A huge sea change in California asset protection law is sending assets to sanctuary states, like Nevada, more willing to protect those assets than creditor-friendly California.
That other states better protect funds in self-settled trusts is old news. Many states, Nevada among the best of them, have for years welcomed so-called Domestic Asset Protection Trusts (DAPTs) offering much of the protection of offshore trusts but without the political risk of offshore trusts. On the other hand, DAPTs carry risk of their own including constitutional exposure under the Full Faith & Credit clause and a possibility of clawback for ten years under the federal bankruptcy code. These risks can be minimized with sophisticated planning, and DAPTs (or Hybrid DAPTs) set up well enough in advance are an important asset protection strategy.
What’s new in sue-happy California is that now even third-party trusts, long thought to be safe, appear to be at risk.
First, California’s recently enacted Uniform Voidable Transactions Act puts even innocent estate planning transfers at risk of being set aside, lowering the bar creditors faced under the previous law on fraudulent transfers.
Second, the California Supreme Court in Carmack v. Reynolds, 391 P.3d 625 (Cal. 2017), recently clarified California law as allowing general creditors to reach the entire amount held by a trustee to the extent it is currently due and payable, except to the extent earmarked for the beneficiary’s support or education, and necessary for those purposes; PLUS up to 25% of expected future distributions, except to the extent necessary for support of beneficiary or dependents. Thus, rather than be limited to an order for 25% of future payments, patient creditors can reach 100% of future payments as they become due and payable. The court illustrates:
As an illustration, suppose a trust instrument specified that a beneficiary was to receive distributions of principal of $10,000 on March 1 of each year for 10 years. Suppose further that a general creditor had a money judgment of $50,000 against the beneficiary and that the trust distributions are neither specifically intended nor required for the beneficiary‘s support. On March 1 of the first year, upon the creditor‘s petition a court could order the trustee to remit the full distribution of $10,000 for that year to the creditor directly if it has not already been paid to the beneficiary, as well as $2,500 from each of the nine anticipated payments (a total of $22,500) as they are paid out. If the creditor were not otherwise able to satisfy the remaining $17,500 balance on the judgment, then on March 1 of the following years, upon the general creditor‘s petition the court could order the trustee to pay directly to the creditor a sum up to the remainder of that year‘s principal distribution ($7,500), as the court in its discretion finds appropriate, until the judgment is satisfied.
Third, a recent Ninth Circuit case, US v. Harris (No. 16-10152) upheld the government’s writ of continuing garnishment for restitution against a convicted criminal’s beneficial interests in a couple of irrevocable trusts even though the trusts were set up as discretionary support trusts, where payments are made under trustee’s discretion. The court reasoned that the beneficiary’s interest was property, not a mere expectancy, because the beneficiary had a right to compel trustees to distribute in accordance with fiduciary standards and the trust’s purpose.
So while fully discretionary trusts seem to be a way around Carmack, they seem to run straight into Harris. But there might be a way to break through Harris by stating clearly an intent that trust purpose is also to benefit remainder beneficiaries and that trust assets must be preserved for that purpose. Also, remember that trust protector provisions may come in handy for making necessary changes to trust language or moving the trust to a better jurisdiction.
Thus, in order for a third-party trust to have any likelihood of significantly protecting assets in California, the following features should be considered:
- Independent trustee, or at least a mechanism in place for one to take over quickly (at least distribution, in states that allow furcation of trustee functions);
- Trust protector provisions allowing amendment of trust language, change of trust situs to another jurisdiction, change of trust governing law, removal and appointment of trustees, construction of ambiguous trust language, etc.;
- Provision for trustee decanting trust assets to a new trust;
- Fully discretionary distributions (no rights of withdrawal);
- A statement that trust purpose is to benefit not just primary beneficiary, but also remaindermen, and consequently trust assets are to be preserved for remaindermen.
