DBTC Law Firm

Putting Family Wealth Beyond the Reach of Creditors: Using the “Spendthrift” Clause.

An ancient and often overlooked drafting technique can have huge ramifications for preserving family wealth, and regularly disappoints creditors of the “wealthy” when debts are not paid. This is the “spendthrift clause,” which has existed under both case law and specific state statutes for centuries. Its concept is simple: when assets are put into trust for various beneficiaries, typically a spouse, children or descendants, if the trust includes a “spendthrift clause” which specifically prohibits the trust assets from being sold, assigned, mortgaged or seized by creditors, then it is possible for the beneficiaries to receive substantial, continuing, long-term benefits from the trust, while all of their creditors are “frozen out” from recovering any unpaid debts from the trust. Sometimes, this creates great surprise to creditors who believe they are dealing with a wealthy person, who lives in an expensive house, drives expensive cars, takes expensive vacations and lives well – all as the beneficiary of a spendthrift trust which the creditor cannot reach. Families are wise to include trusts with spendthrift clauses in their estate planning, and it is essential for creditors of all kinds to scrutinize these trusts before extending credit, lest they find themselves without remedy to collect their debts.  A recent federal case decided in Arkansas, and confirmed on appeal at the United States Court of Appeals for the Eighth Circuit (Wetzel vs. Regions Bank), protected $2.4 million of assets left by a husband for his wife and those assets survived intact for her when she later filed bankruptcy. The Court ruled that the creditors in bankruptcy could not touch the money, because it had been left in a spendthrift trust for the benefit of the wife; the wife then discharged in bankruptcy all of the debts of the creditors, retaining nevertheless the full assets of the trust and her beneficial interests in it.

A spendthrift clause has different important perspectives. From the perspective of a wealthy family, it becomes a tool to preserve almost indefinitely the family wealth for the benefit of the descendants, despite their financial imprudence or misfortunes. From a creditor standpoint, it is very much a trap for the unwary, if the creditor in making lending decisions does not discover that the source of the borrower’s apparent wealth is actually a trust with a spendthrift clause which, for all practical purposes, makes the borrower a very bad credit risk. From the aspect of the estate planning draftsman, it requires care to ensure that the spendthrift clause is properly drafted so that it will provide the family the protection needed.

Clients will regularly ask if they can establish a trust for their own benefit which includes a spendthrift clause, so that they can use their wealth but protect it from creditors. On its surface, this appears to be a valid use of the technique. However, another legal doctrine, that of “self-settled trusts,” generally holds that a person cannot put their own assets into trusts, retain the benefit of them and still defeat the claims that creditors would make against the trust. In summary, a self-settled trust cannot enjoy the protections of a spendthrift clause.

It is thus a cardinal principle that spendthrift clauses can only be used to protect beneficiaries when the money in the trust comes from another source– typically a parent, grandparent, spouse or other family member who has created the trust with wealth during life or at their death. Even with a valid spendthrift trust in place, which has been funded by a third party gift or bequest, the strength of the spendthrift clause is defeated if the trustee of the funds is also the beneficiary of the funds. Thus, leaving funds in trust for a surviving spouse or surviving children, and making that spouse or those children the trustee for their own benefit, has caused some courts to set aside the spendthrift clause because the decisions to distribute are not truly independent of the beneficiary’s own desires. In such cases, it is advisable that the draftsman provide alternate trustees, and if the beneficiary foresees financial difficulties, that they resign in favor of an independent trustee.

Used in ancient English law, the spendthrift clause remains a very viable and effective technique for family wealth planning.

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