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Mary Vandenack & Dan Wintz: Drafting Considerations for the Third-Party Spendthrift Trust after In re Castellano

As published in Steve Leimberg's Asset Protection Planning Newsletter on 9/10/14.

Reproduced Courtesy of Leimberg Information Services, Inc. (LISI) at https://www.leimbergservices.com.

"The court's expansive ruling and failure to apply correct law in the Castellano case is concerning for practitioners using spendthrift clauses in third-party trusts. Fortunately, the decision of the Northern District of Illinois Bankruptcy Court is not mandatory authority for any courts, in Illinois or otherwise.

Additionally, it is our understanding that Castellano's counsel is appealing the case. We can only hope counsel does so and that the court is overruled. If the ruling stands as it is, we can only hope that other courts will not cite this decision as persuasive authority.

The value of the case to asset protection planners is a reminder that many courts will err in favor of creditors if at all possible. Careful drafters will consider rulings such as Castellano for the purpose of advising in the most protective approach possible when working with settlors concerned with asset protection or beneficiaries with creditor issues."

In Asset Protection Planning Newsletter #258, Jay Adkisson, David Slenn and Philip Martino provided members with their analysis of In re Castellano. Now, LISI gives Mary Vandenack and Dan Wintz the final word on this controversial decision.

Mary E. Vandenack is founding and managing partner of Vandenack Weaver LLC in Omaha, Nebraska, where she manages the firms Trusts, Estates and Tax Practice. Mary practices in the areas of tax, high net worth estate planning, asset protection planning, business succession planning, tax dispute resolution, and tax-exempt entities. Mary's practice serves business owners, executives, real estate investors, health care providers, tax exempt organizations, and foundations. Mary is a member of the American Bar Association Real Property Trust and Estate Section, Taxation Section, and Business Section and serves on several committees in those sections. Mary regularly writes and speaks on tax, asset protection planning, and estate planning topics. Mary is also a member of the American Bar Association Law Practice Division and is a regular contributor to the Law Practice Magazine, of which she currently serves as Features Editor. Mary also serves on the American Bar Association Youth at Risk Commission and the American Bar Association Commission on the Future of Legal Services.

Dan Wintz is a senior member of Fraser Stryker PC LLO's Estate Planning & Probate and Trust & Estate Administration Practice in Omaha, Nebraska. He is the first and only Certified Estate Planning Law Specialist (Certified by Estate Law Specialist Board, Inc.) in Nebraska. Dan is also an Adjunct Professor at Creighton University School College of Law where he teaches Estate Planning. Dan has developed a practice focused on estate planning with special emphasis on addressing the unique issues that arise in effective and tax-efficient planning for significant qualified plan, executive deferred compensation, and equity-based compensation accumulations. He also works with many C-level clients and their families to develop planned giving and charitable foundations to facilitate making returns to the communities that have been generous to and supportive of them.

Here is their commentary:

EXECUTIVE SUMMARY:

In the case of In re Castellano,[i] the United States Bankruptcy Court, N.D. Illinois, applied Section 548(e) of the Bankruptcy Code[ii] to disregard a third-party trust containing spendthrift provisions created by the mother of debtor for the benefit of the debtor. The court concluded that the debtor had transferred assets to a "device" similar to a self-settled trust with the intent to delay or hinder creditors.

Fortunately, the case is not mandatory authority for any other court and it is our understanding that counsel for Castellano is considering an appeal. To the extent any case like this gets published, asset planning practitioners should consider the case and the general trend of courts regarding asset protection planning in recommending asset planning strategies to clients.

FACTS:

Faith F. Campbell created the Faith F. Campbell Living Trust February 18, 1997 ("Living Trust"). The Living Trust provided that upon Faith's death, the assets of the trust would be divided equally among her four children. The Living Trust stated that "[upon] the death of Faith F. Campbell and upon settlement of her estate, this Living Trust shall terminate." The Living Trust was created in South Carolina, where Faith lived.

Faith's Living Trust contained a spendthrift clause as follows:

If any beneficiary should attempt to alienate, encumber, or dispose of all or any part of the income or principal of this trust before it has been delivered by the Trustee, of if by reason of bankruptcy or insolvency or any attempted execution, levy, attachment, or seizure of any assets remaining in the hands of the Trustee under claims of creditors or otherwise, all or any part of the income or principal might fail to be enjoyed by any beneficiary or might vest in or be enjoyed by some other person, the interest of that beneficiary shall immediately terminate...Thereafter, the Trustee shall pay to or for the benefit of that beneficiary only those amounts that the Trustee, in its sole and absolute discretion, deems advisable for the education and support of that beneficiary until the death of the beneficiary or the maximum period permissible under the South Carolina rule against perpetuities, whichever first occurs.

Faith died on February 11, 2011. All four of Faith's children survived her. Faith's daughter, Linda K. Castellano, was a debtor in the case, In re Bruno and Linda K. Castellano, which was filed before a Bankruptcy Court in Illinois on November 18, 2011.

When Faith created the trust, Faith appointed Bank of America to act as Trustee of the Living Trust. After Faith's death, Bank of America declined its appointment as Trustee. In March 2011, Faith's children, including Castellano, named the husband of one of Faith's grandchildren (a nephew by marriage of Castellano) as Trustee.

On October 5, 2011, Castellano's attorney sent a letter (the "Insolvency Letter") to the Trustee stating that the debtor was insolvent and that the Trustee should act in accordance with the spendthrift provisions of the Living Trust. After receiving the notification of Castellano's insolvency, the Trustee opened an account at Merrill Lynch titled the "Faith M. Campbell Spendthrift Trust fbo Linda Castellano" ("Spendthrift Trust").

As of October 31, 2011, the Living Trust contained $1.8 million in assets plus a cabin in Wisconsin. On November 11, 2011, Castellano executed a Receipt, Approval of Accounting, Release and Discharge of Trustee ("Receipt"). In that document, Castellano acknowledged that she would receive no current distribution from the Living Trust and that the Spendthrift Trust would receive her lifetime, beneficial interest.

Castellano's bankruptcy petition reflected Castellano's interest in the Spendthrift Trust as "[b]eneficiary of deceased mother's trust protected by spendthrift provision."

The Chapter 7 Trustee in Castellano's bankruptcy proceeding took the position that Castellano's interest in the Spendthrift Trust should be subject to seizure on behalf of Castellano's creditors based on Section 548 of the Bankruptcy Code. The bankruptcy court agreed with the Chapter 7 Trustee.

In making its conclusion against Castellano, the bankruptcy court relied on Section 548(e)(1) of the Bankruptcy Code. Section 548(e)(1) provides as follows:

(e)(1) [T]he trustee may avoid any transfer of an interest of the debtor in property that was made on or within 10 years before the date of the filing of the petition, if-

(A) such transfer was made to a self-settled trust or similar device;

(B) such transfer was by the debtor;

(C) the debtor is a beneficiary of such trust or similar device; and

(D) the debtor made such transfer with actual intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that the transfer was made, indebted.

To conclude that Castellano made a transfer, the court reasoned that she had effectuated an indirect transfer by refusing to accept a distribution of trust assets and directing the trustee to distribute the assets to the spendthrift trust. The court stated that the "combined effect of the Insolvency Letter, the Receipt, and the familial relationship with the Spendthrift Trustee enabled the Debtor to effectuate a 'transfer' of her share of the Living Trust assets."

The court concluded that Castellano made the transfer because rather than accepting a distribution of Living Trust assets, she directed the assets to the Spendthrift Trust. The court stated that Castellano's actions were essentially the equivalent of Castellano receiving the assets and then transferring them to a self-settled trust.

To arrive at the conclusion that Castellano had made a transfer "to a self-settled trust or similar device," the court identified characteristics of the Spendthrift Trust the court considered similar to a self-settled trust in order to conclude that the Spendthrift Trust was a "similar device." The characteristics identified by the court are as follows:

1. Like a self-settled trust, the Spendthrift Trust was created in part to shield the Debtor's assets from her creditors:

2. Like a self-settled trust, the Spendthrift Trust was created to preserve the right of the Debtor to receive future distributions from the Living Trust:

3. Although not directly created by the Debtor, the Debtor indirectly caused the creation of the Spendthrift Trust via the instructions she conveyed to the Spendthrift Trust in the Insolvency Letter:

4. It is irrelevant for purposes of §548 whether the formal requirements for establishing a trust under South Carolina law were satisfied:

In concluding that Castellano sought to hinder creditors, the court noted that no assets were distributed to any of the beneficiaries until after October 31, 2011. However, this observation is contradicted by the court in Footnote 7 that states: "The Spendthrift Trustee's authority to make disbursements and distributions was established by his testimony that he made a number of disbursements shortly after Ms. Campbell's death ...". The court concluded that Castellano and the Spendthrift Trustee contemplated and planned the use of the Spendthrift Trust to avoid creditors.

COMMENT:

The court's expansive ruling and failure to apply correct law in the Castellano case is concerning for practitioners using spendthrift clauses in third party trusts. Fortunately, the decision of the Northern District of Illinois Bankruptcy Court is not mandatory authority for any courts, in Illinois or otherwise. Additionally, it is our understanding that Castellano's counsel is appealing the case. We can only hope counsel does so and that the court is overruled. If the ruling stands as it is, we can only hope that other courts will not cite this decision as persuasive authority.

The value of the case to asset protection planners is a reminder that many courts will err in favor of creditors if at all possible. Careful drafters will consider rulings such as Castellano for the purpose of advising in the most protective approach possible when working with settlors concerned with asset protection or beneficiaries with creditor issues.

Although state law concerning third-party trusts, self-settled trusts and spendthrift clauses vary, spendthrift clauses exist in some form in every state. Many states have statutes that prevent a spendthrift clause from applying in a self-settled trust, but most states respect spendthrift clauses in third party trusts.

Distribution Provisions

A significant issue for the court in the Castellano case was the trust language that provided that the Living Trust would distribute upon the death of Faith F. Campbell and would thereafter terminate. While the Living Trust language provided that "[upon] the death of Faith F. Campbell and upon settlement of her estate, this Living Trust shall terminate" (emphasis added), the court ignored the language referencing settlement of the estate and concluded that the trust assets were subject to immediate distribution.

If the court were right about its conclusion that Castellano had a right to immediate distribution upon Campbell's death, the court should have ended its opinion at that point. There would have been no need to discuss Section 548.

Of course, practitioners all know that nine months is not an unreasonable time to administer an estate or trust, especially when your appointed trustee refuses to accept appointment. In addition, there is evidence that the Spendthrift Trustee knew of Castellano's financial issues prior to receipt of the Insolvency Letter.

While the court didn't adequately address the issue of when Castellano had a right to distribution, drafters should certainly consider the issue in trust design. There are a number of strategies a drafter can employ.

  • Rather than distributing assets outright immediately upon death, the drafter can suggest a deferred distribution.
  • If a settlor does not want to defer distributions, the drafter nonetheless can at least provide that beneficiaries will not have any right to distribution until the end of the trust or estate administration process. Define that point.
  • Provide sole discretion to the Trustee regarding the final timing of any distribution. Alternately or additionally, specify that a Trust Protector is to direct the Trustee not to distribute any assets when there is an identifiable risk that doing so will undermine the spendthrift purposes of the trust.

In those states that have adopted §504 of the Uniform Trust Code or some variation, the practitioner might suggest that a settlor consider a lifetime spendthrift trust with the beneficiary as Trustee. Such a trust would include an ascertainable standard for distributions and name a Trust Protector with protective authority.

Spendthrift Clause Language

In the Castellano case, the court failed to apply applicable state law saying:

[T]he Court finds that, under the "similar device" language of § 548(e), the Chapter 7 Trustee need not establish that a formal trust was established according to South Carolina law; an account that was directly or indirectly created by the Debtor to shield her assets from her creditors while retaining a right to receive the assets from that account suffices to meet the requirements of the statute. Any more restrictive interpretation than that would have the effect of reading the "or-similar-device" language out of § 548(e).

The court, in its desire to reach its result, appears to simply ignore the fact that the terms of the trust were created by a third party and the trust was valid under applicable state law. The court's breath-takingly expansive reading of "or-similar-device" would place in question the efficacy of many trusts that benefit a third party such as a child.

Faith Campbell created her Living Trust in 1997, in the state of South Carolina. At the time the trust was created, South Carolina recognized distinctions between third-party created discretionary trusts and first-party created spendthrift trusts.[iii] It seems probable that Faith Campbell intended for a beneficiary's share of her trust to automatically become a completely discretionary trust prior to distribution by the trustee if it were determined that the beneficiary was bankrupt, insolvent or otherwise subject to creditor levy. The Trustee, regardless of familial relationship likely had an obligation not to distribute funds upon learning of Castellano's financial issues.

While the court did not spend significant time on the language of the spendthrift clause, the spendthrift language of the Living Trust merits is worthy of comment for consideration in future drafting. The drafter of the Living Trust first included appropriate discretionary/spendthrift trust language "Thereafter, the Trustee shall pay to or for the benefit of that beneficiary only those amounts that the Trustee, in its sole and absolute discretion, deems advisable...".

However, the scrivener then went further and added what might create a support trust, "... for the education and support of that beneficiary until the death of the beneficiary...". Although the beneficiary was not the trustee (in fact, Ms. Campbell named an unrelated corporate trustee), was there any reason to add a statement regarding education or support which might be utilized by the beneficiary to compel the trustee to make a distribution?

In drafting a trust with spendthrift provisions, the practitioner should consider the applicable state law of the settlor. In this regard, South Carolina adopted the Uniform Trust Code effective January 1, 2014. Although Section 62-7-504 "Discretionary trusts; effect of standard" provides:

(b) Except as otherwise provided in subsection (c), a creditor of a beneficiary may not compel a distribution from a trust in which the beneficiary has a discretionary trust interest, even if:

(1) the discretion is expressed in the form of a standard of distribution (Emphasis Added)

The Reporter's Comment states:

This section [62-7-504] addresses the ability of a beneficiary's creditor to reach the beneficiary's discretionary trust interest, whether or not the exercise of the trustee's discretion is subject to a standard. This section, similar to the Restatement, eliminates the distinction between discretionary and support trusts, unifying the rules for all trusts fitting within either of the former categories. See Restatement (Third) of Trusts Section 60 Reporter's Notes to cmt. a (Tentative Draft No. 2, approved 1999). This section could have limited application. Pursuant to Section 62-7-502, the effect of a valid spendthrift provision, where applicable, is to prohibit a creditor from collecting on a distribution prior to its receipt by the beneficiary. Only if the trust is not protected by a spendthrift provision, or if the creditor falls within one of the exceptions to spendthrift enforcement created by Section 62-7-503, does this section become relevant. (Emphasis Added)

Arguably, Faith Campbell created a spendthrift trust because under Section 62-7-502, it appears to "restrain[] both voluntary and involuntary transfer of a beneficiary's interest ... [even though it does not contain] A term of a trust providing that the interest of a beneficiary is held subject to a 'spendthrift trust', or words of similar import ...". If the beneficiary's interest is held in a spendthrift trust under South Carolina law, then the creditors should not be able to collect prior to distribution to the beneficiary.

If the beneficiary's interest were determined to not be held in a spendthrift trust, then Section 62-7-504 might have been invoked to prevent the bankruptcy court's invasion of the trust. Section 62-7-1106(a)(3) states that the South Carolina Trust Code "applies to judicial proceedings concerning trusts commenced before its effective date unless the court finds that application of a particular provision of this article would substantially interfere with the effective conduct of the judicial proceedings or prejudice the rights of the parties, in which case the particular provision of this article does not apply and the superseded law applies." If Faith Campbell's trust was intended to create a discretionary trust for the beneficiary, then no distribution can be compelled.

Regardless of whether the beneficiary's interest should have been protected either by application of the interest being held under a discretionary trust or a spendthrift trust, the actual text of Faith Campbell's Living Trust reminds us of important considerations in drafting spendthrift language:

  • Support standards; e.g., the HEMS standard, are unnecessary where the beneficiary is not the trustee;
  • State clearly that the beneficiary may not voluntary and involuntary transfer the beneficiary's interest; and
  • The trustee make take actions or make expenditures that benefit the beneficiary that are not "distributions;" e.g., purchase a residence for the beneficiary to occupy rent free, or make loans to the beneficiary that may have security interests prior to those of other creditors.

Give Consideration to Trustee Succession

In its decision in Castellano, the court did not discuss, but likely should have, the definition of "disinterested party" in the Section 101 of the Bankruptcy Code.[iv] That section provides as follows:

The term 'disinterested person' shall mean a person that:

(A) Is not a creditor, an equity security holder, or an insider;

(B) Is not and was not, within 2 years before the date of filing the petition, a director, officer, or employee of the debtor, and

(C) Does not have an interest materially adverse to the interest of the estate or any class of creditors or equity security holders, by reason of any direct or indirect relationship to, connection with, or interest in, the debtor, or for any other reason.

The bankruptcy court used the relationship of the Trustee (nephew-in-law) as part of the basis for its conclusion that Castellano had made a transfer ("the combined effect of the Insolvency Letter, the Receipt, and the familial relationship with the Spendthrift Trustee"). It is difficult to conclude that the nephew-in-law had "a direct or indirect relationship to, connection with, or interest in the debtor" so as to have "an interest materially adverse to the interest of the estate or any class of creditors."

There were nothing to indicate that the nephew-in-law might expect to receive something from his aunt-in-law if her estate were protected from creditors. The judge's conclusion that the nephew-in-law's familial relationship sufficed to conclude that the transfer was by Castellano simply isn't supported by facts or law.

In addition to the disinterested party provisions of the Bankruptcy Code, many states have adopted the language of Uniform Trust Code Section 504 or some variation. Section 504 generally provides that a creditor may not compel a distribution for the trustee's own benefit where the trustee's discretion to make distributions is subject to an ascertainable standard.[v] The comments to the section specifically provide that the section is intended to prevent creditors from attaching interests of beneficiaries who are also trustees (a common structure) to the extent an ascertainable standard applies.

The court also ignored the fiduciary responsibility of the Spendthrift Trustee under the South Carolina Trust Code. Assuming that Castellano did not have a right to immediate distribution upon Campbell's death, the Spendthrift Trustee likely had the obligation to set aside Castellano's share in the spendthrift trust.

Unfortunately, decisions such as that in Castellano make it difficult to rely entirely on existing statutes. While many settlors will continue to use related trustees, if asset protection is a consideration, an unrelated third party simply provides better asset protection than having the beneficiary or a related party act as Trustee.

When a related party is used as Trustee, the drafter should carefully craft the ascertainable standard and how it applies. Consideration should be given to utilizing a Trust Protector, in states providing for the same, with the ability to veto distributions and appoint co-Trustees.

When an unrelated party is named Trustee, the drafter may want to require that any successor Trustee be a corporate Trustee, or at a minimum, an unrelated party. An independent Trust Protector is still useful for appointing successors to avoid the suggestion that the beneficiaries handpicked someone who would comply with their wishes.

Third Party Trust

The Living Trust was created in 1997. Castellano's bankruptcy occurred in 2011. While there are cases where a parent and child worked together to create a trust just before the child filed bankruptcy, this case certainly doesn't fall in that category. It's difficult to suggest that practitioners should dramatically alter their approach to creating trusts such as the Living Trust.

The court used the letter from Castellano's counsel to the Spendthrift Trustee to determine that Castellano had made a transfer. The last sentence in counsel's letter to the trustee indicated that it was the trustee's obligation to exercise his authority to establish the Spendthrift Trust. When advising a beneficiary of a trust who has creditor issues, the ruling in Castellano should be considered when communicating with a Trustee. Rather than directing the Trustee to take action, a letter to the Trustee might simply advise the Trustee of the beneficiary's financial issues and request the Trustee's conclusion as to the impact of those financial issues on the beneficiary's interest considering the spendthrift provisions of the trust.

HOPE THIS HELPS YOU HELP OTHERS MAKE A POSITIVE DIFFERENCE!

Mary Vandenack
Dan Wintz

TECHNICAL EDITOR: DUNCAN OSBORNE

CITE:

In re Castellano<https://goo.gl/4Ue5Dn>, 2014 WL 3881338 (Bk.N.D.Ill., Aug. 6, 2014).

CITE AS:

LISI Asset Protection Planning Newsletter #259, (September 10, 2014) at https://www.LeimbergServices.com Copyright 2014 Leimberg Information Services, Inc. (LISI). Reproduction in Any Form or Forwarding to Any Person Prohibited - Without Express Written Permission.

CITATIONS:

________________________________

[i] In re Castellano<https://goo.gl/4Ue5Dn>, 11 B.R. 46854 (2014).

[ii] 11 U.S.C §548(e).

[iii] McLean v. McLean, 273 S.C. 571, 257 S.E.2d 751 (1979).

[iv] 11 U.S.C. §101(14).

[v] Unif. Trust Code, §504 (2004).

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