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Discretionary Trusts and Asset Protection

Traditionally, discretionary trusts were used for the following reasons: 1) parents did not want to give money outright to children with intrinsic problems such as drug addiction or poor judgment; 2) parents wanted to supplement the needs of disabled children while still allowing those children to receive government benefits; 3) parents were concerned that a child’s current spouse might become an ex-spouse who would seek to benefit from any money given to the child; 4) parents wanted to preserve the family wealth from one generation to the next; and 5) asset protection.

Until quite recently, the strong majority rule in almost every U.S. jurisdiction was that no creditor, not even an exception creditor or a Federal “super” creditor, was able to attach their claims to the principal in a discretionary trust.  Over the last decade, however, this common law principle has been put on its head in a few minority jurisdictions due to the publication of the Restatement Third of Trusts and the Uniform Trust Code; both of which ignored the common law on this point.  The reaction by a number of strong “trust jurisdictions” – such as South Dakota – was swift and clear.  They passed what are, in essence, anti-Third Restatement and anti-UTC laws which maintain the status quo ante.

The following are commonly-recognized as exception creditors: child support and alimony, the necessary expenses of a beneficiary, attorney fees, and governmental claims.  Note that jurisdictions vary on whether or not each of the above creditors is recognized as an exception creditor; some allow one or more while some recognize all of the above.  The IRS, the FTC, and Title 42 § 9607(1) (i.e., “CERCLA”) are Federal “super” creditors which means that they have their own lien or enforcement statute and do not rely on state statutes for enforcement.  More importantly, they do not recognize state law as it relates to “spendthrift protection” clauses found in most trust documents.

The only type of trust that protects against both Federal “super” creditors and state-recognized exception creditors is the discretionary trust (as opposed to a mandatory or a support trust). This is because the beneficiaries of a discretionary trust do not have a property interest in the trust; rather, they are deemed to hold a mere expectancy.  Because trust beneficiaries do not have a property right they are unable to sue the trustee to force a distribution (and, therefore, cannot be forced to do so by a creditor who stands in their shoes).  On the contrary, the typical or purely discretionary trust allows the trustee complete and uncontrolled discretion to make allocations of trust funds when they deem appropriate.  In general, a court would only review a trustee’s discretion if the trustee: a) had an improper motive; b) acted dishonestly; or c) failed to use their judgment.

For those who are unwilling to completely place their confidence in a trustee, please know that a “trustee replacement” provision is standard in most trust documents.  When the trustee knows that they may be replaced at any time, they tend to do exactly what they are told to do by the person holding the power of replacement.

There will be many more estate planning blog posts here in the future.  Please check back on a regular basis to see what’s new.  If you have a question about a certain estate planning issue/topic and would like me to blog about it, please send me an e-mail and I will put it in the queue.

As always, if you have an further questions about this post or any other issues relating to estate planning, asset protection, or tax law (domestic and international), please don’t hesitate to contact me.

Marion A. Keyes, J.D., LL.M.

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