Creditors’ Rights vs. Trustees’ Protections
“Creditors’ Rights vs. Trustees Protection,” that’s the subject of today’s ACTEC Trust and Estate Talk.
This is Toni Ann Kruse, ACTEC fellow from New York City. Today, we will explore a general overview of creditor rights and trustee protections. To educate us on this topic, you will be hearing from ACTEC Fellows, Paul Barulich of Burlingame, California; John Moran of West Palm Beach, Florida; Eric Penzer of Uniondale, New York; and Beth Weinewuth of Cincinnati, Ohio. Please welcome Paul, John, Eric, and Beth.
Hello folks. This is Paul Barulich, and I have the privilege of moderating this podcast. Let’s first focus on deceased settlor trust estates. There are two important concepts that one must be aware when confronted with creditor claims against the deceased settlor. First, each state has codified specific processes that the creditor must be aware of or risk being entirely barred from satisfying the claim. And second, most all states have a specific, if not latent time limitations, which are designed to cut off creditor claims. Most importantly, these procedures in time and limitation periods vary from state to state.
Creditor Claims and Limits: California
For example, here in California, with few exceptions, the creditor of a deceased settlor cannot present its claim directly to a trustee of the revocable trust but must first seek recovery from the deceased settlor’s probate estate and may even have to open up the probate estate to satisfy this procedural condition. In addition, California has a one-year time limitation for claims to be commenced, if not otherwise cut short by the four-month statutory limitations period once the probate estate is open. And importantly, a California trustee owes no duty to a creditor to alert them as to the existence of the trust estate or the fact the claims must be brought within the one-year time period, again, subject to certain exceptions.
Eric, what are some of the general rules applicable to creditors of deceased settlors in New York?
Creditor Claims and Limits: New York
New York’s procedure governing the presentation and determination of a creditors’ claims against an estate is set forth in Article 18 of our Surrogate’s Court Procedure Act, and I could talk about that for an hour, which of course I won’t do. What I’ve discovered having prepared this presentation is that our procedure differs from that in other states in a couple of significant respects. One of which is that a fiduciary isn’t required to search for creditors, isn’t required to provide any notice published or otherwise to creditors. It’s presumed that a creditor acting with diligence will learn of the death of its debtor and proceed against his or her estate. Another big distinction is that there’s no claims barred period, for lack of a better term. There’s no period in which a creditor is required to present its claim would be precluded from doing so. And, in fact, we look back to the statute of limitations that would govern the claim had it been asserted during the decedent’s lifetime. I believe that’s different than a lot of other states, including yours, right, Beth?
Creditor Claims and Limits: Ohio
Yes, that’s right, Eric. In Ohio, there is a strict limitations period for a creditor to present a claim to a duly appointed executor or administrator of an estate. That strict limitations period is six months from the date of death of the decedent, not from the time that the estate is open, from the date of death. So, if no probate estate is open before that time, the creditor must open the estate themselves, which is permitted by statute in Ohio, or risk bar of their claims. I’ve discovered through our work together on this presentation that this is a pretty unique situation in Ohio, that there is a very strict claims presentment statute triggered by date of death of the decedent in Ohio, and so, that’s something that we need to really pay close attention to. That’s very different for Ohio. How about you, John?
Creditor Claims and Limits: Florida
Well, similar to some of the things you guys are saying, down here in Florida, a creditor’s right to recover goes through the estate. All roads to recovery lead through the decedent’s estate. Even if there is a revocable trust. There’s actually a mechanism, similar to what you guys have described in your own states, where the personal representative of a Florida estate gets a claim and then can request funds if the estate’s a liquid from a decedent’s revocable trust.
But only six months in Ohio, Beth? That’s a pretty short time. I thought the two-year statute of non-claim in Florida was pretty short. You guys have talked about this a little bit in the context of a statute of limitations. Down here in Florida it’s pretty strict. It’s a two year from the decedent’s date of death statute of non-claim, a jurisdictional bar. So, we have a little bit more time than you do up in the heart of it all. But, two years, if you wait too long, you’re out.
Creditors’ Rights Against Debtor Beneficiary
Well, that differs from California, John, that we have that one-year statute that I mentioned earlier. So, with that in mind, let’s switch gears and let’s talk about creditors’ rights as against a debtor beneficiary of an irrevocable trust. We’ll discuss the four types of trust provisions that are for most of us thought to be one in the same but have different effects on creditor rights. And they are: spendthrift provisions, which focus on the protections against creditor claims asserted against the beneficiary; support provisions, which have as its focus, beneficiary needs; discretionary provisions, which places emphasis on the breadth and scope of the trustee powers; and forfeiture provisions, which serves as a draconian penalty for acts of the beneficiary that the settlor intended to discourage. Eric, take us away on spendthrifts.
Okay. A spendthrift trust restrains alienation of the beneficiary’s interest in the trust, making restricted beneficiary from assigning his or her interest, and it could also prevent the creditors of the beneficiary from accessing or attaching the beneficiary’s interest. You can’t have one without the other. I mean, you cannot prevent creditors from accessing or attaching the beneficiary’s interests without also restraining the beneficiary from alienating the interest. Significantly, a spendthrift trust has no application once the money’s out of the trust. So, it doesn’t prevent beneficiaries from alienating trust property that’s been distributed to them. It also doesn’t prevent creditors from reaching property that’s been distributed to a beneficiary.
Now, historically, it might surprise you to learn that under English common law, spendthrift provisions were void as creating an unlawful restraint on alienation and as against public policy. By contrast, spendthrift provisions are now recognized under the laws of all 50 states- either statutorily, judicially, or both- thirty states have adopted the spendthrift rules under the UTC. In the early to mid-1800s, the state courts started to view spendthrift provisions with favor, and in 1875 United States Supreme Court case in dicta, the court made the formal break with English common law.
You said, Paul, tell us about creditors’ rights. The enforceability of spendthrift restraints in the United States is not really grounded in a beneficiary’s protection; the rights of the creditor don’t factor into it primarily as much as the enforceability is a function of acknowledging donors’ rights. If a donor is making a voluntary gift of property, the theory goes that the donor should be able to condition that gift and to make sure that the intended beneficiary has the continued use and the uninterrupted benefit of the gift.
A couple of things to keep you aware of though, you have to control, just like we’re talking about with respect to creditors of a decedent, with respect to a beneficiary, we have to look to state law. State law differs with respect to the scope of enforceability of spendthrift restraints. A lot of states have what we call exception creditors, dependents, tort creditors, taxing authorities. These are creditors that are not always bound by the limitation of spendthrift restraints. There are state-specific limitations. For example, in California, up to 25% of a beneficiary’s trust interest can be attached by a creditor.
Historically, there’s been prescriptions against the use of spendthrift restraints to shield assets of self-settled trusts. That’s now being chipped away at a bit by offshore asset protection trust laws in other jurisdictions, and also by domestic asset protection trust laws in the United States. It’s important to know your state’s law regarding the enforceability and limitations on the spendthrift restraints. For example, spendthrift restraint is a default in some states, and to get away from spendthrift restraints, you have to opt-out. That’s the law in New York. Like so many aspects of estate planning, the decision, whether to include a spendthrift restraint in an instrument and its scope should turn on the grantor’s intent.
So, know your state’s law and know your grantor’s intent.
All right. That’s interesting and a good segue, Eric, to John and Beth. Let’s talk about support provisions and discretionary rights.
Well, Paul, when you’re talking about support provisions, really what you’re just talking about is a trust that has distribution standards based on a beneficiary’s support needs. And when we’re talking about it, what we’re really talking about is an ascertainable standard or more commonly, the HEMS standard, right? That’s the health, education, and maintenance and support standard. And it’s different from what Eric’s been talking about with spendthrift provisions.
A support standard, a provision that’s limited to a HEMS standard, looks to the beneficiary and what’s going on with the beneficiary to determine whether or not there’s going to be a distribution of any assets from a trust. From the perspective of the UTC and the restatement, there’s really not supposed to be a distinction between a support trust and a discretionary trust, but from a practical perspective, they’re really not viewed the same way from a creditor protection standpoint.
And this is particularly true in kind of blurry situations wherein a support trust, the HEMS’s trust, you’ve got a beneficiary who is also a trustee, or you have in some circumstances a beneficiary, depending on state law, who might be deemed a settlor if they have a power of appointment or some other power to invade or distribute property for the benefit of themselves.
And so, in those circumstances, at least according to the restatement, the court will typically balance those needs. The beneficiary’s needs and cross the support standard versus the creditors demands to access the funds. But, Beth, what’s the difference between that and a fully discretionary trust? Because if you ask estate planners, they kind of point out a big difference.
Discretionary Trust Provisions
Exactly right, John. The discretionary trust is generally regarded as the go-to, the gold standard, for protection from creditors’ claims against trust beneficiaries. The reason for this is that the beneficiary has no right, legal or equitable, to any distributions from the trust when there is a wholly discretionary standard. In the language we’re talking about, there would be distributions in the sole discretion of the trustee, if any, as opposed to distributions for the comfort, maintenance, and support of the beneficiary, that would be the difference.
Because the trustee has the sole discretion, whether to make any distribution, there is even less to grab onto for the creditor, less argument for the creditor to be able to grab onto any right or interest that beneficiary has in the trust. If the beneficiary has no rights to compel distributions, the creditor has no rights to collect against those. The trade-off being that when you’re considering a wholly discretionary trust, you got to put a great deal of trust in that trustee in whom you are vesting such power.
So, select your trustee wisely, Beth; correct?
Exactly. Exactly. All right.
Well, Beth, take us home on the forfeiture provisions.
Well, forfeiture on alienation clauses in trusts are the most draconian of methods for protecting trust assets from the creditors of a beneficiary. Generally speaking, they provide that if the beneficiary attempts to transfer or assign, voluntarily or involuntary (I’m thinking of bankruptcy) then their interest in the trust is forfeited completely. They are no longer a beneficiary. If you try to alienate, if you try to assign, you are out.
Similar to a no-contest clause, for example, they are punitive and pedagogical in nature. The purpose of them generally is to incentivize or disincentivize behavior by the beneficiary. So, if the beneficiary does this thing that the settlor does not want them to do, then they are out.
Now, there are some forfeiture on alienation clauses that provide a safety net to say, “If you alienate your interest in the trust, then you no longer get the assets outright, but the trustee can continue to make distributions under a wholly discretionary standard.” So, you’re still sort of protected.
Now, as a practical matter, forfeiture clauses, they are enforceable under the laws of most states and they do provide creditor protection for the same reason that a discretionary trust does, in that if the beneficiary is no longer a beneficiary, there’s no beneficial interest for the creditor to attach. But their highest and best use is likely that teaching mechanism, that incentive for good behavior or disincentive for bad, raising the question: if you’re going to put that safety net in of it slipping to a wholly discretionary standard, does it really achieve that pedagogical purpose, that draconian risk of losing your fortune? And so, if that is indeed the intention, the pure forfeiture on alienation clause is probably the best planning tool.
Thank you for that, Beth, and thank you all for listening to the podcast. Probably the most important takeaways for the listener who represents either the trustee or the creditors to know the state rules that govern both presentation and timing of creditor claims, or risk dealing with the upset and disappointed client. Thank you for your time today.
Wonderful. Thank you all so much for educating us on this topic. We appreciate all of your time. Have a great day.
You may also be interested in:
This podcast was produced by The American College of Trust and Estate Counsel, ACTEC. Listeners, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal or tax advice from their own counsel. The material in this podcast is for information purposes only and is not intended to and should not be treated as legal advice or tax advice. The views expressed are those of speakers as of the date noted and not necessarily those of ACTEC or any speaker’s employer or firm. The information, opinions, and recommendations presented in this Podcast are for general information only and any reliance on the information provided in this Podcast is done at your own risk. The entire contents and design of this Podcast, are the property of ACTEC, or used by ACTEC with permission, and are protected under U.S. and international copyright and trademark laws. Except as otherwise provided herein, users of this Podcast may save and use information contained in the Podcast only for personal or other non-commercial, educational purposes. No other use, including, without limitation, reproduction, retransmission or editing, of this Podcast may be made without the prior written permission of The American College of Trust and Estate Counsel.
If you have ideas for a future ACTEC Trust & Estate Talk topic, please contact us at ACTECpodcast@ACTEC.org.
© 2018 – 2023 The American College of Trust and Estate Counsel. All rights reserved.
Latest ACTEC Trust and Estate Talk Podcasts
Patagonia Purpose Trusts
The founder of Patagonia clothing transferred $3B of stock to a Purpose Trust. What is a Purpose Trust and how does it meet Patagonia’s corporate objectives?
Tips for Joint Representation of Spouses: Part 2 of 2
Podcast two of joint representation offers four more tips for lawyers and the red flags to watch out for as they ensure both spouses are represented equally.
Tips for Joint Representation of Spouses: Engagement Letters (Pt. 1 of 2)
Four tips practitioners need to keep in mind when providing joint representation to spouses and where to find sample attorney engagement letters.