ESTATE PLANNING PROBATE NEWSLETTER
Trusts are commonly recognized as a legal entity organized to hold and administer one's assets. The person establishing the trust (the "Settlor") transfers legal title to the Settlor's assets to the person administering the trust (the "Trustee"). Unlike a will, a trust does not necessitate probate, the sometimes costly and time-consuming process by which the court oversees the administration of an estate. In addition to the benefit of probate avoidance, a trust may also offer some protection from creditors.
"Spendthrift" or "Anti-Alienation" Clauses
Trusts have long been able to provide some protection from creditors of the beneficiaries. Parents or grandparents with kids and grand kids incapable of handling money have thereby been able to "protect" the beneficiaries from themselves and their own folly.
To achieve this, a provision is commonly added to the trust instrument, requiring that the Trustee (who administers the trust) must not recognize or allow any attempted encumbrance, sale, or other transfer of a beneficiary's interest in the trust. This is usually referred to as a "spendthrift" or "anti-alienation" clause. Most states recognize and allow enforcement of such clauses, even to the detriment of most creditors.
Spendthrift Trusts and Limits to Their Protection
Some Settlors have attempted to shield their own assets from current and potential creditors by transferring their assets to a trust. In general, the law has rejected a Settlor's ability to shield assets from the Settlor's creditors through the use of a trust. The general philosophy has been that people cannot enjoy and use their own assets through a trust, while preventing their creditors from access to trust assets to satisfy debt. In most states, by law, Settlors cannot prevent their own creditors from seeking payment from assets in the Settlor's trust.
Spendthrift Protection for Self-Settled Trusts in Some States
A trust which provides that the Settlor is also the beneficiary is sometimes called a "self-settled" trust. In 1997, Alaska passed legislation allowing the enforcement of spendthrift provisions in self-settled trusts in most circumstances, even against creditors of the Settlor. Such trusts are also sometimes called "asset protection trusts" (APT). Several other states followed suit, passing legislation authorizing similar APT protection.
Some Laws Governing Self-Settled Spendthrift Trusts
Laws regarding APT's vary among the states recognizing such trusts. Generally, an APT must be irrevocable. The Alaska statute states that spendthrift clauses in APT's can be effective against both existing and future creditors, with the following exceptions:
- Where the transfer of assets to the trust was intended, in whole or in part, to defraud creditors or certain "other persons."
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If the Settlor may revoke or terminate the trust, in whole or in part, without the consent of a beneficiary adversely affected by the revocation or termination.
- When the APT requires mandatory distributions of all or part of principal and/or income to the Settlor; discretionary distributions may be allowed, but mandatory distributions are not permitted.
- If the Settlor was more than 30 days in default under a child support judgment or order at the time the assets are transferred into the APT.
The trust instrument will usually specify which state's law applies to the trust. Most of the states that allow APT's require some connection between the state and the trust, in order for the state's laws to apply. For example, Delaware law requires that at least one Trustee be a resident of Delaware (if a natural person) or an entity authorized to act under Delaware law, such as a Delaware bank or trust company. The Delaware resident Trustee must have some responsibility for trust administration and taxes. Additionally, at least a portion of the trust assets must be held in Delaware.
Effectiveness of Spendthrift Clauses in APT's
There is no clear answer on the effectiveness of APT's against creditors. If a person lives in a state whose laws recognize APT's, enforcement against local creditors seems clear. A Settlor living in Nebraska , however, may create an APT under Delaware law to avail himself of the perceived asset protection. However, if a Nebraska creditor obtains a judgment against the Settlor in a Nebraska court, the effectiveness of the APT in preventing the enforcement of the creditor's judgment may be limited. For example:
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The Nebraska court may refuse to apply Delaware law and may instead apply Nebraska law, which may not enforce the spendthrift provision in a self-settled trust. The Nebraska creditor may thereby enforce the judgment on APT assets located in Nebraska . The U.S. Constitution generally requires that each state enforce a judgment handed down by a court in a different state. The Nebraska creditor may thus be able to enforce a valid Nebraska judgment against APT assets held in Delaware , despite the validity of an APT under the Delaware statute.
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If the creditor is able to bring the action in a federal court, it may not be bound by state law. In addition, federal courts such as the bankruptcy court have proved unwilling to accept the enforceability of APT's, requiring that APT assets be considered part of the bankruptcy estate, and therefore available to creditors. Note, however, that the court must have jurisdiction over the Trustee of the APT in order for a judgment to be effective. This usually means that Trustee must be doing business in or located in the state where the judgment is sought. A landmark U.S. Supreme Court case held that a Florida judgment could not be enforced against trust assets of a Delaware trust located in Delaware, because the Florida court lacked jurisdiction over the Delaware Trustee.