Protecting Beneficiaries with Spendthrift Clauses

Usage and establishment clause

by N. Dean Hawkins

Excerpted from Texas Trusts & Clauses

Spendthrift clauses protect the interests of beneficiaries (except the settlor) from their creditors and prevent the beneficiaries from transferring their interests.

Specifically, the trust may provide that the interest of the beneficiary in the income or in the principal or in both may not be voluntarily or involuntarily transferred before payment or delivery of the interest to the beneficiary by the trustee. [Prop C §112.035(a).]

Example:

If a husband and wife form a revocable trust with a spendthrift clause:

• During the lifetimes of both settlors, the spendthrift clause will not protect the interests of the settlors. [See Prop C §112.035(d).]

• Upon the death of the first spouse to die, the spendthrift clause will protect the interest of the surviving spouse in the marital trust and the interests of the surviving spouse and all other beneficiaries in the non-marital trust. [See Prop C §112.035(a).] However, the surviving spouse will continue to hold an interest in his or her share of the assets of the revocable trust. Consequently, the spendthrift clause will not protect the surviving spouse’s interest in his or her share of the assets of the revocable trust. [See Prop C §112.035(d).]

• Upon the death of the surviving spouse, the spendthrift clause will apply to all trusts that remain in existence and will protect all interests in those trusts. [See Prop C §112.035(a).]

Establishing a Spendthrift Trust

Establishing a spendthrift trust does not require an elaborate provision in the trust. A declaration that the interest of a beneficiary shall be held subject to a spendthrift trust is sufficient to restrain voluntary or involuntary alienation of the interest by a beneficiary to the maximum extent permitted by the Texas Trust Code. [Prop C §112.035(b).]

Clause Does Not Protect Assets After Distributions

A spendthrift clause prevents seizure by creditors or transfer by the beneficiaries before payment or delivery of the interest to the beneficiary by the trustee. [See Prop C §112.035(a).]

However, once a distribution of property is made to the beneficiary the property distributed to the beneficiary is subject to seizure by creditors of the trust beneficiary.

FORM: Clause Establishing Spendthrift Trust

Comment:

Although simple language may be sufficient to establish a spendthrift trust, most trust instruments use more comprehensive language. This clause establishes a spendthrift trust and provides that property may not be seized prior to distribution to a trust beneficiary.

The clause excludes “Qualified Income” from the anti-alienation provisions of the trust, but only if a marital deduction is allowed with respect to the property under IRC §2056(b)(7).

For example, the anti-alienation provisions do not apply to the surviving spouse’s interest in the QTIP trust. However, the surviving spouse is prohibited from transferring any interest in the non-marital trust. If only a partial QTIP election is made, the surviving spouse is prohibited from transferring any interest to the extent the QTIP election is not made with respect to the trust.

Without these restrictions on transfer, the surviving spouse might gift an interest that is not otherwise includible in the surviving spouse’s gross estate and cause unnecessary transfer taxation. [See Chapter 11, Marital Trust Issues. See also Reg. §25.2519-1(g) Example (3).]

While transfers of Qualified Income may be excluded from the anti-alienation rule, such transfers are not advisable. Once a marital deduction has been allowed for the QTIP trust, transferring all or a portion of the income interest in the QTIP trust has severe gift tax consequences.

Spendthrift Trust

Each trust created under this Agreement shall be a “spendthrift trust,” as defined by the Texas Trust Code. Prior to the actual receipt by any beneficiary:

• No income or principal distributable from a trust created under this Agreement shall be subject to:

• The anticipation or assignment by any beneficiary; or

• The attachment by, or the interference or control of, any creditor of, any person seeking support from, any person furnishing necessary services to, or any assignee of, any beneficiary;

• No property shall be taken, seized or otherwise reached by any legal or equitable process in satisfaction of any debt or liability of any beneficiary (including governmental claims); and

• To the fullest extent permitted by law, any such attempted action by any beneficiary or by any claimant shall be null and void and wholly ineffectual.

This Section shall not prohibit the Surviving Spouse from assigning all or any part of his or her interest in any Qualified Income (as defined herein) to any individual or charitable organization (other than a creditor of the Surviving Spouse or of the Surviving Spouse’s estate).

N. Dean Hawkins has a general tax practice in Dallas, including estate planning, business tax planning, and tax controversy and litigation.  Mr. Hawkins has an LL.M. in Taxation from New York University, and is the author of Texas Trusts & Clauses, from which this article is excerpted.