Creating shifting trust provisions
The shifting trust allows you to give the client ease of understanding while preserving considerable (but not total) asset protection and flexibility. A shifting trust provision is particularly helpful after your attorney has suggested to the client an excellent asset-protected and extremely flexible trust (a non-self-settled, discretionary, spendthrift trust, with a letter of wishes and a protector), but the client isn’t able to understand the benefits and states: “All I want is to give each of my two children half of my estate in equal parts when they turn 25, 30 and 35, and do so in a way that they will be asset-protected.”
The trust states that the distributions are to occur at ages 25, 30 and 35 unless creditors, divorce, a lawsuit, an Internal Revenue Service lien or other adverse circumstances (about which the client has concern) are present. If these circumstances are present, the trust shifts from being mandatory to being discretionary.
In a mandatory trust, trustee liability is minimal because the trustee generally doesn’t need to exercise discretion. That is, he or she has been told what to do and when to do it.
However, in a discretionary trust, the trustee must use his or her discretion in regard to who among a class of beneficiaries should receive a distribution or a trust benefit, how much they should receive and when they should receive it.
How a Shifting Trust Works
Like the “shape shifter” of “Star Trek” fame, this type of trust shifts its purpose, its terms or its beneficiaries if either a creditor tries to penetrate it or the law changes. Because of this flexibility, a premium is placed on drafting the needed language into the trust.
Whether the shift is effective to avoid creditors depends on the nature of the interest retained by the beneficiary. The greater the equity of the claim, the less the beneficiary can retain in order to protect trust property. Where the beneficiary has no interest after the shift, the interest is spared creditor attachment. Under many circumstances, the beneficiary can retain a limited power of appointment over the interest.
It’s critical that the shift occurs because of language in the trust drafted to reflect the settlor’s intent to have his or her trust benefit certain persons and not others. The basis of the trust has nothing to do with the protection of the beneficiary but rather with implementing the donor’s intent and protecting his or her right to choose the objects of his or her bounty.
With a shifting trust, when terminating a beneficiary’s interest on the occurrence of a specified event, the beneficiary’s interests sometimes are characterized as being subject to a condition subsequent. If the beneficiary has any voice in exercising a shift, we would have to run the full gamut of a fraudulent transfer analysis.
The shift language for a shifting trust can be tied to any of the following instances:
Notice or belief by the trustee that the interest of the beneficiary can be diverted from the stated trust purpose.
A creditor attempting to attach a beneficiary’s interest.
The beneficiary initiating bankruptcy or becoming insolvent.
Any other criteria drafted to evidence the settlor’s intent.
[See, e.g., Miller v. Miller, 31 S.E.2d 844 (W.Va. 1944) (interest shifted upon filing for bankruptcy). See alsoIndustrial Nat’l Bank v. Budlong, 264 A2d 18 (1970); Jones v. Coon, 295 NW 162 (1940). Cf. Riggs Nat’l Bank, 57 AFTR 2d 86-1358, 636 F Supp 172, 86-1 USTC ¶9398.]
Exemption From Creditor Attachment
Forfeiture of a trust interest on any attempted alienation or attempted attachment by creditors, or upon the beneficiary’s insolvency or bankruptcy, generally is valid, even in jurisdictions that don’t recognize spendthrift trusts. This termination of a beneficiary’s interest shields the trust interest from creditor claims. The effectiveness of this device applies against the most tenacious claims.
Example: In re Fitzsimmons, 896 F2d 373 (9th Cir. 1990). In this case, the debtor was a beneficiary of a trust against which a tax lien was asserted. The trust provided that the termination of the beneficiary’s interest prevented the IRS from satisfying its tax claim. The Ninth Circuit held that the forfeiture was valid and “[b]ecause the beneficiary’s interest had terminated, no interest was left in him which would be reached by the assignee in bankruptcy for the benefit of creditors.”
Trusts that are exempted from creditor attachment under local law are excluded from the debtor’s estate in bankruptcy. Therefore, to the extent that shifting trusts provide protection under local law, they also provide protection in bankruptcy.
Termination is the surest way of protecting trust assets from the reach of creditors. However, shifting trusts also can protect against creditors, even if the beneficiary retains some interest in the trust, if the retained interest is so tenuous that he or she can’t force the trustee to make distributions.
Example: Industrial National Bank v. Budlong, 106 RI 780, 264 A2d 18 (1970). In this case, the court was faced with a trust that provided that if the beneficiary attempted to assign her right to income, the trust would shift to a discretionary trust. The court held that the attempted shift to a discretionary trust was ineffective because it didn’t extend the trustee’s discretion to distribute to persons other than the original beneficiary. However, the court stated that it’s possible to shift to a discretionary trust with more than one current beneficiary, which would be exempt from creditor attachment, but only if the trust’s terms “are sufficiently elastic to permit the trustee at his discretion to pay income, not only to the original beneficiary, but to others as well.” This agrees with the definition of “discretionary trust.” A beneficiary holds an interest not subject to attachment since the trustee’s broad discretion can be exercised to preclude or make any distribution to the beneficiary.
Suspension of Distributions on Specific Conditions
Some trust provisions suspend the beneficiary’s right to receive distributions upon the occurrence of various events (such as financial hardship) and reinstate that interest after those problems have passed.
Such trusts will be effective if the trustee’s discretion can be exercised so as to indefinitely suspend such distributions. The breadth of the discretion prevents it from being treated as a condition limited to merely the time of payment, which would result in the interest being subject to creditor attachment.
Trust provisions that suspend a beneficiary’s interest are valid if the trust provides that subsequent distributions to the beneficiary are subject to the trustee’s discretion to either withhold or make such distributions. Also, the trustee’s discretion must be broad enough to be exercised in connection with factors that take into account more than the beneficiary’s financial condition.
Example: A trust can provide that the trustee should withhold distributions if the beneficiary is taking drugs, is in litigation or is experiencing other difficulties that would make it unlikely that he or she would benefit from the trust assets as the settlor intended. This broad discretion will tend to counter a public policy argument that the trust arrangement is being misused to allow a beneficiary to avoid creditors.
Shifting Trust Clause Language
The shifting trust will need to include very specific language to cover certain situations. To terminate interest and create a discretionary interest, for example, the clause could start with:
Each beneficiary’s portion of the Trust shall be delivered to him free of trust:
One-Third (1/3) when the beneficiary turns __ [insert age];
Fifty Percent (50 percent) of the balance when he turns __; and
The balance when he turns __, unless the beneficiary is [being sued, involved in a bankruptcy proceeding, etc.].
The following clause is from Domo v. McCarthy, 612 N.E.2d 706, 709 (Ohio 1993). Some extra drafting work will be needed to fit the case language to the client’s specific situation.
“If [any of the above conditions apply] any part or all of such interest, but for this provision, would vest in or be enjoyed by any other individual or entity, other than by disclaimer, such interest shall terminate. Thereafter the Trustees may, in their discretion, pay to or expend for such person, any dependent of his or any other lineal descendant of mine, such amounts of the income or principal comprising such interest as the Trustees in their discretion deem proper. Upon the death of such person all such income or principal, if any, then held by the Trustees shall be treated as provided in this agreement for disposition upon his death.”
When converting from a spendthrift to a discretionary trust, your shifting trust clause language should be as follows:
In the event that the beneficiary attempts to assign, sell, transfer or otherwise dispose of his interest, this trust shall be held, administered and distributed as follows:
The beneficiaries of the trust shall be [name at least two or more];
The trustee shall have the power to distribute the income, principal or both for the benefit of all, or one or more of the beneficiaries as the trustee in his discretion thinks fit;
It’s settlor’s intention to hereby create a discretionary trust and, except as otherwise provided herein, no beneficiary hereunder has any ascertainable right to any portion of the trust assets.
Alan R. Eber is a pioneer in the asset protection field, having established a wide variety of wealth preservation structures since 1974. His firm’s Web site is http://assetprotectionlaw.com. He is the author of “Asset Protection Strategies and Forms” (www.jamespublishing.com or (800) 440-4780), from which this article is excerpted.