¶ 1701
Overview
Scope of the chapter. A third-party trust is a trust created by one person for the benefit of others, funded with the settlor's own property, in which the settlor keeps no beneficial interest. Gifts and inheritances that pass to a beneficiary in trust are the most reliable protection the law allows against the beneficiary's creditors. A settlor may give property on any terms the settlor chooses. A creditor of the beneficiary has no claim on property that never belonged to the beneficiary, and courts in every American state enforce terms that keep the property out of the beneficiary's hands until the trustee distributes it. This chapter examines the spendthrift trust (see infra ¶ 1710), the discretionary and support trust (see infra ¶ 1720), the creditors who can reach a beneficiary's interest despite those terms (see infra ¶ 1730), the beneficiary's own powers as trustee, holder of a power of appointment or holder of a withdrawal right (see infra ¶ 1740), the treatment of distributions once made (see infra ¶ 1750), the beneficiary's divorce (see infra ¶ 1760), the dynasty trust (see infra ¶ 1770) and the spousal lifetime access trust (see infra ¶ 1780). It closes with the place of third-party trusts in the Threat Matrix (see infra ¶ 1790).
The self-settled trust, in which the settlor is also a beneficiary, raises different questions and is the subject of chapter 18 (see infra ch. 18). Trust governance, including directed trusts, protectors, decanting and private trust companies, is the subject of chapter 19 (see infra ch. 19). The gifts that fund third-party trusts, and the voidable transfer risk they carry for the donor, are the subject of chapter 20 (see infra ch. 20).
Why the third-party trust is the strongest structure. Every protective structure examined in this treatise depends on separating the debtor from the asset. Exemptions do so by statute (see supra ch. 12). Entities do so by interposing a legal person and a charging order (see supra ch. 16). Self-settled trusts do so by a statute that departs from the common law (see infra ch. 18). The third-party trust does so at the source. The beneficiary never owned the property, never transferred it and never had the power to transfer it. Three consequences follow.
First, voidable transfer law has nothing to act on as against the beneficiary. A beneficiary who receives an inheritance in trust has made no transfer, and the beneficiary's creditors cannot avoid the settlor's gift as a transfer by the debtor (see supra ch. 7). The donor's own creditors may attack the gift (see infra ch. 20), but the beneficiary's creditors may not.
Second, the common law and the Uniform Trust Code respect the settlor's freedom to impose restraints on the beneficiary's interest. The settlor may withhold any enforceable right from the beneficiary, and a creditor of the beneficiary takes no more than the beneficiary has.
Third, the protection is recognized throughout the United States and in most common-law jurisdictions abroad, so the forum risk that limits self-settled trusts (see infra ch. 18; see infra ch. 35) is much smaller. A Wyoming court, a New York court and a California court will each enforce a spendthrift clause in a trust created by a parent for a child, subject to the exception creditors examined below (see infra ¶ 1730).
The vocabulary. The terms used in this chapter have settled meanings that drafters often blur.
| Term | Meaning |
|---|---|
| Spendthrift provision | A term of the trust that restrains both voluntary and involuntary transfer of a beneficiary's interest. Unif. Trust Code § 103(16) (Unif. L. Comm'n 2000, amended 2023). |
| Mandatory interest | A right to distributions that the trustee must make, such as all income annually or a fixed annuity. |
| Support interest | A right to distributions for the beneficiary's health, education, maintenance and support, enforceable by the beneficiary against an unreasonable trustee. |
| Discretionary interest | An interest in distributions that the trustee may make or withhold in its discretion, with or without a standard. |
| Exception creditor | A creditor whom statute or case law allows to reach a beneficiary's interest despite a spendthrift provision. |
| Power of appointment | A power to designate the recipients of trust property, general if exercisable in favor of the holder, the holder's estate or creditors. |
| Withdrawal right | A beneficiary's power to demand distribution of a stated amount of trust property, often limited in time. |
| Dynasty trust | A trust designed to last for several generations or in perpetuity, typically sheltered from transfer tax by the generation-skipping transfer tax exemption. |
| SLAT | A spousal lifetime access trust: a trust created by one spouse for the other spouse and descendants. |
Sources of law. The law of third-party trusts rests on three sources. The first is the common law of each state, stated for most purposes in the Restatement (Second) of Trusts (Am. L. Inst. 1959) and, with significant changes, in the Restatement (Third) of Trusts (Am. L. Inst. 2003–2012). The second is the Uniform Trust Code, adopted in some form by most states and the District of Columbia, whose Article 5 governs creditors' claims against beneficiaries. The third is the nonuniform statute: several states with active trust industries, including Delaware, Nevada and South Dakota, have enacted their own provisions on spendthrift and discretionary interests, often more protective than the Uniform Trust Code. See, e.g., Del. Code Ann. tit. 12, §§ 3315(b), 3536(a); Nev. Rev. Stat. §§ 163.417, 163.419; S.D. Codified Laws §§ 55-1-35, 55-1-43. The planner must read the governing law's statute and the cases under it. A spendthrift clause that is fully effective in Nevada may yield to a child support creditor in a Uniform Trust Code state and to a tort creditor in a state that follows the Restatement (Third).
The planning question. Every client who will leave property to children, grandchildren or others should be asked whether that property should pass outright or in trust. Outright gifts and inheritances become the recipient's property, exposed to every creditor the recipient has or will have, to the recipient's divorcing spouse and to the recipient's own poor judgment. Property held in a well-drafted third-party trust is exposed to none of these, except to the extent of the exception creditors examined below. The cost of the trust is the cost of administration and the loss of the beneficiary's unrestricted control. For most families with significant wealth, that cost is small compared to the protection obtained. The planner who recommends outright distribution to adult children should be able to explain why the family has chosen to forgo that protection.