NEW CASE LAW: CREDITOR ACCESS TO SPENDTHRIFT TRUSTS

The California Supreme Court recently published the case of Carmack v. Reynolds where the beneficiary of a spendthrift trust filed for bankruptcy before any distributions were made from the trust. The bankruptcy trustee sought to determine which interest the bankruptcy estate has in the trust. The case clarifies Probate Code Section 15306.5 which appears to limit the bankruptcy estate to 25 percent of the beneficiary‘s interest whereas other provisions of the Probate Code suggest no such limitation.

A spendthrift trust provides that a beneficiary’s interest cannot be alienated before it is distributed, meaning a creditor cannot reach the assets until distributed by the trustee. Case law has supported this concept because donors have “the right to choose the object of [their] bounty and to protect their gifts from the donees’ creditors.” (Canfield v. Security-First Nat. Bank (1939) 13 Cal.2d 1, 11). Certain limitations to this protection apply including for payment of child or spousal support, restitution, and spendthrift provisions that benefit the grantor himself.

In interpreting Probate Code Section 15301(b), the court found that a creditor is also allowed to petition the court for direct payment from the trustee once principal becomes “due and payable.” Clarifying a concern brought up by the lower court that a creditor could have “immediate access to all of a beneficiary‘s trust principal.”  However, if that distribution is for the support or education of the beneficiary a creditor cannot reach the assets until in the hands of the beneficiary.

The bankruptcy trustee also argued that Section 15306.5 gives creditors an automatic 25% of a beneficiary’s trust interest with the burden on the beneficiary to prove that the amount should be reduced for support or education. The bankruptcy trustee further argued that the creditor, under Section 1507, could petition the court for further approval to access more than 25% of the beneficiary’s interest if they could show that the interest would not impact the beneficiary’s support or education. The court concluded that the enactment of section 15307 without apparent limitations on the reach of general creditors was inadvertent and that the Legislature plainly intended general creditors to be limited to 25% of future distributions from the trust.

Finally the court determined that the 25% limitation does not apply to Section 15301(b), instead the creditor may petition for the full amount, unless the trust is for the support and education. If no distribution is due and payable, then the creditor may petition the court to receive up to 25% of future distributions subject to the support needs of the beneficiary.

In conclusion:

“a bankruptcy trustee, standing as a hypothetical judgment creditor, can reach a beneficiary‘s interest in a trust that pays entirely out of principal in two ways. It may reach up to the full amount of any distributions of principal that are currently due and payable to the beneficiary, unless the trust instrument specifies that those distributions are for the beneficiary‘s support or education and the beneficiary needs those distributions for either purpose. Separately, the bankruptcy trustee can reach up to 25 percent of any anticipated payments made to, or for the benefit of, the beneficiary, reduced to the extent necessary by the support needs of the beneficiary and any dependents.”