One important consideration in estate planning is whether assets left in trust to a beneficiary may become subject to the beneficiary’s own creditors’ claims. The California Supreme Court recently addressed this issue in Carmack v. Reynolds (2017) 2 C5th 844 and resolved certain ambiguities in California’s Probate Code sections 15300 et. seq.
In Carmack, the beneficiary had filed for bankruptcy protection and the bankruptcy trustee, who collects assets to pay creditor claims, proceeded against the beneficiary’s interest in his deceased father’s trust. The trust provided that the beneficiary would receive $250,000 outright immediately, a further $100,000 annually for the next ten (10) years, and finally one-third of whatever then still remained. All distributions involved trust principal as the trust did not produce income.
Like most trusts, this trust contained a protective “spendthrift clause” that prohibits the trustee from directly honoring any voluntary or involuntary transfers (of the beneficiary’s interest) made by or against the beneficiary, such as to pay the beneficiary’s judgment debts.
At issue was the extent to which the beneficiary’s rights to receive undistributed trust assets could become subject to a court order directing the Trustee to pay the beneficiary’s own judgment debts.
To the extent that the trust beneficiary inside bankruptcy could limit the bankruptcy trustee’s actions to collect against the beneficiary’s interest in his father’s spendthrift trust (inheritance) then that inheritance would eventually be received after the conclusion of the bankruptcy. The beneficiary would then no longer be answerable for the debts discharged inside the bankruptcy.
The general rule in California is, “that principal held in a spendthrift trust may not be touched by creditors until it is paid to the beneficiary.” The Carmack case, however, focused on what the Court called a corollary rule, “that once an amount of principal has become due and payable, the court can order the trustee to pay that amount directly to the beneficiary’s creditors instead.”
Thus the $250,000 trust distribution that was due and payable immediately was subject to creditor action to enforce their claims. Accordingly, the bankruptcy trustee could petition the court to enforce some or all of the beneficiary’s bankruptcy debts against the first $250,000.
However, to the extent that a trust distribution is both intended and necessary for the support and education of a trust beneficiary then some or all of it is protected in the hands of the trustee. If authorized, the trustee could make payments for the benefit of the beneficiary and avoid paying the beneficiary directly. Once received by the beneficiary, the distributed money is subject to creditor actions against the beneficiary personally.
With respect to the ten (10) future annual distributions of principal, however, a different rule applied. These future distributions could also be included in the present order for collection but only up to twenty-five percent (25%) of each distribution; itself subject reduction to the extent that the, “… court determines is necessary for the support of the beneficiary and all the persons the beneficiary is required to support.”
However, down the road, as these annual distributions became presently due payable, the remaining seventy-five percent (75%) could then also become subject to further petitions by judgment creditors.
The results in the Carmack case could have been avoided if the father’s trust had been drafted to provide the Trustee special discretionary power to withhold all distributions in the event that the beneficiary had compelling creditor problems. The trust could have provided that the trustee then distribute trust income and principal only to the extent necessary for the beneficiary’s own support and education. The trustee in that case could not be ordered to pay ordinary judgement debts.