How Does a Spendthrift Trust Differ from an Asset Protection Trust?

My clients often want to protect their legacy from their own children’s poor planning or misfortune. A trust offers protections many beneficiaries cannot obtain for themselves from creditor claims, untutored investment choices, overspending and unnecessary taxation. These protections, especially from the beneficiary’s own extravagance, fuel the greatest interest in asset protection provisions.

Black’s Law Dictionary defines a “spendthrift” as: “One who spends money profusely and improvidently; a prodigal; one who lavishes or wastes his estate.” A “spendthrift trust” is: “A trust created to provide a fund for the maintenance of a beneficiary and at the same time to secure the fund against his improvidence or incapacity … and places it beyond his creditor’s reach.”

Most trusts include a “spendthrift provision” regardless of any anticipated, or unanticipated, profligacy by the beneficiaries and are, therefore, spendthrift trusts. Without the inclusion of such a provision, the assets in a trust are statutorily available to creditors. In fact, the law favors the protection of creditor claims and has provided the means to challenge a debtor’s “fraudulent conveyance” of assets into an irrevocable trust since the Statute of 13 Elizabeth in 1571. The present form of that law is the Uniform Voidable Transaction Act (UVTA), which has been adopted in some form in 44 states, Washington, D.C., and the U.S. Virgin Islands.

Subscribe to Kiplinger’s Personal Finance

Be a smarter, better informed investor.

Save up to 74%

Sign up for Kiplinger’s Free E-Newsletters

Profit and prosper with the best of Kiplinger’s expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of Kiplinger’s expert advice - straight to your e-mail.

Sign up

The gist of the UVTA may be summed up by these two statutory excerpts:

1. “Unless prohibited under the Act, a court may authorize a creditor to invade a beneficiary’s trust and charge against all present or future distributions.”
2. “A transfer made or obligation incurred by a debtor is fraudulent … if the debtor made the transfer or incurred the obligation…[w]ith actual intent to hinder, delay or defraud any creditor of the debtor.”

Each state’s law on spendthrift trusts is different, but Tennessee law, one of the leading states in the domestic asset protection trusts, provides a useful example. See my discussion of liability limits here in favor of balancing protections for creditors and debtors before you judge the use of spendthrift trusts.

What a spendthrift trust can do

In Tennessee, a spendthrift provision is valid to restrain both voluntary and involuntary distributions of a beneficiary's interest in the trust, even if the beneficiary is a trustee, simply by stating that the interest is held subject to a “spendthrift trust,” or words of similar import. A beneficiary’s creditor may not reach the trust assets or force a distribution of a beneficiary’s interest if the trust includes a spendthrift provision.

Here is an example of a spendthrift provision: No beneficiary may assign, anticipate, encumber, alienate or otherwise voluntarily transfer the income or principal of any trust created under this trust. In addition, neither the income nor the principal of any trust created under this trust is subject to attachment, bankruptcy proceedings or any other legal process, the interference or control of creditors or others, or any involuntary transfer.

A spendthrift trust must be irrevocable (I’ve also written here previously about what “irrevocable” means in trust law today). A revocable or living trust is subject to the settlor’s creditor’s claims even if it includes a spendthrift provision or references an intent to be subject to one. But if a settlor funds an irrevocable gift trust for his spouse and children, or his living trust becomes irrevocable at his death, with a spendthrift provision each beneficiary is both restrained and protected regarding potential and retained creditors.

Protections of a spendthrift trust

First, the protections. The beneficiary’s share of the trust’s income and principal cannot be forced out by any of these possible creditors in the event she fails to meet an obligation to pay:

• A judgment creditor, i.e., a person she injures through some negligence, such as an auto accident, a failure to maintain property, some malfeasance or malpractice, or some criminal conduct;
• A property settlement order in a divorce or other dissolution action;
• A lender for a personal debt, i.e., student loans, mortgages, home improvement lines of credit, promissory notes, etc.; or
• A judgment in bankruptcy court.

However, some states will allow a charge against mandatory income distributions and even against discretionary distributions that the trustee chooses to make to recover unpaid spousal maintenance and child support payments.

Limitations on a spendthrift trust

Now, the limitations. The beneficiary cannot assign the income or principal of the trust or proffer trust assets as collateral or security for any debt he may incur or to secure a loan for any purpose. In other words, the assets of a spendthrift trust are not in any way owned by a trust beneficiary.

However, this line can be blurred if the trust empowers a beneficiary to:

• Withdraw or distribute income or principal from the trust to himself or for his benefit without the consent of an adverse party or subject to an ascertainable standard, or
• Withdraw or make a distribution that discharges a legal obligation, such as the support of a minor or other legal dependent.

If the settlor wants to give the beneficiary that kind of control over trust assets, but still qualify the trust for creditor protections, then such distributions must:

• Be limited to funds used for health, education, maintenance and support, or
• Require the approval of one or more other trust beneficiaries (considered adverse because any funds to one beneficiary reduce funds available to other beneficiaries).

How a domestic asset protection trust differs

A domestic asset protection trust (“DAPT”) is a completely different concept. The DAPT concept is that a settlor can fund an irrevocable trust with himself, as well as his spouse and descendants, as current beneficiaries and that the trust will be beyond the reach of any of his, his spouse’s and the trust beneficiaries’ creditors.

In Tennessee, a DAPT is controlled by the Tennessee Investment Services Trust Act of 2007 (and is called a “TIST”). The TIST qualifies as a DAPT because it is irrevocable, includes a spendthrift provision, is administered in Tennessee by a resident trustee and the settlor transfers his property to the TIST.

Tennessee law protects the TIST from any action to attach TIST property unless:

• The creditor’s claim arose either before or after the qualified disposition to the trust,
• The creditor can prove that the qualified disposition was made with actual intent to defraud that specific creditor, and
• The action is brought within a very limited time period after the qualified disposition.

The settlor can establish a rebuttable presumption setting the date the assets were transferred to the trust by executing a “qualified affidavit” before the qualified disposition that states that the settlor:

• Has full right, title and authority to transfer the assets to the trust;
• Will not be insolvent after the transfer;
• Does not intend to defraud a creditor by transferring the assets to the trust;
• Does not have any pending or threatened court actions or administrative proceedings against him, except those he identifies on an attachment to the affidavit;
• Does not contemplate filing for bankruptcy; and
• Is not transferring assets to the trust derived from unlawful activities.

Simply put, a spendthrift trust is widely available under almost every state law and protects assets the settlor places in trust for her loved ones, but not herself. A domestic asset protection trust is available in many fewer states (including Tennessee, Delaware and 17 others (opens in new tab)) and seeks to protect assets the settlor intends for his own use, as well as for his family. Both trusts only limit a creditor claim if the settlor had no intent to avoid a known creditor.

One additional important note: Usually the creditor must prove there was an intent to defraud that particular creditor with clear and convincing evidence. And this is why almost every trust includes a spendthrift provision.