Limiting the Rights of Trust Beneficiaries with a “Spendthrift” Clause

People who have accumulated wealth during their lifetime often want to pass it on to their children or grandchildren, but are afraid the inheritance will be quickly squandered. A “spendthrift trust” may help protect a beneficiary’s inheritance.

Trusts
A trust can be a legally-recognized entity with a separate existence, into which people transfer all or a portion of their assets. It is usually created by a trust “instrument” or “agreement,” which sets forth the procedures for dealing with the trust and its assets and how such assets will be managed and distributed, both during the lifetime of the person establishing the trust (the “trustor”) and after the death of the trustor.

Some trust beneficiaries are incapable of managing large sums of money. A “spendthrift” is one who is wasteful and foolish, especially when managing financial affairs. A common way of dealing with a spendthrift beneficiary is to put a “spendthrift” or “anti-alienation” clause in the trust instrument.

“Spendthrift” or “Anti-Alienation” Clauses
Courts generally agree that the person who establishes a trust has the ability to impose restrictions on distributions from the trust, provided such restrictions do not violate the law. Spendthrift clauses take many forms, but they basically accomplish the following:

• Creditors of the spendthrift beneficiary are unable to directly attach the assets of the trust or force the trustee to make payment directly to the creditor; the creditor must wait until the trustee distributes a payment or trust assets to the beneficiary and then pursue collection.
• The beneficiary is usually not allowed to sell, assign or transfer the beneficiary’s interest in the trust.
• The trustee may be given the power to refuse to distribute assets or the beneficiary may forfeit his interest in the trust if the beneficiary violates the spendthrift clause by attempting to sell, assign or transfer his interest in the trust, or files for bankruptcy.

Enforcement of Spendthrift Clauses
Spendthrift clauses are generally recognized by most states. However, most states will not allow spendthrift protection in a “self-settled” trust, i.e. when someone transfers assets to a trust and retains the right to the use and enjoyment of such assets, or to receive distributions from the trust. A Uniform Trust Code was completed by the Uniform Law Commission in 2000 to provide a comprehensive model for state trust law (Model Code). Although it has been adopted by only a few states, many others are considering adoption of the Model Code.

The Model Code states that a spendthrift clause is valid only if it restricts both “voluntary” and “involuntary” transfers by a beneficiary, i.e. a trust cannot allow a beneficiary to sell his expected interest, while preventing creditors from reaching the beneficiary’s interest. The Model Code states such clauses are enforceable, but not against:

• A judgment or court order for support or maintenance of a child, spouse, or former spouse;
• A creditor who has provided services for the protection of the beneficiary’s interest in the trust, such as an attorney; and
• A claim by a state or federal government, such as for non-payment of taxes, to the extent allowed under state or federal law.

Protection in Bankruptcy
A person filing for bankruptcy must generally reveal all assets to the court; such assets may be used to pay the claims of creditors. However, a beneficiary’s interest in a trust with a spendthrift clause may be exempt from consideration as an asset of the bankruptcy estate, as long as the spendthrift clause is valid under applicable state law and the beneficiary does not have immediate entitlement to it.

For example, Aunt Flo left a large bequest in her trust to her niece, Mary. Before Mary is entitled to receive her share of the trust, she spends herself deep into debt and files for bankruptcy. Aunt Flo’s trust contains a spendthrift clause stipulating that Mary’s share of the trust cannot be used to pay her creditors. If the spendthrift clause is enforceable under applicable law, Mary’s share of the trust may not be part of her bankruptcy assets and therefore may not be used to satisfy Mary’s present debts.