On March 23, 2017, at the request of a certified question from the U.S. Ninth Circuit Court of Appeals, the California Supreme Court answered the age-old question – “what gives”?
That is to say, what gives – the impenetrable wall of a spendthrift trust or the ability of a bankruptcy trustee to tap trust funds for the benefit of the bankruptcy estate? The answer is neither really, but our state Supreme Court did clarify the appropriate reach of creditors into trust-protected assets in light of what the Ninth Circuit observed as “opaque” statutory provisions in the California Probate Code.
A spendthrift trust is one that includes a provision restricting the “alienation” of a beneficiary’s interest, which is a technical term meaning folks can’t get at it, transfer it, assign it, sell it, buy it, give it, or take it.
In Carmack v. Reynolds the California Supreme Court reviewed the unfortunate circumstance of Rick Reynolds, who was entitled to receive over a million dollars over time from the Reynolds Family Trust, and who filed chapter 7 bankruptcy one day after his father died and before he received any payments or distributions from the Trust. The trustees of the Reynolds Family Trust sought a declaratory judgment on the extent of the bankruptcy trustee’s interest in the trust.
In analyzing this issue, the Supreme Court discussed ostensibly competing provisions of the California Probate Code, including section 15306.5 which appears to limit the reach of the bankruptcy trustee to 25 percent of Mr. Reynolds’ interest, and other relevant Code sections which contain no such limitation. While it has been generally understood that creditors can reach funds once distributed, the California Supreme Court went further to explain that creditors can reach un-distributed (but distributable) funds and also principal. (In the Carmack case, the trust instrument happened to direct that all distributions be made from principal, as opposed to the more typical direction that principal is reserved and income distributed.)
In finding that there are no absolute limits to a creditor’s access to trust funds such as the one codified in section 15306.5, the court held 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.
The court explained that “due and payable” means the amount of principal that is “set to be distributed and only up to the extent of that distribution.” The issue can turn on whether the beneficiary’s rights to the distributable amount in question have vested. But, and a big but, if the distributable amount is specified for the beneficiary’s support or education, then the funds cannot be reached by creditors until they are in the beneficiary’s hands.
The court included a nice illustration of how these rules would work in practice, outlined here:
As an illustration, suppose a trust instrument specified that a beneficiary was to receive distributions of principal of $10,000 on March 1 of each year for 10 years. Suppose further that a general creditor had a money judgment of $50,000 against the beneficiary and that the trust distributions are neither specifically intended nor required for the beneficiary’s support. On March 1 of the first year, upon the creditor’s petition a court could order the trustee to remit the full distribution of $10,000 for that year to the creditor directly if it has not already been paid to the beneficiary, as well as $2,500 from each of the nine anticipated payments (a total of $22,500) as they are paid out. If the creditor were not otherwise able to satisfy the remaining $17,500 balance on the judgment, then on March 1 of the following years, upon the general creditor’s petition the court could order the trustee to pay directly to the creditor a sum up to the remainder of that year’s principal distribution ($7,500), as the court in its discretion finds appropriate, until the judgment is satisfied.
The bottom line is that your typical spendthrift trust may not be as sacrosanct as once thought. Not only can creditors reach 25 percent of principal, but they can also reach amounts set to be distributed, even if not actually distributed. In this case, the spendthrift trust has given way.