Some Important Wrinkles to Consider Regarding Spendthrift Trusts

 
   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.[1]  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. 
 


[1] This is from section 502 of the Uniform Trust Code.