By Jonathan E. Gopman

EXECUTIVE SUMMARY:

In In re: Coumbe, 304 B.R. 378 (2004), the principal of a spendthrift trust established and administered under Arizona law was held excludable from a debtor-beneficiary’s bankruptcy estate even though the debtor was the sole trustee of the trust.

FACTS:

In 1994, the debtor's mother created a testamentary trust for the primary benefit of her children (the debtor and his sister) and the secondary benefit of her grandchildren. The grandchildren were only entitled to receive distributions if the debtor and his sister predeceased them. The debtor was appointed as the sole initial trustee of the trust. The debtor’s sister was named as the successor trustee if the debtor was unable or unwilling to serve as the trustee. Upon the death of the debtor’s mother, the trust was divided into two equal shares. One share was set aside in further trust for the primary benefit of the debtor and the other share for the primary benefit of the debtor’s sister. At that time, the debtor and his sister became the sole trustees of their respective separate shares of the trust.

The trust agreement contained a spendthrift provision that provides:

The interest of a beneficiary in the income or principal of the Trust hereunder shall be free from the control or interference of any creditor of the beneficiary or of the spouse of the beneficiary and shall not be subject to attachment, execution or other process of law or susceptible to anticipation, alienation or assignment, whether voluntarily or involuntarily encumbered, except in those cases where Trustee, in Trustee's sole discretion, approves the credit extended and the assignment of the beneficiary's interest hereunder as collateral therefor . . . .

In 2002, the debtor and his wife filed for bankruptcy. It was estimated that there was $120,000 in the debtor’s trust on the date the petition was filed. The debtor withdrew $20,000 from the trust within 180 days of filing his petition.

The bankruptcy trustee argued that the debtor’s trust was not a valid spendthrift trust citing a rule under Arizona trust law related to a trust with a single beneficiary who is also the sole trustee. Thus, the trustee argued that the property in the trust should be property of the bankruptcy estate. The trustee also argued that the $20,000 withdrawn from the trust by the debtor was estate property.

The debtor replied that the trust was a valid spendthrift trust and that the corpus of the trust was not estate property because he was not the sole beneficiary. Furthermore, the debtor argued that the $20,000 he withdrew from the trust was not "acquired" by "bequest, devise, or inheritance" within 180 days of the time the debtor filed his petition. The debtor asserted that any acquisition occurred at his mother’s death in 1994, eight years before he filed his bankruptcy petition.

The bankruptcy court held that while the debtor was the only beneficiary receiving distributions from the trust, the trust was a valid spendthrift trust under applicable law (that is, Arizona law). Therefore, the trust assets were not estate property.

COMMENTS:

Under the Bankruptcy Code, when a petition is filed, an estate is created comprising all property interests of the debtor. Nevertheless, the Bankruptcy Code excludes property from the estate that is subject to a restriction on the ability of the debtor to transfer the debtor’s beneficial interest if such restriction is enforceable under applicable non-bankruptcy law. In other words, an anti-alienation provision in a valid spendthrift trust is an enforceable "restriction on the transfer of a beneficial interest of the debtor." Hence, the assets in such a trust should be excluded from the bankruptcy estate.

According to the Restatement (Second) of Trusts § 152(2), a spendthrift trust is a "trust in which by the terms of the trust or by statute a valid restraint on the voluntary and involuntary transfer of the interest of the beneficiary is imposed." Such a trust precludes a beneficiary from transferring the beneficiary’s right to receive future distributions from the trust. Likewise, a creditor is also precluded from attacking a beneficiary's interest to satisfy the creditor’s claim against the beneficiary. The fundamental premise of a spendthrift trust is to protect a beneficiary from the beneficiary and the beneficiary’s creditors, that is, the basic reasons a debtor becomes subject to a bankruptcy proceeding.

According to the court, applicable non-bankruptcy law (that is, Arizona law) acknowledges the validity of spendthrift trusts. Under such law, to be a valid spendthrift trust the agreement must contain an enforceable restraint on the ability of a beneficiary to transfer his or her interest in the trust. The court cited Arizona Revised Statutes § 14-7706, which provides:

A. A restraint on voluntary or involuntary transfer pursuant to section 14-7701 or 14-7702 is valid even if the beneficiary or one of the multiple beneficiaries of the trust is also one of the multiple trustees of the trust or if one of the multiple beneficiaries is the sole trustee of the trust.

B. A restraint on voluntary or involuntary transfer pursuant to section 14-7701 or 14-7702 is invalid if the sole beneficiary of the trust is also the sole trustee of the trust.

Thus, under Arizona law, a valid spendthrift trust will not exist when the sole beneficiary also serves as the sole trustee.

In Coumbe, the bankruptcy trustee relied on In re Pugh, 274 B.R. 883 (Bankr. D. Ariz. 2002) to argue that the debtor’s trust was not a valid spendthrift trust because of the sole beneficiary-sole trustee rule under Arizona Revised Statutes § 14-7706. Nevertheless, the court viewed this argument as "misplaced." The trust at issue in Pugh, included a spendthrift provision. The debtor was also the sole beneficiary of the trust, however, the terms of the trust provided that there must be a co-trustee serving before any distributions could be made to the debtor. The debtor could not exercise his discretion as a trustee to make distributions of principal without a co-trustee's consent. Following the grantor’s death, the debtor appointed his sibling as a co-trustee, however, he never informed her about the appointment. After the debtor’s sibling was appointed as a co-trustee, the debtor made distributions from a bank account held in the trust without his sibling's knowledge or consent. Based on the foregoing facts, the court in Pugh ruled that the debtor was the sole trustee because his sibling could not exercise "informed discretion" regarding the distributions that were made to the debtor. Thus, the court in Pugh held that the spendthrift provision was not valid under Arizona Revised Statutes § 14-7706(B).

In Coumbe, it was not disputed that the trust contained a spendthrift provision. The primary issue, however, was whether the debtor was the sole trustee and the sole beneficiary within the meaning of Arizona Revised Statutes § 14-7706(B). The trustee attempted to argue that the contingent interests of the debtor’s children were illusory and, therefore, should be ignored in the same manner the co-trustee was ignored in Pugh. The court disagreed holding that the spendthrift trust was valid under Arizona Revised Statutes § 14-7706(B). It stated:

although Debtor was appointed as the sole trustee of the Trust, the Trust agreement also named multiple beneficiaries. Specifically, Debtor and [his sister] were named the primary beneficiaries, and Debtor's children were named the secondary beneficiaries. After the Trust was divided, Debtor remained the trustee and primary beneficiary of his interest in the Trust. Likewise, Debtor's children remained the secondary beneficiaries of that interest. [The bankruptcy] Trustee did not point to, nor are we aware of, any authority that eliminates from consideration secondary beneficiaries. Under Arizona law, a spendthrift trust is valid "if one of the multiple beneficiaries is the sole trustee of the trust." A.R.S. § 14-7706(A). Here, we have multiple beneficiaries when both Debtor and his children are considered.

Hence, the trust was considered a valid spendthrift trust and the debtor’s interest was not included in his bankruptcy estate.

The Bankruptcy Court ruled that the $20,000 distributed from the trust to the debtor was not part of the bankruptcy estate. The trustee, however, argued that such funds were part of the estate under § 541(a)(5)(A) of the Bankruptcy Code because the distribution was made within one hundred eighty days following the debtor’s petition for bankruptcy. Under § 541(a)(5)(A) of the Bankruptcy Code an estate must include "[a]ny interest in property that would have been property of the estate if such interest had been an interest of the debtor on the date of the filing of the petition, and that the debtor acquires or becomes entitled to acquire within 180 days after such date by bequest, devise, or inheritance."

The Bankruptcy Code does not define the terms "bequest," "devise" or "inheritance." To interpret the meaning of those terms the court examined Black’s Law Dictionary, providing:

Traditionally, a "bequest" is "a gift (transfer) by will of personal property." Black's Law Dictionary 160 (6th ed. 1990). A "devise" is "a testamentary disposition of land or realty; a gift of real property by the last will and testament of the donor." Id. at 452. Finally, an "inheritance" is "[p]roperty which descends to heir on the intestate death of another." Id. at 782.

According to the court, the issue was whether the $20,000 distribution was a "bequest, devise, or inheritance" under § 541(a)(5)(A) of the Bankruptcy Code. The answer to that question depends on whether the $20,000 was corpus or income of the trust.

The principal of a spendthrift trust will not be property of a bankruptcy estate. Hence, a distribution of principal from such a trust should not be part of a bankruptcy estate. Interpreting § 541(a)(5)(A), however, most courts have held that income distributed from a testamentary spendthrift trust is a "bequest." Thus, such a distribution would be considered part of the bankruptcy estate. Furthermore, after such income is distributed to a debtor beneficiary, it is not subject to the protection of the spendthrift trust.

In Coumbe, the court held that the trust was a testamentary spendthrift trust, therefore, distribution of income to the debtor within 180 days following bankruptcy is considered property of the estate under § 541(a)(5)(A). Nevertheless, the court could not determine whether any part of the $20,000 the debtor received during the 180-day period was income or principal. Thus, it remanded the case to the Bankruptcy Court to determine what part of the distribution was income and what part was principal.

PLANNING TIPS:

Coumbe illustrates the enormous benefits of using discretionary spendthrift trusts as a vehicle to pass wealth to children, more remote descendants and other family members or beneficiaries. Such trusts can be used to effectively protect even nominal funds from the reach of a creditor or the bankruptcy estate. Careful consideration, however, must be given to the appointment of a beneficiary as a trustee and the powers given to a trustee-beneficiary.

CITATIONS:

11 U.S.C. § 541; Patterson v. Shumate, 504 U.S. 753, 757-58 (1992); Restatement (Second) of Trusts § 152(2); Togut v. Hecht (In re Hecht), 54 B.R. 379, 383 (Bankr. S.D.N.Y. 1985); Richardson v. McCullough (In re McCullough), 259 B.R. 509, 517 (Bankr. D.R.I. 2001); Vucurevich v. Stragalas (In re Stragalas), 208 B.R. 693, 695 (Bankr. D. Ariz. 1997); Arizon Revised Statutes §§ 14-7701, 14-7702 and 14-7706; Riley v. Pugh (In re Pugh), 274 B.R. 883, 885 (Bankr. D. Ariz. 2002); Magill v. Newman (In re Newman), 903 F.2d 1150, 1152 (7th Cir. 1990); Mitchell v. West (In re West), 81 B.R. 22, 25-26 (9th Cir. BAP 1987); Roy v. Edgar, 11 B.R. 853, 855-56 (Bankr. N.D. Fla. 1981)); Gordon C. York, Inc. v. Kragness (In re Kragness), 58 B.R. 939 (Bankr. D. Or. 1986); Smith v. Moody (In re Moody), 837 F.2d 719, 723 (5th Cir. 1988); In re Schauer, 246 B.R. 384 (Bankr. D.N.D. 2000); In re Hunter, 261 B.R. 789, 793 (Bankr. M.D. Fla. 2001); Togut v. Hecht, 69 B.R. 290, 291 (S.D.N.Y. 1987); Burton v. Ulrich (In re Schmitt), 215 B.R. 417, 422 n.2 (9th Cir. BAP 1997); In re Crandall, 173 B.R. 836, 839 (Bankr. D. Conn. 1994); and Chappel v. Proctor (In re Chappel), 189 B.R. 489 (9th Cir. BAP 1995).