In California, creditors have limited access to irrevocable trusts because the trust creators cede all control of trust assets. But on rare occasions, the trust language could allow creditors to reach a beneficiary’s distributions from an irrevocable trust.
Can Creditors Reach a Settlor’s Assets in an Irrevocable Trust?
When a settlor creates an irrevocable trust and places assets in it, he or she gives up all control over the assets. The trust language specifies that the settlor cannot take assets out of the trust or make any other changes. Instead, the trustee takes legal title to the trust assets, managing them for the beneficiaries’ use in the future.
Because a settlor of an irrevocable trust no longer has any control over the trust assets, the settlor’s creditors cannot reach the assets in most situations. If the settlor dies, the trust assets are not considered part of the probate estate (and may not count for estate tax liability if transferred long before the settlor’s death). If the settlor goes into bankruptcy, creditors probably won’t be able to access the trust assets to pay off debts.
Can Creditors Reach a Beneficiary’s Interest in an Irrevocable Trust?
Often, creditors cannot reach a beneficiary’s interest in an irrevocable trust – however, one recent case in California created a narrow exception to this rule. Carmack v. Frealy, 2017 WL 1090497 (Cal. March 23, 2017). In the case, the beneficiary of a “spendthrift” irrevocable trust declared bankruptcy. At the time, he was entitled to several mandatory distributions from the trust principal (not just the interest) that the trustee had not yet paid.
The court had to decide whether the beneficiary had to give up his trust distributions to the bankruptcy creditors, and if so, how much of the distributions he had to give up. After examining relevant California law, the court determined that because some of the distributions had “vested” – in other words, the trustee was required to pay them to the beneficiary and in fact already should have done so – the distributions were effectively the beneficiary’s property and thus 100% available to creditors. For future distributions, the creditors could access 25% of them with the exclusion of payments made for the beneficiary’s support.
As you can see, beneficiaries may not want to pay such large proportions of their trust income to creditors. The trust language can affect creditor access. If the trust in this case had been purely discretionary, the trustee could simply have not made any distributions, and nothing would be available to creditors.
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