Sometimes, the most difficult part of creating an estate plan is not deciding who to include as beneficiaries, but deciding how to gift assets to those beneficiaries. For example, you may be reluctant to pass down assets directly to a beneficiary because that individual cannot be trusted to manage his/her own money for one reason or another. If you find yourself in that position, a spendthrift trust may be the solution. For those who are unfamiliar with the concept, let’s see how a spendthrift trust works.
The Spendthrift Beneficiary
Do you have an adult child, or other beneficiary, who qualifies as a spendthrift? This is someone who never seems to be able to handle money and/or who spends way more money than he/she should. Most families have one. Sometimes the lack of financial acumen has an actual cause, such as an addiction problem or a mental illness. For other spendthrifts, there is no obvious reason why they don’t handle money well; however, it is a universally agreed upon fact that money management is not their strong suit. Understandably, the thought of handing a spendthrift beneficiary a sizeable inheritance likely makes you nervous. Fortunately, there is an estate planning tool that can help.
What Is a Trust Agreement?
At its most basic, trust is a relationship whereby property is held by one party for the benefit of another. The terms and provisions of a trust are reduced to writing in a document referred to as a “trust agreement.” Trusts are broadly divided into living trusts and testamentary trusts with the former activating during the lifetime of the Settlor (the creator of the trust) and the latter typically being activated at the time of the Settlor’s death by a provision in the Settlor’s Will. Living trusts can be further sub-divided into revocable and irrevocable living trusts.
How Does a Spendthrift Trust Work?
One of the many benefits to using a trust instead of a Will to distribute an inheritance is the ability to retain a certain amount of control over how that inheritance is used. A spendthrift trust is a specialized type of trust that is aimed at preventing the beneficiaries of the trust from squandering their inheritance. Very specific language must be used to create a spendthrift clause; however, when drafted properly, a spendthrift clause will prevent a beneficiary from spending the trust funds frivolously as well as prevent borrowing against those funds or encumbering the funds in any way. A spendthrift clause can also prevent creditors of the beneficiary from accessing the trust funds to pay debts of the beneficiary. In short, a spendthrift trust wraps the trust assets in a layer of protection against both outside claims to the assets and against the beneficiary’s inability to handle money.
California Law and Spendthrift Provisions
Because state laws govern most aspects of trust creation and trust administration, we must look to California law to determine if a spendthrift provision within a trust agreement is enforceable. In 2017, the California Supreme Court handed down a ruling that significantly weakened the protection offered by a spendthrift provision within a trust. Prior to the holding in Carmack v. Reynolds, the law essentially protected assets held by a trust until those assets were distributed to the beneficiary. Now, the law allows creditors to reach undistributed assets. Specifically, the court said that
“[w]ith limited exceptions for distributions explicitly intended or actually required for the beneficiary’s support, a general creditor may reach a sum up to the full amount of any distributions that are currently due and payable to the beneficiary even though they are still in the trustee’s hands, and separately may reach up to 25 percent of any payments that are anticipated to be made to the beneficiary.”
Note — While the new ruling takes much of the protection afforded by a spendthrift trust away, the ruling did not do away with the “beneficiary support” exception. The beneficiary support exception continues to protect assets that are designated for the support of the beneficiary. Therefore, a carefully worded spendthrift provision in a trust agreement may still be able to shelter and protect assets.
Please download our FREE estate planning checklist. If you have additional questions or concerns about how a spendthrift trust works or you wish to discuss including one in your estate plan, contact us at the Northern California Center for Estate Planning & Elder Law by calling (916)-437-3500 or by filling out our online contact form.
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