Trust Beneficiary Liability – A Few Surprises

Take-Away: There has been considerable discussion recently about a trustee’s liability, especially with the adoption of Michigan’s directed and divided trustee statute, which are intended to shield a trustee from unwarranted liability. [MCL 700.7703a.] Far less attention is given to a beneficiary’s potential liability for debts of their trust or for their own actions with regard to the trust.

Background: In general, a trust beneficiary is not personally liable for the obligations that are incurred by the trustee in the course of the trust’s administration. Accordingly, a beneficiary is not liable for the trust’s debts to third-parties, nor is the beneficiary liable for contracts made by the trustee, or for torts committed by the trustee. [Restatement (Second) of Trusts, Sections, 275, 276, and 277 (1959) and Restatement (Third) of Trusts, Section 103 (2012).] If a third-party has a claim against the trustee based on the trustee’s ownership of trust property, the third-party is not entitled to enforce their claim against the trust beneficiary personally. Therefore, a beneficiary who receives a trust distribution is not liable for the debts and liabilities of the trustee. However, with every general rule, there are always exceptions.

Exceptions: The Restatement (Third) indicates that a trust beneficiary can be held personally liable for a trust’s obligations “as provided by other law, such as the law of contracts, torts, or unjust enrichment.” [Section 103.] Examples of this personal liability provided by the Restatement (Third) include situations where the beneficiary agrees to indemnify a third-party if the  trustee fails to perform, or where the beneficiary induces a third-party to do business with the trustee through fraudulent representations. [Comment c(2).] The Restatement (Third) also specifies that a beneficiary can be held liable to a third-party creditor based on the beneficiary’s liability to the trust itself, to the extent (i) of a loan or advance to the beneficiary from the trust; (ii) the beneficiary’s debt to the settlor that is held in the trust; (iii) the trust estate suffered a loss that results from a breach of trust in which the beneficiary participated; (or) (iv) liability is provided by “other laws, such as the law of contract, tort, or unjust enrichment.” [Section 104.] Situations where a trust beneficiary might become liable to the trust, or to the creditor of the trust, include the following:

1. The trustee acts as the beneficiary’s agent. If the trustee acts as agent, it can bind the beneficiary for trust liability. An example would be when the trustee holds the beneficiary’s durable power of attorney. [Restatement (Second) of Trusts, Section 274.]
2. The beneficiary is a joint tortfeasor with the trustee. If the beneficiary participates in a tort committed by the trustee, the beneficiary can be held liable for the trust’s debts arising from that tortious behavior. An example is where the beneficiary assists the trustee in the theft or the conversion of the property of another. [Restatement (Second) of Trusts, Section 276.]
3. The beneficiary participates in a breach of trust. A surprise to some, a trust beneficiary has a duty to the other beneficiaries of the same trust to not participate in a breach of trust, and is thus liable for such a breach, just as any non-beneficiary would be held liable. An example would be where the beneficiary induces the trustee to lend or distribute trust assets to the beneficiary or to another person contrary to the terms of the trust. [4 Scott & Ascher, Trusts, Sections 25.2 and 25.2.6. ; Bogert, Trusts and Trustees, Section 256.]
4. A tort is committed by the beneficiary. An example of this personal liability of the trust beneficiary is if he/she misappropriates trust property. [Restatement (Third) of Trusts, Section 104.]
5. The facts and circumstances indicate a situation where the beneficiary is unjustly enriched. An example of this is when the trust beneficiary receives a distribution of trust property to which the trust beneficiary is not entitled, regardless of whether the distribution resulted from a breach of trust or whether the beneficiary knew the distribution was improper, such as when a beneficiary receives an overpayment or receives a misdelivery of property. [Loring and Rounds, A Trustee’s Handbook, Section 5.6.]
6. The trust beneficiary participates in a voidable transfer or transaction. If the trustee makes a fraudulent transfer of trust property to avoid paying trust obligations, the beneficiary can be held liable to the trust. The Restatement (Second) of Trusts, Section 279, provides: “If a creditor is entitled by a proceeding in equity to reach trust property and apply it to the satisfaction of his claim, and the trustee conveys the trust property to the beneficiary before the claim has been paid, the creditor can by a proceeding in equity hold the beneficiary personally liable for the claim to the extent of the value of the trust property so conveyed, unless the beneficiary is a bona fide purchase or has so changed his position that it is inequitable to hold him personally liable. An example of this where the beneficiary was held personally liable and subject to the imposition of a constructive trust is Wendell Corp. Trustee v Thurston, 680 A.2d 1314 (Conn. S.Ct. 1996) where the trust was depleted with distributions to the trust beneficiary, leaving the trust with only illiquid promissory notes that could not be used to satisfy a preexisting debt owed by the trust. The trust beneficiary was compelled to satisfy the trust’s debt, reasoning that the beneficiary had received the assets from which that debt could have been repaid by the trustee.

What about the trust’s spendthrift provision? Would such a clause not protect the beneficiary’s interest in the trust from creditor claims? About a year ago a short summary was provided about a recent Oregon court decision where the trustee-beneficiary was found liable for breach of trust. The trustee, and also the primary lifetime beneficiary (it appeared to be a fairly conventional credit shelter trust), was a surviving spouse who invested  excessive amounts in her son’s (from a prior marriage) California winery, and who made excessive distributions to herself contrary to the terms (or limitations) of the trust. The trust’s remainder beneficiaries, the late-husband’s children from a prior marriage, not surprisingly successfully challenged their step-mother’s abuse of the trust and filed a petition to surcharge and have her removed as trustee. When it came to collecting the surcharge against the former trustee-beneficiary, she raised the interesting argument that because the trust contained a spendthrift provision, the surcharge amount to ,could not be taken from the trust, i.e. her right to annual principal distributions would be diverted to satisfy the surcharge amount which the spendthrift clause was intended to protect.  The court had no problem finding that the widow’s distribution rights under the trust could be diverted under equitable principles to prevent her from being unjustly enriched, and thus a constructive trust was an appropriate remedy notwithstanding the presence of the trust’s spendthrift provision.

Conclusion: Admittedly the occasions where a trust beneficiary might be held liable for the debts of a trust are rare. It would seem, however, that such exposure would be more likely to occur in situations where an individual who is unfamiliar with fiduciary duties acts as the trustee. This is just one more reason when a professional trustee that is familiar with the duties and responsibilities of a fiduciary can provide even greater protection to trust beneficiaries.