Thanks to that fountain of misinformation known as the internet, there is a great deal of confusion about what happens when a creditor attempts to enforce a judgment against a settlor of beneficiary of a trust. This article will attempt to clear up some of that confusion, using California law as an example (the laws of most states are similar, if not identical in effect, as to most issues). Note that this article is not aimed at trusts specifically designed for asset protection, i.e., so called Asset Protection Trusts (APTs), but rather the more common varietals of estate planning trusts. Statutory references herein are to the California Probate Code unless otherwise noted.
A. Creditors Of A Settlor
The settlor of a trust is a person who funds a trust, either initially or by making a subsequent gift to the trust. This part will consider how creditors will attempt to enforce a judgment against such a settlor.
1. Voidable Transaction
A creditor’s primary tool in dealing with a debtor who has settled a trust is to simply claw back the gift to the trust as a voidable transaction (was: fraudulent transfer). A creditor may seek to set aside a debtor’s gift to a trust as a voidable transaction (fraudulent transfer) under Civil Code § 3439.01, et seq. Because a gift inherently lacks reasonably equivalent value (REV), such gifts are highly susceptible to being set aside by creditors within the applicable extinguishment periods. These periods are:
- Generally, four years from the date of transfer, § 3439.09(a) and (b);
- For a claim that a debtor had an intent to diminish the rights of any creditor, greater of four years or one year from the date the transfer was or reasonably could have been discovered by the creditor, up to seven years, § 3439.09(a) and (c);
- Ten years in bankruptcy for transfers to a “self-settled trust or similar device” where a debtor had an intent to diminish the rights of any creditor, 11 U.S.C. § 548(e); or
- Ten years in bankruptcy where the debtor scheduled a federal tax liability, see, e.g., Mitchell v. Zagaroli (In re Zagaroli), 2020 WL 6495156 (Bk.W.D.N.C., Nov. 3, 2020).
Because of these relatively long periods, it is critical that a settlor not settle a trust unless three conditions exist: (1) the settlor is not insolvent, near insolvent, or rendered insolvent by the transfer (excluding from the solvency calculation exempt assets); (2) the settlor not have any significant creditors at the time of the transfer; and (3) the settlor must not have the intent to diminish the rights of any creditors, past, present or future.
The aforementioned conditions are sometimes referred to by the expression “severe clear”, i.e., the skies are completely clear of creditors and there are no clouds even on the horizon. Some planners will attempt to document the settlor’s condition of solvency and absence of creditors by way of a so-called “Affidavit of Solvency”.
2. Self-Settled Trusts
Self-settled trusts are those where a settlor is also a beneficiary of the trust. In a nutshell, here is what Probate Code § 15304 provides:
The spendthrift clause of a self-settled trust is not enforceable against a creditor of the settlor. § 15304(a), see also In re Cutter, 398 B.R. 6, 20 (B.A.P. 9th Cir. 2008), aff’d, 468 F. App’x 657 (9th Cir. 2011) (“While California law recognizes the validity of spendthrift trusts, any spendthrift provisions are invalid when the settlor is a beneficiary.” Id., at 20). However, the trust shall not be considered to be a self-settled trust if the settlor is a beneficiary of the trust only to the extent of taxes which may be paid or reimbursed. § 15304(c).
If the trust provides for discretionary distributions a settlor/beneficiary, a creditor may reach the maximum amount of the trust that the trustee could distribute to the settlor, but capped by the amount of the settlor/beneficiary’s contribution to the trust. § 15304(b).
Note that what constitutes a “self-settled trust” is not ipso facto determined by the trust instrument, but rather a court may look to the totality of the facts and circumstances to determine, basically, what is “really going on” in a particular situation:
“California law invalidating efforts of a settlor from using a trust to shield property from his or her creditors applies ‘even where the settlor is not a nominal beneficiary, as where a settlor attempts to create a spendthrift trust for the benefit of his or her minor children, to be managed by the settlor and revocable at his or her pleasure.’ ” 60 Cal. Jur.3d Trusts § 134 (2008)(emphasis added), citing Sheean v. Michel, 6 Cal.2d 324, 57 P.2d 127 (1936).
In re Cutter, 398 B.R. 6, 20 (B.A.P. 9th Cir. 2008), aff’d, 468 F. App’x 657 (9th Cir. 2011) (emphasis in original) (debtor funded trust for ostensible benefit of his children but was the trustee).
Self-settled spendthrift trusts, a/k/a “asset protection trusts”, are further discussed at § VI, infra.
3. Revocable Trusts
The most popular type of trust in the United States is the revocable trust, usually found in the form of the so-called “Living Trust” where the settlor is also (but not necessarily) the initial trustee and the primary lifetime beneficiary.
The assets of revocable trusts are available to creditor of the settlor during the settlor’s lifetime, § 18200, and then upon the settlor’s death are subject to claims against the settlor’s estate. § 19001(a). However, the settlor’s exemptions against judgment enforcement are preserved. § 18201.
Because of this, it is sometimes said that revocable trusts provide no asset protection. This may be true as to the settlor and the settlor’s estate, but not as to other non-settlor beneficiaries who do not hold a right of revocation. In other words, a revocable living trust may provide no asset protection to Dad as the settlor, but it may ― if structured correctly ― provide substantial asset protection to the kids against their own creditors upon Dad’s passing.
B. Creditors Of A Beneficiary (Including A Settlor/Beneficiary)
This section will consider the scenario the creditor attempts to enforce a judgment against the debtor in the debtor’s capacity as the beneficiary of a trust. Note that these same rules apply even where it is the settlor who is the targeted beneficiary. The import of these Probate Code provisions is as follows.
A beneficiary’s interest in principal and income is not available to creditors until it is paid if the trust has a spendthrift provision. § 15300 and 15301(a).
A creditor may enforce the judgment against principal due to be paid to a beneficiary if the creditor petitions under CCP § 709.010, and the court in its discretion orders the trustee to pay the principal to the creditor. § 15301(b).
A creditor may enforce the judgment against education or support payments, arising from either income or principal, only after those payments are made to the beneficiary. § 15302.
A creditor may not compel a trustee to pay principal or income to a beneficiary if the trustee has the discretion whether to make such payment. § 15303(a). This is true even if the trust instrument provides a standard for the exercise of the trustee’s discretion. § 15303(c).
Unless the trust has a spendthrift provision, the trustee will be liable to a creditor for making a discretionary payment to a beneficiary if the trustee has been served with process in a proceeding under CCP § 709.010 which seeks to reach the beneficiary’s interest in the trust. § 15303(b). This is true even if the trust instrument provides a standard for the exercise of the trustee’s discretion. § 15303(c).
Even where the trust has a spendthrift provision, a creditor may petition the court for an order directing that a trustee pay the creditor for any and all current and future distributions to the beneficiary from the trust, whether discretionary or not. § 15306.5(a). In this instance, however, the court may not order the trustee to pay creditor for any amount the court determines is necessary for the support of the beneficiary and the beneficiary’s dependents, § 15306(c), and the creditor shall only be paid 25% of other distributions. § 15306.5(b).
Even if the trust has a spendthrift provision, if the trust mandates a distribution or the trustee has decided to make a discretionary distribution, a creditor may petition the court under CCP § 709.010 for an order compelling the distribution to go towards satisfaction of the judgment. § 15307.
From the creditor’s perspective, what this means is that there is a big difference between two types of distributions:
(1) A creditor may obtain 100% of a distribution that is already due to be paid, or the trustee has exercised the discretion to make the payment but has not done so yet, per § 15301; and
(2) A creditor may only obtain 25% of future distributions, per § 15306.5.
Or, to put it differently, if the creditor wants 100% of the distribution, then the creditor should not seek an order as to future distributions under § 15306.5. Instead, the creditor must “catch the falling knife” by obtaining an order under § 15301 as each distribution comes due. See, e.g., Carmack v. Reynolds, 2 Cal.5th 844 (2017) (answering certified question from the 9th Cir. BAP regarding the interplay of §§ 15301 and 15306.5).
Obviously, catching the falling knife of a distribution is easy for a creditor if the distribution is mandatory under the trust document on a particular date. That same trick is, however, all but impossible in the case of a discretionary distribution where as a practical matter the creditor is unlikely to find out about the distribution until it has already been made. This is another reason why it is critically important that trust distributions be purely discretionary.
Note that none of the aforementioned provisions provides any protection to assets which the beneficiary has received; if those assets are protected at all, it will be because of some other creditor exemption under CCP § 704.010 et seq., i.e., once the cash hits the beneficiary’s bank account, all of it becomes fair game for creditors unless some other exemption can be established, such as CCP § 704.220 (money in a judgment debtor’s deposit account).
The foregoing provisions do make one thing crystal-clear from an asset protection perspective, which is that mandatory distributions are likely to end up 100% in the hands of a creditor, while discretionary distributions are more likely to have only 25% caught by a creditor, and in some instances not caught at all. Moreover, where a beneficiary has a creditor, the trustee may determine to exercise the discretion not to make any distribution at all. Thus, mandatory distributions should be avoided.
A caution is that if the creditor is successful in having a receiver appointed for the beneficiary, the receiver might be able to bring an action against the trustee under particular circumstances to compel the trustee to exercise the trustee’s discretion to make a distribution, and per § 15303(d) the foregoing provisions might not act as a check on such an attempt by a creditor.
C. Trusts Created To Defeat Creditors
In certain circumstances, a court may disregard a trust where the court has concluded that the trust was created to defeat creditors. This line of cases is based on Probate Code § 15203: “A trust may be created for any purpose that is not illegal or against public policy.” See, e.g., In re Marriage of Dick, 15 Cal. App. 4th 144, 161, 18 Cal. Rptr. 2d 743, 752 (1993) (“It is well-settled that a trust created for the purpose of defrauding creditors or other persons is illegal and may be disregarded.” Id., at 15 Cal. App. 4th 161, 18 Cal. Rptr. 2d 752).
Although the settlor may claim that the trust was not created to diminish the rights of creditors but for other purposes ― typically estate tax or succession planning ― that intent is often belied by documents other than the trust documents, primarily planning memoranda and e-mails between the settlor and trust planning counsel. To this end, note that attorney-client privilege is usually easier for creditors to get around, and thus obtain the planning memoranda and e-mails, than most counsel suspect. See, e.g., In re Icenhower, 755 F.3d 1130, 1141 (9th Cir. 2014) (A creditor need make only a prima facie showing that a fraudulent transfer has occurred to implicate the crime-fraud exception to attorney-client privilege and thus vitiate the attorney-client privilege).
D. Alter Ego ― Reverse Veil Piercing ― Nominee Theories
In California, alter ego liability may apply to trusts so as to allow a creditor to reverse-pierce the legal separateness of the debtor and the trustee. In re Schwarzkopf, 626 F.3d 1032, 1038 (9th Cir. 2010); Greenspan v. LADT, LLC, 191 Cal. App. 4th 486, 518, 121 Cal. Rptr. 3d 118, 143 (2010).
Alter ego challenges have been described to be “like lightning, it is rare, severe, and unprincipled.” F. Easterbook and D. Fischel, Limited Liability And The Corporation, U.Chi.L.Rev. (1985). Like lightning, it is difficult to predict when a court may find alter ego. While the court at least notionally looks to the elements of commonality of ownership and commonality of control, in practice a court will look at the totality of the relevant surrounding facts and circumstances to determine whether a relationship is sufficiently close for alter ego liability to apply ― basically, a “bad tuna” test where the court determines whether the relationship smells.
The only rational conclusion that we can come to in the area of alter ego challenges as they relate to trusts is this: There is a close relationship to the amount of control exerted by the debtor upon trust assets and the likelihood that the trust will be deemed to be the alter ego of that debtor. The more control that a debtor has over trust assets, the correspondingly more likely it will be that the court will determine the trust to be the alter ego of the debtor, and vice versa.
Note that although it has become popular in recent years to add the settlor or a beneficiary to a trust as some sort of limited co-trustee, such as an “investment trustee” or a “distribution trustee”, that is precisely the sort of control that increases the chances of a court’s alter ego finding. Otherwise stated, the more “strings” that a settlor or beneficiary has over a trust, the more likely that a court may later find it to be an alter ego. Although convenient to, and often desired by, settlors who want to control the trusts assets or activities after they have settled the trust, engaging in that practice is not commensurate with best practices where asset protection is a consideration.
Conclusion
The most important thing for a creditor attempting to get at a debtor’s interest in a trust is simply to first figure out what is going on, i.e., how the trust is structured, the role or roles that the debtor plays in regard to the trust, the transfers and distributions that have been made, and when those transfers and distributions were made. Without that, the creditor is otherwise simply flying blind. Once that information has been obtained, however, a creditor’s rights against the interests of the debtor in a trust is usually quite straightforward and set forth by the Probate Code.
Again, here I have focused on California law as an example but the laws of most other jurisdictions is quite similar. There are, of course, variations from state-to-state; for example, about half the states now protect the interests of a settlor-beneficiary as to a self-settled trust in many instances. But that then leads us into a conflicts of law analysis, which is for another day.
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