Using Spendthrift Trusts in New York
To what extent is a beneficiary’s trust fund available to his or her creditors? Most elder law attorneys are very well versed in how trusts can be used to protect assets from claims by Medicaid, but it has been noticed, at least in my own experience, that the broader rules regarding asset protection and creditor access to funds in trust is not as well understood. A deeper appreciation of these rules can help elder law attorneys to offer better and more sound, cohesive advice to their clients. It can allow a synthesis of understanding across differing areas of the law that can be a value-added service for any elder law attorney.
Asset protection goes right to the heart of trust law and is where estate planning and debtor/creditor law cross. Most people want to shield the inheritance for their children from creditors and adverse claims and keep the inheritance intact and earning income as long as possible. Others go further and want to shield assets from their own creditors including medical or nursing home debt. The law, however, is not uniformly applied in these various scenarios, so it is incumbent on one to learn and know the nuances of asset protection through the use of trusts.
There are many rules and competing interests at play. The main tension is between the policy of preserving a person’s right to dispose of his or her property as he or she sees fit and the competing rights of creditors.[1] As the law has developed in New York, the freedom of disposition generally wins out, with a few exceptions. It is also important to note, however, which party is trying to achieve asset protection. The law does not tend to allow a person to avoid his or her own creditors, but it is more lenient in allowing a donor to protect the funds the donor leaves for his or her beneficiaries from the beneficiaries’ creditors.
It is the general public policy of the state to enable a person to create a trust to protect a beneficiary from the beneficiary’s own spendthrift tendencies as well as the beneficiary’s creditors.[2] Those in favor of spendthrift trusts argue that it is desirable for the trust creators to be allowed to provide protection from life’s hardships for their friends and relatives who may for one reason or another be unable to earn a living, or to preserve and keep their property, and who may meet hardships due to their own mistakes or misfortunes.[3] That is not to say spendthrift trusts are only for spendthrifts, minors and those down on their luck, but also for other able-bodied individuals who can pay their debts but could benefit from increased asset protection.
The common law of spendthrift trusts was codified in New York and makes all property while held in trust for a judgment debtor exempt from satisfaction of a money judgment where the trust was created by or the funds came from someone other than the judgment debtor.[4]
The statute has an exception designed to avoid abuse of the law aimed to frustrate the beneficiary’s existing or imminent creditors. Additions to the trust are not exempt if made within ninety days of interposition of the claim on which the judgment was entered or that are deemed voidable as a fraudulent transaction.[5] A fraudulent conveyance is one made with an intent to defraud creditors constructive evidence of which is that it renders the person insolvent. [6]
The law specifically makes all retirement accounts (including IRA, 401[k], 403[b], etc.) spendthrift and exempt from collection.[7] The exemption for retirement accounts does not include inherited or beneficiary retirement accounts, that is, retirement accounts received from a parent or other donor by way of beneficiary designation.[8] Since inherited retirement accounts are not on their own spendthrift, it is common to direct the retirement account to a spendthrift trust for the benefit of the beneficiary rather than to the beneficiary outright. This will keep the retirement account principal and income protected within the spendthrift trust. Special “conduit” language in the spendthrift trust can ensure that the retirement account required distribution schedule is “stretched” as long as possible, to the extent permitted by the existing law.[9]
Income from a spendthrift trust is treated specifically and with more layers. Since 1973, a beneficiary’s income interest in a trust is inalienable and spendthrift unless the instrument expressly allows it.[10] In other words, income earned within a trust cannot be transferred or pledged to others but can only be used by and for the beneficiary. As a result, the income is shielded from the beneficiaries’ creditors. This restriction is loosened somewhat in that an income beneficiary can transfer or assign income over $10,000 in any year to his or her spouse, issue, ancestors, brothers, sisters, uncles, aunts, nephews or nieces, unless the instrument prohibits it. The restrictions of up to $10,000 don’t apply to extent beneficiary is legally obligated to support others such as a spouse or children.
Regarding the balancing of interests, the law allows creditors to access a certain amount of income. One statute allows a creditor to access ten percent of trust income.[11] Another statute allows a creditor to attach income in excess of what is necessary for education and support, unless there is a valid direction to accumulate income that is not distributed.[12]Courts have been at odds as to whether to look at other sources of income to determine what is necessary for support. To avoid this result, the instrument can include a clause to direct that undistributed income be accumulated. This will avoid this section’s application and should generally be used.
It is important to reiterate that the spendthrift rules apply to a beneficiary’s creditors as opposed to the trust grantor or creator’s creditors. The rules do not give a person carte blanche to create a trust for his or her own benefit to avoid existing or subsequent creditors.[13] Since 1787, a person cannot avoid present or future creditors by placing his or her property in trust for his or her own benefit.
As is often the case, there are a number of very important exceptions to this rule. The first is not necessarily an exception but a distinction, that is, where the trust is not for the benefit of the grantor, then it can be effective to avoid the creditors of the grantor. The Irrevocable Medicaid Asset Protection Trust is an example where the grantor relinquishes any interest in the principal of the assets distributed to the trust. Such trusts usually have income payable to the grantor of the trust, but insulate the principal from Medicaid. The operative language in the trust is that the grantor and grantor’s spouse have no access to principal and, as such, their creditors will not either.
One exemption often utilized by spouses looking to protect each other from long term care costs down the road is called a trigger trust.[14] Under the rule, the first spouse to die can create a trust in his or her last will and testament that, by its terms, will convert to a supplemental needs trust if and when the grantor’s spouse needs long term care nursing services. Even though the trigger trust is for the benefit of a spouse and not the trust creator him or herself, spouses are seen as the same when it comes to spendthrift law and asset protection, so it marks a notable exception to the rule.
Another often utilized exception is the self-settled supplemental needs trust.[15] Such a trust can be created by an individual under the age of 65 with proceeds of an inheritance, personal injury settlement or other monies to qualify for Medicaid without a five-year penalty period. These trusts have various restrictions on when they can be used and the terms, however, they represent another important exception to the rule that one cannot make a trust spendthrift as to one’s own creditors.
Also, unless the trust prohibits it, a trustee can withdraw principal to pay the grantor’s tax liability on trust income, if any, without opening up the principal to the grantor’s creditors.[16]
Finally, asset protection and protection from creditors should be discussed in the context of powers of appointment. A power of appointment is a very useful and flexible tool for estate planners to give beneficiaries rights to control the beneficial enjoyment of assets held in trust. In application, the beneficiary holding a power of appointment can direct the distribution of a trust fund to other beneficiaries upon the happening of an event such as the death of the holder. A common circumstance where a power of appointment would be exercised is in the last will of the holder directing the distribution of certain assets to a beneficiary upon the death of the holder.
Property over which a beneficiary has a general power of appointment is available to the creditors of that beneficiary if and upon it being exercisable.[17] A power is general when it can be exercised in anyone’s favor including the beneficiary him or herself or the spouse of the beneficiary. Assets become available when the power is exercisable, so if it is effective on death of an individual, it is when the person dies. An exception would be where the power is non-general, that is where it is restricted to certain individuals other than the beneficiary him or herself or his/her spouse or creditors; or if can only be used for the beneficiary’s health, education, maintenance and support.[18] In these cases, the fund is not available to creditors.
Finally, how much power should we give a beneficiary over the disposition of his or her trust fund in light of the spendthrift protections we want to give? In other words, what latitude is there to allow a beneficiary to be his or her own trustee without deeming the trust fund a part of his or her estate? This relates to a general power of appointment and making sure the trustee/beneficiary’s access is not deemed a general power of appointment. The use of a savings clause could address this issue to provide that such a trustee may not exercise his or her discretion if to do so would be deemed a general power of appointment. Another way to deal with this situation is to limit the power by only permitting the exercise of discretion to meet an ascertainable standard such as health, education, maintenance and support or to reserve decisions on distributions to the a non-beneficiary co-trustee.
Trusts are extremely valuable tools to employ on behalf of clients looking for asset protection, but they do have their limits. Asset protection is a wide-ranging field and the above only scratches the surface of the issues involved. That said, it is important for every elder law and estate planning attorney to have a working knowledge of the relevant statues and cases so as to serve their client’s better.
[1] N.Y. Est. Powers & Trusts Law § 7-3.1 (McKinney)
[2] General spendthrift law was articulated in old cases as follows: “The restraint on the alienation of the right to income [and principal] from trusts **** represents a declaration of the public policy of the state. Its purpose was to enable a testator to protect the beneficiary *** from his own improvidence.” Helmsley-Spear, Inc. v. Winter, 101 Misc. 2d 17, 19–20, 420 N.Y.S.2d 599, 600 (Sup. Ct. 1979).
[3] § 222.Spendthrift trusts in the United States, Bogert’s The Law of Trusts and Trustees
[4] N.Y. CPLR 5205(c)(1) (McKinney)
[5] N.Y. CPLR 5205(c)(5) (McKinney)
[6] N.Y. Debt. & Cred. Law § 276 (McKinney)
[7] N.Y. CPLR 5205(c)(2) (McKinney)
[8] In re Todd, No. 15-11083 (Bankr. NDNY 3/23/2018) US Banktruptcy Court for Northern District held that debtor’s inherited individual IRA is not exempt from creditors under NY law.
[9] See SECURE Act which requires most non-spouse IRA and retirement plan beneficiaries to drain inherited accounts within 10 years after the account owner’s death.
[10] See EPTL 7-1.5.
[11] See CPLR 5205(5). This exception does not include 10% of an IRA whose income is totally exempt.
[12] See EPTL 7-3.4.
[13] See EPTL 7-31.
[14] EPTL 7-3.1
[15] Social Services Law 366(b)(2)(b)(ii)
[16] EPTL 7-1.11
[17] EPTL 10-7.2.
[18] 26 U.S.C. 2041.