To hear some practitioners tell it, a spendthrift trust is a wonderful creation that provides unlimited asset protection. They’ll probably even tell you it cures cancer. But the reality, like most things in law, is far more nuanced. And while spendthrift trusts are helpful in an overall asset protection structure, they also have limitations that are discussed far too little.
First of all, a spendthrift trust is a trust that prevents beneficiary from voluntarily or involuntarily transferring his interest. For example, suppose a trust beneficiary is in debt. Without a spendthrift provision, the beneficiary could sign a document transferring his beneficial interest to the creditor. Or, the creditor could sue the beneficiary, obtain a judgement and then seek to attach the beneficial interest. In either situation, the beneficial interest can move from the beneficiary to a creditor.
A spendthrift provision prevents alienation, so the beneficiary can’t assign or sell the interest. But there’s a slight wrinkle to this: the Uniform Trust Commentary also states that a creditor “may only attempt to collect directly from the beneficiary after payment is made.” This shifts our discussion to three separate but related U.S. Tax Code sections, beginning with section 11, which provides trust tax rates. These are highly compressed; once trusts have income of just $7,500, they are taxed at a 39% rate. Second, there are two types of trusts; those that distribute all income annually (non-discretionary) and those where the trustee has the discretion to make distributions (discretionary). Each trust distribution is deductible from trust income which are in turn taxed as part of the beneficiary’s income. Therefore, a non-discretionary trust probably won’t be paying a great deal of tax while a discretionary trust may pay an inordinate amount, depending on the trustee’s actions during the taxable year.
Let’s combine all these points. A spendthrift trust would be most effective when the trustee has discretion to make distributions. In the event a creditor makes a claim, the trustee can legitimately say there won’t be a distribution. But if the trust has more than $7,500 in income, it’s taxed at a very high rate. Conversely, a trust that distributes all its income can deduct its distributions and lower its tax burden. But in this case, a creditor could simply wait for a distribution from the trust to the beneficiary and attach the payment once it’s outside of the trust’s spendthrift provision.
And a planner can’t solve the problem by going offshore due to the grantor trust rules. Section 679 states:
A United States person who directly or indirectly transfers property to a foreign trust (other than a trust described in section 6048(a)(3)(B)(ii)) shall be treated as the owner for his taxable year of the portion of such trust attributable to such property if for such year there is a United States beneficiary of any portion of such trust.
This provision effectively incorporates offshore trust income into a grantor’s income in a wide array of circumstances.
In reality, there are standard structures that planners can utilize to minimize the problems associated with this. But that’s not the point of this post. It’s simply to highlight not only the over-selling that has occurred with spendthrift trusts but also shine a spotlight on the unspoken complexity of this very popular structure. As with all things in law, the nuances offer far more wrinkles than appear on first glance.
 This is from section 502 of the Uniform Trust Code.
I regularly use trusts as part of my legal practice. If you have any questions about them, please contact me at 832.330.4101.
Under Texas law, there are 5 methods of creating a trust:
(1) A property owner’s declaration that the owner holds the property as trustee for another person;
(2) A property owner’s inter vivos transfer of the property to another person as trustee for the transferor or a third person;
(3) A property owner’s testamentary transfer to another person as trustee for a third person;
(4) An appointment under a power of appointment to another person as trustee for the donee of the power or for a third person; or
(5) A promise to another person whose rights under the promise are to be held in trust for a third person.
These are the exact same methods stated in §10 of the Restatement of Trusts. And save for number 5, they are consistent with the methods outlined in § 401 of the Uniform Trust Code.
A brief explanation of each follows:
The property owner declares an intent to create a trust – a method potentially fraught with problems. How do you prove such a trust exists? At minimum, there would have to be a second person to attest to the statement. The necessity of beneficiaries, who must exist in all trust relationships and who also have enforceable rights in the trust property, further complicate the picture. They would have to know they are a beneficiary in order to enforce their rights. When are they told about their new found legal status?
The admittedly over-lawyering comments aside, the most obvious fact pattern for this method is one parent saying to the other, “we need to save out child’s education.” Here, the second parent can act as witness if needed. They can also act as guardian for the obviously minor child.
Methods 2 and 3 are the most common: either an individual creates a trust while alive or includes a trust in an estate plan. A written document is always preferable; a trust is simply too complicated to be left to verbal evidence. There are numerous trusts that can be created through an estate plan – too many to mention here. Due to the nature of even moderately complex estate planning, these are also written.
The estate tax code defines a “power of appointment” as “a power which is exercisable in favor of the decedent, his estate, or his creditors of this estate.” It gives the holder the ability to direct property or a property’s income toward a certain goal. The most obvious case occurs where a power holder will create a trust with estate property.
Like the simple declaration that “I’m creating a trust,” the “promise to create a trust” is also a complex matter: it not only involves a trust but probably a contract – an “enforceable promise.” At minimum, the person enforcing the trust must prove that the grantor made the promise, which creates a potential evidentiary headache.
I hope you have found this helpful or useful. If you have any questions, please contact me at 832.330.4101.
 The Restatement of Contracts defines a contract as, “a promise or set of promises for the breach of which the law provides a remedy.”
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