David L. Case, Esq.
Phoenix, Arizona
May 11, 2008
© David L. Case, Esq.

Last week the Arizona Senate passed the new Arizona Trust Code ("ATC"), 28-0 (two Senators did not vote). The House passed the Bill (HB 2806) previously, 60-0. There are some minor amendments in process which should not cause any delay. We should know shortly whether it will become law on January 1, 2009, but most of us that have been involved with this project believe it is now very likely that will occur. As with most very extensive legislation like this a few issues will no doubt arise that will need to be worked through over time, but we believe the Bill is in good shape and deserves to become law.

For many practical reasons the Model Uniform Trust Code ("UTC"), sponsored by the National Conference of Commissioners on Uniform State Laws ("NCCUSL"), has been utilized as the basic framework of the ATC. However, it is very important to note that the version of the UTC which was enacted in Arizona and then repealed before its effective date of January 1, 2004 (at times referred to herein as the "Arizona UTC") has been modified in many respects to address the numerous objections that led to repeal. It should also be noted that many of the problems of the original UTC have also been modified upon passage in other states, and some of the analysis and changes in individual states have resulted in changes to the UTC itself.

The following is a brief summary of some of the most often discussed portions of the ATC. These topics (as well as many of the other ATC provisions) will have a substantial impact on estate planning practitioners, financial institutions and others directly involved in the estate planning and estate and trust administration process. The various State Bar of Arizona members and committees that have been involved with this latest redraft of this Bill believe that the ATC cures most of the problems perceived to have been inherent in the repealed Arizona UTC and that this legislation will provide a foundation of trust law for Arizona that does not now exist and that will be of great benefit to the State of Arizona.

I. Retroactivity.

The originally enacted Arizona UTC was almost entirely retroactive. Also, the settlor (the person establishing the trust) could not opt out of most of the retroactive provisions by the drafting of the trust document. Not only was this generally unacceptable, in addition it made even more contentious the various provisions that created the most outcry. HB 2806 contains an effective date for the ATC of January 1, 2009, and in general it will apply to all trusts and judicial actions from that day forward. However, there are several exceptions to retroactive application under the Act and expanded ability of the draftsman to avoid some provisions altogether (more than with the old Arizona UTC).

One provision under the ATC provides that where rights of beneficiaries and other parties existing as of the effective date would be prejudiced by the new law (see Section 14, Subsection A.3. of the ATC bill), the ATC will not apply. Though this provision will no doubt require judicial interpretation over time, it is a necessary component for this massive legislation. Also, if a period of time prescribed under prior law has begun to run prior to the ATC effective date (such as a statute of limitations, or a right acquired by default, etc.), then the prior statutory period will continue to apply (see Section 14, Subsection B of the ATC Bill).

Thus, it is very important that much of the new ATC is not mandatory if the trust agreement provides otherwise, such as some of the notice provisions that were so objectionable in the repealed legislation. This takes much of the sting out of retroactivity, but will require trust and estate attorneys to make certain desires of the trust settlor are adequately addressed in the document.

II. Notice and Reporting Provisions.

New ATC § 14-10813 of the actual House Bill sets forth provisions entitled "Duty to Inform and Report." (All references to section of the ATC are to HB 2806. Note that the legislation and its status can be viewed online on the Arizona Legislature website.) ATC § 14-10813.E. is a new addition and provides, unlike the Arizona UTC, that the new notice to be given by the trustee immediately after the effective date of the new law to "qualified beneficiaries" regarding trust and trustee information will "apply only to a trustee who accepts a trusteeship on or after January 1, 2009, to an irrevocable trust created on or after January 1, 2009 and to a revocable trust that becomes irrevocable on or after January 1, 2009." This will no doubt be a big relief to banks and trust companies who would have had a formidable task of notifying thousands of beneficiaries immediately. Moreover, due to the fact that the definition of "qualified beneficiary" includes both currently permissible distributees and persons who would become permissible distributees upon termination of the trust or the interest of a current beneficiary, notices would have been required to be sent to many persons with whom the financial institution has had no prior dealings or contact information.

Moreover, the general reporting requirements of ATC § 14-10813.A. to "keep the qualified beneficiaries of the Trust reasonably well informed" may be overridden by the settlor in the Trust instrument. The combination of this ability to control distribution of financial information and the non-retroactivity of some of the ATC notice provisions addresses most of the issues raised in the tremendous uproar regarding this portion of the old Arizona UTC. The primary concern of attorneys and their clients related to allowing a settlor to choose not to provide, for example, extensive trust financial information to his or her children until the settlor believed it would not adversely affect their ambition or conduct. (As under current law, settlors must take into account the countervailing concern related to making sure the beneficiaries can protect their rights by being adequately informed.) Note, however, that the information distribution requirements of ATC § 14-10813.C. must be taken into account.

Another significant change in the new ATC from the repealed Arizona UTC is that a beneficiary is entitled only to the "portions of the trust instrument necessary to describe the beneficiary's interest." ATC § 14-10813.B.1. and B.3. It should be noted that this is aligned with requirements under current law in Arizona when a beneficiary requests information on a trust.

In a separate area of the ATC, new ATC § 14-10417 continues the requirement from the UTC for the trustee to give notice to "qualified beneficiaries" of a merger or division of trusts. (It is not certain whether the division under a revocable trust into the Survivor's, Marital and Credit Trusts format after the death of the first spouse under a typical community property joint trust, and the division into shares for children at the death of the surviving spouse, would be covered by this provision.) However, unlike the UTC this notice requirement can be dispensed with under the ATC if the settlor so provides in the trust agreement.

In general, the draftsmen have attempted in the ATC to give the settlor the autonomy to conform the ATC notice and information distribution requirements to what presently exist under Arizona law by opting out of certain notice provisions, and for the most part have succeeded. Moreover, the new statute is believed to provide some additional clarity in this area.

III. Spendthrift and Creditor Provisions.

In general, a spendthrift provision in a trust agreement prevents a beneficiary from assigning or accelerating his or her interest, and is designed to prevent creditors from garnishing or attaching the interest. ATC § 14-10501.B. clearly provides that a beneficiary's interest in a trust, and distributions to or for the beneficiary's benefit, may not be reached by the beneficiary's creditors or assignees (1) to the extent protected by a spendthrift provision, or (2) where it is a "discretionary trust interest" as defined in new ATC § 14-10504. This is true under the ATC even if the trustee has previously failed to comply with or previously abused its discretion with respect to the applicable standard of distribution (ATC § 14-10504.A.2), thus nullifying an often used argument of creditors attempting to break a spendthrift provision. ATC § 14-10501 also makes clear that a trustee is not liable to a creditor of a beneficiary for distributions made pursuant to a discretionary distribution provision covered by a spendthrift clause.

Under the new law a spendthrift provision is valid if it restrains either voluntary or involuntary transfers of a beneficiary's interest, and general language such as "held subject to a spendthrift trust" is adequate to create an enforceable spendthrift provision. ATC § 14-10502. The ATC continues the exception to the effectiveness of a spendthrift clause for claims for child support. However, in order to protect beneficiaries of "special needs" or "supplemental needs" trusts this child support exception will not apply in those cases. (Note that a Senate amendment seeks to clarify the special needs trust protection.) There is also an exception to enforcement of a spendthrift clause where a specific Arizona or Federal Statute provides to the contrary regarding enforcement of a governmental claim. See ATC §§ 14-10503.

A very important provision added in the new ATC relates to protection of life insurance proceeds payable to a trust. Present law provides that a policy's cash value and death proceeds payable to family members is exempt from creditor claims, but it is unclear whether the exemption extends to a trust established for the same individuals. New ATC § 14-10504.D. provides that the policy and its proceeds are protected "to the extent State law exempts such insurance proceeds from creditors' claims if it had been paid directly to the trust beneficiary." Of course, where an irrevocable life insurance trust is not utilized it is generally necessary to have life insurance proceeds funneled into the settlor's living trust at death in order to allow the trust provisions to apply to this asset, and also for policy proceeds to be more easily included in determining the Survivor's/Marital/Credit Trust split under a joint trust at the first death where the policy is on the life of the first to die.

New ATC § 14-10505 covers issues related to claims against the settlor of a trust. In general, it follows the common law rule that one cannot establish a spendthrift trust for himself or herself which is not subject to claims of that settlor's creditors. The statute adds clarity to current law by providing that this rule will apply (a) only to the portion of the trust corpus that was contributed by the settlor, and (b) only with respect to rights reserved by and for the settlor, such as the right to receive distributions for support which are discretionary with the trustee.

Provisions also have been added to ATC § 14-10505.A.2. to limit the creditor's rights to attach discretionary distributions from reimbursement of income tax payable by the settlor as a result of application of the "grantor trust" provisions of Internal Revenue Code ("I.R.C.") §671 et seq. (relating to taxing the settlor on trust income). The popularity of this tax reimbursement provision in grantor trusts has increased since the release of Revenue Ruling 2004-64, which held that such a provision for discretionary reimbursement for income tax liability would not cause I.R.C. § 2036 estate tax inclusion, and that payment of the tax by the grantor would not be deemed a gift to the trust beneficiaries for gift tax purposes.

Note that there are several other provisions contained in Article 5 of the ATC relating to (1) when powers of withdrawal of a beneficiary will be considered powers retained by a settlor, (2) trusts established by business entities, (3) marital deduction trusts where the settlor is a remainder beneficiary, (4) trusts designed to comply with S Corporation rules requiring mandatory income distributions, and (5) rights of creditors where distributions are delayed to avoid attachment, except as limited by the trust document.

IV. Rule Against Perpetuities.

The Rule Against Perpetuities dates back to old English law and its primary purpose is preventing a settlor from keeping property out of the free flow of commerce for too long of time. Many states have either repealed or substantially modified the rule to allow greater flexibility in structuring trust agreements for long term family protection and benefit. The bill includes modifications to the provisions of Arizona Revised Statues ("A.R.S.") §§ 14-2901 and 2905 relating to Arizona's Rule Against Perpetuities. Though this is not actually a part of the ATC, it is nevertheless very important. Under current law there is an alternative period of qualification to the common law rule of lives in being plus 21 years, which is 90 years. This would be extended to 500 years under the ATC. The new statute makes clear that this will apply both to the vesting of an interest in property or a trust, and to the exercise of powers of appointment. Enactment of this provision would give Arizona settlors great flexibility in establishing long-term dynasty trusts in Arizona, avoid having to set up trusts in other jurisdictions where a more lengthy period is permissible, and provide more business for local financial institutions.

A third method of avoidance of the Rule Against Perpetuities for trusts was added in 1994 to A.R.S. § 14-2901.A. which applies where the trustee has the power to sell assets, and a person has an "unlimited power to terminate the interest" at "one or more times after the creation of the interest." The ATC provides for consistency by adding this same provision to the power of appointment provisions for the Rule Against Perpetuities contained in A.R.S. § 14-2901.B. and C. Some unanswered questions regarding these new provisions relate to (a) whether the "500 years" provision would conflict with Art. II, Section 29 of the Arizona Constitution (which provides that " . . . no law shall be enacted permitting any perpetuity or entailment in this State"), and (b) when is the time of "creation of the interest" under the third exception to the common law rule discussed above regarding the power of a third person to terminate the trust, though most believe it is when the trust first becomes irrevocable.

V. Governing Law for Trust Agreement.

One of the Arizona UTC aspects that many objected to was the inability of an Arizona resident to designate the law of a state other than Arizona to control interpretation or administration of a trust document. The purpose of NCCUSL in including this in the UTC was to make the UTC applicable to all trusts established by Arizona residents. This would not have allowed a settlor to designate the laws of a state that was more favorable to carrying out his or her intent or purposes in numerous areas, or in order to make the same law apply as that for other trusts previously established by the settlor, or just to avoid some of the UTC's unfavorable provisions.

ATC § 14-10107 allows the settlor to select the law of any jurisdiction by designating such in the trust agreement. The ATC also contains practical default provisions where the trust agreement fails to make a designation, providing that the law of the state of execution will determine the validity of the trust and the laws of descent and distribution, and the law of the state of the principal place of administration will govern rules of administration, such as income and principal determination and duties and powers of the trustee.

VI. Conclusion.

The author believes that the new ATC should be enacted. It will provide clarity to many areas and fill in gaps in other areas of trust law in Arizona. It is believed that most all of the issues that were raised by the public and attorneys under the old Arizona UTC have been adequately addressed and this legislation would greatly improve the trust law of our state.