This article was co-authored by Tax Partner Robert S. Barnett.

Asset protection is often an important goal in estate and financial planning. The central vehicle is often a family asset protection trust. In drafting such a trust, the settlor’s intent is of central importance and needs to be clearly presented. A discretionary trust may be the ideal method of providing increased coverage. The law regarding asset protection trusts is a changing area, as the Restatement (Third) of Trusts modifies the traditional approach long promoted by the Restatement (Second). Careful attention must be paid to the trust distribution provisions, and this article presents some practical considerations.

Discretionary Trusts – Generally

Generally, creditors can only reach those assets that have been distributed or to which a beneficiary has an enforceable right. In a pure discretionary trust, the trustee is granted absolute and complete discretion, thereby limiting the beneficiary’s rights. In a well-prepared asset protection trust, the trustee has discretion regarding the amount to distribute, the timing of a distribution, whether to make any distributions at all, and which beneficiaries, if any, will receive distributions.

A distribution provision in a pure discretionary trust might read: “So much, all, or none of the principal may be paid to any, all, or none of the beneficiaries at any time or from time to time, as the trustee, in his or her sole, absolute, and unfettered discretion may determine.” This language can be contrasted with that found in many trusts: “Income and/or principal shall be paid to the beneficiary for health, education, maintenance, and support.” This type of provision is referred to as an ascertainable standard and is less effective for asset protection purposes, due to the use of the word “shall” and due to the fact that a court may determine that beneficiaries or creditors have an enforceable right to a distribution.

In a pure discretionary trust, the beneficiary’s rights are more limited than in a trust with an ascertainable standard. If a beneficiary “shall” or “may for health, education, maintenance, and support” receive a certain amount of trust principal, a trustee could be compelled to make a distribution to a creditor. Conversely, if the beneficiary “may in the trustee’s sole and absolute discretion” receive trust principal, neither the beneficiary nor the beneficiary’s creditors can require that a distribution be made. Note, however, that New York Civil Practice Laws and Rules Section 5205(d)(1) provides that up to ten percent of trust income may be available to a creditor seeking satisfaction of a money judgment. Notwithstanding this ten-percent invasion right, under a pure discretionary standard, both the beneficiary’s and the creditor’s access to the trust fund is limited. It is recommended that the trust also contain provisions regarding the settlor’s intent that the trust not be invaded.

This was the approach long taken by the Restatement (Second), published in 1959. The Restatement (Second) provides that the extent of a beneficiary’s enforceable interest in the trust (and the extent of creditor protection) is determined by the amount of discretion granted to the trustee. Provided that the trustee is afforded “sole, absolute, and unfettered” discretion, the trust is likely to be classified as purely discretionary with complete asset protection.

Restatement (Third)

The Restatement (Third), published in 2003, takes a new approach to discretionary trusts, which is of concern to asset protection planners. According to the Restatement (Third), even if the trust grants the trustee complete discretion, a standard of reasonableness or good faith may be imputed based on “the extent of the trustee’s discretion, the various beneficial interests created, the beneficiaries’ circumstances and relationships to the settlor, and the general purposes of the trust.” The Restatement goes on to state that even if the trustee has complete discretion, “it is rare [ ] that the beneficiary’s circumstances, the terms of the discretionary power, and the purposes of the trust leave the beneficiary so powerless” that a distribution could not be compelled.

The Restatement Third does not provide any absolutes with regard to asset protection, nor does it provide any instruction for drafting a pure discretionary trust in which a beneficiary has no enforceable interest. It is unclear to what extent the courts will interpret and apply this language, and different jurisdictions will likely take different approaches. If the court treats discretionary trusts as if they contain an ascertainable standard, asset protection may be negated or severely limited. Thus, in jurisdictions that have not enacted laws governing the issue, drafters may be advised either to grant the trustee absolute discretion or to draft the trust under the laws of a jurisdiction with a statute affording creditor protection to discretionary trusts. In all events, the settlor’s intent should be clearly established, as this may be a defining characteristic of asset protection trusts.

The Use of Discretionary Trusts in New York

New York has no statute on point with regard to asset protection and discretionary trusts, nor has it expressly adopted the approach of either Restatement (Second) or Restatement (Third). There is, however, ample case law on the subject.
When the trustee is granted complete and absolute discretion, the law “is clear that a creditor … cannot compel the trustee to pay any part of the income or principal to the beneficiary.” Vanderbilt Credit Corp. v. Chase Manhattan Bank, NA, 473 N.Y.S.2d 242, 245 (1984). However, if discretion must be exercised according to a specific standard, there may not be complete creditor protection and the beneficiary (or creditor) may have an enforceable interest.

If the discretionary trust contains an ascertainable standard, a creditor may be able to reach the trust assets. The settlor’s intent is often determinative when examining a beneficiary’s or creditor’s ability to compel a distribution. Take for instance, the case of Estate of Escher, 407 N.Y.S.2d 106 (N.Y. Surr. 1978), affirmed by 52 N.Y.2d 1006 (1981), in which the trust instrument granted the trustee discretion to distribute principal as needed for emergency situations. Here, the court determined, and the Court of Appeals affirmed, that a distribution could not be compelled, as the nature of the creditor’s claim did not constitute an “emergency situation,” as intended by the settlor. The court examined the settlor’s intent through the trust language, the relationships between the settlor and the beneficiary and between the settlor and the remaindermen, the identities of the remaindermen, and “any other pertinent facts indicative of intent.”

As illustrated by Escher, the settlor’s intent will be examined if the discretion is limited by an ascertainable standard. If the creditor can compel a distribution on behalf of a beneficiary, the creditor may be able to reach the trust assets, thereby negating any asset protection. Therefore, in situations where creditor protection is a significant concern, it is advisable to avoid the use of such standards and to grant the trustee complete discretion or, if a standard is insisted upon, to clearly express how the settlor intends for the discretion to be exercised. Additional consideration may be given to placing the trust situs in a jurisdiction that has not adopted the Restatement (Third) or has enacted statutes to enforce asset protection trusts.

In conclusion, the law regarding asset protection and discretionary trusts is currently in flux due to the changes set forth in the Restatement (Third). When asset protection is desired, it is recommended that the trust grant the trustee complete discretionary and clearly express the settlor’s intent to prohibit beneficiaries and creditors from compelling distributions.

This article first appeared in the January 2013 NYSSCPA newsletter.
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