8.5 The Beneficiary as Trustee of Third Party Trusts
There is little question but that a beneficiary may serve as the sole trustee of a trust established by a third person for his or her own benefit and not be treated as the owner of the trust assets for estate tax purposes as long as the distribution discretion is limited by an ascertainable standard. For asset protection purposes, however, such limitations on the beneficiary/trustee will probably not be respected and the entire trust will be exposed to the creditors of the beneficiary/trustee.
The rule, at least in the abstract, is that the creditors of a debtor should be “able to reach from time to time the maximum amount the trustee-beneficiary can properly reach.” Restatement (Third) Trusts, § 60 (g) (emphasis added). Thus, in illustration 9 of the Restatement comment for § 60 (g), a testamentary trust with a daughter as the beneficiary/trustee that contains a sprinkle provision limited by ascertainable standards for her benefit and for that of her children exposes to the daughter’s creditors “the maximum amount of trust funds that she may, without abuse of her discretion, distribute to herself for the authorized purposes…” This implies that the restrictions afforded by the ascertainable standards may, in fact, be respected. The cases, however, are not as nuanced. In In re McCoy, 274 B.R. 751 (Bankr. N.D. Ill. 2002), for example, the Court essentially examined a situation closely paralleling illustration 9. In that case, the beneficiary/trustee was the sole income beneficiary and could distribute to herself or her children such amounts as may be “desirable” for health, education, maintenance or support. The Court held that because the beneficiary/trustee could distribute funds to herself as may be “desirable” that constituted “unfettered” discretion so the creditor could reach the entire fund. The Court claimed that it looked to the state law to make this determination. One could argue that the result be different in Maryland by virtue of Est. & Trusts § 14-109 (“Prohibition from exercising powers conferred upon trustee”) which limits powers of a beneficiary/trustee to ascertainable standards regardless of the terms of the instrument. As with the McCoy case, the cases elsewhere, however, do not show respect for the restrictions imposed by the ascertainable standards on the discretion by the beneficiary/trustee. Regardless of how the rule may be stated, if the beneficiary could reach the asset under a distribution power, even only by abusing that distribution power, the creditor be also be able to reach the asset.
To immunize trust assets from the creditor claims of the beneficiaries, the most prudent approach is to use an independent trustee and not use the beneficiary as trustee. Many clients, however, may want to permit their beneficiaries to control their own lives to the greatest extent possible and they only create trusts to minimize estate and generation skipping transfer taxes. Those clients may want to name the beneficiaries as trustee and rely on ascertainable standards for the sought-after tax savings. One approach may be to name the beneficiary as trustee subject to an automatic removal and replacement if that beneficiary/trustee is the subject of any claim or suit. Because of the uncertainty of that approach, it should be used only when asset protection considerations are not as important to the client as beneficiary autonomy and the client is aware that it is an unproven asset protection technique that potentially may fail.