Irrevocable Trust Drafting Tips
Of the two varieties of trusts — revocable and irrevocable – only the latter affords creditor protection. An irrevocable trust is what it implies: a trust that’s difficult to revoke.
Let me mention two features of an irrevocable trust that bolster asset protection: First, an irrevocable trust should not be a self-settled trust. Second, it is advantageous to have a discretionary distribution standard.
The Self-Settled Trust
A self-settled trust is one where the settlor and beneficiary are the same. In California, a self-settled trust fails as an asset protection vehicle. If the trust settlor is also a beneficiary, then those assets to which the settlor has retained the benefits will not be shielded from creditors.
The California Probate code provides,
(a) If the settlor is a beneficiary of a trust created by the settlor and the settlor’s interest is subject to a provision restraining the voluntary or involuntary transfer of the settlor’s interest, the restrain is invalid against transferees or creditors of the settlor. The invalidity of the restrain on transfer does not affect the validity of the trust.
(Prob. Code § 15304(a))
In plain English: The standard spendthrift clause is toothless in a self-settled trust. Creditors of settlor-beneficiary may execute against settlor-beneficiary’s assets held in such a trust. The toothless spendthrift provision, however, doesn’t invalidate the trust.
The code further provides:
(b) If the settlor is the beneficiary of a trust created by the settlor and the trust instrument provides that the trustee shall pay income or principal or both for the education or support of the beneficiary or gives the trustee discretion to determine the amount of income or principal or both to be paid to or for the benefit of the settlor, a transferee or creditor of the settlor may reach the maximum amount that the trustee could pay to or for the benefit of the settlor under the trust instrument, not exceeding the amount of the settlor’s proportionate contribution to the trust.
(Prob. Code § 15304(a))
The means that a discretionary standard is dangerous when combined with a self-settled trust. The settlor-beneficiary’s creditor can compel “the maximum” distribution amount that the trustee could pay to that settlor-beneficiary. The limitation on the amount reachable is the settlor’s proportionate contribution to the trust corpus.
To restate, a person who furnishes the consideration (asset, property, etc.) for the creation of a trust is the settlor. (McColgan v. Walter Magee, Inc., Cal. 1916).
This area of law is well-settled in California. Although a few states (such as Nevada and Alaska) have broken off from the traditional prohibition against self-settled trusts, a cautious California resident with California property would be wise to think twice before establishing one of these out-of-state irrevocable trusts.
The Discretionary Trust
By “discretionary trust,” we mean that the distribution standard imposed on the trustee is very liberal – the trustee’s discretion. In such an irrevocable trust, the trustee has discretion as to timing and amount of any distribution. The trustee even has the discretion as to whether to make a distribution!
The opposition of a discretionary standard is a mandatory standard. In the latter case, the trust directs that the trustee “shall” pay a given amount to a given person.
In terms of asset protection, the drafter aims for permissive language, rather than mandatory phrases (provided the trust is not a self-settled trust, see above). The settlor’s property right is so amorphous that the trustee cannot be compelled to pay a beneficiary’s creditor.
Does Irrevocable Mean Irrevocable
A postscript on the irrevocability of irrevocable trusts is in order. Even in California, an irrevocable trust can be revoked with the beneficiaries’ permission. The grantor may not withdraw contributions from the trust. As soon as assets are distributed from the trust to the beneficiary, they are no longer protected from taxation and creditors. Beneficiaries are not granted demand rights; the power of the irrevocable trust lies predominately with the trustee. It is important too, however, to take care when drafting an irrevocable trust, as the wording may unintentionally limit to whom and how much a trustee may distribute with their trust.