Protecting Your Beneficiaries’ Assets from Creditors

People in certain professions, like medicine and law, understand the value of asset protection because those professions are often the target of lawsuits. Others may not feel that their assets are vulnerable to a lawsuit. They may not have existing creditors, and they don’t expect to be sued—or that their children might be. In short, they are not concerned about creditors’ rights to their assets, because they don’t expect to have significant exposure.

But that would be a mistake. The truth is that any of us can find ourselves facing a situation in which a court rules that we owe someone else a lot of money. It is for that reason that discretionary trusts for asset protection have become increasingly popular. Discretionary trusts and trusts with spendthrift provisions are commonly used to protect beneficiaries’ assets from potential creditors.

Creditors’ Rights and Powers of Withdrawal

There are a number of common scenarios from which settlors (creators) of such trusts hope to protect their beneficiaries’ assets. Trusts can protect beneficiaries from dissipating trust assets through wild spending. But even the most responsible beneficiary can find him- or herself in bankruptcy due to medical bills, or embroiled in a divorce, or the defendant in a personal injury lawsuit. A properly drafted trust for asset protection is designed to lift trust assets out of the reach of bankruptcy trustees, greedy estranged spouses, and judgment creditors.

As a general rule, creditors can reach trust assets which are available to a beneficiary of a trust. If a trust beneficiary has the right to demand a distribution of a certain amount of assets, their creditors can claim against those assets. Many trusts therefore allow only a limited power of withdrawal, such as letting a beneficiary withdraw only the greater of $5000 or 5% of the trust property annually. The beneficiary (or their creditors) could only access that amount of the trust assets in a given year).

Unfortunately, until very recently, there was a provision in Ohio trust law that, taken together with another provision, elevated creditors’ rights in some trust assets and destroyed asset protection for trust beneficiaries forever. The Ohio legislature addressed the issue in a recent session.

Beneficiary Rights Enhanced by Trust Code Section Repeal

Ohio has adopted much of the Uniform Trust Code, one provision of which became Ohio Revised Code § 5805.06(B)(2). That provision treated beneficiaries of an irrevocable trust to be treated as the settlor of the trust for creditors’ rights purposes if they had a power of withdrawal in the trust that had expired, lapsed, or been waived. That, in turn allowed creditors to reach trust assets that were subject to a beneficiary’s right of withdrawal, even after the right of withdrawal had previously lapsed or terminated.

In other words, even if the window for a beneficiary to make a withdrawal of trust assets had closed, the beneficiary’s creditors could still get at those assets because the beneficiary had previously had a right of withdrawal. Under the law that existed until recently, a right of withdrawal that had expired decades earlier destroyed irrevocable trusts’ asset protection features for the rest of the beneficiary’s life.

The Ohio State Bar Association issued a statement in favor of House Bill 7, which sought to repeal Ohio Revised Code § 5805.06(B)(2). The statement pointed out that if trust assets were no longer available to the beneficiary of a trust, that property should not be accessible to the beneficiary’s creditors. The OSBA statement further observed that the language in the Revised Code section at issue was copied from the Uniform Trust Code, and that numerous other states that had adopted the UTC had also dropped that problematic provision.

Fortunately, the Ohio House of Representatives agreed with the OSBA’s sensible position, and passed House Bill 7, closing the loophole in favor of creditors’ rights and allowing wholly discretionary trusts to provide beneficiaries with meaningful asset protection.

What the Repeal of Ohio Revised Code § 5805.06(B)(2) Means for Trust Beneficiaries

The repeal of Ohio Revised Code § 5805.06(B)(2) should cause settlors and beneficiaries of trusts to heave a sigh of relief. Estate planning attorneys can offer their clients greater flexibility, knowing that a lapse in a power of withdrawal will not expose beneficiaries' interests to potential creditors’ claims years into the future.

Another benefit of the repeal of Ohio Revised Code § 5805.06(B)(2) is that it eliminates the risk of a Medicaid challenge to certain types of wholly discretionary trusts. Some trusts allow a trustee to convert the interest of a newly-disabled beneficiary into a wholly discretionary trust. But if that beneficiary had a power of withdrawal at any point prior to the conversion, under the old law they could have been treated as the settlor of the trust. That would have made all assets in the trust to a Medicaid challenge, and possibly rendered the trust beneficiary ineligible for Medicaid and SSI.

While all of those things are good for beneficiaries, it is important to note that the lapse of a right of withdrawal could have significant tax consequences for beneficiaries who might be subject to the federal estate tax. Accordingly, it is important to discuss tax implications with an estate planning and tax attorney before allowing a power of withdrawal to expire.