Shifting the Paradigm

Should Most Tennessee Trusts Last Indefinitely?

Many of our clients make their first wills in order to name guardians and trustees for their minor children. Traditionally, trusts for minors contained a scheduled termination date, providing that the entire trust would distribute when the beneficiary reached a certain age or in installments over time. However, the divorce and creditor protections afforded by Tennessee trust law raise the question, should any trust include an automatic termination date?

Disinheriting Future Ex-Sons-in-Law. My daughters will not find husbands good enough to deserve them. I pray they will have lifelong marriages, but the statistics are not encouraging. Even worse than having an ex-son-in-law is his having part of my daughter’s inheritance.

In a divorce, the court seeks to divide marital assets among the ex-spouses, but each spouse generally gets to keep his or her separate property, including inheritance.[1] While trust beneficiaries can title assets received from a terminating trust separately from marital property, they often fail to do so because they don’t think of it, don’t think divorce will happen to them, or don’t want to explain to their spouses why they are not inclined to title inheritance jointly. Once separate property is commingled with marital property, it can become marital property.

I can do for my daughters what they might not do for themselves. I can leave their inheritance to them in trusts for their lifetimes, allowing each to become sole trustee of her trust on whatever schedule I choose, without providing for any termination event.[2] The segregated trust assets should remain separate property, protected in a divorce.[3] Plus, my daughters can make me the bad guy: “Dear, I wouldn’t think of keeping assets from you, but you know how cranky Daddy was.”

Disinheriting a Trust Beneficiary’s Creditors.[4] In addition to providing divorce protection, Tennessee trusts offer robust creditor protection. Tenn. Code Ann. Section 35-15-501 (creditor’s rights) provides the general rule that creditors can reach a beneficiary’s interest by attachment of present or future distributions or other means. However, the general rule is almost entirely swallowed up by its exceptions.

Tenn. Code Ann. Section 35-15-502 (spendthrift provision) says if a trust has a spendthrift provision, the beneficiary’s creditors cannot reach anything in the trust, with the trustee explicitly allowed to withhold “mandatory” distributions or to make mandatory distributions to third parties on the beneficiary’s behalf, rather than to the beneficiary. Tenn. Code Ann. Section 35-15-506 (distributions relative to support, mandatory and certain remainder interests) goes further by saying, even if the trust contains no spendthrift provision, a beneficiary’s mandatory interest is not a property right (so creditors cannot reach it) and the trustee may make distributions on the beneficiary’s behalf, rather than to the beneficiary. Under Section 35-15-504 (discretionary interests), if the trustee has discretion whether to make distributions to a beneficiary, the beneficiary’s creditors cannot reach trust assets whether or not the trust includes a spendthrift provision.[5] Section 35-15-506 says if a beneficiary’s interest is a support interest, meaning the trustee is directed or has discretion to distribute for some combination of health, support, maintenance and education, then whether or not the trust contains a spendthrift provision, the beneficiary’s creditor cannot force distributions and cannot reach amounts distributed for those purposes even after the beneficiary receives them. Tenn. Code Ann. Sections 35-15-508 and 35-15-509 provide that a creditor cannot reach trust assets solely because the debtor-beneficiary is a fiduciary, may remove and replace a fiduciary, has a power of appointment, or has any power over the trust.

So, what is left of the general rule? Only when the trust has no spendthrift provision, a creditor can reach (1) amounts actually distributed to a beneficiary other than pursuant to a support standard, (2) a remainder interest guaranteed to be distributed within one year, and (3) amounts contributed by the beneficiary in certain circumstances. That level of creditor protection is unusually strong among the states and should lead Tennessee lawyers to educate clients about the advantages of assets remaining in trust.[6]

Control Versus Ownership. Rather than asking when a young beneficiary’s trust should end, I now ask on what schedule the beneficiary should gain control of the inheritance. I then explain that control can mean the trust distributes to the beneficiary, but it might be better for the trust to continue, with the beneficiary acquiring the desired level of control over the trust.

Any such trust should include a spendthrift provision, required by Tenn. Code Ann. Section 35-15-502(a) to include restraints on both voluntary and involuntary alienation. The trust should provide that distributions are in the trustee’s discretion, rather than mandatory (saying the trustee “may” make distributions for specified purposes, rather than “shall"). The trustee may distribute trust assets to third parties for the benefit of a beneficiary, rather than distributing to the beneficiary.

How much control may the beneficiary possess while retaining creditor protection? There are few bright lines in the area of creditor protection, particularly given that many of the key statutes have not been tested in courts. Therefore, trust design features should be viewed on a spectrum from beneficiary autonomy to strong creditor protection. Clients whose primary consideration is beneficiary control may give the beneficiary the broadest possible powers (without explicitly or impliedly removing the trustee’s fiduciary duties to other beneficiaries) and hope that the trust will stand up to any attacks by the beneficiary’s creditors. Clients more concerned with creditor protection might choose not to name the beneficiary as sole trustee and/or not to give the beneficiary nonfiduciary powers.

What if the client wants to balance beneficiary autonomy with creditor protection, a “have your cake and guard it, too” approach? The law is developing, so the following conclusions are tentative but, appear reliable based on the strong creditor-unfriendly stance taken by the statutes. It should be safe for the beneficiary to be the sole trustee, if the beneficiary-trustee may distribute to self only for ascertainable standards (health, education, support and maintenance).[7] The beneficiary should not have a non-fiduciary power of withdrawal, but the beneficiary may have lifetime and testamentary powers to appoint (direct) trust assets to others. The beneficiary may have the power to veto distributions to or for the benefit of others. The beneficiary may have the power to remove and replace trustees and to fill trustee vacancies, but consider prohibiting the beneficiary from appointing a trustee who is “related or subordinate” to the beneficiary as defined in Internal Revenue Code section 672(c).[8]

What should happen to the trust at the beneficiary’s death? The beneficiary may be given the right to appoint (direct) trust assets to desired beneficiaries, but the default can be that the trust divides into separate trusts for the next desired beneficiaries and continues for them with the same potential protective benefits, creating an effectively perpetual divorce and creditor shield.[9]

Trust Protectors/Advisors. To add flexibility without jeopardizing creditor protection, powers that a beneficiary will not possess may be given to one or more individuals designated as “trust protectors” or “trust advisors.”[10] These are family members, friends or trusted professional advisors (including the estate planning attorney) who are legally independent of the beneficiary and trustee, and trusted to look after the beneficiary’s best interests.

Conclusion. Our clients can do their children a favor by leaving assets to them in trust rather than outright. In addition, while some trusts have limited purposes that call for limited durations, many trusts should be designed to last so long as there are sufficient assets remaining, for a beneficiary’s lifetime and beyond.

Notes

  1. Tenn. Code Ann. § 36-4-121(b)(2)(D).
  2. I put my (father-in-law’s) money where my mouth is. At my recommendation, my father-in-law is leaving his daughter’s inheritance to her in trust, in case his son-in-law gets stupid.
  3. Some courts take into consideration a trust created for one spouse when dividing marital assets, but only rarely (and apparently never in Tennessee) give one spouse anything from a trust created for the other spouse.
  4. This section is adapted from my contributions to Griswold, et al., “Big Changes to Tennessee’s Uniform Trust Code: 10 Things You Should Know,” Tennessee Bar Journal (Dec. 2013), www.tba.org/journal/big-changes-to-tennessee-s-uniform-trust-code.
  5. If the beneficiary is a fiduciary, the preceding rules apply if (1) the beneficiary-fiduciary does not have discretion to make or participate in making distributions to self, (2) the beneficiary-fiduciary's discretion to make or participate in making distributions to self is limited by an “ascertainable standard” (health, support, maintenance, or education), or (3) the beneficiary-fiduciary’s discretion to make or participate in making distributions to self is exercisable only with consent of someone holding an adverse interest. A creditor can compel or reach a distribution only to the extent the creditor “may” reach if the beneficiary were not also a fiduciary.
  6. See Oshins, “Dynasty Trust State Rankings Chart,” https://docs.wixstatic.com/ugd/b211fb_5ba497da4c374872be424209eaf7ca7b.pdf.
  7. Broader standards for distributions to self might be treated as a power of withdrawal. However, Tenn. Code Ann. § 35-50-124 imposes such limitations on a trustee who also is a beneficiary unless the trust references the statute and explicitly overrides it. Any beneficiary who is the sole trustee should consider resigning if creditors become a significant concern. Naming a co-trustee to serve with the beneficiary is one way to err on the side of creditor protection over autonomy for the beneficiary.
  8. While that is a tax provision, it provides a useful safeguard for creditor protection purposes.
  9. Long-term trusts require designed flexibility and thoughtful approaches to income tax and transfer tax planning.
  10. See Tenn. Code Ann. §§ 35-15-1201 et seq. for provisions governing trust protectors.

Eddy R. Smith EDDY R. SMITH practices trust and estate law with Holbrook Peterson Smith PLLC in Knoxville. He is a fellow of the American College of Trust and Estate Counsel and past chair of the Tennessee Bar Association Estate Planning and Probate Section. He can be reached at esmith@SmartLawTN.com.

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