This is a memo prepared for me from my law clerk regarding irrevocable trusts and their effectiveness. I hope you enjoy it as a fyi. I believe they are a very effective tool.
Irrevocable Trusts and Asset Protection
In general, an irrevocable inter vivos trust or otherwise known as "Irrevocable Trust" is an effective way for an individual to protect his assets from creditors. This is because the assets are no longer in the control of the individual; rather, they are in the control of the trustee. The scene gets slightly complicated, though, when the settlor retains the right to receive income for his life from the trust.
In the case In re Brown, 303 F.3d 1261 (11th Cir. 2002), a Chapter 7 bankruptcy settlor-debtor received an inheritance from her mother and put the inheritance in an irrevocable trust with the proviso that she would receive a monthly income payment for her life. Id. at 1263. The settlor-debtor was the trustee, but her powers were limited to making investment decisions; she could not assign her income interest because of a spendthrift provision in the trust agreement. Id. at 1264. The debtor-settlor eventually filed for bankruptcy and sought to keep the trust out of her bankruptcy estate,
The Eleventh Circuit first articulated that under the Bankruptcy Code, if a restriction of the debtor’s interests is applicable and valid under non-bankruptcy law, then the restriction is effective and valid under the Code as well. Id. at 1265; 11 U.S.C. § 541(c)(2). In looking at Florida law, the court determined that spendthrift provisions are effective to keep creditors from reaching trust assets, but only if the beneficiaries of the trust do not have any power over the trust assets. Id. at 1265. When the beneficiary is also the settlor, though, the spendthrift provision is not valid against creditors and they can reach the trust assets that the settlor has an interest in. Id. at 1266.
In looking at Florida law, the court determined that assets within a spendthrift trust are not protected to the extent the settlor creates the trust for his own benefit, as opposed to the benefit of another person. Id. at 1266. The court noted that this is not a concept unique to Florida, and the court cited several other cases from various jurisdictions (e.g. Ninth Circuit, Florida bankruptcy court (applying New York law), Maine bankruptcy court, Florida bankruptcy court (applying Ohio law) and Texas Appellate Court) all reaching the same conclusion. Id. at 1267 n. 6.
Furthermore, this interpretation follows the common law of trusts. Scott’s treatise, The Law of Trusts, specifically distinguishes between trusts reserving an interest for the settlor and trusts reserving an interest for a third-party remainderman. Id. at 1267 (citing II Austin Wakeman Scott, The Law of Trusts § 114 (3d ed. 1967). This treatise also finds that when a settlor reserves a right or interest for himself, a creditor can reach that interest even if the trust says otherwise. Id. A creditor can reach this interest of a settlor-beneficiary even if the settlor was solvent at the time of creating the trust, and even if the settlor had no fraudulent intent. In re Brown, 303 F.3d at 1267.
So, without a valid spendthrift provision, an interest in a trust is a property right. Id. at 1268. Thus, a beneficiary’s right to receive income is a property right that a creditor can attach. Id. But, when this right to receive income is the only right a beneficiary-settlor has reserved for himself, then it is only this income that a creditor can attach. Id. A creditor cannot pierce the trust and reach the corpus (unless the creation of the trust was a fraudulent conveyance). Id.
In Estate of German, 7 Cl. Ct. 641 (1985), the court reached a similar conclusion. The settlor created six trusts, three for each of her two sons, and named both her sons the trustees of all trusts. The trustees had the power to pay the settlor any income or part of the principal as they determined necessary. Id. at 642. The issue was whether the settlor owed an estate tax or gift tax on the property she transferred into the trusts, and the court could only answer this by determining whether the transfer to the trust was a completed gift. Id. at 643. If the settlor’s creditors could have reached the assets under state law (Maryland law, in this case), then the gift was not complete and the estate tax applied; if the creditors could not reach the assets (because the settlor divested herself of all rights to possession and enjoyment of the property), the gift was complete and the gift tax applied. Id. at 643.
The court relied on a Maryland Court of Appeals case, Mercantile Trust Co. v. Bergdorf Goodman, which found that creditors’ rights in trust property depend on whether the property in the trust which is not distributed returns to the settlor or goes to a remainderman at the settlor’s death. Id. at 645. If the trust property goes to a remainderman, then the creditors cannot reach the assets because the remaindermen have a vested interest in the property, even if that interest is delayed. Id. But the creditors can reach the life estate of income the settlor receives. Id. This is because that income returns to the settlor and the remaindermen do not have an interest in the income.
Finally, it is important to note that just because a spendthrift provision fails, the entire trust does not fail. In re Brown, 303 F.3d at 1269; In re Goff, 812 F.2d 931, 933 (5th Cir, 1987). In In re Goff, Mr. and Mrs. Goff, the settlors, created an irrevocable trust containing real property. In re Goff, 812 F.2d at 932. Citizen National Bank had a judgment lien against the property, which it properly recorded in the county records. Id. The settlors filed for Chapter 7 bankruptcy and Citizen National Bank submitted a secured proof of claim based on their judgment lien. Id. The issue the court had to resolve was what type of title the debtors held in the real property in the trust: legal or equitable? Id. If the settlors had legal title, the creditors could attach their judgment lien to the real property. Id. at 933. But, if the settlors had only equitable title, then the judgment lien would not attach and the bank would only have an unsecured claim in bankruptcy. Id.
A valid trust results in the settlors holding only equitable title. The bank argued that because the trust contained a spendthrift clause restricting alienation, the entire trust was void from the beginning. Id. The Fifth Circuit rejected that argument and found the trust to be valid, even though the spendthrift clause is invalid for a self-settled trust. Id. Therefore, the court found that the settlors held only an equitable title in their real property and a judgment lien cannot attach to equitable title. Id. Therefore, the bank can only have an unsecured claim in bankruptcy.
What these cases make clear is that an irrevocable inter vivos trust may be an effective way to protect assets from creditors. However, if the settlor retains any sort of interest in the trust, such as income interest, a creditor can attach a claim to the income interest the settlor receives. Finally, spendthrift clause for the benefit of the settlor is an ineffective way to protect income interest, and it will likely be deemed void (even though the trust itself will remain valid).
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