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George F. Bearup, J.D. Senior Legal Trust Advisor

19-Sep-17

Spendthrift Trust Primer

Take-Away: A spendthrift trust is the foundation for most asset protection planning strategies, including Michigan’s new Qualified Dispositions in Trust Act, aka Michigan’s asset protection trust. But there are both legal and practical limits on the scope of protection afforded by a trust’s spendthrift provision.

Background:

  • Legality: The Michigan Trust Code makes it clear that a spendthrift provision is valid and enforceable in Michigan. MCL 700.7502(1).
  • Definition: The short definition of a spendthrift provision is that it is a term of a trust that restrains either the voluntary or involuntary transfers of a beneficiary’s interest in a trust. MCL 700.7103(j)
  • The Trust Code provides a second  definition of a spendthrift provision as one where the interest of a trust beneficiary which is subject to a spendthrift trust or words of similar import, restrains both the voluntary and the involuntary transfer of the trust beneficiary’s interest. MCL 700.7502(2). An attempted voluntary transfer would be where the trust beneficiary who is entitled to receive all trust income tries to sell that right to receive trust income in exchange for a lump sum payment of cash. An involuntary transfer is when a judgment creditor attempts to attach and force a judicial sale of the beneficiary’s income interest in the trust, i.e. to raise cash to satisfy the judgment creditor.
  • Principal and Income: Unlike Michigan’s common law and the Restatement (Second) of Trusts, Sections 152 and 153, the Michigan Trust Code does not distinguish between a spendthrift provision applied to income as opposed to principal. Consequently, the spendthrift prohibition is presumed to apply to both income and principal interests a trust beneficiary may hold in the trust.
  • Pay for the Benefit: In general, with a few exceptions noted below, the trust beneficiary’s interest in the trust may not be transferred in violation of the valid spendthrift provision. Any trust property held in a spendthrift trust is not subject to enforcement of a judgment until the property is actually distributed from the trust directly to the trust beneficiary. MCL 700.7502(3). Once the property is out of the trust and in the hands of the trust beneficiary, then it is ‘fair game.’ This is where the discretion conferred on the trustee to ‘pay to or for the benefit of the beneficiary’ comes into play and is so important if there are creditors lurking awaiting trust distributions to the beneficiary. The trustee can make distributions not to the trust beneficiary, but in payment of some of the trust beneficiary’s on-going financial obligations, e.g. the trustee directly pays the beneficiary’s monthly mortgage payment, and not violate the spendthrift prohibition.
  • Beneficiary’s Request: A trustee will not be liable to the beneficiary of a spendthrift trust for making a distribution to which the trust beneficiary is otherwise entitled to receive pursuant to the direction of the trust beneficiary. MCL 700.7502(4). Thus, a spendthrift provision will not be violated if the trustee follows the direction of the trust beneficiary to make a payment to which the trust beneficiary is entitled under the terms of the trust directly to a third party. In short, the beneficiary’s direction to make a distribution to a third party will not be viewed as an assignment of the interest by the beneficiary or a transfer of the beneficiary’s interest contrary to the prohibition of the spendthrift provision.

Exceptions: As noted, there are some exceptions to the general spendthrift protection afforded to a trust beneficiary.

  • Exception Creditors: The Trust Code identifies a handful of creditors of the trust beneficiary who may still reach assets in the trust to satisfy an enforceable claim against the trust beneficiary. Those exception creditors are the following: (i) a trust beneficiary’s child or former spouse who has a judgment or court order against the trust beneficiary for support or maintenance [note: the statute says former spouse so arguably a spouse who is awarded interim spousal support during the pendency of a divorce action cannot access the assets held in the trust;] (ii) a judgment creditor who has provided services that enhance, preserve, or protect the trust beneficiary’s interest in the trust [note: this exception is not fully defined as to what services are considered to preserve or protect the beneficiary’s interests, although arguably at a minimum it would include the trustee’s fees;] and (iii) the State of Michigan or the United States. MCL 700.7504 (1)
  • Exceptions to the Exception Creditors: While the claims held by an exception creditor normally cannot be thwarted by a spendthrift clause, there are two notable exceptions to the exception creditors. First, if the trust that contains the spendthrift trust is classified as a discretionary trust as defined in MCL 700.7103(d) then the exception creditor cannot proceed against the trust assets at all. MCL 700.7504(3) and MCL 700.7505. Second, the exception creditors can only be paid from the trust as the distributions of income or principal become due under the trust instrument. MCL 700.7504(2). Consequently, the exception creditor cannot force an acceleration of distributions from the trust to the beneficiary in order to satisfy their  judgment or a court order. [From practical experience over the years I am pretty sure that most divorce judges do not understand this distinction when they threaten to hold trust beneficiaries, and even some trustees, in contempt of court for not accelerating distributions from a trust.]
  • Self-Settled Trusts: Generally a person cannot create a trust for their own benefit, insert a spendthrift clause in that trust, and then claim that the person’s creditors cannot access the trust assets to satisfy their claims. MCL 700.7506 (1) (a). That statute codifies the general common law rule, as most recently recognized by the US Bankruptcy Court. Kohut v Lewiston Living Trust, 532 BR 36 ( Bankr ED Mich 2015) that a settlor cannot create their own spendthrift trust.  But now we have the Michigan Qualified Dispositions in Trust Act, which clearly authorizes a self-settled trust with spendthrift protective provisions, so long as all the formalities of that Act are followed.
  • Overdue Distributions: The final exception is not really so much an exception to the rule, but rather a practical solution to how a creditor’s claim might be circumvented with the aid of the trustee. If the trust beneficiary possesses the absolute right to receive a distribution from the trust, the creditor of the trust beneficiary cannot be thwarted by the trustee unreasonably delaying the mandatory distribution from when it becomes due. MCL 700.7507(1). Mandatory distribution is defined to mean a distribution of income or principal that the trustee is required to make to a trust beneficiary, including a distribution on the termination of a trust. But a mandatory distribution does not include a distribution that is subject to the exercise of the trustee’s discretion. MCL 700.7507(2).

Practical Implications of A Spendthrift Clause

  • Beneficiary’s Interest: The obvious import of the spendthrift clause placed in a trust instrument is to protect the beneficiary’s interest in the trust from being taken by a creditor. But, as noted, there are some exception creditors whose claims cannot be deterred by a spendthrift clause. If absolute protection for the trust beneficiary is the goal, then it is  better to use a discretionary trust instead of a ascertainable standard trust coupled with a protective spendthrift clause.
  • Trust Modification or Termination: When Michigan adopted its version of the Uniform Trust Code in 2010 it deliberately decided, with a handful of other states,  to not adopt an optional provision in the UTC 411(c) that stated that a spendthrift clause was not a material purpose of the trust. Instead, Michigan left that optional statement out of its version of Section 411 [see MCL 700.7411.] The import of that ‘silence’ is that a spendthrift clause in a Michigan trust will presumably be considered to be a material purpose of the trust that is established. Consequently, if a trust instrument contains a spendthrift provision, it may be more difficult to terminate or modify the trust instrument under Michigan’s Trust Code. The Code provision that permits a trust modification or termination contains the limitation ‘if the court concludes that the modification or termination of the trust is consistent with the material purposes of the trust or that continuance of the trust is not necessary to achieve any material purpose of the trust.’ MCL 700.411(1)(a). While estate planning attorneys normally include a spendthrift clause as part of a trust’s ‘boilerplate’ provisions, it is a good idea to formally ask their client just how important it is to include a spendthrift clause in the final document. Or, a spendthrift clause could be modified to indicate that while the settlor has included the spendthrift provision in the trust to protect the trust beneficiary’s interest from creditor claims, the provision should not be viewed as so material so as to prohibit any future modification to the trust that would otherwise be permitted under the Michigan Trust Code.
  • Michigan Courts: A fair reading of some Court of Appeals decisions issued in recent years suggests that the judges often will continue to look at Michigan’s common law on spendthrift trusts, and not pay much attention to the provisions of Michigan’s Trust Code that directly deal with the rights of third parties to pursue claims against the trust assets when a judgment exists against the trust beneficiary. See  Wright v Department of Treasury, nos 319832, 319834, 2015 Mich App LEXIS 543 (Mar 17, 2015)(unpublished).
  • Change in Situs: This is a summary of Michigan’s spendthrift laws. If the situs of the trust is changed to a different jurisdiction it would be wise to identify that other jurisdiction’s spendthrift laws, since there is a good chance that they will not be the same as Michigan’s, especially when it comes to identifying exception creditors in other jurisdictions, many of which permit divorce property settlements to be satisfied from spendthrift trusts, or which permit victims of tort claims, e.g. auto accidents, to recover judgments from spendthrift trusts.
  • Defending Spendthrift Clauses: Most spendthrift clauses tend to state the obvious, which is that the trust beneficiary may not assign or transfer their interest in the trust to third parties. Fewer trust spendthrift clauses address the right (or responsibility) of the trustee to formally defend the trust from creditor claims, including hiring attorneys and initiating court proceedings to assert the protection afforded by the spendthrift clause. When you  review a trust instrument on behalf of a client and you encounter a the spendthrift clause, you need to confirm if it is written in a way where the trustee is given the authority to defend the trust and its spendthrift provision at the expense of the trust (or at the expense of the trust share that is established for the beneficiary whose creditors, or spouse, is causing the legal expenses.)