Spendthrift Clauses In Bankruptcy

An Overview of the Bankruptcy Ramifications for Debtors who are Beneficiaries or Trustees of  a Trust with a Spendthrift Clause

Prepared for  the Tucson Tax Study Group – October 21 2016

 By Isaac D. Rothschild¹ and Elissa Harshman²

1. Spendthrift Clauses in Bankruptcy

Federal law creates a bankruptcy estate, but it is state law that defines the scope and existence of the debtor’s interest in property. Millard Refrigerated Servs. v. LandAmerica 1031 Exch. Servs. (In re LandAmerica Fin. Group, Inc.), 412 B.R. 800, 811, 2009 Bankr. LEXIS 940, 51 Bankr. Ct. Dec. 148 (Bankr. E.D. Va. 2009). When a debtor files for Chapter 7 bankruptcy, a bankruptcy trustee will be appointed by the U.S. Trustee to administer the debtor’s estate. The bankruptcy trustee has power over all of a debtor’s non-exempt property. Pursuant to “[Section] 704 of the Bankruptcy Code, a chapter 7 trustee is responsible for collecting and reducing to money all property of the estate in an expeditious manner.” Walsh v. Diamond (In re Century City Doctors Hosp., LLC), 2010 Bankr. LEXIS 5048, 2010 WL 6452903 (B.A.P. 9th Cir. 2010).

Property of a bankruptcy does not include property held in a trust with a spendthrift clause unless discretionary powers to withdraw trust assets have been given to the trustee-debtor, enabling the bankruptcy trustee to obtain those powers and exercise them for “the benefit” of the beneficiary-debtor. If discretionary powers have been given to the trustee-debtor, a bankruptcy trustee is able to exercise a trustee-debtor’s powers, which could include taking the maximum allowable amount that the trustee-debtor may withdraw from the trust.

Spendthrift trusts are trusts that are used to insure that the property of a trust will be used only for the beneficiary and bar the seizure of the trust’s assets by a beneficiary’s creditors. “The Bankruptcy Code recognizes spendthrift trusts to the extent that they are enforceable under state law, and assets in a valid spendthrift trust do not become property of the estate.” Riley v. Pugh (In re Pugh), 274 B.R. 883, 885 (Bankr. D. Ariz. 2002); citing Bankruptcy Code § 541(c)(2).

In Arizona, the use of a spendthrift provision is acceptable only when it restrains the transfer of a beneficiary’s interest. A.R.S. § 14-10502(A). Similar to the Bankruptcy Code, in Arizona, a beneficiary’s creditor is unable to reach a beneficiary’s interest in a trust if “either the trustee’s discretion to make distributions for the trustee’s or beneficiary’s own benefit is purely discretionary or is limited by an ascertainable standard, including a standard relating to the beneficiary’s health, education, support or maintenance or similar language…” A.R.S. §14-10504(E).

For a valid spendthrift trust to be enforceable, the following factors must be present: “(1) the settler of the trust is not the trust beneficiary; [known as a self-settled trust] (2) the beneficiary of the trust has only limited or no control over the trust corpus; and (3) an anti-alienation clause in the trust prohibits both the voluntary and involuntary transfer of the beneficiary’s interest in the trust.” In re Hansen, 84 B.R. 598 (Bankr. D. Minn. 1987). Most bankruptcy courts follow that “The primary consideration in determining whether a trust qualifies as a spendthrift trust is the debtor’s degree of control over his trust.” In re Kaplan, 97 B.R. 572, 577 (B.A.P. 9th Cir. 1989). However, some courts implement other factors into the determination. For example, the court in In re Perkins, applied the following factors in determining if a trust qualified as a spendthrift trust:

1. Whether the trust restricts the beneficiary’s ability to alienate and the beneficiary’s creditors’ ability to attach the trust corpus;
2. Whether the beneficiary settled and retained the right to revoke the trust; and
3. Whether the beneficiary has exclusive and effective dominion and control over the trust corpus, distribution of the trust corpus and termination of the trust.

902 F.2d 1254, 1257 n.2 (7th Cir. Ill. 1990). Although, the court noted that “The degree of control which a beneficiary exercises over the trust corpus is the principal consideration under Illinois law.” Id.

The court in Fid. Nat’l Fin., Inc. v. Friedman, stated that “Under the revised Arizona Trust Code the sole beneficiary of a spendthrift trust may also function as the sole trustee as long as the trust contains a discretionary distribution provision.” 2010 U.S. Dist. LEXIS 61835, 2010 WL 2569219 (C.D. Cal. June 17, 2010), citing A.R.S. § 14-10504(E).

A judgment creditor may not become the trustee of this type of trust or exercise the powers of the Trustee. A debtor’s powers “under the sole, equal, or joint management and control” are property of a bankruptcy estate pursuant to the Bankruptcy Code. 11 U.S.C. §541(a)(2). Therefore, the bankruptcy trustee will exercise discretionary powers as part of the bankruptcy estate.

Furthermore, the court in Fid. Nat’l Fin., Inc. v. Friedman, stated that “Under the revised Arizona Trust Code, the only time a spendthrift provision is unenforceable is against (i) a child support judgment, (ii) a judgment creditor who has provided services relating to the protection of a beneficiary’s interest in the trust, or (iii) a claim of the state of Arizona or the United States.” Id.; citing A.R.S. § 14-10503.

2. Uniform Trust Code (UTC) and Implementation of UTC Section 504(e)

Section 504(e) of the Uniform Trust Code (UTC) states:

e. If the trustee’s or cotrustee’s discretion to make distributions for the trustee’s or cotrustee’s own benefit is limited by an ascertainable standard, a creditor may not reach or compel distribution of the beneficial interest except to the extent the intent would be subject to the creditor’s claim were the beneficiary not acting as trustee or cotrustee.

UTC §504(e).

Arizona has not adopted Section 504(e) of the Uniform Trust Code (UTC) verbatim but has adopted substantially similar language under Section 14-10504(e), A.R.S. Eleven other states have adopted substantially similar language and two states have adopted 504(e) verbatim. Therefore, in these states, it is especially important to include language in a trust that allows a trustee to make distributions to himself or herself for the benefit of his or her health, education, maintenance, and support.

Of the nine remaining UTC states who have not adopted some version of section 504(e), common law determines creditor protections.

3. The General Rule

When it comes to filing for bankruptcy, the law in Arizona states that a trust becomes property of the bankruptcy estate, unless the trust includes an enforceable spendthrift clause. A.R.S. § 14-10502(A) (emphasis added). However, this does not prevent a debtor-trustee’s powers from becoming property of the bankruptcy estate.

4. Tensions Between Bankruptcy and State Law

There are a few federal court decisions that address the issue of whether a trust is a spendthrift trust under state law, which removes the assets contained in the trust from the claims of creditors. These federal cases arise in the context of the filing of a bankruptcy proceeding by the debtor/beneficiary of the trust. The determination of whether the trust qualifies as a spendthrift trust under state law is critical because a bankruptcy estate is comprised of all legal and equitable rights of the debtor as of the date of the filing of the bankruptcy petition. See 11 U.S.C. § 541. An exception to this concept of estate property is found under 11 U.S.C. § 541(c)(2). That provision indicates that an interest of the debtor in property becomes property of the estate unless the property is subject to a restriction on its transfer of a beneficial interest of the debtor in a trust that is enforceable under applicable nonbankruptcy law. Bankruptcy courts have interpreted this Bankruptcy Code provision to mean that if a trust qualifies as a spendthrift trust under state law and the beneficiary of the trust is the debtor, the property of the trust does not become property of the debtor’s bankruptcy estate. The federal bankruptcy cases interpreting spendthrift trust law provides some important principals.

In In re Moses v. Southern California Permanente Med. Group, a Chapter 7 trustee objected to a claim of exemption by a debtor in a retirement plan. 167 F.3d 470 (9th Cir. 1999). The In re Moses court stated that the critical inquiry in determining whether a spendthrift trust is valid under California law is whether the trust beneficiaries exercised excessive control over the trust. Id. at 473. The court stated that California law does not allow a participant with excessive control over his/her trust to shield that trust with an anti-alienation provision lacking true substance. Id. In California, a settlor of a spendthrift trust cannot also act as beneficiary of that trust. Id. California law voids self-settled trusts to prevent individuals from placing their property beyond the reach of their creditors while simultaneously reaping the bounties of such property. Id.

Additionally, in In re Pugh, a Chapter 7 trustee sought a determination that a spendthrift provision in a trust was invalid. 274 B.R. 883 (Bankr. D. Ariz. 2002). In analyzing the trust, the court noted that a trust cannot exist where the sole beneficiary is the sole trustee. Id. at 885, citing In re Kaplan, 97 B.R. 572, 577 (B.A.P. 9th Cir. 1989) (the primary consideration in determining whether a trust qualifies as a spendthrift trust is the debtor’s degree of control over the trust). The In re Pugh court stated that the Arizona spendthrift trust statutes contain an express provision prohibiting self-settled trusts. 274 B.R. at 886, citing Arizona Bank v. Morris, 6 Ariz. 566, 435 P.2d 73 (App. 1967), as amended, 7 Ariz. 107, 436 P.2d 499 (App. 1968). The In re Pugh court concluded that a spendthrift trust is not valid if the trustee(s), other than the beneficiary, (1) is either not capable of exercising informed discretion as to distributions to the beneficiary, either because of lack of knowledge or otherwise, or (2) does not in fact do so. 274 B.R. at 887. In the absence of a knowledgeable and discretion-exercising trustee, the beneficiary is in reality the sole trustee, so that the spendthrift provision is invalidated by A.R.S. § 14-7706(B) (amended by A.R.S. §§ 14-10402, 14-10502 on January 1, 2009) and by the common law relied upon in Kaplan. 274 B.R. at 887.

There are numerous, more recent cases reported in the Ninth Circuit, which have concluded that the beneficial interest in a trust, if protected by valid spendthrift language, is not property of the estate. See In re Cutter, 398 B.R. 6 (B.A.P. 9th Cir. 2008); In re Cogliano, 355 B.R. (B.A.P. 9th Cir. 2006). This standard has similarly been followed by Arizona bankruptcy courts, which have concluded that property subject to a valid spendthrift provision with a restriction on the transfer of such beneficial interest is not property of the estate and is beyond the reach of creditors. See In re Kent, 396 B.R. 46 (Bankr. D. AZ. 2008). Perhaps most important for the analysis of the federal law is that in each of the cited cases, the Ninth Circuit BAP and Arizona bankruptcy courts have looked to state law to determine the validity of the spendthrift language and whether such property was beyond the reach of creditors. (Notably, 11 U.S.C. §541(c)(2) references property which includes a restriction on transfer, according to applicable nonbankruptcy law.)

It is possible to have a valid spendthrift clause where the debtor-beneficiary’s interest does not become part of the bankruptcy estate, but the debtor-trustee’s powers do become part of the bankruptcy estate allowing a bankruptcy trustee to exercise those powers for the benefit of the bankruptcy estate. The trustee can only exercise those powers within the principles set forth in the trust, provided the trust never “abused” those powers for its entire existence – a situation in which the debtors are current trustees and the current beneficiaries of a trust invites a fact intensive challenge to whether or not the trust is or is not property of the estate. The bankruptcy judge will be the arbiter of whether or not a definitive standard was strictly held to.

5. Fraudulent Transfers and Filing a Statement of Financial Affairs during Bankruptcy

Typically, when a trust qualifies as a spendthrift trust, a creditor is unable to access the funds in the trust; but there are exceptions. For example, a creditor is able to access assets that were fraudulently transferred to a spendthrift trust. With this in mind, every state has implemented fraudulent conveyance laws to regulate the transfer of assets.

Section 548 of the Bankruptcy Code guides fraudulent transfers and allows a trustee to avoid a fraudulent transfer if the debtor voluntarily or involuntarily made a transfer within two years prior to filing, where the debtor “inten[ded] to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made.” 11 U.S.C. § 548(a)(1)(A). Furthermore, under Section 548(e), the statute of limitations for avoiding fraudulent transfers in a self-settled trust is ten years prior to filing.

In bankruptcy, there are two kinds of fraudulent transfers: (1) actual fraud and (2) constructive fraud. Actual fraud occurs when a debtor intentionally transfers an asset to defraud a creditor within a year prior to filing bankruptcy. 11 U.S.C. § 548(a)(1)(A). Actual fraud is difficult to prove because it requires a trustee to establish that the debtor intended to defraud a creditor. Constructive fraud occurs when a debtor transfers an asset and receives a “reasonably [low] equivalent value,” and the debtor is unable to pay a debt at the time the assets were transferred; or the debtor is unable to pay the debt because of the actual transfer. 11 U.S.C. § 548(a)(1)(B). Constructive fraud is easier to prove because the creditor does not have to establish intent. A debtor is able to commit this kind of fraud without even having knowledge of doing so.

Courts utilize the “badges of fraud” provided in the Uniform Fraudulent Transfer Act (UFTA) to identify a debtor’s subjective intent when determining if a debtor committed a fraudulent transfer of assets. These factors include:

1. Whether the transfer or obligation was to an insider;
2. Whether the debtor retained possession or control of the property transferred after the transfer;
3. Whether the transfer or obligation was disclosed or concealed;
4. Whether, before the transfer was made or obligation was incurred, the debtor had been sued or threatened with suit;
5. Whether the transfer was of substantially all of the debtor’s assets;
6. Whether the debtor absconded;
7. Whether the debtor removed or concealed assets; or
8. Whether the value of the consideration received by the debtor was reasonably equivalent to the value of the asset transferred or the amount of the obligation incurred.

UFTA §4(b).

If the bankruptcy court finds that a debtor fraudulently transferred assets into a spendthrift trust, then the bankruptcy trustee is able to recover the asset for the benefit of the bankruptcy estate, regardless of a spendthrift provision within the trust.

When filing for bankruptcy, the Bankruptcy Code requires the debtor to complete a Statement of Financial Affairs (SOFA), which provides the bankruptcy trustee with a debtor’s financial transaction history for ten years prior to filing. This allows the bankruptcy trustee to undo certain transactions and be able to distribute the recovered money to the debtor’s creditors. “The purpose of the requirement of filing a Statement of Financial Affairs is to furnish the [parties] with detailed information about the debtor’s financial condition, thereby saving the expense of [a] long and protracted examination for the purpose of soliciting the information.” Walkton v. Dellutri Law Group (In re Dellutri Law Group), 482 B.R. 642, 650 (Bankr. M.D. Fla. 2012); citing Garcia v. Coombs (In re Coombs), 193 B.R. 557, 563 (Bankr. S.D. Cal. 1996).

Furthermore, relinquishing management powers can be considered a transfer subject to a fraudulent transfer analysis. See 11 U.S.C. § 548.

6. A Trust Filing for Bankruptcy

Under 11 U.S.C. § 109, only a person is eligible to be a debtor. The definition of a person includes a corporation. 11 U.S.C. § 101(41). Furthermore, the definition of a corporation includes a business trust. 11 U.S.C. § 101(9)(A)(v). Therefore, under the Bankruptcy Code, a personal trust is unable to file for bankruptcy. If a trust meets the definition of a “business trust,” then it is considered a debtor and can file for Chapter 11 bankruptcy.

To be classified as a business trust, a trust needs to involve business activity. In a business trust, trustees are appointed and are responsible to manage the assets of the trust for the benefit of one or more beneficiaries. In In re Star Trust, the court described the characteristics of a business trust:

1. A trust [is] created and maintained for a business purpose;
2. Title to property [is] held by [a] trustee;
3. Centralized management [exists];
4. Continuity [is] uninterrupted by death among beneficial owners;
5. Transferability of interests [exist]; and
6. [There is] limited liability.

237 B.R. 827, 831 (Bankr. M.D. Fla. 1999); citing Morrissey v. Commissioner, 296 U.S. 344 (1935).

7. The Effect of Bankruptcy on LLCs

A limited liability company (LLC) provides asset protection by entirely restricting a creditor’s ability to gain access to its assets simply because those assets are not owned by individual members but instead by the LLC itself. “Charging order” limitations protect the interests of an LLC and allow a debtor to maintain control over an LLC.

Pursuant to a valid charging order, a creditor only has rights to a member’s interest, is unable to manage an LLC, and is not entitled to voting rights. Under the Uniform Limited Liability Company (ULLCA), a creditor is prevented from obtaining a debtor’s voting or managerial rights in accordance with the LLC because the creditor is limited to only the rights of an assignee or transferee. Furthermore, a creditor may only obtain LLC distributions that would have been distributed to a debtor member had there not been a charging order. Lastly, a charging order only provides a lien on partnership distributions.

The benefits of an LLC do not necessarily carry over to bankruptcy situations. For example, in Movitz v. Fiesta Invs., LLC (In re Ehmann), the court held that a bankruptcy trustee obtains all rights and powers that a debtor-member held at the beginning of the case. 319 B.R. 200, 206 (Bankr. D. Ariz. 2005).  In this case, an LLC member owned less than all of the LLC and filed for bankruptcy. Id. at 201. The bankruptcy trustee sued the LLC claiming that the LLC diverted and misapplied assets, and therefore, the trustee wanted to be treated as a substitute member of the LLC. Id. The court allowed the trustee to obtain the debtor’s full membership rights. Id. at 206.

Similarly, the court in Samson, (In re Smith), held that a bankruptcy trustee obtains all rights that a bankrupt limited partner held, and therefore, the trustee was allowed to file suit to dissolve the partnership because no business was being conducted. 185 B.R. 285, 294 (Bankr. S.D. Ill. 1995).

a. Single-Member LLCs

When a member of a single-member LLC files for Chapter 7 bankruptcy, all of the debts of the member become property of the estate. Some courts argue that single-member LLCs are protected by charging orders, but most courts, like In re Albright, have held that single-member LLCs are not protected by charging orders. 291 B.R. 538 (Bankr. D. Colo. 2003). In In re Albright, the debtor served as the LLC’s only member and manager. Id. at 539. The bankruptcy trustee claimed that it obtained the right to control the LLC, which meant it could sell the LLC’s assets, but the debtor denied these rights. Id. Based on Colorado law, the court held that the trustee was entitled to management rights because membership interests in an LLC are assignable. Id. at 541. The court stated that had the LLC had more members, then the trustee would not have been able to obtain management and control rights and instead would have been limited to the distribution of profits. Id. at 540.

b. Multi-Member LLCs

Typically, a multi-member LLC is unable to file for Chapter 7 bankruptcy unless there is consensus amongst all the members of the LLC to file for bankruptcy. However, if two or more members maintain exclusive control over the management of the LLC, then those members may file for bankruptcy without the approval of all members.

Determining if a bankruptcy trustee is eligible to acquire a debtor’s managerial powers in a multi-member LLC depends on the applicable state laws and on the LLC’s operating agreement. In terms of filing bankruptcy, most courts have held under section 541 of the Bankruptcy Code that a debtor’s rights within a multi-member company become property of the estate, regardless of what restrictions are included in the LLC’s operating agreement. See Klingerman v. ExecuCorp, LLC (In re Klingerman), 388 B.R. 677, 679 (Bankr. E.D.N.C. 2008); LaHood v. Covey (In re LaHood), 437 B.R. 330, 336 (Bankr. C.D. Ill. 2010). However, there are usually greater protections to all members in these situations and therefore provide greater asset protection when rights become property of the bankruptcy estate.