The trust spendthrift clause has been an important line of defense providing asset protection for third-party discretionary irrevocable trusts. Generally, the spendthrift clause prevents the attachment or assignment of a beneficiary’s interest in an irrevocable trust before the interest is distributed. As such, the spendthrift clause typically protects against creditors of the beneficiaries, involving cases of divorce, financial troubles or substance abuse. Despite this, it’s important to note that there have been many successful attacks on these spendthrift trusts over the last few years.1 These attacks are generally a result of the spendthrift clause exception creditors.2 The two common exception creditors specifically related to the spendthrift clause are alimony and child support.3 In the past decade, cases around the country have illustrated that the courts may disregard a spendthrift clause of third-party trusts when exception creditors are involved; for example, the Berlinger v. Casselberry4 case in Florida and indirectly the Pfannenstiehl v. Pfannenstiehl5 case in Massachusetts.6 This trend continues today, and consequently, advisors should be aware of the law and the situs of their client’s trust as they relate to discretionary interests.
Recap of Discretionary Interest Law
Historically in the United States under the Restatement (Second) of Trusts (Restatement Second) and most case law, a discretionary interest7 was deemed not to be an enforceable right to any income or principal from the trust.8 As such, beneficiaries can’t force any action by the trustee, nor is the interest assignable, thus providing that the discretionary interest isn’t a property interest; rather, it’s nothing more than a mere expectancy.9
The Restatement (Third) of Trusts (Restatement Third) reversed the Restatement Second and previous case law according to many advisors by rewriting the definition of the discretionary trust and thus substantially reducing the asset protection it provides. Generally, this may present an issue for many states that have codified the Restatement Third, which includes those states that have adopted the Uniform Trust Code. In response, some states have codified their own laws to correct this interpretation.10 Consequently, in those states, a discretionary interest in a trust isn’t a property interest or an entitlement.11
Levitan v. Rosen
An example of a recent attack on the spendthrift clause is Levitan v. Rosen,12 a Massachusetts case. In Levitan, the wife in a divorce action was the sole beneficiary of an irrevocable trust set up by her father under Florida law. Pursuant to the trust, the trustee had authority to distribute to the wife income and principal in its sole discretion. The wife, however, also had an annual 5% withdrawal right.
The trial court held that the 5% withdrawal right wasn’t subject to the spendthrift clause but excluded the remainder of the wife’s share from equitable distribution due to the spendthrift clause. The Massachusetts Appeals Court ultimately reversed the trial court ruling on the 5% withdrawal right and held that the wife’s entire interest in the trust was to be “considered as an asset subject to equitable distribution.”13 The court went on to say that the wife’s interest wasn’t speculative, and it wasn’t subject to reduction because it was more than a mere expectancy.
In addition, the Massachusetts courts stated that “Florida law appears to be consistent with Massachusetts law in all material respects on the question of the enforceability of the spendthrift provision [clause].”14 This is important because in Casselberry, the Florida court ordered a writ of garnishment of present and future direct or indirect distributions for alimony against a Florida third-party spendthrift discretionary trust established by a father for his son.15 Consequently, the statement by the Massachusetts court is telling. It’s important to note that neither Massachusetts nor Florida have discretionary interest statutes following the Restatement Second.
Interestingly, in Levitan’s predecessor, Pfannenstiehl, the Massachusetts Supreme Court reversed the lower courts’ decisions and held that a beneficiary’s discretionary share of a third-party irrevocable trust with a spendthrift provision was speculative at best. The key distinguishing factor in that case, however, was that the husband was one of 11 beneficiaries of a single pot trust, as opposed to the sole beneficiary of the trust or a beneficiary of a separate share trust. The court, however, left the door open for future courts to “consider the expectancy [of a distribution] as part of the opportunity of each (spouse) for future acquisition of capital assets and income” if the beneficiary’s interest could be identified and further stated that “the existence of a spendthrift provision alone does not bar equitable division of a trust,” which is what occurred in Levitan.16
In re Cleopatra Cameron Gift Trust
Another important recent case involving an attack on the spendthrift provision of a third-party trust was In re Cleopatra Cameron Gift Trust.17 This was a California case involving a divorce in which the wife was a primary beneficiary of two California irrevocable spendthrift trusts established by her father. During the divorce proceedings, the California court ordered the wife’s trusts to pay spousal support, child support and attorney’s fees. Generally, California allows its courts to “order the trustee to satisfy . . . [a] support judgment out of . . . future payments that the trustee, pursuant to the exercise of the trustee’s discretion, determines to make to or for the benefit of the beneficiary.”18 The California Court of Appeal’s interpretation resulted in the authorization of an order compelling a trustee to satisfy an unpaid support obligation after the trial court found that the trustee had exercised its discretion in bad faith to deny a request for a distribution. It’s important to note that after the trusts began making payments pursuant to the California court order, the trusts changed situs to South Dakota. Subsequent to the change of situs, the trusts stopped making support payments at the direction of the trust protector,19 who determined that the payments would violate the spendthrift clause of the trust as well as rapidly deplete the trust.
The wife then petitioned South Dakota for court supervision to clarify whether the trust was prohibited from making the payments directly to the husband due to the spendthrift provision. The Supreme Court of South Dakota ultimately agreed with the wife and trial court and denied full faith and credit to the California judgment. Specifically, the court held that enforcing judgments doesn’t implicate full faith and credit considerations. As such, the South Dakota circuit court wasn’t required to submit to the California order compelling direct payments from the trust if this method of self-executing enforcement wasn’t authorized by South Dakota law.20
The court went on to explain that the enforcement did in fact violate South Dakota law as South Dakota doesn’t have irrevocable third-party trust spendthrift clause exception creditors and doesn’t follow the Restatement Third.21 Alternatively, South Dakota follows the Restatement Second so the beneficiaries are unable to force an action by the trustee, and the interest isn’t assignable. Consequently, a discretionary interest as defined by South Dakota statute isn’t a property interest; rather, it’s a mere expectancy.22
As previously illustrated, the spendthrift provision alone may not be enough for asset protection purposes due to possible exception creditors and lack of a discretionary interest statute following the Restatement Second.23 Cleopatra is a unique case in that it highlights an initial successful attack of the traditionally protected third-party discretionary trust spendthrift provision in a state such as California, juxtaposed with a jurisdiction like South Dakota that follows the Restatement Second and common law as its historical interpretation of a discretionary interest and spendthrift provision.
Increased Use of Discretionary Trusts
The trend towards establishing third-party irrevocable discretionary trusts with spendthrift provisions rather than drafting mandatory income and principal distribution provisions (for example, trust principal distributions of one-third at 25, one-third at 30 and one-third at 35) has significantly increased in the past two decades.24 Often, these trusts are established in states with directed trust statutes so as to allow families and their advisors to make the distribution decisions.25 Moreover, such trusts are often established in states that have codified the definition of a discretionary trust as one that gives the trustee any discretion regarding distributions,26 regardless of whether there’s an ascertainable standard (that is, health, education, maintenance and support), provided the decision is in the sole and absolute discretion of the trustee.27 Trusts with single pots versus separate shares are also frequently used. Generally, this is a result of a shift in focus to protecting trust assets from third-party creditors of current and future beneficiaries (for example, divorcing spouses), from the beneficiaries themselves (such as drug addiction or misspending) and to foster personal growth (for example, incentive trusts).28
In addition, advisors may look to state income tax savings as another reason to establish a family’s trust as discretionary; for example, generally California won’t tax the income of a trust if there are no California fiduciaries and/or source income, even if there are resident beneficiaries, so long as the beneficiaries are contingent beneficiaries (that is, discretionary).29 Now, state income tax considerations will likely play an even more important role in the decision as to whether to form a discretionary trust as a result of the U.S. Supreme Court decision in Dep’t of Revenue v. Kimberley Rice Kaestner 1992 Family Trust.30 In Kaestner, the Supreme Court held that an in-state beneficiary of a discretionary trust was insufficient alone for the state of North Carolina to tax the trust. The Supreme Court focused on the fact that the trust was discretionary, and consequently, the beneficiary wasn’t entitled to demand distributions and didn’t have a right to income or any control over the trust assets. As a result of Kaestner, many advisors also suggest drafting a fully discretionary trust for state income tax planning purposes.31
Also, some families may be able to add discretionary interest protection to existing trusts by judicial or nonjudicial modification/reformation or by decanting.32 An example of this strategy is exemplified in the recent Connecticut case, Ferri v. Powell.33 In Ferri,a father established an irrevocable trust in Massachusetts, governed by Massachusetts law, with his son as beneficiary, and provided withdrawal rights to the son. As the divorce proceedings were ongoing, the trustees decanted to a new spendthrift trust. The purpose of the decant was to remove the son’s withdrawal rights and instead make the trust strictly discretionary to garner the protection of the discretionary trust with spendthrift protection. The court ultimately found that the decanting was authorized under Massachusetts law and that the trustee’s authority to decant was a parallel but separate power to the withdrawal right of the son.34 Consequently, the property was moved out of reach of the divorce by the decant.35
Lastly, it should be noted that the increased asset protection provided for by using a discretionary support statute also applies to self-settled domestic asset protection trusts (DAPTs).36 This is of particular importance given the high transfer tax exemption amounts ($11.4 million per spouse) combined with the recent increase in the use of DAPTs as a flexible wealth preservation and asset protection vehicle. If properly structured, the DAPTs can provide four levels of protection: the trust, the limited liability company owning the trust property, a discretionary support provision and a spendthrift provision.37
Consequently, planning with irrevocable discretionary trusts continues to increase in popularity as a result of directed trust laws, asset protection, income tax savings and incentive trusts. These advantages depend on the law and situs of the trust. In many instances, a change of law and situs to a jurisdiction that offers greater protection may be necessary for an irrevocable third-party discretionary trust.
Endnotes
1. See Al W. King III, “The Spendthrift Provision—Does it Really Protect?” Trusts & Estates (December 2016).
2. Al W. King III, “Defend Against Attacks on DAPTs?” Trusts & Estates (October 2014). In general, exception creditors can include tort victims, divorcing spouses and those receiving alimony or child support.
3. See Restatement (Second) of Trusts (Restatement Second), Section 157; Restatement (Third) of Trusts, Section 59; Mark Merric, “DAPTs: Which States Offer the Best Situs?” Merric Law Firm LLC (2008); Gideon Rothschild and Daniel S. Rubin, “Discretionary Spendthrift Trust Deemed Includible in Marital Estate for Equitable Distribution Purposes” LISI Estate Planning Newsletter #332 (Sept. 15, 2016), www.leimbergservices.com.
4. Berlinger v. Casselberry, 133 So.3d 961 (Fla. 2d DCA Nov. 27, 2013) (Husband and wife divorced, husband stopped paying alimony. Wife filed a motion to enforce payment of the alimony in arrears and for contempt. A settlement was reached, and husband agreed to satisfy his delinquent alimony obligations. The trial court then issued writs of garnishment to the trustee of the third-party trusts established by husband’s father).
5. Pfannenstiehl v. Pfannenstiehl, Mass. App. Ct., Nos. 13-P-906, 13-P-686 & 13-P-1385 (Aug. 27, 2015), Pfannenstiehl v. Pfannenstiehl, 2016 WL 4131248, SJC 12031 (Aug. 4, 2016) (Father/settlor formed an irrevocable spendthrift trust for a class composed of his living issue, which included his son (the husband in the case). Trust provided for income/principal to the class (that is, the husband) for health, education, maintenance and support (HEMS) in sole discretion of trustee; at later event to be separated into shares for siblings, and trust was “open to future offspring” (that is, multi-generational). Wife sought interest in trust as divisible property in divorce.); see also Al W. King III, “A Domestic Asset Protection Trust Update: Important Strategies, Statutes & Cases” PAC Seminar for Professionals (June 2016).
6. See supra note 1.
7. The courts have typically focused on the following in determining whether a trust is discretionary: (1) words of uncontrolled discretion; (2) permissive language; (3) no requirement of equality; and 4) standard of distribution wasn’t ascertainable.
8. Restatement Second, Section 155(1) and comment 1(b); See also Merric, supra note 3, Endnote 42, which lists cases from 16 states noting that a discretionary distribution interest isn’t a property interest.
9. Ibid.
10. For example, Alaska, Delaware, New Hampshire, Nevada, Ohio, South Dakota, Tennessee and Wyoming; See Merric and Worthington, infra note 15, see also Steven J. Oshins, “7th Annual Dynasty Trust State Rankings Chart,” www.oshins.com/images/Dynasty_Trust_Rankings.pdf.
11. Further, some states have codified the definition of a “discretionary trust” as one that gives the trustee any discretion regarding distributions, regardless of whether there’s an ascertainable standard (that is, HEMS), provided the decision is in the sole and absolute discretion of the trustee.
12. Levitan v. Rosen, Mass. Appeals Court No 18-P-847 (May 6, 2019).
13. Ibid.
14. Ibid.
15. Florida Statutes Section 736.0504(2) (discretionary interest statute). The court stated that under Florida law, “a former spouse may not compel a distribution that is subject to the trustee’s discretion or attach or otherwise reach the interest, if any, which the beneficiary may have. The section does not expressly prohibit a former spouse from obtaining a writ of garnishment against discretionary disbursements made by a trustee exercising its discretion. As a result, it makes no difference that the instant trusts are discretionary.” See also Mark Merric and Daniel G. Worthington, “Find the Best Situs for Domestic Asset Protection Trusts,” Trusts & Estates (January 2017).
16. Ibid.
17. In re Cleopatra Cameron Gift Trust, 2019 S.D. 35.
18. Ibid.
19. A trust protector is generally an individual (though a committee of individuals or an entity may serve) with specified powers over the trust. The typical purpose of a trust protector is to provide flexibility to an irrevocable trust. Common trust protector powers include the power to remove or to replace trustees; the power to veto or direct trust distributions; the power to add or remove beneficiaries; the power to change situs and the governing law of the trust; the power to approve, veto or direct investment decisions; the right to consent to exercise power of appointment; the power to amend the trust as to the administrative and dispositive provisions; the power to approve trustee accounts; the power to add a grantor as a beneficiary from a class of beneficiaries; and the power to terminate the trust.
20. See supra note 17.
21. Ibid.
22. Francis Becker and Pierce McDowell III, “Where Should You Situs Your Trust? A Look at South Dakota’s New Third Party Discretionary-Support Statute” LISI Estate Planning Newsletter #104 (May 10, 2007), www.leimbergservices.com.
23. See supra note 1.
24. See Al W. King III, “Trust Designs in Light of Kaestner And Other Trends,” Trusts & Estates (June 2019).
25. For example, Alaska, Delaware, New Hampshire, Nevada, South Dakota and Wyoming.
26. See supra note 1. For example, Alaska, South Dakota, Tennessee and Wyoming.
27. See supra note 1.
28. Ibid. Al W. King III, “Are Incentive Trusts Gaining Popularity?” Trusts & Estates (October 2017).
29. Advisors maintain that while not defined in the statute, the Franchise Tax Board regulations state that a non-contingent beneficiary is one whose interest isn’t subject to a condition precedent. A “condition precedent” is generally an event that must occur before the interest to which it’s annexed can vest or an act that’s to be performed before some right dependent thereon accrues. On the basis of this meaning, many advisors indicate that it would appear reasonable to assert that a beneficiary’s discretionary interest in a trust, such as a dynasty trust, is a contingent one.
30. Dep’t of Revenue v. Kimberley Rice Kaestner 1992 Family Trust, 139 S. Ct. 2213 (2019).
31. See supra note 24.
32. Al W. King III, “Decanting is a Popular Strategy, but Don’t Ignore Several Key Consideration,” Trusts & Estates (August 2018). Non-judicial modification/non-judicial settlement agreement statutes typically allow the beneficiaries, the grantor and/or other interested parties to modify an existing trust document without having to go to court. Certain states also provide judicial reformations/modifications, typically brought by a petition to court by the trustee or majority of beneficiaries. Decanting is the process of appointing trust property from one trust in favor of another trust. Some trusts provide the trustees the power to decant in a trust document. Also, many states have enacted decanting statutes that allow for such power to be exercised.
33. Ferri v. Powell-Ferri, 476 Mass. 651 (2017); Alexander A. Bove Jr. and Melissa Langa, “Ferri v. Powell—Decanting with the Stars,” Leimberg Information Services, Inc. (June 8, 2017); see also supra note 24; Sharon L. Klein, “Ferri v. Powell—Connecticut Supreme Court Finds that Trust Assets Were Moved Out of Reach of Divorcing Spouse, But Would Be Considered for Alimony Purposes,” Leimberg Information Services, Inc. (Sept. 6, 2017).
34. See supra note 24.
35. Ibid. Thereafter, the Connecticut Supreme Court issued two opinions, one regarding the decant and one regarding the divorce. It followed up the Massachusetts court’s ruling approving the decant with a ruling that held that the trust assets were moved out of reach of the divorce by the decant as a result of the discretionary distributions.
36. See supra note 1.
37. Ibid. Al W. King III, “Defend Against Attacks on DAPTs?” Trusts & Estates (October 2014).