A recent case out of Massachusetts, Pfannenstiehl v. Pfannenstiehl,underscores the importance of reviewing your estate plan to address the degree of creditor protection afforded to your family’s wealth. Many parents, like those in Pfannenstiehl, choose to leave their wealth in a trust for their heirs for various reasons, including creditor protection. However, as illustrated in Pfannenstiehl, it is important to carefully review the terms of the trust agreement to determine the level of protection afforded to trust assets if creditor protection is a concern.

Most trusts will contain a “spendthrift clause” to prevent the child, as a trust beneficiary, from assigning his or her interest for the benefit of creditors (referred to as a “spendthrift trust”). Using a spendthrift trust has proven to be effective in protecting a beneficiary’s inheritance from the claims of creditors, even if, for example, the beneficiary files for bankruptcy.

Additional protection exists when distributions from a spendthrift trust are made only in the discretion of the trustee. The use of a trust with this discretionary distribution standard (referred to as a “discretionary trust”) provides another layer of protection for the trust assets since a court will generally not interfere with a trustee’s decision to make (or not make) distributions of trust property. This additional layer of protection is important because under the laws of many states, a spendthrift clause might provide only limited protection when challenged by certain creditors who have a judgment or court order for support or maintenance, including a beneficiary’s spouse.

Notwithstanding the use of a spendthrift clause and discretionary distribution standard, the effectiveness of these provisions in trust agreements has been inconsistent when tested in divorce actions. Whereas one court might conclude that assets of a discretionary trust are included in the marital estate, another court might exclude such assets from the marital estate but consider the assets as an available resource when dividing marital property or calculating alimony.

Pfannenstiehl v. Pfannenstiehl

In Pfannenstiehl v. Pfannenstiehl, a Massachusetts court was faced with the issue of whether the husband’s interest in a discretionary trust (established by the husband’s father) was “marital property” and thus, subject to division in divorce.

As is typical with divorce cases, the court examined the background of the parties and their financial means. The court noted that the husband came from a wealthy family and earned nearly $200,000 per year as a bookstore manager (with such a high salary no doubt due to his “familial relations”). The wife worked one day a week, earning $46 per hour as an ultrasound technician. She was the primary homemaker and caretaker of the couple’s two children, spending much time with the medically challenged daughter.

The court held that the spendthrift clause did not protect the husband’s interest from his wife in divorce. In so holding, the court noted that under Massachusetts law, a trust “even one with a spendthrift provision, may be included in a marital estate for purposes of division.”

The court then turned its focus to the discretionary distribution clause in the trust agreement, and noted that distributions were permitted for “comfortable support, health, maintenance, welfare and education…”

The court noted that the distribution standard in the trust agreement was “ascertainable” as opposed to “wholly discretionary” in nature. The distinction between distribution standards, along with other factors, played a role in the court’s conclusion that the husband had a presently enforceable right in the trust assets. Consequently, the trust assets were considered part of the marital estate and subject to division.

Planning Considerations

Due to cases like Pfannenstiehl, estate plans should be reviewed to determine whether changes should be made to help bolster the protection of trust assets. Attention should be given to the type of distribution language used in a trust agreement, especially if it is likely that the law of a state like Massachusetts could apply. Although a parent might live in a state that currently favors beneficiaries of trusts in divorce, there is no guarantee that the law of that state will apply in a divorce action if the child lives in another state.

Of course, the beneficiary’s execution of a prenuptial agreement will provide some comfort; however, the beneficiary must be willing to do so. Some choose to include language in a trust agreement specifically addressing prenuptial agreements or the rights of a beneficiary upon divorce.

If a potential divorce is a concern, the grant of certain powers to a trust beneficiary should be avoided. For example, children are often given the right to appoint trust property, or to withdraw trust funds based on reaching a certain age. These powers can result in a court concluding the property subject to the power is available to a child’s creditors, including a divorcing spouse.

Pfannenstiehl v. Pfannenstiehl provides an important reminder to review the strength of the creditor protection aspects of your estate plan now to help protect your family wealth in the future.