Trust Considerations
Trusts can be established for many reasons and can dictate virtually anything that the grantor desires. After all, the trust is fundamentally a contract. In contract law, it is often stated that the offeror is the “master of the offer.” In dictating how a trust will be run, the grantor is the master of the trust. There are default rules that govern issues that the trust is silent on, but the trust administration is fundamentally about executing the wishes of the grantor.
This applies to how the trust assets will be distributed, of course, but it also applies to how a trust will be administered. A trust can, for example, require conservative investments (or aggressive investments, for that matter). It can set trustee fees, can specifically indicate when and why its assets can be distributed or spent or even determine in which bank its assets can be held.
However, in crafting a trust for a client, three important things must be considered:
- The wishes of the grantor in terms of his or her overall estate plan;
- The impact that the execution of these wishes could have on the grantor’s estate planning goals such as asset protection, benefits eligibility and tax planning; and
- Legal limitations on what a trust can do. While these are few and far between, they do exist. For example, the archaic “rule against perpetuities” places limitations on how long a trust can last. Moreover, a court may refuse to enforce a trust if it’s purposes are considered against public policy (for example, if they perpetuate racism or other unethical behavior).
In this module, we will break down a series of common trust administration and distribution provisions and discuss their purposes, requirements and effects. We will start with administration and distribution provisions that apply during the continuing viability of the trust and then will focus on distribution provisions that occur when the trust is dissolved and its assets finally distributed. While it is common for trusts to last only until the grantor’s death and the assets to be distributed thereafter, that does not have to be the case.
Distributions of the Trust Assets
The first scenario we will discuss is that of a provision that provides for the distribution of assets to the grantor. This is a typically desirable provision, as many grantors want to maintain some of the benefits of their assets while they are living. Revocable trusts typically provide that the grantor can remove as much of the trust assets as she likes that anytime. There is no downside to this, as the money would be considered hers for all legal purposes anyway.
Potential Distributions to the Grantor
In the case of irrevocable trusts, allowing the grantor to benefit from the trust is trickier. Presumably, at least one of the purposes of the typical irrevocable trust is to ensure that the assets are not considered entirely the assets of the grantor. Therefore, a provision that allows the grantor to withdraw assets at will would be counterproductive.
There are however, two more limited potential distribution powers that we should discuss:
- A grantor’s right to the income earned by the trust assets, but not its principal; and
- Discretionary distribution provisions that allow a trustee to distribute assets to the grantor but do not require such distribution.
Many irrevocable trusts require that some or all its income be distributed to the grantor. Grantors may require such income to live off, or to achieve some other goal. The trust that allows or requires the income to be distributed to the grantor will cause that income to be considered the grantor’s for all legal purposes. For example, that income will be taxable to the grantor and will be considered an available resource for benefits planning purposes. Still, the grantor may be willing to live with that consequence and to protect merely the principal of the trust due to her needing the income to live on. This sort of provision is common, in fact, in the “income only Medicaid trust.” Such a trust protects the principal but not the income if the grantor later needs Medicaid assistance. Allowing the grantor income also has important ramifications for asset protection and tax planning purposes.
Other irrevocable trusts do not require that assets (income or principal) be distributed to the grantor, but allow the trustee to do so at his or her discretion. Allowing the trustee to distribute assets to the grantor, even if it’s within the discretion of the trustee, may nullify the estate tax, Medicaid planning and creditor protection advantages that are the goals of many irrevocable trusts. Therefore, very few irrevocable trusts allow the trustee the power to distribute principal to the grantor. In a later module, we will discuss one notable exception in the case of the “self-settled spendthrift trust” which can allow asset protection benefits even when the grantor is a potential beneficiary.
Potential Distributions to the Beneficiaries
Next, let’s turn our discussion to distribution to the beneficiaries. Just like distribution provisions to the grantor, distribution provisions to the beneficiaries can be limited to income or can extend to principal. They can also be mandatory or discretionary. Let’s discuss them in turn.
Some trusts require all their income to be distributed to an individual beneficiary or to a specified group of beneficiaries. Such trusts are referred to as “simple trusts” for income tax purposes and all their income is taxed directly to the recipient beneficiaries. The income distributed by simple trusts are considered the assets of the beneficiaries to whom they are distributed. The downside to this sort of arrangement is that the income will be subject to the creditors of those beneficiaries and will be considered theirs for all other legal purposes. It decreases the flexibility that the trust might otherwise enjoy in a variety of ways.
Most trusts, therefore, are set up as “complex” trusts, which means that the income earned by the trust is either held by it or can be distributed at the discretion of the trustee. Most trusts give the trustee the discretion to distribute income and/or principal among the trust beneficiaries. This provision is often referred to as a “sprinkling” provision since it allows the trustee to sprinkle the trust assets among the beneficiaries.
There is generally little danger in allowing the trustee this sort of discretionary power. However, there may be some potential pitfalls. For example, if the trustee is, herself, a beneficiary, then giving her the power to distribute trust assets among beneficiaries (including herself) may be tantamount to giving her a “general power of appointment” over the trust assets. Since she can give money to herself, she may be required to do so for the benefit of her creditors. Fortunately, there are ways to minimize this risk.
Limiting Powers of Distribution by an Ascertainable Standard
To minimize the chance that anyone, trustee or beneficiary, will be considered to have too much authority over the trust assets and in general, to bolster the integrity of the trust, trusts often limit the purposes for which the trustee can distribute trust assets. If the distribution power of the trustee is clearly defined within the trust document, the law considers the power to be limited by an “ascertainable standard.” This has significance in many areas of law.
One formula that can be employed for this purpose is to allow the trustee to make distributions for the “health, education maintenance and support” of the trust beneficiaries. While this is certainly not the only language that can express a power limited by an ascertainable standard, it is tried and true ascertainable standard language. Because this language is quite broad and yet is certain to be respected as an ascertainable standard, it is far and away the most common language used to define the distribution powers of the trustee. It should be noted though, that additional powers may also be granted if they are reasonably definite. These may include the powers to distribute assets for the beneficiaries’ housing, wedding expenses, sports equipment, vacation expenditures, etc.
Discretionary Charitable Distributions
It is common, helpful and generally harmless to also allow the trustee to distribute assets to charitable beneficiaries. This can allow the trustees to make charitable contributions to organizations favored by the grantor and can allow the trustee the flexibility to achieve the income tax benefits of the charitable income tax deduction. Trust income can often be taxed at very high rates. If undistributed income is going to be taxed at the highest marginal tax rates, the trustee may decide that making a charitable contribution makes economic sense for the trust. Trusts, unlike individuals, can take unlimited charitable income tax deductions.
Still, it’s critical that discretionary charitable distributions be limited to tax-exempt charitable organizations. That way, any distributions to charities can certainly be written off under the charitable income tax deduction. Moreover, if a charitable distribution provision is not limited to tax-exempt charities, it could be argued that the trustee has a functionally unlimited ability to distribute trust assets since “charity” is a vague term outside such a limitation.
Termination of the Trust
A trust can last for as short or long as the trust agreement stipulates. The most typical examples involve the trust terminating upon the death of the grantor or the grantor’s spouse or upon the grantors’ children or other beneficiaries reaching some age or milestone. Less common, but also possible, or trusts that are designed to last for generations.
When a trust terminates under its own terms, it’s assets are typically distributed amongst beneficiaries. One very common distribution plan calls for trust assets to be distributed equally amongst the children of the grantor. In this way, the trust is serving the same function as a will normally would. However, a trust adds flexibility in that termination and distribution can be conditional and can be spread over time.
For example, a trust provision may stipulate that upon the death of the grantor, if all her children are over the age of 30, the trust assets are to be distributed equally amongst them, while if some are under the age of 30, then the trust does not terminate until the youngest reaches that age. Alternatively, the children over the age of 30 may receive their shares outright while the trust may continue to hold the shares of each child until he or she reaches that age.
Subtrusts
Another possible strategy is to have the shares of individual beneficiaries separate into subtrusts for each of them. Parents also may wish to ensure that their children don’t receive all their assets outright for fear that the assets can be squandered.
For example, one popular trust provision calls for the staggering of trust distributions by age. A trust can stipulate, for example, that until age 25, the trust assets are held for the benefit of the beneficiary but that he is not automatically entitled to any distributions unless the trustee believes that a distribution is advisable. At age 25, the beneficiary becomes entitled to one third of the trust assets. The second third is distributed to the beneficiary at age 30, with the remainder being distributed at age 35.
Staggering distributions like this minimizes the chances that the trust assets will be squandered by the beneficiary. Subtrusts like these are often known as “individual single beneficiary trusts.” Family trusts, wherein assets are held for the benefit of larger numbers of young beneficiaries, are also common. These have the advantage of being more easily administered than separate trusts, but the complexity of requiring the trustee to account for ways the trust assets are spent for each individual beneficiary to ensure fairness to the others.
Of course, these are just some possibilities. The grantor, through the professional who is drafting the trust, can choose any distribution plan. Some grantors, for example, want their children’s trust shares to be held for their entire lifetimes and distributed only as necessary and advisable.
One reason to keep assets in trust rather than to distribute them outright to the beneficiary is to protect the assets from the creditors of the beneficiary and to protect them from equitable distribution upon a failed marriage. It is common, for example, for clients with assets that are earmarked for their children who are in rocky marriages, to insist that their assets be held in trust perpetually. Remember, a trusted family member or friend can serve as trustee and ensure that assets are distributed to the extent necessary to keep the child comfortable and to provide for his needs, while ensuring that those assets are not subject to claim by the other spouse in a divorce proceeding.
Another provision that is common in wills and trusts that it is often considered part of the standard boilerplate of these documents is the provision establishing subtrusts for minor beneficiaries. For obvious reasons, it’s impractical and unwise to leave large amounts of money to minor children. Therefore, standard provisions dictate that the shares of minor beneficiaries in any distribution plan are instead held for their benefit until they reach adulthood.