The standard rule in most U.S. jurisdictions is that a person may not create a trust, retain an interest in that trust, and have the retained interest immune from his or her creditors:
“Can a settlor shelter trust assets from creditors’ claims by reserving a discretionary interest in the trust? In the United States, the traditional answer to this question is ‘no.’ Although the settlor of a discretionary trust cannot compel the trustee to distribute trust income or principal to the settlor, the settlor’s creditors are able to compel such distributions. The standard formulation of this rule is set forth in Section 156(2) of the Restatement (Second) of Trusts as follows:
‘Where a person creates for his own benefit a trust for support or a discretionary trust, this transferee or creditors can reach the maximum amount which the trustee under the terms of the trust could pay to him or apply for his benefit.’
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Note two essential components of the Restatement rule. First, the rule grants to creditors greater rights than those retained by the settlor himself or herself: the settlor cannot complete trust distributions, but the settlor’s creditors can. Second, the rule applies notwithstanding that allowing the settlor’s creditors to reach the assets of the trust may defeat not just the settlor’s interests, but also the interests of other beneficiaries.”
Danforth, Rethinking the Law of Creditors’ Rights in Trusts, 53 Hastings L.J. 287, 293-295 (January 2002).
Maryland follows the traditional rule: “Since the late 19th Century, it has been the rule in Maryland that a person may not effectively create a spendthrift trust for his own benefit.” In re Robbins, 826 F.2d 293, 294 (1987). In Robbins, the court held that any amount that a trustee is authorized to apply for the benefit of the settlor is available to the settlor’s creditors: “One may wish to have one’s cake and eat it, but the law need not bring their wish to fruition.” Id. at 295.
Robbins distinguished an earlier Maryland decision: United States v. Baldwin, 283 Md. 586, 391 A.2d 844 (1978). Baldwin was a federal tax lien collection case that went to the Court of Appeals in order to certify a question involving a limited power of appointment. In Baldwin, the settlor established an irrevocable trust reserving to himself income for life and retained a limited testamentary power of appointment. Because the power of appointment was not general, the corpus could not be reached by the settlor’s creditors. The only interest retained by the settlor was an income interest, and that was the only interest available to his creditors.
The creditors can only reach an interest retained by the settlor. In Wiltshire Credit Corp. v. Karlin, 988 F. Supp. 570 (1997), a creditor tried to set aside a trust based on the “alter ego” doctrine applicable to piercing the corporate veil. The settlors established a trust reserving a life estate (income interest) in their residence with the remainder to their children. Because the trustees held legal title and the children held equitable title, only the life estate interest was available to creditors. [The life estate was later sold to the trust and the settlors became tenants of the residence.] The court rejected the “alter ego” attack and upheld the trust.
As noted, the general law of trusts holds that a creditor should be able to “reach the maximum amount which the trustee could pay to him or apply for his benefit.” Restatement (Second) of Trusts, § 156(2) (emphasis added). This rule was narrowed somewhat in Est. of German v. United States, 7 Cl. Ct. 641 (1985). German involved whether the decedent’s gross estate included the value of trusts created inter vivos for the benefit of children but where the trustee could make discretionary payments to the settlor if those children consented to the distribution. The court concluded that the trusts were not includable in the gross estate because the creditors of the decedent could not reach those assets. In German, the question was not certified to the Court of Appeals because the then existing Uniform Certification of Questions of Law Act did not permit questions coming from the U.S. Court of Claims. Now Cts. & Jud. Proc. Art. § 12-603 enables the Court of Appeals to answer questions submitted by any U.S. Court.
As noted above, an exception to the general rule may have been created by the tenant by the entirety trust.
