A better alternative to withdrawal rights in trusts for children

Such rights can undermine protection from creditors, which is an important benefit of leaving assets in trust

Parents with young children generally provide in their estate plans that upon the death of both parents, assets are to be held in trust rather than distributed to the children outright. For children under the age of majority, a trust helps avoid the need for a court-supervised guardianship estate to be established for the children’s inheritance.

Most parents would also hesitate to have their young adult children come into full control of a potentially substantial inheritance — as most of us would not have benefitted from having unrestricted access to a large pool of funds at age, say, 21 — and therefore prefer to keep funds restricted until their children are older and (theoretically) more mature.

To address this issue, trusts for children have historically been structured to provide “withdrawal rights” upon reaching specified ages. For example, a child may be given the unilateral power to withdraw up to half of the trust assets upon reaching age 30 and the remaining trust assets upon reaching age 35. This structure allows the child two “bites at the apple” — if the child fritters away the first half of his or her inheritance after reaching age 30, he or she will at least have the opportunity to conserve the remainder.

This approach is straightforward and may be appropriate for some smaller estates. However, withdrawal rights undermine an important benefit of leaving assets in trust, namely, protection from the beneficiary’s creditors. Nearly every modern trust contains a “spendthrift clause,” which in theory prevents the creditors of the beneficiary from attaching the beneficiary’s interest in the trust (unless the beneficiary created the trust for himself or herself). However, if the beneficiary has the unrestricted power to withdraw a portion of the trust assets, the spendthrift clause is ineffective as to the portion of the trust assets subject to the withdrawal right, and the assets subject to withdrawal can be lost to creditors.

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Withdrawal rights also undermine the potential to transfer assets to grandchildren and more remote descendants free of transfer tax. Thanks to the current $11.58 million federal gift, estate, and generation-skipping transfer tax exemptions, a properly structured “dynasty trust” can pass substantial assets to grandchildren and more remote descendants free of any transfer tax. If a child has a presently exercisable right of withdrawal over trust assets, however, the trust assets will be includible in the child’s estate and subject to estate tax at the child’s death — thus undermining the potential to transfer assets to grandchildren and more remote descendants free of transfer tax.

For the above reasons, granting unrestricted withdrawal rights to children is generally not ideal. A better approach may be to instead grant a child the power to become a co-trustee, and potentially the sole trustee, of his or her trust upon reaching specified ages. If the distribution standard of the trust is drafted so as to be “ascertainable” as defined under federal estate tax laws, the trust assets, even though they’re available to the child, and even though the child is the trustee and beneficiary, will generally not be subject to estate tax at the child’s death.

Furthermore, while protection from creditors is an evolving legal area, a trust without withdrawal rights will almost always offer a greater degree of creditor protection, especially if the child is not the sole trustee of the trust. Distributions from such a trust can still be made for the child’s benefit, and the child can still possess a “limited power of appointment” to redirect the trust assets to other individuals or charities (other than the child, the child’s creditors, the child’s estate, or the creditors of the child’s estate).

All in all, given the substantial flexibility, creditor protection, and estate tax benefits that can be obtained through the careful selection of trustees and limited powers of appointment, dynasty trusts are generally a better alternative to withdrawal rights in trusts for children.

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Luke Harriman is an associate at the law firm Much Shelist.