How Bulletproof are Spendthrift Trusts in Bankruptcy?

What is a trust?

A trust is a document that places ownership of an asset in a separate entity – also called a trust –for the benefit of the trust’s beneficiaries.¹ The assets are managed by a trustee, who invests and distributes funds according to the trust’s instructions. Often a trust is created by a parent for the benefit of the parent and his or her children simply to avoid probate. As such, many trusts do not include a spendthrift provision and instruct the trustee to distribute a certain amount per year until the principal is consumed.

What is a spendthrift trust?

A spendthrift trust is defined as “a trust that prohibits the beneficiary’s interest from being assigned and also prevents a creditor from attaching that interest.”² It is primarily used to protect the trust from the reach of the beneficiaries’ creditors. California generally allows the use of spendthrift provisions in Probate Code §§ 15300 and 15301(a), while allowing creditors to reach part of the trust in related sections.³ For example, normal judgment creditors may reach 25% of the funds that are payable to the debtor, unless the debtor needs those funds for their support or the support of their dependents.⁴ Once funds are in the debtor’s possession, they are reachable like any other asset.⁵

What happens when a debtor files a bankruptcy?

When a debtor files a bankruptcy, a bankruptcy estate is created.⁶ This estate includes “all [the] legal or equitable interests of the debtor,” which includes a debtor’s interest in a trust.”⁷ If the debtor files a Chapter 7 bankruptcy, a trustee is appointed to administer the estate’s assets and maximize revenue for the benefit of the debtor’s creditors.⁸ As such, the bankruptcy trustee has broad authority to reach all of the debtor’s assets.⁹

However, there are a few limitations. First, the trustee is required to administer the estate “as expeditiously as is compatible with the best interests of parties in interest.”¹⁰ Therefore the trustee cannot keep a case open indefinitely, waiting for payments to come in. Second, an asset protected by a spendthrift provision is generally excluded from the bankruptcy estate, to the extent recognized by nonbankruptcy law.¹¹ After In re: Neuton, it was understood that a trustee could only reach up to 25% of the spendthrift trust’s funds, when paid out by the trust’s trustee.¹² That amount was further lowered by debtors claiming the “necessary for support” protection of Probate Code § 15306.5(c). Finally, debtors often limited their requests for disbursements, allowing the funds to remain in the trust or to go to another beneficiary.

In re: Reynolds
Rick H. Reynolds filed a Chapter 7 bankruptcy in the Central District of California on March 4, 2009.¹³ In his initial petition and schedules, he listed over a million dollars in assets and almost two million dollars in debts.¹⁴ In response to question 20 on his Schedule B regarding “contingent and noncontingent interests in estate of a decedent … or trust” he checked the box for “none.”¹⁵ However, at the time of filing he was a contingent beneficiary under several spendthrift trusts, worth at least one million dollars.

Not long after, on April 28, 2009, the trustees of the Reynolds Family Trust asked the bankruptcy court to decide how much of the trust the bankruptcy trustee could reach. Following In re: Neuton, the bankruptcy court held that the estate’s interest was capped at 25%. The bankruptcy trustee appealed, first to the Bankruptcy Appellate Panel, which affirmed, then to the 9th Circuit Court of Appeals, that certified a question to the California Supreme Court. Did the 25% cap under Probate Code § 15306.5 apply to Probate Code § 15301(b)?

Carmack v. Reynolds – S224985
The California Supreme Court issued a unanimous ruling on March 23, 2017. It held that the 25% cap under § 15306.5 did not apply to judgment creditors seeking access to principal payments under § 15301(b).¹⁶ Thus, bankruptcy trustees now have two different ways to reach a spendthrift trust – all principal currently due and payable to the debtor and 25% of all future payments. However, debtors are still entitled to exclude some or all of those proceeds, to the extent needed for support.¹⁷

The court also mentioned a non-bankruptcy scenario, where a hypothetical judgment creditor could come in annually when payments were due and payable and petition the court for the remaining 75% under § 15301(b).¹⁸ The court did not explicitly state whether a bankruptcy trustee had that ability or whether the estate could potentially include those funds. If so, the bankruptcy estate could now include the debtor’s entire interest in a spendthrift trust. Regardless, to the extent In re: Neuton capped the estate’s interest at 25%, it is no longer good law.

Future Reynolds litigation
The matter now returns to federal court, with the 9th Circuit likely to explicitly overturn In re: Neuton before sending the matter back to the Bankruptcy Court for further hearing. Hopefully the 9th Circuit will also resolve the discrepancy in the Supreme Court’s opinion – whether the estate’s § 15301(b) interest is capped at the principal due and payable at the time of filing or whether it includes amounts that come due later.

What this means for debtors:

1. Be prepared for bankruptcy trustees to be more aggressive in going after spendthrift trusts.
2. Examine the spendthrift provisions of a trust carefully before filing a bankruptcy petition, as well as the language terminating the trust. Know what is protected (principal, interest, or both), what mandatory payments are being made when, and when the trust ends. The sooner it ends, the more likely creditors and bankruptcy trustees will be able to reach the entire amount. You may want an estate planning attorney to assist you with this.
3. A bankruptcy estate contains (a) all of the principal currently due and payable, excluding the amount necessary for the support and education of the debtor, and (b) at least 25% of the future payments to be made, excluding the amount necessary for the support of the debtor and the debtor’s dependents. List this amount on Schedules A/B and expect to prove those expenses.¹⁹
4. Next, exempt the proceeds as allowed under whichever code provision you are claiming your exemptions (ie., wildcard under Cal. Civ. Proc. § 703.140(b)(5))
5. If there are nonexempt funds, bankruptcy may not be the right road for that debtor.

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[1]See also Black’s Law Dictionary 1513 (7th ed. 1999). “A property interest held by one person (the trustee) at the request of another (the settlor), for the benefit of a third party (the beneficiary).
[2] Id. at 1518.
[3] Including Cal. Prob. Code §§ 15301(b), 15305, 15305.5, 15306, & 15306.5.
[4] Cal. Prob. Code § 15306.5
[5] Cal. Prob. Code §§ 15300 and 15301(a)
[6] 11 U.S.C. § 541(a)
[7] 11 U.S.C. § 541(a)(1)
[8] 11 U.S.C. § 704
[9] 11 U.S.C. § 541(a)(1) and § 704(a)(1)
[10] 11 U.S.C. § 541(a)(1)
[11] 11 U.S.C. § 541(c)(2)
[12] In re: Neuton, 922 F.2d 1379 (9th Cir. 1990)
[13] In re: Reynolds, 6:09-bk-14039-MJ (Bankr. C.D. Cal – matter still pending)
[14] In re: Reynolds, docket #1, page 1
[15] Id. at 14.
[16] “In sum, after an amount of principal has become due and payable … a creditor can petition to have the trustee pay directly to the creditor a sum up to the full amount of that distribution (§ 15301(b)) unless the trust instrument specifies that the distribution is for the beneficiary’s support or education and the beneficiary needs the distribution for those purposes (§ 15302). If no such distribution is pending or if the distribution is not adequate to satisfy a judgment, a general creditor can petition to levy up to 25 percent of the payments expected to be made to the beneficiary, reduced by the amount other creditors have already obtained and subject to the support needs of the beneficiary and any dependents. (§ 15306.5). Carmack v. Reynolds, S224985 at 14.
[17] Id. at 16.
[18] Id. at 15.
[19] Cal. Prob. Code §§ 15302 and 15306.5(c), 11 U.S.C. § 541(c)(2), and either Cal. Civ. Proc. Code § 703.030(b) or § 704.120