiary of a discretionary trust has no property right in a trust interest that is subject to a discretionary trust provisions. [MCL 700.7815(1).]
Enforcement of Discretionary Trust: An action can be brought against the trustee of a discretionary trust only if the trustee does any of the following: (i) acts dishonestly; (ii) acts with improper motive, even though an honest motive; or (iii) fails to exercise the trustee’s judgment in accordance with the terms and purpose of the trust. [MCL 700.7815(1).]

As a result of these Michigan Trust Code provisions, the property held in a discretionary trust are extremely well protected from the beneficiary’s creditors. A couple of Michigan court decisions confirm the protection of a discretionary trust’s assets from the beneficiary’s creditor claims: In re Antonia Gualtieri Living Trust, Michigan Court of Appeals, No. 341816 (March 19, 2019;) In re John Gordon Trust, Michigan Court of Appeals, No. 308008 (June 25, 2013).

However, there is one outlier decision, where the Michigan Court of Appeals found that even if the trust was a discretionary trust, the Michigan Department of Treasury could nonetheless reach the trust’s assets since the beneficiary possessed an ‘indefeasible vested interest in the trust’ i.e. the beneficiary was destined in the future to ultimately receive the trust’s assets (assuming he lived until the date of that distribution event.) In re Darrell V. Wright Trust Agreement, Michigan Court of Appeals, Nos. 319832, 319834 (March 17, 2015.)

Trust Administration Might Make a Discretionary Trust Vulnerable: The trustee of a discretionary trust can still screw up creditor protection otherwise provided by the Michigan Trust Code.

Example: On their death Homer and Marge created an irrevocable wholly discretionary trust for the benefit of their son Bart., a well-known spendthrift. Homer and Marge’s daughter Lisa is named as trustee. Bart and Lisa meet to discuss Bart’s financial needs. They agree that Lisa will distribute to Bart $5,000 a month from the trust. Lisa would prefer to not have much involvement with Bart, so she conveniently decides to continue that distribution arrangement each year. That monthly amount is distributed to Bart for the next five years; each month Bart receives a $5,000 distribution from his parents’ trust, like clockwork. While the trust reads like a discretionary trust, the trust functions more like it is on auto-pilot when Lisa pays the same amount to Bart each month without consideration of his needs, or for that matter, Lisa’s duty of impartiality to the remainder beneficiaries of the trust. Were Lisa to suddenly stop all distributions to Bart, it is not hard to imagine that Bart would have a strong claim against Lisa in the probate court for breach of her fiduciary duty. The pattern of $5,000 a month trust distributions creates some type of enforceable right that Bart might seek to enforce, a right that Bart’s creditors may also wish to exploit.
Enforceable Rights: If the beneficiary of a discretionary trust possesses enforceable rights, then those enforceable rights against the fiduciary may be viewed as sufficient to permit the trust beneficiary’s creditors access to the assets held in the trust. This is especially the case when dealing with the IRS, where property rights may be found in a discretionary trust if the delinquent taxpayer-beneficiary had enforceable rights against the trustee. Magavern v. United States, 550 F2d 797 (2d Cir 1977.) Note, that this was the same result in the In re Darrell V. Wright Trust Agreement, decision referred to above, where the Michigan Department of Treasury was permitted to access a discretionary trust’s assets.
Pattern of Payments: Even if the trust is on its face a discretionary trust, if there is a history of payments or distributions from the trust that establish a pattern that supports an implied right to payment, i.e. a tacit agreement to make distributions resulting in an ‘entitlement’, the that pattern could create an enforceable right to compel a distribution, which the trust beneficiary’s creditors would then seek to exploit. This was the position taken by the IRS in Private Letter Ruling 9024076. Such a pattern of distributions was also the basis for taking a beneficiary’s interest in a discretionary trust into account in a New Jersey divorce where the trial judge was directed to consider the historical record of payments made to the beneficiary-spouse from the discretionary Tannen v Tannen, 416 NJ Super 248; 3 Ad3 1129, aff’d 208 NJ 409, 31 A3d 621 (2011.)

Protecting the Discretionary Trust: Some steps to take to better protect a discretionary trust from the beneficiary’s creditors might include the following:

Actually Use Discretion: This is the most obvious solution. A discretionary trust means just that, that the trustee exercises discretion and documents how that discretion was applied to meet the needs to the trust beneficiary. Professional trustees are very good at documenting the exercise of discretion in making distributions; individual trustees, especially family members, are not good at all in creating a ‘paper trail’ that shows that discretion was actually exercised. This is where discretionary trusts can be most vulnerable to the beneficiary’s creditors.
Third Party Consent: If the trustee’s discretionary distributions are made contingent on the consent of another person, which consent is optional, that would better insulate the trust from creditor claims because more is involved than just the trustee’s exercise of discretion, but also the consent of a third party. [See Private Letter Ruling 200426027 where the optional consent of a third party caused the beneficiary to have no enforceable rights.]
Avoid Any Mandatory Language: Silly as it sounds, the trustee should be expressly authorized in the trust instrument to ‘possess the discretion to make no payments.’ The absence of the discretion to make no distributions may cause the trust to be treated as a support trust, which is accessible by ‘exception creditors.’ See, Magavern v. United States, supra, and United States v. Delano, 182 F. Supp. 2d 1020 (D. Colo. 2001.)
Avoid Establishing a Regular Pattern of Distributions: Since patterns of distributions can lead to enforceable rights, it would make sense, since we are dealing with a discretionary trust, for the trustee to actually manifest the exercise of its discretion. While there is always the temptation to ‘go with what works’, it is best for the trustee to demonstrate each year the exercise of its discretion, to vary the amounts distributed, and in some situations, actually exercise its discretion to not make any distribution from the trust to the trust beneficiary, even if that exposes trust income to higher federal income tax rates.

Conclusion: Michigan has very favorable laws that protect the assets held in a discretionary trust. To exploit those laws in the face of the trust beneficiary’s creditors requires that the trustee actually exercise discretion to make, or to not make distributions. The trustee needs to be vigilant to avoid falling into the easy trap of just doing this year what worked last year, year after year, which results in a pattern from which enforceable rights emanate.