Creditor protection means protection from your creditors.
What are spendthrift trusts?
A spendthrift provision in a trust is used to prevent the trust beneficiary from wasting the trust funds, and creditors from reaching the money in the trust. Most irrevocable trusts can be made into a spendthrift trust by using a spendthrift clause. Spendthrift is an archaic term, 400 years ago thrift meant wealth (today it means frugality). In the older sense of thrift, spendthrift describes a person who squanders their money.
The spendthrift trust was conceived in Pennsylvania, its birthplace and stronghold. While the idea spread to other states, there has been a general uneasiness with the idea that trusts can enlist the coercive power of the state in preventing honest debts from being paid. In consequence, states have gradually dialed back the degree of creditor protection.
What does a valid spendthrift clause look like?
A spendthrift clause is valid if the provision restrains both voluntary and involuntary transfer of a beneficiary’s interest. In other words, James, our spendthrift, can neither spend the trust funds directly, nor are his creditors allowed to get a valid judgment against the funds. There are no magic words to set this up, however, you will often find something like this:
“As beneficiary of this trust, James is hereby restrained from alienating, anticipating, encumbering, or in any manner assigning his or her interest or estate, either in principal or income, and is without the power so to do, nor shall such interest or estate be subject to his or her liabilities or obligations not to judgment or other legal process, bankruptcy proceedings or claims of creditors or others.” Source.
Now, a trust is a bit like a contract, while we have theoretical freedom to put anything into a contract, some provisions may not be enforceable, because of public policy or statutes that speak directly to the matter.
While many states have similar laws, they may differ in subtle but important ways. Here is the situation in California.
California Law
Spendthrift clauses are valid with respect to trust income and principal provided they remain in the trust. However, once the trustee makes a distribution to the beneficiary (the spendthrift) the trust protection is lost. The creditors can enforce a judgment against the distributed funds, even funds that have been earmarked for distributions (have become “due and payable”, see below). For this reason, many spendthrift trusts contain a shutdown clause that stops payments to a beneficiary during any time that the trust could be subject to creditors’ claims.
This shutdown clause does not work as far as support payments for spouses or minor children are concerned, see Probate Code Section 15305. Under California law, the trial court has the power to order a trustee to satisfy a final child support order, irrespective of any shutdown clause.
The California Supreme Court also clarified some points that previously led to confusion in its opinion filed on 3/23/17:
- Even when an amount of the trust’s principal has not been paid out but is “due and payable” according to the provisions of the trust, creditors can petition the court for an order directing the trustee to satisfy a judgment against the beneficiary by paying that principal amount to the creditor. Probate Code Section 15301(b). An exception applies to distributions that are necessary (actually required) for the support or education* of the beneficiary. Probate Code Section 15302.
- In addition to the above, Probate Code Section 15306.5(b) allows a creditor to reach up to 25 percent of any anticipated payments to be made to the beneficiary, reduced by amounts needed to support the beneficiary and dependents (or already obtained by other creditors).
- Probate Code Section 15307 clashes with the above 25% rule above (allowing for 100 % of the amounts a beneficiary is entitled to to be reached by creditors). The California Supreme Court has determined that this provision must represent a legislative drafting error. The courts will consequently not apply it.
The CA Supreme Court provides a helpful illustration in its opinion:
“As an illustration, suppose a trust instrument specified that a beneficiary was to receive distributions of principal of $10,000 on March 1 of each year for 10 years. Suppose further that a general creditor had a money judgment of $50,000 against the beneficiary and that the trust distributions are neither specifically intended nor required for the beneficiary‘s support. On March 1 of the first year, upon the creditor‘s petition a court could order the trustee to remit the full distribution of $10,000 for that year to the creditor directly if it has not already been paid to the beneficiary, as well as $2,500 from each of the nine anticipated payments (a total of $22,500) as they are paid out. If the creditor were not otherwise able to satisfy the remaining $17,500 balance on the judgment, then on March 1 of the following years, upon the general creditor‘s petition the court could order the trustee to pay directly to the creditor a sum up to the remainder of that year‘s principal distribution ($7,500), as the court in its discretion finds appropriate, until the judgment is satisfied.”
Creditor protection elsewhere
Given the limits of creditor protection California law imposes on trusts, other states have tried to meet a perceived need for more protection. These trusts are generally known as Domestic Asset Protection Trusts. Read a previous post about them here: Domestic Asset Protection Trusts – A good choice for Californians?
* The phrase in the Probate Code (15302), “pay income or principal or both for the education or support of a beneficiary,” is an ascertainable distribution standard that may also help avoid estate taxes. Frequently it is expanded to include Health, Education, Maintenance, and Support, and it is then known as the HEMS standard. For a deep dive see here.
