By: Randall A. Denha, J.D., LL.M.
Generally, creditors can only reach those assets that have been distributed or to which a beneficiary has an enforceable right. In a pure discretionary trust, the trustee is granted absolute and complete discretion, thereby limiting the beneficiary’s rights. In a well-prepared asset protection trust, the trustee has discretion regarding the amount to distribute, the timing of a distribution, whether to make any distributions at all, and which beneficiaries, if any, will receive distributions.
A distribution provision in a pure discretionary trust might read: “So much, all, or none of the principal may be paid to any, all, or none of the beneficiaries at any time or from time to time, as the trustee, in his or her sole, absolute, and unfettered discretion may determine.” This language can be contrasted with that found in many trusts: “Income and/or principal shall be paid to the beneficiary for health, education, maintenance, and support.” This type of provision is referred to as an ascertainable standard and is less effective for asset protection purposes, due to the use of the word “shall” and due to the fact that a court may determine that beneficiaries or creditors have an enforceable right to a distribution.
In a pure discretionary trust, the beneficiary’s rights are more limited than in a trust with an ascertainable standard. If a beneficiary “shall” or “may for health, education, maintenance, and support” receive a certain amount of trust principal, a trustee could be compelled to make a distribution to a creditor. Conversely, if the beneficiary “may in the trustee’s sole and absolute discretion” receive trust principal, neither the beneficiary nor the beneficiary’s creditors can require that a distribution be made.
A few examples clarify the protection and the positions of the courts on this issue. In Re Estate of Isabelle Skaff involved a state of Michigan prisoner, Mr. Tom Martin, who was the beneficiary of a trust. The terms of the trust provided for distributions to be made to him in the sole discretion of the Trustee. Put another way, it was a purely discretionary trust. The Court ruled that the state was not allowed to access the moneys of the trust to recover the costs of Mr. Martin’s incarceration because of the discretionary nature of the trust.
In Duckett v. Enomoto, U.S. District Court, D. Arizona (April 18, 2016), posed the question of whether a beneficiary’s interest in a trust is a property right that the IRS can lien? This case involves a certain tax code provision which imposes a federal tax lien for unpaid taxes upon “all property and rights to property, whether real or personal” that belong to the delinquent taxpayer.
The court answered the question in the Duckett matter by looking to state law, and the rights of a beneficiary and the obligation of the trustee under that law. However, there are some general rules. If amounts are distributable only in the discretion of the trustee, the lien will not usually attach. If the trust provides for mandatory distributions or distributions required under a discretionary standard, then the lien probably applies.
Sometimes and quite honestly, oftentimes, trusts will be halfway between a wholly discretionary trust and one that requires distributions under an ascertainable standard, such as distributions for health, education, support and maintenance. In the Duckett case, the distribution language provided:
The Trustee shall pay to DENNIS MASAKI ENOMOTO so much or all of the net income and principal of the trust as in the sole discretion of the Trustee may be required for support in the beneficiary’s accustomed manner of living, for medical, dental, hospital, and nursing expenses, or for reasonable expenses of education, including study at college and graduate levels.
So the trustee is obligated to distribute under an ascertainable standard, but only in his or her “sole discretion.” This particular court stated that the case law is mixed on whether a lienable property interest arises from such a clause. In the end, it ruled that there was an interest that could be liened.
The court noted some criteria in these cases that favor the finding of a lien. The first is that there is mandatory language in the clause, such as use of the word “shall.” It may be better to use the term “may” in this regard, thereby further strengthening the discretionary nature of the trust. More particularly, courts note that such clauses often require payment (“shall pay”) and then leave the amount up to the discretion of the trustee.
If there is a lien, how can the IRS enforce it? Some possibilities include waiting around until the trustee makes a distribution and then attaching the distribution, compelling the trustee to make regular distributions under the standard and then attaching those, or attempting to attach and receive the entirety of the trust corpus immediately. The IRS decided to go after the entirety of the trust. At present, the court has not yet fully resolved the issue, so we wait.