THE BLOG
09/28/2015 11:07 am ET Updated Sep 28, 2016

A Legal Introduction to the Spendthrift Trust

An individual may have concerns that an heir will recklessly waste an inheritance or, even if placed within a trust fund, in some manner sell (via financial discounting) the right to future payments. For example, tragic disabilities associated with drug addiction and alcoholism are well known. In these circumstances, a well-constructed spendthrift trust as a method of financial support or to contain an inheritance may be appropriate. The basic concept of a spendthrift trust is to protect both assets and the income produced by assets from the claims of third party creditors. While not unbreakable, when properly created a spendthrift trust may provide a measure of financial protection for a reckless or improvident heir, for example, or one lacking the foresight to properly manage her or his money. This comment provides a brief and incomplete educational overview of the spendthrift trust. Always consult experienced professionals in specific situations.

Creating a spendthrift trust requires that specific language be used, such as provisions against the alienation (transfer) of the trust property or funds, as well as present or future payments, by the voluntary act of the beneficiary, and against its involuntary seizure in satisfaction of the beneficiary's debts. The trustee, such as a reputable financial institution, must specifically be granted discretion as to the timing and amount of payments to the beneficiary and be allowed to direct the specific purposes for which the payments may be utilized. It is desirable to have an introductory clause in the spendthrift trust document carefully stating the intention of the trust and containing the word "spendthrift." It is also desirable to have separate individuals involved in the creation (settlor), administration (trustee), and recipient (beneficiary) roles of the trust. Preparing the appropriate language to create a spendthrift trust requires consultation with an experienced professional.

Spendthrift trusts may also shield assets from division in divorce cases but may be invaded (ignored) to collect court ordered child support and possibly alimony. The general judicial movement toward considerations of fairness in ordering divorce property divisions may well weaken the protections provided by the traditional spendthrift trust. The circumstances surrounding the creation of the spendthrift trust and the precise provisions contained within the spendthrift trust document may be crucial. Consult an experienced professional to ascertain the latest developments in a given state.

There are provisions in the federal Bankruptcy Code that shield a spendthrift trust from creditors' claims; however, distributions of income made within 180 days after the debtor files for bankruptcy are assets that the bankruptcy trustee, and ultimately the creditors, may seize. In general, it is important that the trustee and beneficiary not act together or in concert as this provides creditors with a potential argument that the trust is a sham. It is especially crucial that the beneficiary not have potential or actual control of the trust assets. Again, this is a complex matter that requires consultation with an experienced professional.

Some commentators suggest that one create a family limited partnership (FLP) or a limited liability company (LLC) inside of the spendthrift trust and additionally create discretionary so-called sprinkling or spray trusts that allow a trustee broad discretion in distributing assets to beneficiaries or other trust funds. Whether or not this "wheels within wheels" approach is appropriate in a specific situation, there is virtual uniformity of professional opinion that the trustee of the spendthrift trust must be granted absolute, unfettered, and unlimited discretion in distributing income in order to maximize the potential protections provided by the spendthrift trust.

Creditors and individuals attempting to break through the legal protections of the spendthrift trust frequently begin with an argument that the trust was not properly created or that procedures mandated by the trust document itself were not followed. For example, for what purposes may the trust assets be utilized by the trustee? Ideal language in the trust document would say, in an incomplete limited example only, that the trustee may use funds for the "health, education, maintenance and well-being of the beneficiary in accordance with his/her usual and customary standard of living." Overlapping trust roles, where the same individual is the creator (settlor), trustee, and beneficiary, also provides a point of attack under a merger (combination) doctrine or a self-interested conflict of interest concept. Careful planning in consultation with an experienced professional should prevent these attacks on the spendthrift trust from being successful.

Most states have a Fraudulent Transfer Act (FTA) that is designed to prevent the hindering or defrauding of creditors by transferring assets without receiving a reasonably equivalent fair market value. For example, giving all of one's assets, after a serious traffic accident, to a relative, and then asserting that one has no assets with which to pay liability claims, would likely violate the FTA. The look back time period in which transfers may be invalidated by creditors under an FTA varies with state law and may typically be anywhere from 3 to 6 years. The potential application of a FTA to any asset protection plan must be reviewed in consultation with an experienced professional. One broad concept is that the earlier in time asset protection plans, such as the spendthrift trust, are created, the better.

This comment provides an incomplete general educational overview of a complex topic and is not intended to provide legal advice. Always consult experienced legal, financial, and tax professionals in a specific situation.