The Sole Trustee-Beneficiary: Proceed with Caution

Take-Away Message: When clients name a child as the sole trustee of an irrevocable trust for that child’s benefit, there is a risk that creditors will be able to claim the trust assets, even if the trust contains an ascertainable standard for distributions and a spendthrift or anti-alienation clause.

Background Assumption: We often encounter irrevocable trusts established for beneficiaries who become the sole trustee over the trust for which they are the current beneficiary, e.g. a credit shelter trust for the surviving spouse; a QTIP trust for a spouse; or a continuing trust for a child after their parent’s death. Sometimes the motivation to use a trust is to protect the assets from the beneficiary’s creditors. The assumption is that if the trustee-beneficiary’s ability to make distributions is limited by an ascertainable standard, e.g. for their own “health, education, maintenance and support,” the trustee-beneficiary will not encounter any problems. This is generally true when it comes to excluding the trust’s assets from inclusion in the trustee-beneficiary’s taxable estate. IRC 2041. Conversely, if the trustee-beneficiary holds unlimited discretion to distribute assets to themselves without any ascertainable standard, that discretion would be classified as a general power of appointment, thus causing estate tax inclusion of the trust’s assets in determining the trustee-beneficiary’s estate tax liability. Reg. 20.2041-1(c)(2). Consequently, the insertion of an ascertainable standard is often viewed as a shield that protects the trust’s assets from threats the trustee-beneficiary faces. Far less clear however is whether the same assets held by the trustee-beneficiary which are subject to an ascertainable distribution standard will be protected from the beneficiary’s creditors. The belief among many is if the trust contains a spendthrift clause the trustee-beneficiary’s creditors will not be able to access the trust’s assets. Then again, maybe not.

Spendthrift Clauses: A spendthrift clause added to a trust is important, especially for bankruptcy purposes. If there is no spendthrift clause, the US Bankruptcy Code permits a bankruptcy trustee to access the debtor’s beneficial interest in the irrevocable trust. [Bankruptcy Code Sections 56 and 501]. For example, where a trust established for the settlor’s daughter did not contain a spendthrift clause, the daughter/beneficiary’s right to receive $600 a month income was included in her bankruptcy estate. In re Demoe, 365 BR 124 (2007). But almost all irrevocable trusts contain a spendthrift clause of some type; even the simplest spendthrift clause should be able to protect most trust beneficial interests from creditor claims in state court or in bankruptcy court, except for self-settled trusts.

But some states, like California or New York, have statues that permit a specific amount of trust distributions to be garnished by the beneficiary’s creditors, e.g. 25%, unless needed for the beneficiary’s support, despite the existence of a spendthrift clause in the trust. Consequently, in those states, a portion of the trust assets may still be taken by a judgment creditor, or included in the beneficiary’s bankruptcy estate, despite the presence of a protective spendthrift clause in the trust.

Spendthrift Exception: Dominion and Control: The big surprise to many is that the mere existence of a spendthrift or anti-alienation clause in a trust may not, standing by itself, qualify the trust to be treated as a spendthrift trust which is otherwise excluded from the beneficiary’s bankruptcy or judgment creditor claims. Practically speaking, a bankruptcy court can go beyond basic state spendthrift law to look at other provisions of the trust that might mitigate against the finding that a spendthrift trust was intended by the settlor (and thus excluded from the beneficiary’s bankruptcy estate.) Several bankruptcy courts have held that even if the trust instrument contains a spendthrift provision, the trust will not be treated as a spendthrift trust for federal bankruptcy law purposes if: (i) the beneficiary has dominion and control over the trust; (ii) the beneficiary may revoke the trust; or (iii) the beneficiary has powers over the trust. It is the existence of these powers, rather than the actual exercise of the powers, that will deny spendthrift status to the trust. In short, the bankruptcy trustee ‘stands in the shoes’ of the trust beneficiary to determine if the beneficiary has dominion and/or control over the trust’s assets or the power to remove the spendthrift limitation.

One surprise was when the power conferred on the trust beneficiary to fire and replace the independent corporate trustee with another independent corporate trustee was found by one bankruptcy court to be sufficient to constitute the beneficiary’s dominion and control over the entire trust [admittedly the court had to stretch long and hard to find this result which was premised on the fact that the corporate trustee held broad discretionary provisions, from which the court concluded that the beneficiary would, through the exercise of this power, indirectly have unfettered control over the trust corpus.] Scott v. Bank One Trust Co. (1992). This might be one of those ‘bad facts make bad law’ but it is out there as one basis on which to attack the validity of a spendthrift trust.
In yet another bankruptcy case, the court ignored the presence of a spendthrift limitation when it looked at the facts as to how the trust was actually administered (or more accurately not independently administered by the other co-trustee) and concluded: “the original trust should not be examined in a vacuum, but must be looked at together with the conduct of the debtor (beneficiary) which discloses blatant and unfettered dominion and control over the trust assets.” In re McCullough (2007) This was one of those cases where the co-trustee was simply along for the ride in name only.
In yet another bankruptcy decision the court announced: “In bankruptcy proceedings, the debtor’s degree of control over the spendthrift trust is often the primary consideration in determining its validity. It is clear that if the beneficiary has absolute and sole discretion to compel distribution of the trust assets, the spendthrift provision must fail” (noting that the sole trustee and the sole beneficiary cannot be one and the same and enjoy the protection of a spendthrift clause.) Govaert v Strehlow (1988).
Yet another example is a 2007 Florida bankruptcy decision. There a mother died and left her estate in trust for the benefit of her son. The son was co-trustee of the trust along with his sister. The son went to probate court and reformed the trust to remove the requirement that the trust had to use a co-trustee. The sister promptly resigned as co-trustee leaving the son as the sole acting trustee of his trust. The trust corpus was later included in the son’s bankruptcy estate and depleted to pay his creditors. The Court noted: “Upon her resignation, all legal and equitable title to the trust assets merged into one person, the debtor [beneficiary] pursuant to state law and spendthrift protection was lost….only in a situation where the debtor is the only trustee and the only beneficiary is spendthrift protection lost, and that is what occurred in this case. The [bankruptcy] trustee does not dispute that a trustee can be a beneficiary; the trustee simply posits that there is no spendthrift protection if the sole trustee and the sole beneficiary are one and the same. This Court agrees.” In re Scott (2007) The bankruptcy court could care less that the trustee-beneficiary was restricted by an ascertainable standard in making distributions to himself and it seemed to ignore the existence of any remainder beneficiaries of the trust in expressing it reliance on the merger of interests doctrine.

In sum, if a bankruptcy court encounters an irrevocable trust with a lack of administrative compliance by the independent trustee, or the trustee-beneficiary skirts the distribution limitations otherwise imposed by the instrument, the spendthrift limitation will be ignored and the beneficiary’s trust interest will be available to the bankruptcy trustee to pay the beneficiary’s creditors.

Other Risks: Consider how modern trusts are now drafted, where a trustee may be given the power to modify the trust through a non-judicial agreement, the unilateral power to terminate an uneconomical trust, or the statutory power to decant the trust, aka amend the trust, i.e.. a trustee-beneficiary could decant the trust to remove a spendthrift clause. The Uniform Trust Decanting Act only mentions a spendthrift clause in passing as not preventing a power held by the trustee to decant the trust and that uniform law permits a trustee-beneficiary to remove a spendthrift clause in their trust (see comments to Section 11). Yet another example of where the power to eliminate a spendthrift clause would be in a customary trust boilerplate provision that permits the trustee to consolidate the trust’s assets with a similar trust (perhaps another trust created by the beneficiary for his own benefit, but one that does not contain a spendthrift provision.) As noted above, the ability of a bankruptcy court to access the irrevocable trust’s assets turns on the existence of the power of the beneficiary, not whether that power was actually exercised by the beneficiary. If the bankruptcy trustee can ‘stand in the shoes’ of the trustee-beneficiary and eliminate a spendthrift clause in the trust, then there is little standing in the way between the bankruptcy trustee and the trust’s assets, ascertainable distribution standard or not.

Possible Solutions:

The obvious solution is to not use a sole trustee-beneficiary if creditor protection is one of the purposes for the settlor’s use of a trust.
Naming a co-trustee to act with the trustee-beneficiary can still pose some risk, especially if that co-trustee exhibits little knowledge of the trust or demonstrates little or no control over the trust’s assets. If the use of a co-trustee is viewed as one way to mitigate this risk of exposing the trust’s assets to the beneficiary’s creditors, then the best solution would be to name an independent professional trustee, even if the co-trustee-beneficiary possesses the right to remove and replace the professional trustee. Courts seem to give considerable credence to the ‘gate-keeper’ role that the professional trustee often plays in the administration of a trust.
The next best solution if a sole-trustee-beneficiary is to be used is to limit many of the powers that are ordinarily conferred on the trustee in order to preserve the spendthrift clause and its intended protection. Such a trust provision might read: Notwithstanding any other provision of this Trust to the contrary, if the beneficiary of this trust also serves as the sole trustee of this Trust, then the trustee-beneficiary shall not possess any power or authority, directly or indirectly, to unilaterally remove their own spendthrift restriction, to terminate their trust or its spendthrift limitation via a trustee’s power to decant, a nonjudicial settlement agreement, a consolidation of trusts, or through any statutory authority to terminate an uneconomical trust.
The trust instrument should not mandate a reasonable trustee fee to be paid to the trustee-beneficiary. If such a provision exists in the trust instrument, the IRS might impute taxable income to the trustee-beneficiary under the constructive receipt rules, or if a trustee fee is not taken , the IRS might impute a taxable gift by the trustee-beneficiary to the remainder beneficiaries of the trust. Moreover, if the right to take a trustee fee exists, then that right to take a current fee could be claimed as part of the trustee-beneficiary’s bankruptcy estate, or become available to satisfy part of a creditor’s judgment. It would be best to indicate in the trust instrument that the trustee-beneficiary serves without a fiduciary fee unless the remainder beneficiary’s agree to that fee in writing.

Conclusion: The use of an ascertainable standard will keep a trust’s assets from being included in the trustee-beneficiary’s taxable estate, but it will not protect the trust from the trustee-beneficiary’s creditors. Creditor protection is gained by including a spendthrift clause in the trust. But even then bankruptcy courts will ignore the existence of a spendthrift clause in the trust if the trustee-beneficiary exercises too much dominion and control over the trust (a facts and circumstances analysis of which no one can predict the outcome) or if the trustee-beneficiary possesses other powers, directly or indirectly, to remove the spendthrift clause from the trust. This one of those occasions where if a client expresses the intent to use their child as the sole trustee-beneficiary of the trust for that child’s lifetime benefit, they need to be cautioned that the trust’s assets may not be protected from the child’s creditors or in a future bankruptcy.