Griff’s Notes, March 21, 2022: Can a Spendthrift Trust File for Bankruptcy?
Tax, trusts and estates updates from around the country
For some reason, certain memories get locked in our minds. For me, today’s case took me back to a memory which is 14 years removed, but feels like yesterday.
I was sitting in the law library at law school, as a 3L, doing research as part of a business planning course. I was reviewing a BNA portfolio on choice of business entity (Portfolio 700 to be exact) where I stumbled across a confusing concept…
Business trusts.
I wondered, “How can a donative and/or testamentary tool be used as a business entity?”
That was a question I never answered until now. But, today’s case deals with a twist on the question – whether one can force a donative trust to be a business trust, in order to avail the trust of the bankruptcy process. The answer is no.
This case is especially poignant for me, as it was decided in the U.S. Bankruptcy Court of my own home state – Colorado.
In re Quadruple D Trust, U.S. Bankruptcy Ct., D.Colo, March 18, 2022
Central Issue: Whether a trust can file for Chapter 11 bankruptcy?
Value Added Score: 7
Holding: A trust cannot file for Chapter 11 bankruptcy unless it is a “business trust,” which is a confusing concept but is actually well-defined and narrow in scope and attributes, and a spendthrift trust cannot be a business trust.
Facts:
This case involved a self-settled irrevocable trust (which has its own unaddressed issues below), but the Bankruptcy Court was highly critical of the trust. Noting the numerous spelling and grammatical errors (including an error in the name typed on the trust instrument – the “Quadrupe [sic] D Trust”) – the Court did not have a good impression to begin with.
Nonetheless, the Court elected to engage in an extensive analysis of whether the trust was eligible for bankruptcy protection.
As background, the trust lacked the schedules of assets referenced in the body of the trust, and the debtor trust could produce evidence of only a $100.00 initial transfer, plus current ownership of a residence primarily used by the settlor’s spouse. The settlor was the trustee, and had the right to live in the residence free of rent so long as the expenses of ownership and use were paid by settlor. (The facts noted that the settlor did pay these expenses through a separate entity).
The trust owed a debt, impliedly related to a 2012 judgment related to settlor, which was secured by the residence in the trust. The trust sought Chapter 11 bankruptcy protection with respect to this debt.
This case was unique in a couple of regards. One, it was the trust – and not the individual settlor – seeking bankruptcy protection. Two, the trust claimed no unsecured debts. Reading between the lines, this could seem a sneaky way to avail oneself of bankruptcy protection in a more controlled manner. In a sense, this could allow you to isolate personal liabilities in a trust and later restructure or discharge them.
But, as we will find out, this is not possible. The creditor and Court challenged, among other things, the eligibility of the trust for bankruptcy protection, and concluded that the trust was not eligible in an extremely lengthy opinion which I have greatly condensed below.
Analysis
I am taking the liberty of paraphrasing a lot of the bankruptcy code and analysis in this write-up, but the interesting point here was that only an individual, partnership, or corporation is generally eligible for bankruptcy protection. A trust does not fit into these categories except for one narrow exception – the “business trust” – which is a subcategory of corporations.
As you can guess, the debtor trust (through its settlor/trustee) tried to argue that the trust was, indeed, a business trust.
However, there were a couple of problems with this, which I will tackle out of order.
First, the Court engaged in an extremely lengthy analysis of the definition of a business trust which is reminiscent of a certain scene from Billy Madison where a simple “no” may have sufficed. Needless to say, the Court appeared to take it upon itself to create a definitive magnum opus designed to settle, once and for all, the definition of “business trust.”
After a lengthy analysis of the meaning of this term for federal law versus state law purposes, the history of its use, the meaning at the time of enactment of the U.S. Bankruptcy Code in 1978, and other factors, the Court settled on some common elements of a business trust:
· It is created for the conduct of a business, managed by compensated trustees.
· It is maintained for the conduct of a business, managed by compensated trustees.
· The interests of the beneficiaries are evidenced by a certificate of ownership, like stock, and are fully transferable and not terminated at a beneficiary’s death.
Interestingly, the Court noted that at one time, the Bankruptcy Code had included in its definition the reference to transferable beneficial interests, but had eliminated it. This did not, however, have the significance of expanding what the Court had (up to now) concluded was a very narrow definition of “business trust.” Instead, the Court concluded that this deletion was designed to simplify the language by accepting that the transfer of interests was implied at the time to be included in the accepted definition of a business trust.
From there, it did not take the Court long to conclude that the debtor trust was not a business trust.
First, the Court tested the question of whether the trust was created with the intent of conducting business from the beginning, and concluded that it was not based on a statement of intent within the trust that was more in line with a “donative trust” which had the primary purpose of managing res (principal) for a select group of related, defined beneficiaries whose interests were not defined in value or amount.
Second, the Court looked to the history of the trust, and found that it had never conducted anything that could be considered a business. The trust had owned real property previously, possibly for investment purposes, but had surrendered it to the United States years prior. No facts were given regarding the circumstances surrounding this forfeiture, nor did the trust show any history of ever receiving any income whatsoever. The only history available was the trust’s mere ownership of a personal use asset (a residence) for the family of the settlor/trustee.
Having concluded that the trust was neither established, nor maintained, for the conduct of business, the Court could have stopped there, but they looked to a third prong which is extremely important for practitioners to note.
Recall that the business trust has, as a common element under the Court’s accepted definition, free transferability of beneficial interests. Most estate planning trusts lack this element, because most estate planning trusts contain a spendthrift clause which restricts alienation of beneficial interests. Thus, it was easy for the Court to conclude that the trust was not a business trust, based on the mere inclusion of a spendthrift clause.
Takeaways
Perhaps the simplest takeaway here is the fact that if a trust has a spendthrift clause, it is not a business trust. Thus, practically all estate planning trusts are ineligible for bankruptcy protection.
Most trusts created for asset protection purposes are designed to protect certain assets from claims against the settlor of the trust, and/or the beneficiaries, hence the inclusion of a spendthrift clause. States vary on how this is treated, and also vary based on the protection granted to the settlor of the trust versus a beneficiary who is not the settlor. This case, however, appeared to involve the reverse scenario.
The Bankruptcy Court noted that the definition of business trust was reliant on a generally-accepted federal definition, instead of state law, but only for the narrow determination of eligibility of a trust under the Bankruptcy Code. The Court left the door open for state law to continue to define property rights for federal law purposes, which has important implications for both tax and bankruptcy purposes in the world of trusts.
Without diving too much into this distinction for bankruptcy purposes, I found one omission in this opinion which will continue to bother me. In Colorado, conveyances to a self-settled trust are void against creditors of the settlor existing at the time of transfer. This question did not come into play here, because the settlor was not the debtor. Nonetheless, it is important to note that Colorado recently adopted Part 5 of the Uniform Trust Code, addressing the treatment of trust interests between beneficiaries and the settlor. This new statutory adoption clarifies that a creditor (present or future is not clarified) of the settlor of an irrevocable trust can reach the maximum amount that could be distributed to or for the settlor’s benefit. This applies regardless of the presence of a spendthrift clause.
These new changes in Colorado do not take effect until July 1, 2022, but will apply to judicial proceedings on or after that date with respect to previously existing trusts.
For now, I don’t know of many people who draft or use business trusts. The only recent approximate use I have seen is to bypass or block the Garn-St. Germain Act for transfers of mortgaged rental properties to an LLC, by creating a revocable trust without a spendthrift clause (to which a transfer of mortgaged property does not trigger a due-on-sale clause) and then assigning the settlor’s trust interest (instead of the property itself) to the LLC. But, one thing is for certain – trying to shoehorn most trusts into the definition of “business trust” for bankruptcy purposes will now be a losing proposition after this opinion of the Bankruptcy Court.