Take-Away: At common law, any person who contributes assets to an irrevocable trust can be treated as a settlor of that trust. A self-settled trust can have its assets taken to satisfy the settlor’s creditor claims. The Michigan Trust Code provides a different definition of trust settlor, which helps to protect trust assets from a beneficiary’s creditor claims.

Background: Normally, when identifying the settlor of a trust, we look to the trust instrument itself to identify its settlor. Identifying the settlor is usually self-evident. Who is the settlor of a trust is important in order to determine, for both tax responsibility, as well as creditor rights if the trust is determined to be a self-settled trust, when creditors can pierce the trust and seize its assets. Importantly, the settlor of the trust, for self-settled trust purposes, can be yet another person who is not identified as the settlor, at least at common law.  

Common Law: The definition of settlor in Black’s Law Dictionary states that the settlor is the person who conveys property or contributes property to a trust. If a person, not identified as the trust’s settlor, transfers property to the irrevocable trust, that transferor will nonetheless be treated as a settlor of that trust. 3 Scott & Ascher, Trusts,  Section 15.4.4. Consequently, the transfer of property to an irrevocable trust can result in the transferor being treated as an ‘indirect’ settlor of the trust for tax and creditor rights purposes.

Examples where an individual not identified as the settlor might nonetheless be treated as the trust’s settlor include:

  • (i) Husband creates irrevocable trust for his wife and children; the trust is funded using a joint bank account that was held in the names of both husband and wife. The wife-beneficiary would be treated as a settlor of the trust at common law, and thus the trust would be classified as a self-settled trust, thus permitting the wife’s creditors to gain access to the irrevocable trust’s assets;
  • (ii) Assets that are transferred into the irrevocable trust by husband are classified as community property because the assets were acquired in a community property jurisdiction, e.g. California. The wife-beneficiary will be treated as a settlor who creates a self-settled trust for her own benefit, again giving her creditors access to the irrevocable trust’s assets;
  • (iii) Husband creates a spousal lifetime access trust (SLAT) for his wife; the wife-beneficiary dies and exercises a limited power of appointment over the SLAT naming husband as a continuing beneficiary of the SLAT. Husband will be treated as creating the SLAT-trust for his own benefit, which enables his creditors to access the SLAT’s assets;
  • (iv) A court orders the creation of an irrevocable trust to resolve a personal injury lawsuit for the disabled victim. The disabled individual for whose benefit the trust is created, and not the court, will be treated as the settlor of the court-created irrevocable trust;
  • (v) A 30-day crummey withdrawal power given to a lifetime trust beneficiary over contributions to an irrevocable trust. The beneficiary’s withdrawal right lapses. If the assets that are subject to that lapsing withdrawal right are less than 5% of the total corpus, the trust beneficiary who possesses the withdrawal right is not considered a settlor of the trust. However, if the assets subject to the withdrawal right-lapse are greater than 5% of the trust’s assets, that lapse above the 5% ceiling will result in the trust beneficiary being treated as having made a contribution to the trust and thus being treated as a settlor of that trust; and
  • (vi) Husband and wife each create identical SLATs for the other’s benefit. The IRS asserts the reciprocal trust doctrine and ‘uncrosses’ the two SLATs. Consequently, each spouse SLAT beneficiary is treated as the settlor of that trust.

Grantor Trust: An individual creates a grantor trust for income tax reporting purposes. The settlor retains the power to substitute assets of equivalent value to cause the trust to be treated as a grantor trust in order to achieve that income tax result. The trust instrument authorizes the trustee, from time to time, to reimburse the grantor for the income taxes paid. It is possible that in this situation the irrevocable grantor trust could be deemed self-settled for creditor access purposes,  if the trustee can reimburse the settlor’s payment of income taxes, i.e. it is claimed that the grantor-settlor retained a right to obtain assets held in the trust [which is why the trustee should NOT reimburse the settlor each time an income tax is imposed on the irrevocable grantor trust, where a prearrangement could be claimed by the settlor’s creditors.]

Restatements of Trust: The original Restatement of Trusts and the Second and Third versions of the Restatement define the settlor as “the person who creates the trust.” Neither definition requires that the settlor actually contribute property to the trust in order to be classified as its settlor. [Section 3 of each Restatement.]

Michigan Trust Code: The Michigan Trust Code defines a trust settlor as: “Settlor means a person, including a testator or a trustee, who creates a trust. If more than 1 person creates a trust, each person is a settlor of the portion of the trust property attributable to that person’s contribution. The lapse, release, or waiver of a power of appointment does not cause the holder of a power of appointment to be treated as a settlor of the trust.” [MCL 700.7103(i).] Thus, to the extent that at common law some situations might give rise to a self-settled trust by finding an indirect contribution of assets to a trust by its beneficiary, that is not the case under the Michigan Trust Code.

QTIP Trust: This limiting definition of a trust’s settlor also applies in Michigan with regard to a lifetime QTIP trust that continues for the benefit of its settlor, after the death of the beneficiary spouse. It is NOT treated as a self-settled trust. “An individual who creates a trust shall not be considered a settlor with regard to the individual’s retained beneficial interest in the trust that follows the termination of the individual’s spouse’s prior beneficial interest in the trust if all of the following apply (it is a QTIP trust under 26 UC 2523.) [MCL 700.7506(4).]

Conclusion: In order to avoid a third-party created trust being classified as a self-settled trust, an independent trustee can go a long way to protect the trust’s assets from a beneficiary’s creditors. It is also important to pay close attention to the source of assets used to fund the trust, e.g. do not use jointly held asset, or community property assets to fund the trust. Concerns at common law about powers of appointment and lapsing withdrawal rights appear to be addressed in the Michigan Trust Code’s formal definition of a trust settlor. Finally, third-party created trusts are often successfully attacked by a beneficiary’s creditors when the trust is not well administered or the trust’s assets are not segregated from either the beneficiary’s or the trustee’s separate assets, or the trust’s distributions are not followed.