Protecting Heirs With A Spendthrift Trust

By: Randall A. Denha, J.D., LL.M.

A spendthrift trust grants an independent trustee the power to determine how the trust funds are spent for the benefit of the beneficiary. The trustee has a duty to act in the best interest of the trust beneficiary. The spendthrift trust was originally one that people set up for a person who has a history of reckless spending. The trustee has oversight over the use of trust resources. With such an arrangement, the beneficiary does not squander his or her inheritance. More commonly today, professionals insert spendthrift provisions into trusts to protect assets from creditors. That is, the trustee can distribute funds to or for the beneficiary or beneficiaries but not their respective creditors.

You’ve likely spent most of your adult life accumulating wealth that you intend to eventually pass on to your loved ones. But are you concerned that the beneficiaries of your estate might squander their inheritance?

One solution is to establish a spendthrift trust that can provide protection for the rest of your lifetime and beyond. Along with certain other trusts, a spendthrift trust may incorporate various tax benefits, including taking advantage of the federal gift and estate tax exemption. But that’s not its primary focus: Its main purpose is asset protection.

Reasons A Spendthrift Trust Is Popular

There has been growing interest in the spendthrift trust for a couple of reasons.

One is the unprecedented amount of wealth which estates will pass along to the next generations during the next 25 years. For a specific group of those benefactors, the spendthrift trust can provide a proven passageway through the complexities and pitfalls of that process. It also is a way of bypassing the public ordeal of probate. The terms and conditions are private. That can be important to families.

The second reason for the growing interest in spendthrift trust is the litigiousness of American society. The boundaries between business and personal have become blurred. Creditors, for example, rush to court to seize the personal assets of the owners of distressed businesses. And, in civil lawsuits against professionals such as medical doctors or lawyers, defendants push for the right to attach their homes, cars, and stock portfolios.  One version of the spendthrift trust – the Domestic Asset Protection Trust (DAPT) or the self-settled spendthrift trust – can prevent that. In addition, the DAPT can be useful in reducing taxes and in providing income for retirement.

Restricting Trust Fund Access

The benefit of a spendthrift trust is that it restricts a beneficiary’s ability to access and use trust funds. Briefly stated, the beneficiary can’t tap directly into the principal or transfer rights to it to someone else. This can also deny access to creditors or a divorced spouse of a beneficiary.

Instead, the trust beneficiary relies on the trustee to provide payments based on the trust’s terms. This could be in the form of regular periodic payouts or on an “as needed” basis. The trust document will spell out the nature and frequency, if any, of the payments. Once a payment has been made to a beneficiary, the money then becomes fair game to any creditors.

As previously mentioned, a spendthrift trust isn’t designed primarily for tax-reduction purposes. Typically, this trust type is most beneficial when you want to leave money or property to a family member but worry that he or she may squander the inheritance. For example, you might think that the beneficiary doesn’t handle money well based on past experience or that he or she could easily be defrauded, has had prior run-ins with creditors or suffers from an addiction that may result in a substantial loss of funds.

If any of these scenarios is a possibility, a spendthrift trust can provide asset protection. It enables the designated trustee to provide funds for the beneficiary without the risk of misuse or overspending. But that brings up another critical issue.

Determining The Trustee

The trustee is responsible not only for managing the trust, but also protecting the assets from being squandered by the beneficiary. This requires the trustee to manage the trust in a manner that preserves the value of the assets while providing for the beneficiary. In order to do so, the trustee should have the power to make set payments to the beneficiary on a regular basis. Similarly, the trustee must also be able to withhold payments under certain conditions, particularly if the beneficiary gambles or gets into debt. However, this would also require the trustee to monitor the beneficiary’s behavior, which could be problematic.

Depending on the trust terms, the trustee may be responsible for making scheduled payments or have wide discretion as to whether funds should be paid, how much and when. For instance, the trust may empower the trustee to make set payments or retain discretion over amounts to be paid or even if there should be any payment at all.

Or perhaps the trustee will be directed to pay a specified percentage of the trust assets, so the payouts fluctuate, depending on investment performance. Similarly, the trustee may be authorized to withhold payment upon the occurrence of certain events (for example, if the beneficiary exceeds a debt threshold or declares bankruptcy).

The designation of the trustee can take on even greater significance if you expect to provide this person with broad discretion. Frequently, the trustee will be a CPA, attorney, financial planner or investment advisor, or someone else with the requisite experience and financial know-how. You should also name a successor trustee in the event the designated trustee passes away before the term ends or otherwise becomes incapable of handling these duties.

Termination Of A Trust

Is that all there is? Not quite. Consider various other issues relating to spendthrift trusts. For example, you must establish how and when the trust should terminate. It could be set up for a term of years or for termination to occur upon a stated event, such as a child reaching the age of majority.

Finally, work with your estate planning advisor to anticipate other possibilities, such as enactment of new tax legislation or changes in family circumstances that could affect your spendthrift trust.

Unless you’re an experienced legal or financial professional, drafting a spendthrift trust isn’t a do-it-yourself proposition. An experienced estate planning advisor or attorney will know how to satisfy all the legal formalities. Typically, the advisor will ask you a series of questions to determine the best way to proceed. The questions will likely touch on the method and timing of payments, plans should the beneficiary’s circumstances change, and provisions for terminating the trust.