Michigan Bankruptcy Blog

Trust Spendthrift Provision Can be Negated by Other Trust Provisions

The Bankruptcy Court of the Western District of Michigan recently held that a spendthrift provision in a trust was negated by other trust provisions, and resulted in a debtor’s beneficial interest in the trust becoming property of the estate.¹

The issue before the Court was whether the trust restrictions prevented the debtor’s beneficial interest from being included in property of the estate.² In this case, the debtor’s mother created a trust in 2001, and the debtor was one of four named beneficiaries of the trust. Upon the settlor’s death in August, 2011, the trust became irrevocable. The trust included a spendthrift provision that prevented any beneficiary from assigning his interest in trust income or principal. The trust also included a provision authorizing the trustees, in their discretion, to distribute trust principal to a beneficiary in the event the beneficiary could not support himself. The trust further contained an “age-based restriction” on a beneficiary’s withdrawal rights (including the debtor’s rights). The “age-based restriction” specifically provided that after a beneficiary reaches age 25, the beneficiary has a “continuing right to withdraw any amount up to one half of the value of the trust assets; and after the beneficiary attains age 30, the beneficiary has a continuing right to withdraw all trust assets.” When the settlor of the trust died, the debtor was 42-years-old. 

The Court analyzed the general rule in bankruptcy that all legal or equitable interests of the debtor are included within property of the bankruptcy estate upon the petition filing. The Court further noted that the Bankruptcy Code provides an exception in cases involving a debtor’s interest in a trust that expressly excludes such interest from the estate if the debtor’s ability to transfer the interest is limited by an enforceable transfer restriction. The Court quoted § 541(c)(2) which provides, “A restriction on the transfer of a beneficial interest of the debtor in a trust that is enforceable under applicable nonbankruptcy law is enforceable in a case under this title.” The Court applied the three-part test established by the Sixth Circuit to be used when determining whether a restriction included in a trust is enforceable under nonbankruptcy law. The three-part test analyzes whether:

1. a debtor has a beneficial interest in the trust;
2. there is a restriction on the transfer of that interest; and
3. the restriction is enforceable under nonbankruptcy law.

First, the Court concluded that as of the petition date, the debtor had a beneficial interest in the trust. Second, the trust included a spendthrift provision that imposed a restriction on the transfer of the debtor’s interest.³ As a result, the remaining question for the Court was whether or not the restriction was enforceable under nonbankruptcy law.

After review of Michigan law, the Court concluded that when the trust contains a provision that allows the beneficiary to withdraw the entire principal for his own benefit, despite the restriction included in the spendthrift clause, the restraint on the transfer is deemed invalid. The Bankruptcy Court reasoned that upon the debtor reaching the age of 30, he enjoyed a continuing right to withdraw all of the trust assets - as specifically provided in the trust. Under these circumstances, the restraint included in the spendthrift clause is no longer effective because the debtor had the equivalent of complete ownership of the entire trust estate. As a result, the Court held that based upon the language of the trust, the settlor intended to impose a spendthrift protection while the beneficiaries were under the age of 30 only, but after they reached an age the settlor clearly viewed as “suitable discretion and judgment,” the transfer restrictions were lifted by giving the beneficiaries the equivalent of ownership and continuing right to withdraw all trust assets.

Based upon this recent decision, trustee and debtor attorneys must carefully review the terms of a trust that includes a spendthrift clause for other provisions that may negate the restriction.

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¹Meoli v. Thrun, et al. (In Re Frisch - Case No. DG11-12290), Adv. Proc. No. 13-80072 (Bankr. W.D. Mich., June 26, 2013).

²The case also included two other issues not discussed in this blog post: (1) whether the trustees breached their fiduciary duty; and (2) whether the Bankruptcy Court should resolve the dispute given the probate nature of the issues.

³There were other restrictions and arguments alleged by the parties in this case related to the trust; however, the Court disregarded those restrictions and arguments as not being restrictions on the transfer of the debtor’s interest. 

Categories: Western District of Michigan