The California Supreme Court’s recent opinion in Carmack v. Reynolds clarifies the effect of “spendthrift” trust clauses, which are intended to prevent the trust’s beneficiary from assigning away an interest in the trust, and protect the trust’s assets from the beneficiary’s creditors. Under the California Probate Code, spendthrift clauses are valid with respect to trust income and principal. However, they offer protection only while assets remain in trust. Once a distribution is made, it can be reached to satisfy a creditor’s judgment just like any other asset the beneficiary owns. Conflicting provisions of the California Probate Code have long made it difficult to determine exactly what creditors can reach, and when.

In Carmack v. Reynolds, a trust instrument provided that the beneficiary was entitled to receive $100,000 of trust principal annually for 10 years, and then receive one-third of the remaining trust principal. The trust was governed by California law and contained a valid spendthrift clause. One day after the death of his last surviving parent, the beneficiary filed for bankruptcy under Chapter 7 of the Bankruptcy Code. The trustees of the trust sought a declaratory judgment as to the bankruptcy trustee’s rights to the trust assets. The case was heard by the U.S. Bankruptcy Court and then appealed to the U.S. Court of Appeals for the Ninth Circuit. The Ninth Circuit was faced with three apparently contradictory California Probate Code statutes on the reach of creditors with respect to spendthrift trust assets that are going to be distributed to the beneficiary but are still in the trustee’s hands. The Ninth Circuit therefore asked the California Supreme Court to clarify how these statutes should be reconciled.

Under Section 15301(b), when an amount of principal has become “due and payable” by the trust to the beneficiary, a creditor may apply for a court order directing the trustee to satisfy a judgment against the beneficiary by paying that principal amount to the creditor. In other words, the creditor can ask a court to apply up to 100 percent of a due and payable distribution to satisfy the debt. An exception under Section 15302 provides that if the trust instrument specifies a distribution is for the support or education of the beneficiary, the amount the beneficiary actually needs for those purposes may not be taken by the creditor.

Two other statutes governing a creditor’s reach seem to conflict with Section 15301(b), however. Section 15306.5(b) also allows a creditor to obtain an order directing a trustee to satisfy his judgment out of trust payments to which the beneficiary is entitled, but limits the creditor’s reach to 25 percent of any payments that are not needed for the support of the beneficiary and his or her dependents. Second, and most confusing, Section 15307 provides that, regardless of these other statutes, a creditor can obtain an order directing the trustee to satisfy a judgment from any amount to which the beneficiary is entitled, except for amounts needed for the beneficiary’s support and education. This provision, if taken at face value, would abolish the restrictions placed on a creditor’s reach by other statutes.

The California Supreme Court had to reconcile statutes that together seem to provide that (i) a creditor can reach up to 100 percent of the amount “due and payable” to the beneficiary, except any amount the trust provides that is for the beneficiary’s support or education and that is needed for those purposes (Section 15301(b)); (ii) a creditor can reach up to 25 percent of any amount the beneficiary is entitled to receive, except any amount needed to support the beneficiary and dependents (Section 15306.5(b)); and (iii) a creditor can reach up to 100 percent of any amount the beneficiary is entitled to receive, except any amount needed for the beneficiary’s support or education (Section 15307).

The court determined that Section 15307 must reflect a legislative drafting error, or else the more restrictive and specific provisions of Section 15306.5(b) would not have been enacted. Concluding that the legislature actually intended to limit creditors’ reach to 25 percent of distributions to which the beneficiary was entitled (aside from amounts needed to support the beneficiary and dependents), the court set aside Section 15307 to the extent it conflicted with that intent.

The court then turned to reconciling the 25 percent limitation of Section 15306.5(b) with Section 15301(b), which contains no limitation. Looking closely at the language of each statute, the court determined that the key issue was the timing of the distributions each statute described.

Section 15301(b) applies to amounts “due and payable,” that is, distributions that are currently payable to the beneficiary but not yet actually distributed. These amounts are practically in the beneficiary’s hands, though they have not yet been transferred. This is a narrower class of distributions than those described in Section 15306.5(b), which applies to any future distributions to which the beneficiary is entitled. This would include, for example, payments required to be made to the beneficiary in future years under the trust instrument. Since these assets will continue in the trust for some period of time and are not practically in the beneficiary’s hands, they are entitled to the greater protection of the 25 percent cap.

Having reconciled these statutes, the court created a much clearer set of rules. A creditor can reach up to 100 percent of any amount that has become due and payable (but is still in the trustee’s hands), reduced by amounts that the trust instrument specifies are for the beneficiary’s support or education and are needed for those purposes (Section 15301(b)). In addition, a creditor can reach up to 25 percent of any anticipated payments to be made to the beneficiary, reduced by amounts needed to support the beneficiary and dependents (or already obtained by other creditors).

The opinion illustrates these rules with the example of a beneficiary who is entitled to receive $10,000 from a spendthrift trust each March 1 for the next 10 years. The trust does not specify the distributions are for his support or education. On March 1 of the first year, a creditor who has a $50,000 judgment against the beneficiary could petition for an order directing the trustee to distribute to the creditor (i) the entire $10,000 distribution for that year and (ii) $2.500 from each of the nine expected distributions as they are paid out in future years. And if the balance of the judgment were not satisfied, then each year the creditor could seek a new order to collect from the trustee the remaining $7,500 of that year’s distribution. The creditor’s recovery would be limited only to the extent distributions were required for support of the beneficiary and dependents. Although the court does not highlight the fact, the creditor would have been in a less advantageous position if this trust provided that distributions were to be made only for the beneficiary’s support or education. Such provisions are not appropriate for every spendthrift trust, but they do maximize creditor protection.

Although not relevant to this case, some trusts do not provide for mandatory distributions and instead give the trustee total discretion over the timing and amount of distributions. With respect to these “discretionary” trusts, Section 15306.5 allows a creditor to reach assets only when the trustee has decided to make a distribution to the beneficiary. If the beneficiary of a discretionary trust has a judgment against him or her, the trustee can protect the trust assets by deciding not to distribute them.  The trustee can make this  decision only if he is not required under the trust instrument to make distributions as required for the beneficiary’s support, however.