A Trust Beneficiary is in Prison for a Felony: Is the Trust Exposed to Creditor Liability?
Recently, a client contacted our office because one of their trust beneficiaries was convicted of a felony and sent to prison. The client wanted to know what happens to the beneficiary’s interest and whether it could be accessed by creditors or the government after the client passes away.
The first question to ask, as is true for most issues surrounding trusts, is what does your trust say? Answers to trust questions will often vary depending upon the specific language contained within the trust itself. Important areas to know about your trust are:
1) Does the trust have discretionary language?
2) Does the trust have a spendthrift provision?
Discretionary Language
Discretionary language basically means that a Trustee has sole discretion to distribute to a beneficiary. The Trustee has control over the amount of the distribution and whether or not to make any distribution at all. As such, there is no guarantee any distributions from the trust would be made to a beneficiary. While the beneficiary does have an interest, it is not 100% certain they will see the money. This uncertainty allows the Trust to be protected from having to make distributions to some creditors.
Each trust generally has guidance on what factors the Trustee should consider when using their discretion. Most commonly used is what is known as a “Health, Education, Maintenance, and Support” standard, or HEMS for short. This comes from health, education, support, or maintenance within the meaning of Sections 2041 and 2514 of the Internal Revenue Code. This is generally interpreted to cover an individual’s basic needs for living, but will vary depending upon the specific standards for each beneficiary. Everyone is different, and these differences are why a Trustee is given discretion.
It is important to keep in mind that a beneficiary or other interested party can challenge a Trustee’s discretion. The question is whether the Trustee “acted in the state of mind contemplated by the trustor.” Young v. McCoy, 147 Cal.App.4th 1078 (2007) (quoting In re Greenleaf’s Estate, 101 Cal.App.2d 658 (1951)).
In Young v. McCoy, a trust beneficiary was sent to prison for attempted murder. The victim attempted to enforce a judgment awarding personal injury damages against the beneficiary’s interest in the trust. That trust’s language gave the Trustee discretion to provide money for the needs of the beneficiary. However, the Trustee determined that no distributions should be made because the State of California was providing for the beneficiary’s needs in prison. The court agreed with the Trustee and could not compel distributions at the request of the beneficiary’s victim.
Spendthrift Provisions
Spendthrift provisions prevent a beneficiary from assigning away their interest in a trust to a third party, such a creditor. To prevent a beneficiary from having the ability to assign their interest in a trust, many settlors include a “spendthrift provision” in their trust which is language that stops a beneficiary from being able to assign their interest. This helps ensure that the person or entity the settlors intend to receive a distribution actually receives it and that the beneficiary cannot pass it to someone else before they receive it, such as a creditor.
If your trust has both discretionary language and a spendthrift provision, there are some protections available.
HOWEVER, Discretion Cannot Prevent All Distributions
Pursuant to California Probate Code Section 16081(a), “…if a trust instrument confers “absolute,” “sole,” or “uncontrolled” discretion on a Trustee, the Trustee shall act in accordance with fiduciary principles and shall not act in bad faith or in disregard of the purposes of the trust.”
Basically, if the Trustee would have made a distribution to a beneficiary but did not solely to keep the creditor from access the money, there is a question of whether the Trustee is acting appropriately and in good faith. The answer to this question depends on the specific facts. A decision could go either way in a court, but regardless the Trustee would have to spend time and money defending itself.
Restitution Judgments
Under California Probate Code Section 15305.5, “restitution judgment” means a judgment awarding restitution for the commission of a felony or a money judgment for damages incurred as a result of conduct for which the defendant was convicted of a felony.
Under California Probate Code Section 15305.5(c), the court may, to the extent that the court determines it is equitable and reasonable under the circumstances of the particular case, order the Trustee to satisfy all or part of the restitution judgment out of all or part of future distributions that the Trustee, pursuant to the exercise of the Trustee’s discretion, determines to make to or for the benefit of the beneficiary.
In U.S. v. Harris (9th Cir 2017) 854 F3d 1053, the court held that discretionary language did not protect the beneficiary’s interest in a restitution context. In 1997, Michael Harris was convicted of eight federal criminal counts related to theft from an employee benefit plan. He was sentenced to 30 months in prison and ordered to pay over $600,000 in restitution. He paid only a small fraction of that amount when the government learned that he was a beneficiary of two irrevocable, discretionary trusts established by his parents for his support. Both Trusts had discretionary language.
The first trust provided that “[t]he Trustee shall payout of income which in the Trustee’s absolute discretion will help support [Harris], which in the opinion of the Trustee will allow [Harris] to properly manage his affairs.” The second trust stated that “[t]he Trustee may pay to [Harris] or for his benefit, so much of the principal as the Trustee deems necessary or advisable from time to time for his health, maintenance, education, and best interest.” Each trust also contained a spendthrift clause, which provides that “[t]he interest of the beneficiary in principal or income shall not be subject to the claims of any creditor, any spouse for alimony or support, or others, or to legal process, and may not be voluntarily or involuntarily alienated or encumbered.”
Despite having both spendthrift provisions and discretionary language, the court found the government could enforce their writ of garnishment. Citing United States v. Taylor, 254 F.Supp. 752 (N.D. Cal. 1966), the court found that when a beneficiary “has a basic beneficial right to receive distributions” from a discretionary trust, a government lien may “attach to and subsist against that right.” Id. at 756. In this respect, a taxpayer’s property right in a discretionary trust “differs from any other property right only in that it has no permanently fixed dollar value.” Id. Harris attempted to argue that he had only a “mere expectation” of future distributions, and that a federal lien may not attach to this expectation. Despite the discretion not being a guarantee, the court held that because Harris has a right to receive distributions under California law, his interest in the discretionary trusts was not a mere expectation. Instead, it constituted “property” under the expansive definition stated in 28 U.S.C. § 3002(12).
However, importantly, in Harris the government did not attempt to compel distributions from the trusts. The court only held that any current or future distributions from the trusts would be subject to the continuing writ of garnishment, until the restitution judgment is satisfied.
In short, if restitution is owed to the victim of a crime, it is likely the court can order payment from the trust. But it is unclear whether a Trustee’s decision not to issue distributions for the reasoning found to be valid under Young v. McCoy and would be compelled to make distributions. Keep in mind that Young v. McCoy (discussed above) was for a personal injury award, not for a restitution judgment. The court has more authority to order distributions and likely would. But by using a discretionary standard a Trustee might be able to properly determine no payment is appropriate.
Future Distributions Can Be Accessed by Creditors
Since the Trustee has discretion not to make distributions, what happens if the Trustee decides to start making distributions at a later date?
Discretion only limits creditors from accessing the assets now. Creditors can file liens against future distributions. A judgment creditor can petition the court for an order directing the Trustee to satisfy all or part of the judgment out of the distributions to which the beneficiary is entitled under the trust instrument or that the Trustee, in the exercise of the Trustee’s discretion, has determined or determines in the future to pay to the beneficiary. Basically, if you distribute anything to that beneficiary in the future, the distribution will go to the creditor; not to the beneficiary.
However, under Probate Code Section 15306.5(b), an order cannot require the Trustee to pay an amount exceeding 25% of the payment that otherwise would be made to, or for the benefit of, the beneficiary.
Summary
What should you do to protect your assets from your beneficiary’s creditors? Give your Trustee sole discretion to make distributions. If they can, in good faith, not intend to make distributions, then the creditors cannot compel distributions, except possibly for victims of the crime related to restitution judgments which is still uncertain.
Lastly, if you are concerned about exposing your trust to making distributions to creditors, amendments are always an available option to update language and change beneficiaries.
