Spendthrift Clauses and Choice of Law: How to Shield a Beneficiary’s Trust Assets in Bankruptcy

In an earlier blog post, we discussed choice of law provisions (commonly referred to as forum selection clauses) which control both the place where a contract dispute would be litigated and which jurisdiction’s laws would apply to the dispute.  A similar concept applies to trusts.

A trust is essentially a contract between the settlor (the person establishing the trust) and the trustee (the person holding title to the property).  It also governs the rights of third parties to the contract.  For example, if a beneficiary of a trust is sued, certain provisions in the trust could protect that beneficiary from having his or her trust property taken away in that lawsuit.

One of those protective provisions is a spendthrift clause, which can operate to prevent a creditor from seizing the beneficiary’s property.  Many trusts provide that the trust assets cannot be seized by a creditor, and courts routinely uphold those provisions.  However, in certain limited circumstances, the spendthrift clause will not protect all of the beneficiary’s trust interest.

Another way to protect the beneficiary’s interest is by including a choice of law provision.  In In re Zukerkorn, Sally Zukerkorn established a trust for the benefit of her children.  Her trust specifically selected Hawaii as the applicable law.

Thirty years later, Sally’s son, Herbert, filed for bankruptcy in his home state of California.  Herbert attempted to shield his trust income from the bankruptcy estate.  Under California’s bankruptcy laws, Herbert would have to turn over 25% of his trust income to pay his creditors in the bankruptcy.  Under Hawaii law, he wouldn’t have to turn over any of his trust income.

Ultimately, the court decided that Hawaii law applied.  Sally’s choice of law in her trust was upheld because Hawaii had a “substantial relation” to the trust.  At the time the trust was created, Sally lived in Hawaii, the trust property was located in Hawaii, and at least one of the beneficiaries lived in Hawaii.  Also, the court noted that the trust was currently being administered by a Hawaii corporate trustee.

The Court’s decision in Zukerkorn does not mean that every trust containing a choice of law provision will be governed by that state’s law.  A “substantial relation” must exist between the trust and the chosen state, and even still, a court might disregard the provision under certain circumstances, e.g., if the trust was a self-settled trust created for the sole purpose of shielding assets, or if certain public policy exceptions apply.

However, in cases like Zukerkorn, choosing the state law which will apply to your trust and ensuring that you establish a substantial relation between that state and the trust property could provide an additional protection for your beneficiaries.

If you’d like to create a trust for your own beneficiaries, or if you’d like us to take a second look at your estate plan to evaluate whether it achieves your goals, please feel free to give us a call.

In Re Zukerkorn, BAP No. NC-11-1506-JuKiJo (2012).

Author: Amy Howse