Trust Beneficiary Case Reversed

A contentious case for estate planners has been reversed, allowing attorneys and clients both to breathe a sigh of relief. The case revolved around whether creditors could go after assets left to a beneficiary in a spendthrift trust. The issue arose in Bankruptcy Court and was recently reversed in the Northern District of Illinois federal court.

Facts of the Case

In the case of Safanda v. Castellano, Faith Campbell created a living trust in 1997 for the benefit of her four children. The trust provided that at her death the assets of the trust would be divided equally among her four children. In addition, the document provided a spendthrift clause that was meant to shield the assets of the trust from any creditors. She passed away in 2007 and one of her children, Linda Castellano, along with her husband filed for bankruptcy in 2011.

The Chapter 7 Bankruptcy trustee sued the Castellanos for fraudulent transfers under U.S.C. §548(e)(1) of the bankruptcy code and demanded that Linda turn over her share of the trust assets. This section of law pertains to the transfer of trust funds in order to hinder, delay, or defraud any creditors as to the debtor’s assets. The Bankruptcy Court agreed that Ms. Castellano’s trust assets belonged as part of the bankruptcy estate and were accessible to the Chapter 7 trustee. The Castellanos then appealed to the federal district court.

Ruling of the Court

The U.S. District Court reversed the ruling of the Bankruptcy Court and found in favor of the Castellanos. It found that the largest question of the case was whether Ms. Castellano’s share in the spendthrift trust was in her bankruptcy estate or not. It found that the trust did not terminate upon the mother’s death but continued to exist during the time that Ms. Castellano filed for bankruptcy.

Next, the court looked at whether Ms. Castellano had any rights to her portion of the trust assets on the day that she filed for bankruptcy. The terms of the spendthrift trust prevented her from selling or encumbering her interests in the trust, thereby protecting them from creditors on the day that she filed for bankruptcy.

In terms of the Bankruptcy Court’s application of U.S.C. §548(e)(1), the district court quickly overruled the lower court’s application of the law. It stated that “At all times, Castellano’s potential share remained the property of the Living Trust . . . Although [the Trustee of Faith’s Trust] segregated a portion of the Living Trust into a second account at Merrill Lynch earmarked for potential discretionary distributions to Castellano, that act did not end the Living Trust’s ownership of those funds, constitute a distribution to Castellano, or create a new trust . . . Accordingly, because there was no transfer of an interest of the debtor, sec. 548(e) does not apply.”

Therefore, the Chapter 7 bankruptcy trustee was not allowed to access the funds in the spendthrift trust. The Bankruptcy Court was overruled and the court found in favor of the Castellanos. This is an important case for estate planners everywhere because it ensures the protection of assets when they are placed into a spendthrift vehicle for future heirs and protects them from the reach of creditors.

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