Discretionary Trusts Can Trump Bankruptcy Liquidation

 

The simple answers are usually painfully wrong, and the real art of asset protection is the exercise of considerable forethought as to how the structure will work under extreme duress, with creditors getting writs and orders so as to financially strangle the Debtor.

Sometimes giving assets to a loved one in hopes of protecting those assets from future creditors may not be such a good idea. This is especially true when the loved one is a young one. No, if you want your asset protection planning to be successful, then that usually means a trust is necessary.

Trusts are incredibly powerful tools for a number of reasons, foremost because they allow you to protect both the beneficiary and the assets.

A powerful lesson on trusts recently came out and is featured in a recent Forbes article. It’s the case of re McCoy, 2011 WL 6748388 (Bkrtcy.W.D.Wis., Slip Copy, Dec. 21, 2011) and it’s worth a look.

The case focuses on a trust containing a “spendthrift provision” against bankruptcy. A mother set up the trust for her daughter (and soon to be debtor) with her son as trustee. The trust has a spendthrift provision, meaning that the assets are controlled and kept from the beneficiary except in regular distributions. Further, the trust provided that the brother, as trustee, has discretionary control over the distributions, and can release them or hold them in the trust as deemed appropriate in his capacity as trustee.

The daughter went bankrupt. Soon thereafter, her bankruptcy trustee soon turned a leering eye to those trust funds. You see, bankruptcy is about marshalling the available assets of a debtor to pay as many debts as possible. However, thanks to the spendthrift provision the trust funds are immediately disqualified from consideration.

Why? Because the beneficiary doesn’t “own or exercise control” over them. Nevertheless, the bankruptcy trustee did try to grab an upcoming distribution, thinking it was leaving the trust and therefore fair game. This, too, was denied, because the trustee had discretionary control over its release and simply wouldn’t release it into the hungry jaws of creditors.

If the trust had appointed the brother as trustee without granting discretionary powers and, instead, required mandatory distributions, then the distributions would have fallen into the hands of the creditors – but instead it was saved.

In the end, there are a few good lessons for the wise in this case. Here are a succinct few advanced by the Forbes author:

1. A well-drafted Living Trust can provide, as here, very substantial asset protection for beneficiaries. Mark me as in the camp that says that children should never be given a significant gift outside of a trust, since children (particularly those with money, but without experience) are prone to develop creditors.
2. A well-drafted non-self-settled trust can provide, as here, very substantial asset protection for beneficiaries. Contrast this with self-settled spendthrift trusts (a/k/a “asset protection trusts” which despite their nickname provide at best highly dubious and almost entirely untested asset protection advantages). See Chart Regarding Effectiveness of Asset Protection Trusts
3. For asset protection purposes, trusts should be drafted as discretionary trusts. Remember: If a beneficiary has a right to the trust assets or payments, etc., so will creditors.

To learn more and to successfully set up a trust for your loved ones, you will want competent counsel. This is not a Do-It-Yourself project.

Reference: Forbes (December 28, 2011) “The Real McCoy: Living Trust Provides Spendthrift Protection To Assets Of Beneficiary In Bankruptcy”