Creditors' access to trust distributions

Estate and trust attorneys and their litigation brethren have for decades understood that creditors have only limited rights to reach distributions payable to beneficiaries from spendthrift trusts. Spendthrift provisions in trusts for profligate beneficiaries have always been respected by statute and the courts, and Probate Code Sections 15300 and 15301 shelter income and principal, respectively, of a beneficiary's interest in a trust with a provision for restraint on transfer. Probate Code Sections 15302 and 15307 provide that creditors cannot reach sums necessary for the support and maintenance of a beneficiary, and Section 15306.5 provides that creditors can reach only 25 percent of the distributions in excess of such support and maintenance, mirroring the civil code provisions for wage garnishment.

In Carmack v. Reynolds, 2017 DJDAR 2819 (Mar. 23, 2017), the 9th U.S. Circuit Court of Appeals asked the California Supreme Court whether these Probate Code sections limit a bankruptcy estate's access to a beneficiary's interest a spendthrift trust, and the court responded with an interpretation of the statute broadly more generous than was previously understood.

In Carmack, a large spendthrift trust worth at least several million dollars was on its terms distributable to a beneficiary in installments over a set period of years. One day after the settlor of the trust died, the beneficiary sought bankruptcy relief, presumably to achieve discharge of indebtedness before sums would become due to him under the terms of the trust. Once trust distributions are in the hands of a beneficiary, the funds lose any shield of protection against judgment creditors.

After a long discussion of the relevant probate code sections which regulate the rights of creditors to reach trust assets held for debtor/beneficiaries, the court held that while the 25 percent limit of Probate Code Section 15306.5 was effective against distributions that a trustee makes in its discretion to the beneficiary, that limitation did not apply to the distributions required to be made from principal under the terms of the trust. "After an amount of principal has become due and payable (but has not yet been distributed) a creditor can petition to have the trustee pay directly to the creditor the sum up to the full amount of the distribution 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."

Under the facts of Carmack, where the trust provided that the beneficiary was to receive principal of $100,000 per year for 10 years, each year when that principal was distributable a creditor was entitled to an order requiring that it be paid to the creditor in its entirety. Effectively, the court ruled that when a distribution is mandated from principal it is no longer sheltered by the spendthrift provision of the trust.

In illustration, the court stated that if a beneficiary was to receive distributions of principal of $10,000 on March 1 of each year for 10 years, a judgment creditor is entitled to an order in year one requiring the trustee to pay the full $10,000 of principal distribution directly to the creditor, as that amount was presently due, and to an additional order requiring the 25 percent of each of the nine anticipated future payments be similarly paid to the judgment creditor when they became due. If this was insufficient to satisfy the creditor, the court stated that the creditor could return to the court and obtain an order requiring payment on account of its judgment for the remaining $7,500 on March 1 of each subsequent year until the total sum due was paid.

In reaching this result, the Supreme Court read the inconsistent provisions in the Probate Code dealing with limitations as a draft error of the Legislature, perhaps inviting legislative action to rectify this emasculation of Probate Code Section 15306.5. The court also suggested possible limiting reach of its opinion by stating that its ruling applied only to distributions from principal, and the possible application of the new rules only to bankruptcy creditors. Since the Probate Code sections do not limit the rights of judgment creditors only to those who are bankruptcy trustees, this last possible limitation has no apparent founding in statute.

Estate planning practitioners will want to be careful to include language conditioning distributions to maintenance and support of beneficiaries who might likely become debtors or bankrupts. Litigation practitioners will undoubtedly find a new source of satisfaction of their judgments unless and until the legislature clarifies the impact of Carmack on the applicable provisions of the Probate Code.