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Understanding Spendthrift Trusts

Trusts can be structured to provide superior asset protection against creditor claims.  Spendthrift trust  provisions prevent creditors of the trust beneficiary from reaching the trust assets as long as the assets are held in the trust. This type of provision may or may not be upheld, depending on who created the trust and what the other provisions of the trust are.

Generally trusts can be divided into to categories based on who established the trust: namely, self-settled trusts  and non-self-settled trusts. Self-settled spendthrift trusts are irrevocable trusts that contain a spendthrift provision that are created by one person for their own benefit. There are very few states that extend asset protection to self settled trusts (Colorado does extend protection to self-settled trusts). The thought is that it violates public policy for an individual to be able to place his or her assets in trust for his or herself and thereby exempt those assets from their own creditors. On the other hand non-self-settled spendthrift trusts are irrevocable trusts created by someone other than the trust beneficiary for the benefit of the trust beneficiary. Almost all jurisdictions provide full protection to assets held in non-self-settled spendthrift trusts.

There are a number of trust provisions that may compromise the protections provided by self-settled spendthrift trusts (in the states that afford asset protection to these trusts) and for non-self-settled spendthrift trusts. The general rule is that if the trust beneficiary has the power to get at the trust assets, then the trust beneficiaries creditors have the power to get at the trust assets.

Thus, a valid non-self-settled spendthrift trust may be compromised if the trust beneficiary is also the trustee and the trustee is the party that has the power to make trust distributions. In this case the trust beneficiary has the ability to get at the trust assets via their serving as trustee. By not being the trustee, individuals can create sprinkle/spray, discretionary, and shifting/suspension trusts to ensure that the trust beneficiary, and his or her creditors, cannot get at the trust assets.

Sprinkle or spray trusts provide the trustee (who, presumably, is not the trust beneficiary) with the ability allocate trust distributions amongst a class of beneficiaries. For example, the spray trust beneficiary may opt to make a distribution to one trust beneficiary and not to make distributions to another trust beneficiary.

Discretionary trusts provide the trustee (again, who is presumably not the trust beneficiary) with the ability to decide if any trust distributions are to be made to any trust beneficiary. For example, a discretionary trust may provide that the trustee may or may not make distributions to any one or more beneficiaries. If that trust beneficiary turns out to have creditor issues, the trustee can simply opt not to make distributions to that trust beneficiary.

Shifting trusts provide that upon the occurrence or nonoccurrence of a certain event or lapse or passing of time the right to trust distributions inure to different trust beneficiaries. For example, a shifting trust may provide that a trust beneficiaries distributions will go to a second trust beneficiary so long as the first trust beneficiary is married and has not executed a valid pre/post marital agreement.

Similarly suspension trusts provide that upon the occurrence or nonoccurrence of a certain event or lapse or passing of time trust distributions halt. For example, the suspension trust may provide that trust distributions will cease immediately if a civil lawsuit is filed against the trust beneficiary.

In each of these examples the idea is to put the trust assets outside of the trust beneficiaries reach, which in turn puts the trust assets outside of the trust beneficiaries creditors reach as well. Giving up control over the trust assets is the trade off for creating these types of trusts. This can be a great loss in the event that the trustee opts not to make distributions as the person who created the trust would have liked.

There are a number of ways to deal with this loss of control issue, such as using co-trustees, independent trustees , and/or trust protectors. A co-trustee is one individual or institution that shares the power as trustee with a second (or more) individual or institution. The idea is that, as spelled out in the trust and/or in state law, one co-trustee is not authorized to act without the consent of the other co-trustee or co-trustees.

The independent trustee is a person or institution spelled out in the trust document that is given certain limited powers or functions. For example, the independent trustee’s powers may be limited to vetoing any distributions proposed by the regular trustee.

The trust protector has an even more limited power or function in that their only role is to fire and hire trustees should they so choose. In this case the trust protector can fire a trustee prior to the trustee making distributions to a trust beneficiary who has creditor issues.

In many cases naming family members to serve as the co-trustee, independent trustee, and/or the trust protector helps ensure that the trust creator’s wishes will be carried out. Of course, naming these individuals creates other problems, such as what happens when the named party cannot or will not serve as the person who created the trust intended?

In these cases trusts generally provide that the trust beneficiaries can name subsequent parties (other than themselves) or that the named party has to designate a successor upon taking over the duties outlined in the trust.

If this isn’t complicated enough, a number of tax factors that may preclude certain individuals from serving in these capacities or having the power to name or replace these individuals. The trust is an effective asset protection vehicle and, in most cases, these complexities are manageable.

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