Beneficiary Controlled Trusts — Request for Input

Tye J. Klooster of the Chicago law firm of Katten Muchin Rosenman LLP supplied the material below and has requested your thoughts, comments, suggestions, etc.  If you would like to comment, please use the comment feature below.

In recent years the “beneficiary controlled trust” concept has become very popular. Upon the death of the survivor, the trust is basically split into separate shares for the children and maintained in separate so-called “Discretionary Trusts.” In the trust, distributions can be made to the beneficiary for his health, education, support and maintenance (“HESM”), or if there is another Co-Trustee who is not the beneficiary, the other Co-Trustee can make distributions for his “best interests” (or for whatever reason). Typically the child has the ability to serve as sole Trustee at say age 30, or appoint himself and another (his best friend or spouse) as Co-Trustees. Note that the beneficiary’s children, while contingent remaindermen, are not current beneficiaries of the trust (they have a contingent interest subject to divestment because the beneficiary also has a special power of appointment).

I question whether a trust’s spendthrift provision will be respected by a court where the sole current beneficiary is also the sole Trustee, even if the distributional standard is limited to an ascertainable standard such as HESM.

The Restatement Third of Trusts, comment g, provides that if the sole beneficiary is the sole Trustee, the spendthrift provision is not valid and therefore it is subject to creditors (even if limited to HESM).

The UTC was originally silent on this issue, but then in 2004 amended the Code to hold that the spendthrift protection will be upheld in a sole beneficiary-sole Trustee context if the distributions are limited to HESM.

What are the courts saying?

In re Bottom, 176 B.R. 950 (Bankr. N.D. Fla. 1994): “The Florida courts have indicated that a spendthrift trust is defined to be those trusts that are created with a view of providing a fund for the maintenance of another, and at the same time securing it against his own improvidence or incapacity for self-protection. Such a policy is not served by the facts of the case at bar. Because [debtor] is named as the sole Trustee of his own trust, the only one that can guard [debtor] from his own improvidence is [debtor] himself. It is for this reason that the trustee and the sole beneficiary cannot be one in the same under Florida law.”

In re McCoy, 2002 WL 1611588 (Bankr. N.D. Ill. 2002): In the case the court held that debtor had too much control over the trust. He was the sole Trustee and the primary beneficiary of the trust (children were also beneficiaries). Distributions were limited HESM. Court held that he alone could determine what was necessary for his HESM; that is, “there is nothing in the Family Trust to prevent Debtor, as trustee of the Family Trust, from making a determination that any particular sumptious luxury or indulgence is required or desirable for his health maintenance or support” . . . . Held, part of bankruptcy estate.

In re Coumbe, 304 B.R. 378 (9th Cir. 2003): Under Arizona law, if the sole beneficiary is the sole Trustee, the trust is not a spendthrift trust.

Morrison v. Doyle, 582 N.W.2d 237 (Minn. 1998): Opposite holding. The court, in relying on many Minnesota statutory rules (which I don’t believe we have in Illinois or Florida) basically held that if limited by HESM you have no problem on this issue.

I just worry that in moving toward the “beneficiary controlled trust” concept that we have not focused on creditor protection enough. Rather, most estate planning attorneys focus too much (or only) on estate tax inclusion. If limited by HESM, the power is not a general power and therefore not included in the gross estate. But what about creditor protection? The Restatement and the cases cited above should give us some pause.

It is my belief, at least at the moment, that we should be advising clients of the potential problem with beneficiary-controlled trusts. We should be explaining that these cases exist and that if the sole beneficiary is the sole Trustee a creditor may very well be successful in arguing, particular in outrageous cases (say a tort case or a case where debtor is not respecting HESM), that the trust should be part of bankruptcy estate. We should also advise that if the beneficiary is only a Co-Trustee or the beneficiary’s children are also named as current beneficiaries, that these problems go away.

Anytime there is too much control by a sole beneficiary-sole Trustee you are rolling the dice. Perhaps we need to pursue legislation similar to the 2004 amendment to the UTC in our own jurisdictions that allows sole beneficiary-sole Trustee if limited by HESM. This would comport law with current estate planning practices.

In the meantime, clients need to be advised that if they are looking for greater creditor protection the sole beneficiary should not be the sole Trustee.

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