Eighth Circuit Affirms Exclusion of Debtor's Beneficial Interest in Trust from Property of Bankruptcy Estate
The United States Court of Appeals for the Eighth Circuit affirmed the district court’s judgment affirming the bankruptcy court’s decision that a debtor’s beneficial interest in distributions of net income from a spendthrift trust was not property of the debtor-beneficiary’s bankruptcy estate. In so ruling, the Eighth Circuit reasoned that because the trust’s spendthrift provision restricted the transfer of debtor’s beneficial interest in the trust and was enforceable under applicable state law, the restriction was also enforceable under bankruptcy law. By excluding debtor’s beneficial interest in income in the trust from the bankruptcy estate, despite debtor’s improper conduct as executrix, the Eighth Circuit demonstrated strict reliance on the Code’s statutory language governing property of a bankruptcy estate.
The Spendthrift Trust
In 2000, Ronald Reagan (“Ronald”) died, leaving a $20 million estate. His will created a testamentary trust (“Trust”) for the benefit of his wife, Cheryl (“Cheryl”), which included a spendthrift provision that provided that all principal and income payable to the Trust beneficiary would not be subject to any transfer and such interest could not be liable for or subject to, the debts or obligation of any beneficiary (“Spendthrift Provision”). The Trust provided that upon Ronald’s death, Cheryl would receive distributions of the income generated by the Trust. Ronald named Cheryl as the executrix of his estate and instructed her to fund the Trust by transferring certain stock to Regions Bank (“Regions”), the trustee of the Trust. Cheryl failed to do so and instead, used the proceeds from the sale of the stock to invest in unsuccessful business ventures.
In 2004, Cheryl filed a petition for chapter 11 bankruptcy protection. Thereafter, the probate court removed Cheryl as executrix of Ronald’s estate and appointed Latta Bachelor (“Bachelor”) as the probate estate’s personal representative. In 2007, the bankruptcy court lifted the automatic stay to permit the administration of Ronald’s estate to proceed in probate court. The bankruptcy court appointed Frederick Wetzel (“Wetzel”) as the trustee of Cheryl’s bankruptcy estate. In 2008, the probate court granted Bachelor authority to fund the Trust and to transfer title of the Trust to Regions. Later that same year, as the Trust started to generate income, Regions filed an interpleader and declaratory judgment action (“Action”) requesting that the bankruptcy court determine whether Cheryl, as the Trust’s beneficiary, or Wetzel as the trustee of Cheryl’s bankruptcy estate, was entitled to the Trust distributions. Bachelor, as the personal representative of Ronald’s estate and a creditor in Cheryl’s bankruptcy case, intervened in the Action.
The Lower Courts’ Rulings
Ultimately, the bankruptcy court ruled that because the Trust included the Spendthrift Provision, Cheryl’s interest in income distributions from the Trust was not property of the bankruptcy estate. Accordingly, the bankruptcy court ruled that Cheryl, rather than Wetzel, was entitled to the income distributions from the Trust. Bachelor and Wetzel (“Appellants”) appealed to the district court, which entered a judgment (“Judgment”) affirming the bankruptcy court’s decision. On appeal to the Eighth Circuit, Appellants argued that Cheryl’s conduct as executrix of Ronald’s estate rendered the Spendthrift Provision unenforceable under Arkansas law and therefore, unenforceable under bankruptcy law, thereby entitling Wetzel to recover the Trust distributions for the bankruptcy estate. Further, Appellants asserted that the bankruptcy court erred in holding that once the income distributions from the Trust were paid to Cheryl, they were exempt from execution by creditors under Arkansas law.
Property of the Estate under 11 U.S.C. § 541(a)(1)
Beginning its analysis, the Eighth Circuit considered whether Cheryl’s interest in the Trust distributions were property of the estate. In that regard, the Eighth Circuit distinguished that while federal law dictated whether Cheryl’s interest was property of the estate, state law defined the nature and extent of that interest. See In re MJK Clearing, Inc., 371 F.3d 397, 401 (8th Cir. 2004). Notably, the Eighth Circuit reviewed that pursuant to 11 U.S.C. § 541(a)(1), a bankruptcy estate includes all of a debtor’s legal or equitable interests as of the bankruptcy filing date. Under Arkansas law, the Eighth Circuit reviewed that an income beneficiary of a trust has an interest in trust property beginning on the date set forth in the trust agreement. Applying these principles, the Eighth Circuit noted that under Ronald’s will, Cheryl was entitled to receive income distributions from the Trust beginning on the date of his death in 2000. Thus, the Eighth Circuit reasoned that when Cheryl filed her bankruptcy petition four years later, her interest in the income distributions from the Trust had already been vested for several years. Noting that contingent interests of a debtor at the time of the bankruptcy filing are property of the estate, the Eighth Circuit indicated that barring an exception to § 541(a)(1), Cheryl’s interest in the Trust’s income distributions was property of her estate.
Turning to § 541(a)(1)’s exceptions, the Eighth Circuit explained that under 11 U.S.C. § 541(c)(2), if there is a restriction on the transfer of a debtor’s beneficial interest in a trust and the restriction is enforceable under nonbankruptcy law, the restriction is also enforceable under bankruptcy law. Thus, the Eighth Circuit reasoned that if the Spendthrift Provision restricted the transfer of Cheryl’s interest in the Trust’s income distributions and was enforceable under Arkansas law, then Cheryl’s interest in the Trust’s income distributions was enforceable in bankruptcy, triggering the application of § 541(c)(2). Agreeing with the lower courts, the Eighth Circuit reasoned that the Spendthrift Provision restricted transfers of Cheryl’s interest in the Trust’s income distributions and was enforceable under Arkansas law. Accordingly, the Eighth Circuit declared that § 541(c)(2) applied, such that Cheryl’s interest in the Trust’s income distributions, as well as the actual payments made on account of that interest, were excepted from property of her estate.
Appellants’ Challenges to the Bankruptcy Court’s Ruling
Continuing its analysis, the Eighth Circuit rejected Appellants’ argument that Cheryl invalidated the Spendthrift Provision based on her improper control over the Trust’s assets, making her interest in the Trust property of the bankruptcy estate. While agreeing that Cheryl may have improperly exercised control over the Trust’s assets, the Eighth Circuit declared that such conduct did not invalidate the Spendthrift Provision. Similarly, the Eighth Circuit rejected Appellants’ argument that Cheryl was equitably estopped from receiving the benefit of the Spendthrift Provision. While noting that Cheryl failed in her duties as executrix, the Eighth Circuit observed that Appellants failed to establish the requisite detrimental reliance necessary to bar her from claiming her Trust benefit on the basis of equitable estoppel. Further, the Eighth Circuit rejected Appellants’ position that the bankruptcy court erred in holding that trust income excepted from a beneficiary’s estate under § 541(c)(2) is forever shielded from execution by creditors. Pointing out that the sole issue before the bankruptcy court was whether Cheryl or her estate was entitled to the income from the Trust, the Eighth Circuit noted that Appellants overstated the lower court’s ruling.
Finally, the Eighth Circuit rejected Appellants’ assertion that the bankruptcy court improperly compared the status of payments from the Trust with the status of payments under an employee benefit plan. See Patterson v. Shumate, 504 U.S. 753, 760 (1992). In that regard, the Eighth Circuit clarified that the pension benefits in Patterson were exempt not because they were excluded from the estate under § 541(c)(2), but because those benefits maintained their exempt status under applicable state law after debtor filed for bankruptcy. Accordingly, the Eighth Circuit noted that the bankruptcy court properly cited Patterson as support for its determination that because Cheryl was the beneficiary of a valid spendthrift trust under state law, her interest in the Trust distributions was entitled to the same protections and restrictions after she filed for bankruptcy protection that it enjoyed prepetition.
Eighth Circuit Affirms Judgment
In sum, holding that the Trust income was not estate property, the Eighth Circuit affirmed the Judgment.
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