Griff's Notes, March 29, 2022: Pitfalls of Mandatory Trust Distributions

Tax, trusts and estates updates from around the country

Trust distribution standards come in all sorts of forms and flavors. In estate-planning-attorney-speak, however, we tend to break them down by looking to income and principal separately, and then exploring the following structures from order of least favorable to most favorable:

1. Mandatory distributions - must go to a beneficiary at a certain time, or upon fulfillment or failure of certain condition(s).

2. Discretionary distributions subject to an ascertainable standard - trustee has discretion to make or withhold distributions based on a beneficiary’s needs under a certain, (typically objective) standard such as health, education, maintenance and support; depending on state law beneficiary may be able to compel some level of distribution.

3. Fully discretionary distributions - trustee has unfettered discretion to distribute some, all, or none of the trust income and/or principal to a beneficiary, or standard is too broad to be ascertainable (i.e., “comfort” or “happiness” of beneficiary); beneficiary typically cannot compel a distribution.

Pre-distribution, most trusts are protected by a spendthrift clause. Without a spendthrift clause, a beneficiary’s interest in a trust is treated more like an entity interest that rises to the level of personal property. This means that a beneficiary can transfer their beneficial interest in the trust, voluntarily or involuntarily. This is a bad outcome if, for example, creditor protection is a goal of the trust.

It is against this backdrop that I took great interest at Colorado’s recent adoption of Part 5 of the Uniform Trust Code, which generally sets out the rights of the creditors of a beneficiary and/or settlor of a trust. Of particular importance is the treatment of irrevocable trusts, as it is this permanence that often creates the asset protection sought.

In this article, I am going to explore the backdrop of Colorado law with respect to mandatory distributions, as there is a colorful history. I will not, however, explore marital property rights in a trust today, as this requires a deeper discussion. I also will not discuss protection of a trust’s settlor, or lack thereof.

Mandatory Distributions

As noted above, a spendthrift clause only protects the pre-distribution assets of a trust. It is commonly accepted that creditors may reach trust distributions once the distributed income and/or property is in the hands of the beneficiary.

But, what if a distribution is mandatory? Does a creditor have to wait around for the trustee to distribute the property to the beneficiary before it can enforce its rights against the distributed property? The answer is no, according to the opinion of the Colorado Court of Appeals in Beren v. Beren, 321 P.3d 615, 620-23 (2013).

In Beren, the personal representative of an estate created a liquidating trust as part of the proposed final settlement of a decedent’s estate, which was subject to unliquidated tax claims (which ended up not being collected) and a spousal claim under an elective share. The liquidating trust called for a distribution to the decedent’s son once the statute of limitations for the tax claims expired. The limitations period had expired, but the decedent’s spouse sought a garnishment of the mandatory trust distribution to the son in satisfaction of the son’s share of the elective share claim.

The probate court approved the garnishment, and the son appealed. But, the Court of Appeals held that a mandatory distribution right allows a creditor to garnish the property subject to the distribution before the distribution is made, but only after the distribution becomes certain and the period for holding the trust property is about to end. This outcome rendered a spendthrift clause moot once the conditions to the receipt of the distribution (expiration of tax statute of limitations, and son’s survival) had been satisfied or were about to be satisfied. Thus, garnishment was appropriate.

This is bad news for a trust that calls for mandatory distributions. For example, the traditional child’s trust calling for distributions of one-third at age 25, one-half at age 30, and the balance at age 35 creates the type of conditions that are ripe for garnishment. In such a case, the trustee could wait until just before the child’s 25th birthday and garnish the one-third mandatory distribution.

But, what I have not mentioned so far is the inclusion of one, magic word that sends shivers up the collective spines of estate planners who encounter it:

Shall.

The key to a mandatory distribution standard is the instruction that the trustee shall distribute property. I won’t get into the ways in which an ascertainable standard might affect this, but instead I want to cite a possible loophole.

What if the child has the option, for example, to withdraw one-third at age 25? In other words, what if we state the opposite word - may - to create the option of holding property in the trust? This is an area where Colorado differs from other states.

Powers of Withdrawal

The latter example creates a power of appointment, which in this context is more commonly known as a power of withdrawal.

The defining case in Colorado is Univ. Nat’l Bank v. Rhoadarmer, 827 P.2d 561 (Colo. App. 1991). This case essentially states that a power of withdrawal is not a personal property right, and that a creditor of a beneficiary of a spendthrift clause cannot compel the beneficiary to exercise the power. In essence, even if a beneficiary may withdraw a sum (such as the greater of $5,000 or 5% of the trust assets), the assets subject to this power cannot be garnished until actually withdrawn by the beneficiary.

In Beren, the Court distinguished Rhoadarmer and stated that the power of withdrawal is not the same as a mandatory distribution. However, just a few paragraphs later, the Court noted that a condition to a distribution which is completely within the beneficiary’s control is illusory (in response to the technicality cited by the beneficiary’s son of refusing to sign a release requested by the trustee).

One may read this and think that technically, the power of withdrawal is an illusory condition since it is within the beneficiary’s sole control. However, the Court once again notes that the illusory nature of the condition only becomes a factor where the trustee is required to make distributions and is permitted to set conditions.

In other words, fiduciary duties separate the two. The trustee is bound by a fiduciary duty to make the mandatory distribution, while the beneficiary is under no duty to exercise a power of withdrawal. Now, the two worlds can mix in odd ways (see my prior discussion with Gray Edmondson on this), but typically a beneficiary who is not a trustee cannot be compelled to exercise a power of withdrawal. Again, however, note the use of language - mandatory distributions are usually accompanied by shall while optional powers of withdrawal (or discretionary distributions) are usually accompanied by may.

Semantics matters.

Uniform Trust Code, Part 5

While Colorado’s adoption of Part 5 of the Uniform Trust Code won’t take effect until July 1, 2022, it still alters this analysis in an interesting way.

Section 506, codified at C.R.S. 15-5-506, will serve as the statutory enactment of Beren but with a twist. This section clarifies that a creditor can garnish a mandatory distribution, but only when it is overdue. In other words, the statute opens up a mandatory distribution to garnishment “if the trustee has not made the distribution to the beneficiary within a reasonable time after the designated distribution date.”

Thus, the creditor cannot tee up the garnishment just before the distribution becomes mandatory, contrary to what the Court approved in Beren (using the about to be distributed standard). Instead, the creditor must wait until the distribution is overdue. I can see this leading to a lot of fighting and litigation over the definition of just what constitutes a “reasonable time” after the distribution becomes mandatory.

What is also interesting is Section 502(4), which allows a trustee to take a distribution which is “required… by the terms of the trust” and instead apply it for the benefit of the beneficiary. Doing so prevents the creditor from reaching the funds applied for the beneficiary’s benefit. While this statute does not expressly reference a “mandatory” distribution, it does apply this standard to a distribution that is “required.” While this appears to be intended to cut off the creditor’s access to distributed funds post-distribution, I am curious to see whether this can also be used as a way to circumvent creditor access to mandatory distributions to the extent such distributions can be applied for or for the benefit of the debtor-beneficiary, especially if an independent trustee makes the call.

And, luckily, nothing changes the treatment of a non-fiduciary power of withdrawal held by a beneficiary. In other words, Colorado’s version of Part 5 of the UTC does not appear to alter Rhoadarmer.

Takeaways

While the harm of mandatory distributions has, and will continue to, be front-and-center in the drafting of distribution clauses, there are some helpful takeaways to note when drafting or decanting trusts.

1. Always make sure a trust includes a spendthrift clause, but don’t treat it as a panacea. As noted above, mandatory fiduciary distributions can allow a creditor of a beneficiary to bypass the spendthrift clause by garnishing the mandatory distribution. The only question is timing.

2. Avoid using the word “shall,” even when accompanied by an ascertainable standard. Doing so could convert a discretionary distribution into a mandatory distribution.

3. If you must use a mandatory distribution, consider whether allowing a trustee to apply the distribution for the beneficiary can avoid garnishment, whether under the laws of the trust’s situs or the laws of the state in which the beneficiary is located.

4. Also consider stating mandatory distributions in the form of a power of withdrawal, in states where similar protections are provided to Colorado. Of course, one must be conscious of the tax effects of such a right under the estate tax, gift tax, GST tax, and grantor trust rules, but a power which is subject to a $5,000/5% limitation for example may be tax-effective while also reducing the risks of creditor garnishment.