Written by attorney Kevin J Tillson

Fraudulent Transfers and Irrevocable Living Trusts

The use of trusts in estate planning is a common way for individuals during their lifetime to transfer assets to their children and grandchildren. Generally, a trust can be established for any lawful reason. An individual may establish a trust to avoid probate, to reduce potential estate tax liability, to provide for the special needs of a disabled child or grandchild, or to fund a child or grandchild’s education. Other individuals utilize trusts for nefarious reasons such as to moving their assets out of the reach of their creditors.

Such was the case in a recent 9th Circuit Court of Appeals case, _ In re Schwarkskopf_ [1] where the court set aside two separate trusts established by a couple to benefit their minor child. These two trusts were irrevocable and had an “independent" trustee administering the trusts. The beneficiary was the couple’s daughter. The mother and father were not beneficiaries of the trusts and per the terms of the trust did not have the ability to compel distributions or otherwise receive trust income or principal. Consequently they did not have a legal ownership interest in the trust.

Over time, the couple transferred approximately $4 million in assets to two irrevocable trusts. All things being equal, this sort of planning is legal and the assets transferred to the trust would not be included in the couple’s estate or available to the couple’s future creditors. However, in this case all things were not equal; at the time the couple established both trusts the couple was insolvent and had creditors pursuing their assets. In fact, at the time the couple filed for bankruptcy protection, the couple had over $5.0 million in debts. They also utilized the assets owned by the trusts in such a manner that the court disregarded the trusts as separate legal entities and allowed the couple’s creditors to access trust assets to pay off personal debts.

One trust was funded with stock of a corporation that was essentially worthless at the time of the transfer. However, the corporation was involved in a lawsuit that, after the stock was transferred, resulted in an $8.0 million judgment in favor of the corporation. At the time of the transfer the couple was aware that the lawsuit could result in a large judgment in favor of the corporation. In fact the father admitted that the only reason he transferred the worthless stock to the trust was that he didn’t want to go through all the effort of obtaining a judgment only to see his creditors pursue the stock. After obtaining the judgment, the trustee paid the father a consulting fee of $3,000.00 per week to collect the judgment.

The Court of Appeals found this trust to be invalid since it was established to defraud the couple’s creditors. Although the stated purpose was to benefit the parties’ minor child the court saw through the ruse based on the father’s admission and disregarded the trust.

As for the second trust, the court did not find that trust to be invalid but did find that the transfers made to the trust after it was created were fraudulent and that the trust was an alter ego of the couple. The only asset placed in this trust at its inception was $25.00. However, a few years after its creation another corporation owned by the father purchased four lots of land for the trust. The father’s assets, not the corporation’s, were used to purchase the lots. The court found that the corporation was merely a shell to keep the properties out of the father’s name. At the time of purchasing these lots, the couple was insolvent. The court found that the transfer of the lots to the trust was a fraud on the couple’s creditors.

Additionally, the court found that both trusts were the couple’s alter egos based on the couple’s use of trust assets, the father’s domination of the trustee, and the trustee’s failure to keep accurate or proper records. The father dominated and controlled all decisions related to the lots purchased by the trust and the administration of the trust. The only action taken by the “independent" trustee was to write checks demanded by the father, which included inexplicably paying the father $105,000.00 over an 8 month period.

The couple did use both trusts for the benefit of their daughter: the trusts paid for her education, clothing, medical care, golf lessons and tournament fees. However, the couple also used trust assets to pay for another daughter’s funeral and for a life insurance policy insuring the father’s life. The couple also lived in a manufactured home located on one of the lots owned by the trust and in another home purchased by the other trust. They did not pay rent to either trust to live in these houses. The trustee also failed to document transfers of funds between the trusts, as the trusts paid each other’s expenses, and the trustee would make loans from one trust to the other.

The court found that based on the father’s use of this trust’s assets, he was an equitable owner of the trust – even if he did not have legal ownership in the trust. This finding is significant since, under California law, an entity such as a trust, can be disregarded under the alter ego theory only if the individual debtor has an ownership interest in the trust. Basically the father used this trust as his personal bank account, and exercised extensive control over the trust property making the court’s decision that he was an equitable owner of the trust fairly simple. Based on the alter ego theory, the court found that the trust assets could be used to pay off the couple’s creditors.

Although this case involved the application of California law, it’s illustrative of the pitfalls of creating an irrevocable living trust when you are insolvent or have a large amount of debt. If you are considering forming an irrevocable trust to keep assets from current creditors you need to make sure that the primary purpose of establishing the trust is not to avoid creditors, such as creating the trust to benefit a disabled child. You also need to make sure that after the transfer of your assets to the trust you have sufficient remaining assets to pay those creditors. In administering the trust you have to make sure that the trust is not your personal piggy bank and that you appoint a trustee that can and will exercise independent judgment. By properly forming, funding and administering an irrevocable trust, you can provide for your children or grandchildren while removing assets from your estate.

[1] 626 F.3d 1032 (9th Cir. 2010)

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