Creditor Protection for Your Child’s Inheritance Using a General Needs Trust

When leaving property to a minor or adult child, clients can choose exactly how they want to leave it to them. The property can be left outright, in trust until the beneficiary reaches a certain age or achieves a certain goal in life or in a continuing trust for that child’s lifetime. For the last option, there is a special technique that allows us to help protect the money in a continuing general needs trust for that child for his or her lifetime. I have done this in my own trust to protect my children and always discuss this option with my clients.

To protect your children in your revocable trust, there are two main components to the protection against possible threats to the inheritance. The first is ensuring there is no “demand right” by your child against the Trustee as to the assets in their general needs trust and the second is who you select to be the Trustee. 

To address the first consideration, what does it mean to have “no demand right?” What this means is does the trust allow the beneficiary to “demand” money from the Trustee. Another common term used to explain this is the beneficiary’s “withdrawal right.” For example, imagine that Johnny has the right to withdraw up to 25% of the principal and income from his trust when he reaches the age of 25 and may exercise an unlimited withdrawal right when he reaches 30 for the entire trust balance. These are examples of demand rights against the Trustee of the trust. Although this might seem like a perfectly fine thing to draft for Johnny, having this type of demand right allows a future creditor to potentially obtain a judgement to attach Johnny’s trust assets for up to the percentage that he has a demand right for. Examples of future creditors include a divorcing spouse, a bankruptcy trustee, a plaintiff in a lawsuit, or a business creditor or other predator.

Here is where it gets interesting. There are two types of Trustees: (1) the “interested” Trustee and (2) the “discretionary” Trustee. Under IRC 672(c), an interested Trustee is a related or subordinate party to the beneficiary or trust Grantor. Someone that is a first degree relative is a related party (so think, parent, sibling or child of the beneficiary or trust Grantor). By subordinate we mean someone working directly for the beneficiary or Grantor. One note, a beneficiary’s CPA, attorney or other advisor is not considered a subordinate party under the IRC 672(c) and therefore is not an Interested Trustee in this context.

For the best creditor protection for third-party trusts created for a beneficiary after the death of the trust Grantor, a “discretionary” Trustee provides the best creditor protection from the threats to the inheritance mentioned above. This is because a discretionary Trustee may make distributions for any purpose and may also refuse to make distributions to the beneficiary for any reason. So, if the beneficiary was being sued and plaintiff’s counsel was seeking money from the beneficiary’s trust, a discretionary Trustee (aka Independent Trustee) can decide not to make a distribution to pay a judgment against the beneficiary. That discretionary Trustee could also use his or her discretionary status as a bargaining chip to settle the claim for a lesser amount on behalf of the beneficiary.

On the other hand, although there can be some limited protection with an interested Trustee who is limited to the HEMS Standard (Health, Education, Maintenance or Support), there are some holes. One such hole could be a divorcing spouse of the beneficiary. Because an interested Trustee must make HEMS standard distributions to the beneficiary, a divorcing spouse might be able to argue and successfully force an interested Trustee to distribute for alimony or child support.

Even if a client wants to list an interested party to serve as Trustee, we can still provide more protection by listing a discretionary Trustee in succession after the interested Trustee or by allowing the interested Trustee to resign and appoint an independent discretionary Trustee as his or her successor. That way if a creditor, predator, or divorcing spouse claim were a “potential” threat, the interested Trustee could resign and the discretionary Trustee could accept the trusteeship or could be appointed. There has been debate among practitioners as to how far removed from the Grantor or beneficiary that the independent Trustee should be to provide the best creditor protection. I believe it is a continuum of protection. For example, not many could argue the true discretionary nature of a bank or Trust Company Trustee. Now, on the other hand, although a cousin might technically be a discretionary Trustee, there is probably an argument that can be made that that type of discretionary Trustee is not as far removed and might be subject to some influence by the beneficiary.

Regardless, there is a distinct advantage to having any discretionary Trustee serve over an interested Trustee. The beneficiary can use it as a bargaining chip in negotiations with a creditor. Additionally, the Grantor can provide some creditor protection for their children, but not rule from the grave by allowing the child of a separate share general needs trust to act as the sole Trustee (and/or as co-Trustee) of his or her own trust at a stated age of maturity as an interested Trustee. Then, later on down the road, if a potential creditor threat arises, the beneficiary Trustee (who is considered an interested Trustee) could resign and a discretionary Trustee already named, or then nominated, could take over as Trustee.

If the beneficiary never experiences any threats to his or her inheritance in the general needs trust, the beneficiary could simply continue to manage the trust assets as an interested Trustee. If upon death there are still assets inside the continuing trust, there can be language in the trust that shift the assets to the next generation (or to anyone, really) with the same protective trust provisions.