When Are Trust Funds Vulnerable To The Claims of Creditors?

By: David L. Simmons, Drewry Simmons Vornehm, LLP

A trust is frequently used in estate planning to preserve assets from the claims of creditors. For example, a “settlor” may create a “spendthrift trust” for the welfare and support of a “beneficiary.” The settlor names a “trustee” to administer the trust, and the trustee is authorized to distribute funds from the trust for the benefit of the beneficiary. The trust funds are not under the control of the beneficiary, and are not subject to the claims of his creditors.

However, not all trusts are created equal, and some trusts do not provide protection from the claims of creditors. The law generally requires that a trust be irrevocable to qualify for spendthrift protection, and only property transferred to the trust is subject to the protection. To avoid fraudulent conveyances, most states do not extend spendthrift protection where the beneficiary is also the person who created the trust. Where the settlor of the trust is also the beneficiary, the trust will be deemed “self-settled” and not subject to spendthrift protection.

For example, the validity of a spendthrift trust was considered in the case of In re Bryan, 415 B.R. 454 (Bankr. D. Colo. 2009), where a husband and wife transferred all of their assets to a spendthrift trust shortly before a creditor obtained a judgment against them. The husband and wife thereafter filed bankruptcy and claimed that the assets placed in trust were not part of the bankruptcy estate. The court disagreed, holding that the husband and wife were both the creators and beneficiaries of the trust, and therefore the trust was not valid under state law.

The extent of control exercised by the settlor and beneficiary over the trust property can also impact the validity of a spendthrift provision. In the case of In re Lewiston, 532 B.R. 36 (Bankr. E.D. Mich. 2015), the creator of the trust was also the beneficiary. The beneficiary disregarded restrictions on the use and enjoyment of the assets in the trust, and exerted unfettered control over trust property. The court found that the spendthrift trust was a violation of public policy under Michigan law.

Likewise, a spendthrift trust cannot be utilized as part of a scheme to defraud creditors. A discretionary spendthrift trust will be invalid where the beneficiaries are also creators of the trust, and where they transferred assets to the trust without receiving any valuable consideration. The court concluded that the trust was created to avoid paying obligations to creditors, and was therefore invalid.  In re Bridge, 90 B.R. 839 (Bankr. E.D. Mich. 1988). A spendthrift trust cannot be utilized as part of a scheme or artifice to defraud, where the beneficiary creates or controls a trust for his own benefit.  U.S. v. McBirney, 261 Fed. Appx. 741 (5th Cir. 2008).

The creator of a spendthrift trust must therefore keep in mind the limits imposed by the relevant trust statutes and cases that have construed the same. A settlor of a trust should not be named as a beneficiary, nor should the beneficiary have any control over the trust property. Likewise, a spendthrift trust cannot be used to defraud creditors, and the courts have not hesitated to reverse transfers to a trust where the settlor was attempting to avoid payment of an obligation.