A “spendthrift clause,” enforceable in many states, is a provision written into an irrevocable trust document that restricts creditors of a beneficiary from reaching the trust’s property. The concept is far from new, but for over 100 years, drafting errors have been rendering such provisions moot.
In 1910, Harry S. Langhorne learned this lesson the hard way. The Virginia Supreme Court ruled that creditors could reach a spendthrift trust that he had established and funded for his benefit. The rationale? A person should not be able to shirk his creditors by simply placing his or her property into a trust, whether revocable or irrevocable. Without additional restriction on the use of said property, there is little difference between holding the property in trust and holding it outright. And that’s where creditors find room to make their argument. Thus, when Mr. Langhorne placed his own assets in a revocable trust for his own benefit, he learned that this action did not shield his assets from his creditors.
A recent Virginia case expounds upon this point. Corinne Salahi fell into a similar trap when she tried, but failed, to protect her assets by creating an irrevocable trust for her and her husband’s benefit. In the event of his death, the trust provided that she would then be the sole beneficiary. When Mr. Salahi died, Mrs. Salahi became the sole beneficiary, and the irrevocable trust directed that Ms. Salahi was entitled to the income or principal of the irrevocable trust, as she so directed and desired. Like Mr. Langhorne, Ms. Salahi had a virtually unrestricted ability to use the trust property, and like Harry, she learned that the law would not protect the property from her creditors, just because it was placed these assets in an irrevocable trust, with a spendthrift clause.
While federal bankruptcy law respects spendthrift clauses in irrevocable trusts created by a third parties for a beneficiary (whether related or not), it only does so when there is some real restriction on the beneficiary’s use of the trust property. Such restrictions are interpreted in light of the state law, which applies to the irrevocable trust. And, while Virginia state law honors spendthrift clauses, it will not necessarily do so when the person who creates the trust, contributes property to the trust, and is a beneficiary of the trust. Because Ms. Salahi had more or less full access to, and control over, the assets in the irrevocable trust that she created and funded, the Bankruptcy Court ruled that the property in the irrevocable trust was subject to her creditors.
The lesson? In order to protect your assets from your creditors, you must do more than just placing these assets in an irrevocable trust for your benefit. You must give up some control over the assets and/or use of the assets. The trust document must be carefully drafted, with special attention given to what state law will apply. If done properly, creditors can be held at bay.
This case was before Virginia became the 13th state to adopt legislation to allow for self-settled irrevocable trusts, which are exempt from the creditors of the person who creates and funds the trust. But, even under this new law, the irrevocable trust that Ms.Salahi created would not have protected her assets from her creditors. She just had too much control over the assets of the trust. For more information, see our recent blog Virginia: The New Kid on the Block.
– Gary Altman, Esq. and Coryn Rosenstock