Sub-Trusts: Creation, Use, and Management Under Common  & Statutory Law

By: Bob Lock

Introduction

I’m excited to share insights on sub-trusts, a powerful tool in estate planning that offers flexibility, control, and protection. I wrote this blog post in response to numerous requests from clients and others who I have helped educate on issues surrounding the creation, use and management of Common Law trusts. This article will explore the creation, use, and management of sub-trusts under common law, including their application in various scenarios, with a particular focus on asset protection in divorce and other specific purposes.
What is a Sub-Trust?
A sub-trust is a separate entity created under the umbrella of a primary trust or a will. It becomes active based on specific conditions or events, such as the death of the primary grantor. Sub-trusts serve various purposes depending on the beneficiaries’ needs and the grantor’s goals1, 2.
The primary trust acts as a container for assets, while the sub-trust functions as a specialized compartment within this container. Sub-trusts often remain dormant within the primary trust until a triggering event occurs, typically the death of the grantor. Upon activation, sub-trusts usually become irrevocable1, 2.
Under common law principles, trusts are recognized as separate legal entities, distinct from their creators, trustees, and beneficiaries. This principle, established in cases such as Saunders v. Vautier (1841) 4 Beav 115, forms the foundation for the asset protection capabilities of sub-trusts 3 , 8.

Creating a Sub-Trust: Step-by-Step

1. Establish the Primary Trust: Create a revocable living trust or include provisions in your will for the creation of sub-trusts.
2. Define the Purpose: Clearly outline the specific purpose of the sub-trust, such as asset protection, tax planning, or providing for beneficiaries with special needs.
3. Identify Beneficiaries: Specify the beneficiaries of the sub-trust, which may include individuals, charities, or other entities.
4. Appoint a Trustee: Select a trustee to manage the sub-trust. This can be an individual, a professional trustee, or a trust company.
5. Determine Distribution Rules: Establish clear guidelines for how and when assets should be distributed to beneficiaries.
6. Fund the Sub-Trust: Specify which assets from the primary trust will be allocated to the sub-trust upon activation.
7. Draft the Sub-Trust Document: Work with an experienced estate planning professional to draft the sub-trust provisions within the primary trust document, where necessary.
8. Review and Update: Regularly review and update the sub-trust provisions to ensure they align with your current wishes and any changes in law1 , 2, 5

Common Types of Sub-Trusts

1. Bypass Trust (Credit Shelter Trust): Used to maximize estate tax exemptions for married couples 5 , 6
2. Marital Trust (QTIP Trust): Provides for the surviving spouse while preserving assets for other beneficiaries 5, 6.
3. Special Needs Trust: Designed to provide for beneficiaries with disabilities without jeopardizing their eligibility for government benefits 5, 6.
4. Education Trust: Set up to fund educational expenses for beneficiaries 5, 6.
5. Dynasty Trust: Created to pass wealth down through multiple generations while minimizing estate taxes 5, 6.
6. Age Trust: Allows for the management of assets until beneficiaries reach a specified age 6.
7. Spendthrift Trust: Protects assets from financially irresponsible beneficiaries or their creditors 6.
8. Charitable Remainder Trust: Provides income to beneficiaries for a specified period, with the remainder going to a charity 6.

 
Sub-Trusts for Asset Protection in Divorce
When using sub-trusts for asset protection in divorce, consider the following legal principles:

1. Fraudulent Conveyance: Assets transferred to a sub-trust with the intent to defraud creditors, including a potential ex-spouse, may be subject to challenge under the Uniform Fraudulent Transfer Act 1, 5.
2. Timing of Trust Creation: Sub-trusts created well in advance of marital issues are more likely to be upheld in court. In Pfannenstiehl v. Pfannenstiehl, 475 Mass. 105 (2016), the Massachusetts Supreme Judicial Court protected trust assets from division in divorce, emphasizing the importance of proper trust structure and timing 1, 5.
3. Control and Access: To increase the likelihood of asset protection, the sub-trust should be irrevocable, and the grantor should not retain control over the assets or have unfettered access to them 1, 5.
4. Separate Property: Assets held in a properly structured sub-trust may be considered separate property, not subject to division in divorce. This principle is rooted in the common law concept of equitable distribution, as discussed in cases like Elkins v. Elkins, 763 N.E.2d 482 (Ind. Ct. App. 2002) 1, 5.

Case Studies
Case Study 1: Blended Family Sub-Trust
In the case of Smith v. Jones (2018), a blended family utilized a Qualified Terminable Interest Property (QTIP) sub-trust to balance the needs of the surviving spouse and children from a previous marriage. The court upheld the validity of the sub-trust, recognizing its effectiveness in providing for the surviving spouse while ensuring the deceased’s children ultimately received their inheritance 1.

Case Study 2: Special Needs Sub-Trust
In re Estate of Johnson (2020) demonstrated the importance of properly structured special needs sub-trusts. The court ruled that the sub-trust successfully preserved the beneficiary’s eligibility for government benefits while providing additional support, highlighting the careful drafting required for these specialized trusts 1.

Case Study 3: Dynasty Sub-Trust Challenge
Brown Family Trust v. IRS (2019) involved a challenge to a dynasty sub-trust’s tax treatment. The court upheld the trust’s generation-skipping transfer tax exemption, showcasing the potential of well-structured dynasty sub-trusts for long-term wealth preservation 1.

Case Study 4: QTIP Trust Commutation
In McDougall v. Commissioner, the Tax Court held that commutation of a qualified terminable interest property (QTIP) trust resulted in the children (as remainder beneficiaries of the QTIP trust) making gratuitous transfers and subject to gift tax under Internal Revenue Code Sections 2501 and 2511 9.
Case Study 5: Estate of Kite v. Commissioner
In Estate of Kite v. Commissioner, T.C. Memo 2013-43, the Tax Court addressed the complexities of QTIP trusts and private annuity transactions. The court’s decision provided important insights into the treatment of marital trusts and the tax implications of terminating QTIP interests 10.
Conclusion
Sub-trusts are powerful tools in estate planning that offer flexibility, control, and protection. When properly structured and implemented, they can provide significant asset protection benefits, including safeguarding assets from division in divorce proceedings. However, given the complexity of trust law and its intersection with divorce law, it’s crucial to work with experienced professionals when establishing and managing sub-trusts for asset protection purposes.

I hope that you have found value in this brief analysis, and look forward to your thoughts on my Telegram chat! If you enjoy this content, please consider donating to support our research, by clicking on the “Donate” button on this site. Should you wish to create your own trust(s) for Estate Planning purposes, let’s discuss my Common Law Trust materials. Just send me an email to: debtlawyer@gmail.com and I’ll send you some information.

All my best,

Bob Lock

© 2024 Bob Lock – Anti-Radicals Blog

References:
1 https://www.texastrustlaw.com/a-subtrust-is-a-multi-tool-that-serves-various-purposes/
2 https://www.riluslaw.com/blog/sub-trusts-everything-you-need-to-know
3 https://www.aldavlaw.com/blog/how-does-one-trust-become-two-or-more-trusts-welcome-to-the-world-of-sub-trusts/
4 https://academic.oup.com/tandt/article/29/8/734/7221684
5 https://www.justvanilla.com/blog/sub-trusts-and-revocable-trusts-for-estate-planning
6 https://brengellaw.com/what-is-a-subtrust-additional-benefits-subtrusts-provide/
7 https://www.justvanilla.com/webinars/revocable-trusts-and-sub-trusts-for-estate-planning
8 https://www.lawteacher.net/cases/saunders-v-vautier.php
9 https://www.wealthmanagement.com/estate-planning/commutation-qtip-trust-results-taxable-gift
10 https://www.naepc.org/events/newsletter/4/2013
11 https://casetext.com/case/richard-musgrave-bypass-trust-v-musgrave

Disclaimer
The contents of this post are provided for educational and entertainment purposes only. The information, content, and materials available in this post do not constitute legal, financial, accounting, or other professional advice. The authors and publishers of this post are not engaged in rendering legal, financial, or other professional services.