Spendthrift Trusts: Protecting Your Beneficiaries from Themselves, Others

In structuring a revocable living trust, how the trust’s assets will be distributed to your named beneficiaries, after your death, typically follows one of two options:

• The trust is liquidated, with its assets distributed outright to the beneficiaries (often in cases of small inheritances or low creditor risk, or when administrative simplicity is a priority).
  
  
• The trust becomes irrevocable upon your death and continues to hold all or some assets, which are managed by a successor trustee (a beneficiary or a non-beneficiary third party).

The second option, a “spendthrift” trust, is designed to protect a beneficiary’s inheritance from legal threats and/or the beneficiary’s own bad decision-making.

The differences between the two options can be profound, and this article will describe why many estate plans – especially in high net worth or creditor-sensitive situations – embrace the spendthrift option.

REQUIREMENTS. Before we get into the most common benefits, let’s cover some basic rules. To be effective, a spendthrift trust requires three things:

• irrevocability, as mentioned above;
  
  
• restricted distribution standards (e.g., health, education, maintenance, and support) for trusts that beneficiaries will control directly, or the even more protective purely discretionary standard for trusts managed by third-party trustees; and
  
  
• a spendthrift clause prohibiting the beneficiary from selling or transferring their beneficial interest in the trust.

STRUCTURE. In creating your trust, you can establish “subtrusts,” or separate spendthrift trust shares for each beneficiary, and attach conditions that reflect their individual situations and capacities. For example, you can designate for each beneficiary the age at which they can take over as their own trustee, or you might attach other conditions (e.g., years of sobriety), conveying a tailored level of protection and control. (Caution and restraint are appropriate here; see our article, “Estate Planning: Protecting from the Grave.”)

Not all estate planning attorneys offer this customization in their plans, and it’s a significant value-added feature for clients of Hoopes Adams & Scharber.

BENEFITS. Once the requirements are met and the appropriate structure is in place, your spendthrift trust is ready to deliver substantial benefits to you and your beneficiaries.

1. Asset Protection. With a spendthrift trust, its assets are not legally “owned” outright by the beneficiary. They remain in the trust, where each beneficiary’s share of the trust assets is protected from lawsuits, creditor claims, bankruptcy, divorce claims, and bankruptcy.

This protection is especially important if a beneficiary – by virtue of their occupation, business interests, marital situation, or history of reckless conduct – is unusually vulnerable to litigation or financial losses.

In contrast, any assets that are distributed outright to the beneficiary immediately become the beneficiary’s personal property and lose the above-described protection at the moment of distribution.

2. Business and Professional Liability Shield. In this context, a spendthrift trust can be especially valuable for beneficiaries who, by virtue of their profession or business ownership – e.g., physicians, attorneys, real estate developers, or business owners in high-exposure industries – are especially vulnerable to lawsuits.

A spendthrift structure can insulate them from claims stemming from malpractice or business liability and provide separation between personal risk and inherited wealth.

3. Divorce Protection. Specific to protection in a failed marriage, assets that continue to be held for the beneficiary in a spendthrift trust are typically treated as separate property – i.e., not property of the marital community.

There is little risk of commingling or forced liquidation, and any increase in asset value would also be immune to property claims in a divorce.

Meanwhile, as in the “Asset Protection” example above, outright distribution exposes all assets to spousal claims for 50/50 or other equitable division.

4. Remarriage Protection. Similarly, if a beneficiary remarries, a spendthrift trust can help ensure that assets intended for use by your beneficiary stay segregated from the assets owned by the new marital community; protect the beneficiary’s children from a prior marriage; and reduce the risk of the beneficiary’s inheritance being diverted.

Conversely, with outright distribution, assets may be commingled, used for joint purchases, vulnerable in divorce, and passed unintentionally to the new spouse and his or her children, effectively disinheriting your own children.

5. Income Tax Flexibility. A spendthrift trust that is controlled by a beneficiary can:

• distribute income in ways that reduce current-year tax liability;
  
  
• accumulate income strategically;
  
  
• promote tax-efficient investment timing; and
  
  
• be structured as a grantor trust.

Outright ownership of assets distributed from the trust offers less flexibility for income tax purposes.

6. Estate Tax Efficiency. In a properly drafted spendthrift trust:

• assets remain outside the beneficiary’s taxable estate;
  
  
• there is no estate tax inclusion at the beneficiary’s death;
  
  
• the trust can continue for children and grandchildren;
  
  
• the federal Generation-Skipping Transfer (GST) tax exemption is fully leveraged; and
  
  
• estate tax is avoided at every generation.
  
  

On the other hand, assets that are distributed outright will be included in the beneficiary’s gross estate, subject to estate tax at their death (if the estate is taxable), and require new planning to avoid estate tax liability.

7. Creditor and Bankruptcy Planning. Consistent with the above scenarios, assets that are distributed outright to a beneficiary become that beneficiary’s personal property and are totally vulnerable to creditor claims.

However, for assets in a spendthrift trust, the “trust principal” – cash, stocks, other property that were originally transferred into the trust – is generally excluded from the bankruptcy estate.

Even if the financially distressed beneficiary is also the trustee, protection still exists if there is no unrestricted right to withdraw principal, there is no general power of appointment, and, as mentioned earlier, distributions from the trust are limited by an ascertainable standard.

8. Protection from Poor Decisions. Not everyone is qualified or competent to make wise use of inherited wealth or valuable assets. If a beneficiary lacks investment experience, has a track record of bad financial decisions, is vulnerable to fraud or overly emotional decision-making, or has a history of addiction or mental illness, a spendthrift trust can help protect them from themselves.

You can build into your trust structural guardrails that encourage discipline, provide professional investment guidance, might require co-management of assets, and promotes long-term asset preservation.

9. Long-Term Family Governance. In contrast to the fragmentation that is inherent in an outright distribution, a continuing trust can:

• enhance preservation of family capital;
  
  
• provide for professional investment oversight;
  
  
• support dynasty-style planning; and
  
  
• encourage intergenerational continuity.

IN A NUTSHELL. Properly drafted, a spendthrift trust can be managed by a third-party trustee or by a beneficiary, either of whom, as trustee, can control the trust’s investments, direct distributions within accepted standards, and manage the trust’s overall administration.

The spendthrift trust’s assets are not legally “owned” by the beneficiary, not exposed to creditor claims, and not included in the beneficiary’s estate.

If you have substantial assets and want to preserve them for the long-term benefit of your children or other beneficiaries, structuring your revocable living trust to convert to an irrevocable trust upon your death may offer you the best of both worlds.