Proper Drafting of Trust Protects Trust Assets from Creditors, Including the Internal Revenue Service
It is common practice among estate planning attorneys to draft wills and trusts to distribute all income to the beneficiary and to make “ascertainable standard” distributions of principal for the health, education, maintenance and support of the beneficiary and perhaps the beneficiary’s dependents. This type of provision assures that all income is distributed out to the beneficiary, and thus taxed to the beneficiary (thereby avoiding income taxation at the trust level). It also gives the beneficiary an enforceable right to access the principal of the trust in the event the beneficiary’s income and other assets are inadequate to provide for continued maintenance of the beneficiary’s lifestyle in the manner the beneficiary enjoyed while the creator of the will or trust was alive.
Unfortunately, when a will or trust is drafted in this manner, the right to receive income or force a distribution of principal is not limited to the beneficiary alone. A judgment creditor or lien holder “steps into the shoes” of the beneficiary when attempting to collect a lawful debt. Such a creditor can request a court to order the trustee of a trust or executor of a will to pay to the creditor whatever they would otherwise be required to pay to the beneficiary.
Internal Revenue Code § 6321 provides that a federal tax lien attach to all “property and rights to property” of the taxpayer. Whether a right under state law is considered property or a right to property under Internal Revenue Code § 6321 is a matter determined under federal law. Property is broadly defined to include every type of right or interest protected by law and having a negotiable value. Under Treasury Regulation § 301.6331-1(a)(1), a levy by the IRS seizes a delinquent taxpayer’s property and rights to property as of the time of the levy, however, it will not accelerate a right to receive a payment in the future. Thus, the IRS is entitled to levy all distributions from a trust or will that the beneficiary is currently entitled to receive, but cannot currently seize distributions to which the beneficiary will only be entitled to receive in the future. For example, if the beneficiary is then age 35 and has a right to a distribution at age 50, the IRS would not have a right to seize that future distribution to which the beneficiary has a right.
It has long been the IRS’ position that it can levy against a taxpayer’s right to receive a periodic or a lump sum payment from a trust or will. See Revenue Ruling 55-210, 1955-1 C.B. 544. In CCA 200614006, the IRS Office of Chief Counsel provided guidance to field offices on a particular taxpayer’s situation which might have broad implications. The taxpayer in the case argued that the spendthrift statute under her state law should protect her share of the trust income and principal from an IRS levy. This argument failed. The court in Leuschner v. First Western Bank and Trust, 261 F.2d 682 (9th Cir. 1958) held that “[t]here is no doubt that the paramount right to collect taxes of the federal government overrides a state statute providing for exemptions.” The IRS Office of Chief Counsel opined that once it was determined that the taxpayer’s interest in the trust constitutes property or a right to property, the fact that a state spendthrift clause may be effective against the claims of other creditors under state law was of no consequence to the ability of the IRS to levy against the trust income and assets.
Knowledgeable estate planning attorneys know that mandatory or ascertainable (health, education, maintenance and support) distributions to beneficiaries of income, principal, or both, exposes trust assets to the creditors of the beneficiary. These attorneys inform their clients of this vulnerability and discuss with them various options of how the trust can be drafted – (a) outright distributions to beneficiaries that are subject to all of a beneficiary’s creditors; (b) held in a lifetime trust that offers complete access to trust assets for the beneficiary, yet still protects the trust assets from a divorcing spouse (but not other creditors); (c) some form of spendthrift trust that will protect trust assets from most, but not all, of the beneficiary’s creditors; or (d) a fully discretionary trust with a third party trustee, which offers the greatest degree of asset protection. A fully discretionary trust, if properly drafted and administered, will even protect against a seizure of trust assets by the IRS and other taxing authorities.
Most existing wills and trusts are not drafted to provide maximum asset protection for beneficiaries. You probably have clients that are concerned about protecting and preserving their assets from the creditors of their children and other beneficiaries. You are invited to contact us to schedule a complimentary appointment for your clients during which we will review your client’s existing will or trust and advise them as to the level of asset protection that it currently provides. If it is inadequate, our office will advise your client of what needs to be done in order to assure their assets are protected from divorcing spouses and other creditors of their children and other beneficiaries.