When you create an irrevocable trust, you surrenders ownership over the trust assets; you cannot unilaterally regain control of the property. As a result, your creditors cannot get to the assets to satisfy the your debts. Irrevocable trusts are also generally structured to prevent a beneficiary’s creditors from gaining the trust’s assets to settle his debts. Although laws vary among states, there are cases in which a creditor can “pierce” the trust shield to obtain trust assets as a means of settling outstanding debts.
Trusts cannot be used to defraud creditors. Courts will not allow a person to place his assets in an irrevocable trust in order to avoid paying creditors. The Uniform Fraudulent Transfer Act, which has been adopted by 44 states as of June 2012, addresses these types of transactions meant to defraud creditors. For a creditor to use this law to pierce the trust, she must prove that the debtor created the trust with the intent to defraud creditors or with the knowledge that after the transaction he would lack the resources to pay his obligation. If the creditor can prove this intent, a court will invalidate the transaction, the trust creator would regain ownership of the property and the creditors could claim the assets to satisfy the outstanding debts.
Trust Creator as Beneficiary
If the trust creator names himself as beneficiary of an irrevocable trust, he has the same rights and protection as any other beneficiary. The rights of the beneficiary are defined in the trust agreement, which describes the circumstances in which a beneficiary can obtain the trust assets. Although a creditor may not be able to pierce a trust directly, he may be able to compel a beneficiary to exercise his rights to demand payment from the trust. For example, if a trust agreement permits a beneficiary to request payment at any time, the creditor can compel the beneficiary to request the necessary funds from the trust to pay off the debt.
Read More: Rights of the Beneficiary of an Irrevocable Family Trust
A spendthrift trust is a device used to limit a beneficiary’s ability to claim trust assets. With a spendthrift provision, the beneficiary gets a defined amount of cash annually and cannot receive more. Since the beneficiary has no discretion regarding how much he receives, the beneficiary’s creditors cannot claim the trust assets outright. However, the beneficiary’s creditors can claim any cash that the beneficiary receives from the trust.
Exceptions to Spendthrift Trust
Certain creditors may pierce a spendthrift trust. Spouses or children of the beneficiary may be able to take the trust assets if the beneficiary does not meet his financial obligations to them. For example, people who manage the trust and doctors who provide medical care to the beneficiary may be able to claim trust assets to pay off the beneficiary’s debts. Finally, if the beneficiary has any back taxes or must pay any damages imposed by a court, the trust can be pierced to obtain the necessary funds to settle the debt.
John Cromwell specializes in financial, legal and small business issues. Cromwell holds a bachelor's and master's degree in accounting, as well as a Juris Doctor. He is currently a co-founder of two businesses.