Stupid Trust Tricks – When Asset Protection Fails

A Trust that was supposed to protect assets from creditors didn’t.  The reason why happens every day with most trusts.  Failure to follow simple guidelines could mean that your trust is vulnerable to the creditors of your children.  “Stupid Trust Tricks” are when people either have the wrong kind of trust for what they want to accomplish, or they are using the right kind of trust in the wrong way and defeat the trust’s purpose.

Trust Fail – Trust with Beneficiary Power of Appointment is Exposed to Creditors

Recently Forbes Magazine reported a case where an asset protection trust completely failed.  The Grantor created a Trust for his four children, then died.  The Trust had a classic “spendthrift” clause that was supposed to prevent a Beneficiary’s interest from being taken by that Beneficiary’s creditors.  Unfortunately, the Trust also gave the Beneficiaries what is called a “general power of appointment”.  This means the Beneficiary had the power to compel the Trustee to make distributions from the Trust.  The Trust specifically provided:

“In addition, the Trustees shall pay to or for the benefit of such child all or so much of the principal and accrued income of such share as such child may specifically demand in writing from the Trustees so long as such child is not incapacitated at time of demand.”

The Beneficiary filed Chapter 7 bankruptcy, and claimed that because of the spendthrift clause the Trust assets could not be taken in bankruptcy.  However, because of this general power of appointment, the Court ruled that the general power of appointment defeated the spendthrift clause.

Stupid Trust Tricks

I review hundreds of trusts every year as a complimentary service.  This kind of mistake is extremely common.  Most revocable living trusts do this.  The reason is that most revocable trusts are focused on the point of death and avoiding probate and estate taxes.  They do not look forward to “what then.”  The difference between regular estate planning and “dynasty” estate planning is that dynasty estate planning asks the “what then” question.  Now that we have avoided probate and estate taxes, how are we going to protect the inheritance both for the family and from the family.

There are many ways to do an end-run around a spend thrift clause.  This is just one of them.  Age based distributions are another common mistake.   When I talk to people, protecting their estate from the creditors of their children is a high priority.  This includes protecting their inheritance from divorce, medical crisis, bankruptcy, and car accidents, just to name a few.

What to Look For

If you have a trust, look at it.  If you can’t tell whether or not your trust effectively protects your assets from your children’s creditors, get help.  Have it reviewed by someone who knows what they are looking for.  If your trust does not protect your estate from the creditors of your children, taking it back to the person who prepared it for you with that problem in it in the first place isn’t going to make it any better.  If you don’t have a trust, you are not serious about protecting your assets from anyone, including your children’s creditors and ex-spouses.

To avoid defeating the spendthrift clause, distributions should be discretionary, not mandatory.  A Beneficiary should not have the power to compel distributions.  A Beneficiary should have no vested property interest in the Trust.  If the Beneficiary can compel distributions, the Beneficiary can be forced to do so by the Courts.  The power to protect necessarily includes the power to say “no” to a beneficiary’s demands for distribution.  This requires a level of planning that goes beyond most trusts.

A Trust can protect assets, but not every trust does.  Does yours?  Do you care?  What matters most?