Tuesday, February 24, 2015

Spendthrift Trusts

Here at Shenwick & Associates, as part of our bankruptcy, creditors' rights and asset protection planning practice, we get many questions about spendthrift trusts.

A spendthrift trust is a trust that is settled for the benefit of a person (usually a person who is believed to be unable to control his or her spending) that gives a trustee authority to make decisions as to how the trust funds may be spent for the benefit of the beneficiary. In this post, we are specifically not discussing trusts that are self–settled (where the grantor/settlor is also the beneficiary). Creditors of the beneficiary generally (but with exceptions, discussed below) cannot reach the funds in the trust, and the funds are not actually under the control of the beneficiary.

To qualify as a spendthrift trust, the trust agreement should generally include a spendthrift provision–a provision that creates an irrevocable trust preventing creditors from attaching the interest of the beneficiary in the trust before that interest (cash or property) is actually distributed to him or her. Also, the trust agreement should not provide for mandatory distributions to beneficiaries (which allows the accumulation of income), but should provide for distributions at the discretion of the trustee. However, once a distribution is made from the trust to the beneficiary, creditors can attach that distribution.

In New York, there are two ways a creditor can attach the income a beneficiary receives from a trust. One way is via § 7-3.4 of the Estates, Powers and Trust Law, which provides that if a trust doesn't provide for accumulation of income (i.e. all income from the trust must be distributed at least annually), then a judgment creditor can reach all of the income due the beneficiary in excess of the amounts required for his or her education and support.

The other way is through § 5205(d) of the Civil Practice Law and Rules (CPLR). This section of the CPLR governs personal property exempt from the satisfaction of money judgments. Subsection (d) provides that a creditor can reach 10 percent of the income interest of a trust. However, if a court determines that the reasonable needs of the beneficiary and his or her dependents can be met by less than 90 percent of the trust income, then a greater percentage of the income can be reached by the creditors.

In a Florida bankruptcy case that applied the provisions of the CPLR to a New York spendthrift trust, the bankruptcy court took into account the beneficiary's total income and support from all sources, held that half of the trust income was unnecessary to meet the reasonable needs of the debtor and her dependents and concluded that such income could therefore be reached by the beneficiary's creditors.

In bankruptcy, spendthrift trusts are exempted under § 541(c)(2) of the Bankruptcy Code, which provides that "[a] restriction on the transfer of a beneficial interest of the debtor in a trust that is enforceable under applicable non-bankruptcy law is enforceable in a case under this title." So if a spendthrift trust is validly created pursuant to applicable state or federal (i.e. qualified retirement plans) law, then the spendthrift trust will not be property of a debtor's bankruptcy estate and not be subject to reach by creditors or the bankruptcy trustee.

To learn more about spendthrift trusts or protecting your assets from creditors both inside and outside of bankruptcy, please contact Jim Shenwick.