August 24, 2017
There have been a couple of recent cases that have concluded that there is no asset protection strategy to stop a formidable creditor, who has secured a federal judgment, from attaching a beneficiary’s interest in a trust created by, for example, Mom or Dad for their son or daughter as the beneficiary.
IRS tax lien. One such case was Duckett v. Enomoto, which involved the United States District Court (Arizona) issuing an opinion on April 18, 2016 (Case No. CV-14-01771-PHX-NVW) finding a beneficiary’s interest in a discretionary support trust (also known as a hybrid trust) to be subject to a federal tax lien.
Language in trust agreement. Unfortunately for the beneficiary, the trust in that case used the phrase stating that the independent “trustee shall pay” to the beneficiary trust distributions as needed for health, education and support. The trust did temper that mandate by giving the trustee sole discretion in determining how much (monetarily) such distributions should be.
Discretionary trust or not? The issue in the case was whether that “sole discretion” was sufficient to cause the trust assets to be, under the applicable state law, nothing more than a “mere expectancy” of any distribution being made (or a purely discretionary trust). If so, the beneficiary would have no rights or power to compel a distribution and therefore would not have any “property” right (from a federal law perspective) to the trust assets that the IRS could garnish.
The Court concluded that under Arizona’s Uniform Trust Code (UTC), the term “discretionary trusts” is broadly defined to include “support” trusts such as the one at hand, suggesting that the beneficiary has an enforceable right to compel distributions notwithstanding the discretionary nature of the trust provisions. As such, that right under Arizona law is sufficient under the broad federal definition of property to be an attachable asset for IRS lien purposes.
Recommended approach. To avoid this result, the trust should be created under a state or foreign law that has strong and clear law that establishes that a discretionary trust allows the beneficiaries nothing more than a mere expectancy in distributions, coupled with other favorable factors such as avoiding: (1) language in the trust agreement that includes any mandated distributions to the beneficiary or that suggests a purpose of the trust that would give the beneficiaries any entitlement to, or power to access, trust assets now or in the future (i.e., anything that would (i) impose a duty on the trustee to make a distribution or (ii) grant the beneficiary any power to control the ability to receive trust assets); (2) a history of regular distributions having been made to the beneficiary over the previous years; and (3) having a beneficiary be the sole current beneficiary.
Federal restitution case. Turning now to the more recent case of US v. Harris, No. 16-10152 (April 20, 2017) (Per Curium w/ Tallmun, Watford & Guirola), this Ninth Circuit US Court of Appeals addressed the protection of assets of a beneficiary of some purely discretionary trusts. Although discretionary, the trust agreements nevertheless expressed that the amounts to be distributed in the trustee’s discretion should be based on amounts that the trustee determined to be either necessary or advisable for the beneficiary’s health, education maintenance and best interests, or for his support. This in effect established the apparent purposes of the trusts.
The beneficiary became subject to a federal restitution order of over $600,000. The beneficiary disclaimed any interest he had in these trusts, and yet the federal order overrode (i) the state law spendthrift protections that otherwise applied to the trust assets and (ii) any view that a disclaimer removed an asset from the federal government’s reach.
Discretionary trust or not? The Court determined that the rights and control that the beneficiary held in his beneficial interest in the trust under California law rose to the level of being “property” of the beneficiary notwithstanding the discretionary nature of the trust and the subsequent disclaimer. The simple fact that the beneficiary could have brought an action against the trustee to make a distribution to the beneficiary if he can show that such distribution comports with the purpose of the trust, makes his eligibility for distributions a sufficient property interest that is subject to a federal garnishment. Furthermore, the federal law’s definition of property (specifically 28 U.S.C. Section 3002(12)) is so broad that even a disclaimer cannot remove such property from the reach of a federal writ of garnishment. The Per Curium Opinion also clearly states the general proposition that a spendthrift clause cannot withstand a federal lien.
Recommended approach. Query how this case would have panned out if the trust agreements simply stated that the trustee had sole and absolute discretion to pay distributions or not pay distributions, all as determined by the trustee. Note here no reference is made as to any criteria (health, best interest, support or otherwise) for deciding whether a distribution is to be made, if at all. It seems this is more likely to cause the trust assets to not rise to the level of being a “right,” rather it is a mere expectancy and as such, should not be “property” that could be subject to any federal garnishment or lien attachment.
Query. What if the trust agreements used only one criteria in the foregoing paragraph, stating that distributions are determined based solely on the beneficiary’s “best interests,” but then to define the term “best interests” as not including any distribution in which the beneficiary would be precluded from enjoying. This may appear protective on the surface, but runs the risk of again being attachable “property” because the beneficiary may be able to claim a right to a distribution under the right circumstances. Once that “right” is shown, the trust assets may then be established as property and therefore subject to a federal lien.
In closing, these cases provide some good insights on things to consider when creating and administering trusts. Of course, this is not intended as rendering legal advice upon which the recipient can rely for specific action.
By Edward D. Brown, Esq., LLM. CPA