Spendthrift Trusts: Saving Inheritance from Creditors

Before diving into this article — inspired by a recent question from one of our clients — it should be noted that Washington State residents can open trusts in other states for asset protection in Washington.

Question: What do I do if I have children or a beneficiary that has creditors after them, but I want to provide for them financially?

Answer: It’s tricky, but the best tool is to establish a “spendthrift trust” for their benefit. A valid spendthrift trust is a trust in which the following factors are present:

1. The settler (creator) of the trust is not the trust beneficiary;
2. The beneficiary of the trust has only limited or no control over the trust assets; and
3. An anti-alienation clause in the trust prohibits both the voluntary and involuntary transfer of the beneficiary’s interest in the trust.

Investment Bonus: A spendthrift trust need not sit in a simple savings account. It can be structured to invest for growth, to increase income to the beneficiaries or prolong its effectiveness.

Spendthrift Trusts in Bankruptcy

Question: What if my beneficiary needs to file bankruptcy? Is the trust protected?

Answer: The Bankruptcy Code has been set up as broadly as possible to include as many of the debtor’s assets as possible. However, careful planning can remove certain assets from the reach of creditors.

USC Code Section 541(c)(2) (our bankruptcy law) states that:

[Trusts] which have a restriction on the transfer of a beneficial interest of the debtor in a trust that is enforceable under applicable non-bankruptcy law is enforceable in a case under this title.

In plain English, this means that if the beneficiary of the trust/debtor cannot control or reach assets, then those assets will not be a part of the bankruptcy estate.

There are three typical categories of trusts purporting to be valid spendthrift trusts where the spendthrift provision may be invalidated thereby bringing the trust assets into the bankruptcy estate. These are:

1. Self-settled trusts;
2. Trusts where the debtor-settlor exercises dominion and control over the trust; and
3. Trusts where the debtor-beneficiary exercises dominion and control over the trust.

Self Settled Trusts and Bankruptcy Code

In 1997, Alaska and Delaware became the first states to recognize self settled (created by the Debtor) trusts for creditor protection. These are referred to as “Domestic Asset Protection Trusts.” Currently, there are 11 states with such protection: Rhode Island, Nevada, Utah, Oklahoma, South Dakota, Missouri, Tennessee, Wyoming and New Hampshire have since ‘followed suit.’ (Note: these states have smaller economies and are generally looking for ways to pull money into their economy).

Bottom Line: If you are looking to pass assets to children or grandchildren with creditor problems, or you are going to receive an inheritance and are looking for a way to protect it from creditors, consider a spendthrift trust to protect yourself and your loved ones.

Have questions regarding how to protect your assets? Contact one of our estate planning attorneys.