Changing Conversations: Values Driven Estate Planning

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1 NORTHERN TRUST PROFESSIONAL ADVISOR FORUM Changing Conversations: Values Driven Estate Planning October 21, 2011 R. Hugh Magill Executive Vice President (312) Laura G. Mandel Senior Vice President (312) Stacy E. Singer Senior Vice President (312) The Northern Trust Company 50 S. La Salle Street Chicago, IL 60603

2 Section One: Powers of Appointment Stacy E. Singer Senior Vice President (312) R. Hugh Magill Executive Vice President Chief Fiduciary Officer (312)

3 A. Terminology 1. Donor the person who creates the power of appointment 2. Donee the person who possesses (i.e. can exercise) the power of appointment 3. Appointee the person(s) or entities in favor of whom the power may be exercised 4. Takers in default the person(s) or entities who receive the property if the power of appointment is not exercised 5. Appointive property the assets subject to the power 6. Mode of exercise the way in which the power must be exercised B. The basics of taxation A power of appointment is a power given to an individual to direct the disposition of property. The taxable character of the power is determined under either Section 2041 or Section 2514 of the Internal Revenue Code. Under Section 2041, a power to appoint to any of the following appointees renders the power general, and requires that the assets subject to the power be included in the power holder s gross estate for estate tax purposes: 1. The power holder 2. The power holder s estate 3. Creditors of the power holder 4. Creditors of the power holder s estate If none of these appointees is a permissible appointee, the power is treated as limited, and the assets are not included in the power holder s estate (assuming there are no other characteristics that would otherwise require their inclusion). C. Property Law How the power should be exercised may be defined in the document which grants the power. For example: If a child dies before receiving his or her share in full, then upon the death of the child his or her share shall be held in trust hereunder or distributed to or in trust for such appointee or appointees, with such powers and in such manner and proportions as the child may appoint by his or her Will making specific reference to this power of appointment, except that any part of the child s share not subject to withdrawal prior to the death of the child may be appointed only to or for the benefit of any one or more of the child s surviving spouse, the child s descendants and their respective spouses and my descendants (other than the child) and their respective spouses. For purposes of this agreement, the term spouse shall include a widow or widower, whether or not remarried.

4 The document may also indicate what needs to be done in order for the Trustee to rely on the exercise. For example: In disposing of any trust property subject to a power to appoint by Will, the Trustee may rely upon an instrument admitted to probate in any jurisdiction as the Will of the donee or may assume that the power was not exercised if, within 3 months after the death of the donee, the Trustee has no actual notice of a Will which exercises the power. The Trustee may rely on any document or other evidence in making payment under this agreement and shall not be liable for any payment made in good faith before it receives actual notice of a changed situation. The Trustee may consult with legal counsel and other agents at Trust expense and shall not be liable for any action taken or omitted in good faith reliance upon the advice or recommendation of the legal counsel or other agent. The Trustee shall not be personally liable for acts or omissions done in good faith. If the instrument is silent, state law may provide guidance. For example, in North Carolina, Section 31-4 provides: No appointment, made by will in the exercise of any power, shall be valid unless the same be executed in the manner by law required for the execution of wills; and every will, executed in such manner, shall, so far as respects the execution and attestation thereof, be a valid execution of a power of appointment by will, notwithstanding it shall have been expressly required that a will made in exercise of such power should be executed with some additional or other form of execution or solemnity. D. Challenges in Exercising Powers of Appointment 1. Scope Far too often, the power of appointment is attempted to be exercised to appoint either property over which the individual did not have a power, or in a manner that is not permitted by the grant of the power. This happens most often when the power is attempted to be exercised to add the assets to the power holder s own revocable trust. This can lead to several problems: a. If the power is limited and the exercise simply directs that the assets be added to the revocable trust, the exercise is improper. With rare exception, a revocable trust provides for the payment of the grantor s debts, expenses and taxes. A limited power, by definition, does not allow the assets subject to the power to be appointed to creditors of the power holder or his or her estate.

5 b. The beneficiaries of the revocable trust may include impermissible beneficiaries under the power. This happens if the permissible appointees are the grantor s descendants, and the revocable trust includes a specific bequest to a charity or to an individual who is not within the scope of the power. Many powers provide that the appointment must be to the grantor s descendants. However, many gifts in default provide that the assets are to be distributed to charity, or perhaps one-half to the heirs at law of one spouse and one-half to the heirs at law of the other spouse. This latter gift would violate the scope of many powers, as assets could pass to individuals who are not descendants of the grantor. Note: If the gift in default of both the document granting the power and the recipient trust following the exercise of the power are identical, the drafter may determine that the otherwise impermissible exercise is not an issue. c. The power holder may attempt to appoint assets over which no power is held. For example, if the power holder is given a limited power of appointment over the Marital Trust, an attempt to exercise power over the Family Trust will be ineffective 2. Perpetuities period In many cases, the trust to which the assets are appointed is subject to a different perpetuities period than the appointed trust. This may be because the perpetuities period to which the original trust is subject is based on lives in being at the time of the first death, and in the interim individuals have either been born or died. It may also occur where the recipient trust is a qualified perpetual trust under state law, while the original trust is not and the Rule Against Perpetuities applies. Assets from a trust subject to the Rule Against Perpetuities cannot be appointed to a perpetual trust. E. 5 & 5 Powers 1. A lapse of a post-1942 general power of appointment is generally treated as a release of the power and treated as a taxable gift under Section If the assets subject to the power do not exceed the greater of $5,000 or 5% of the aggregate value of the property, then the lapse of the power will have no gift tax consequences. Code Section 2514(e). 3. 5&5 ( Crummey ) powers may be used to augment beneficiaries discretionary interests in irrevocable trusts

6 4. In irrevocable life insurance trusts, 5&5 powers are necessary to ensure that annual exclusion gifts to the trusts are treated as creating a present interest under Code Section 2503(b)(1). To the extent that such a gift exceeds $5,000 or 5% of the trust corpus, the beneficiary s withdrawal power should be allowed to remain open (a hanging Crummey power) until its lapse will not result in a taxable gift. F. The Delaware Tax Trap If the done of a limited power of appointment exercises the power to create a second power of appointment (either general or limited) which, under local law, could be exercised to postpone the vesting of any estate or interest in such property, or suspend the absolute ownership or power of alienation of such property, for a period ascertainable without regard to the date of creation of the first power the exercise of the power will cause the assets to be included in the power holder s gross estate at death. Code Section 2041(a)(3). This provision, dating to 1951, was intended to ensure that a donee could not use a power of appointment to extend a trust beyond the original period prescribed by the rule against perpetuities. G. Disclaimers Powers of appointment may be disclaimed and, if the requirements of Code Section 2518 have been satisfied, the disclaimer will not be treated as a taxable release of the power. Attempting to reduce a general power of appointment to a limited power via a disclaimer will not be recognized as effective for transfer tax purposes. Treas. Reg. Section (d)(6). Under Code Section 2518 donees of either general or limited powers of appointment must disclaim within 9 months of the transfer creating the power.

7 Section Two Values Driven Estate Planning and The Role of Discretionary Trusts Laura G. Mandel Senior Vice-President (312)

8 A. Introduction As part of Northern Trust s Changing Conversations series, we are reconsidering the role of discretionary trusts in a values driven wealth transfer plan (as contrasted with a tax driven wealth transfer plan). We will explore: Commonly used discretionary standards Existing law regarding standards and adopted constructional preferences Common conundrums faced by trustees in administering discretionary trusts Suggestions for new approaches when discussing discretionary trusts with clients Coordination of statements of intent and discretionary provisions Sample language for consideration B. What is a discretionary trust? A discretionary trust grants some degree of authority to the trustee to determine the amount and type of distributions and, in some cases, to select the beneficiaries from among a class or several classes of beneficiaries. The trustee s authority may be absolute or limited to a standard set forth in the trust document. In general, a trustee has such powers as are conferred by the terms of the trust and such powers as are necessary or appropriate for carrying out the purposes of the trust. Trustees must interpret the grantor s intention as expressed in the document and exercise its judgment as to what is in the best interests of the beneficiary or beneficiaries. In general, courts do not interfere with a trustee s exercise of its power to make discretionary distributions, unless the trustee has acted dishonestly, arbitrarily, or beyond the bounds of reasonableness. See Scott on Trusts, Section 187 (4 th ed. 1987). Courts will not intervene merely because the court would have exercised the power differently. Restatement of the Law of Trusts (Third), Section 50, Enforcement and Construction of Discretionary Interests. In 2003, the American Law Institute adopted Section 50 of the Restatement of the Law of Trusts (Third) which sets forth the general rules on discretionary distributions. (i) A discretionary power conferred upon the trustee to determine the benefits of a trust beneficiary is subject to judicial control only to prevent misinterpretation or abuse of the discretion by the trustee.

9 (ii) The benefits to which a beneficiary of a discretionary interest is entitled, and what may constitute an abuse of discretion by the trustee, depend on the terms of the discretion, including the proper construction of any accompanying standards, and on the settlor s purposes in granting the discretionary power and in creating the trust (emphasis added). There is extensive commentary under Section 50 on the meaning, effect of various standards and omissions encountered in discretionary trusts. A trustee must act in good faith and in a state of mind contemplated by the grantor. It is this last requirement that has proven to be problematic for trustees because most trusts do not provide any indication of the grantor s state of mind. As advisors we are accustomed to relying upon familiar discretionary standards which have become terms of art in the world of estate planning. Unfortunately, overreliance on the discretionary standards and limited case authority and commentary has resulted in limited guidance to trustees and, ultimately, frustration of the grantor s intent as well as frustrated beneficiaries. C. Statements of Intent as the Foundation. Inclusion of a statement of intent is an excellent starting point in any wealth transfer plan. Northern Trust s recent second edition of Legacy offers the view that statements of intent: (1) Help families determine what their core objectives are; (2) Reflect the family s expressed values and beliefs regarding wealth its creation, use, preservation and distribution; (3) Guide decision-making by family members and their advisors around the use of wealth; and (4) Provide the foundation for a wealth transfer plan, leading to the optimal use of resources for family members during their lifetimes, for future generations and for society. As advisors, we are facilitating this process by asking probing questions around the impact of a financial inheritance on family members. Consider the following when drafting discretionary trusts: What does the grantor want to accomplish with his or her money? How does the grantor want wealth to shape the family s future? What legacy does the grantor desire for future generations and for his or her community? Does the grantor have a philosophy regarding the potential benefits or harm to beneficiaries as a result of the transfer of family wealth? What are the grantor s key non tax goals in establishing the trust? Are there potential conflicts among the proposed beneficiaries? Is the trust the primary source of support or intended to supplement the beneficiaries earned income?

10 Is the trust intended to support one or two generations (spouse and children) or multiple generations (generation-skipping)? Who are the primary beneficiaries and does the grantor intend for there to be equality among family branches? What does the grantor consider to be an acceptable lifestyle for beneficiaries and what luxuries if any are included within the standard? What extraordinary distributions should be considered (purchase of a residence, wedding, business venture, charitable and non-charitable gifts)? What level of education should be provided by the trust? What documentation should accompany a beneficiary s request? Should the needs of adult dependents (parents, siblings) be included in the trustee s consideration when making distributions? Is the trust designed principally for wealth enhancement or support of future generations? Can the beneficiaries needs be addressed through loans from the trust and on what terms? Do trustees have the power to make distributions to facilitate family tax planning objectives (annual and taxable gifts, and medical/educational payments not subject to tax) What outside resources are to be considered-only liquid assets or earned income? A well drafted statement of intent could include: (1) a description of the client s overall goals for wealth transfer and guiding principles for future generations; (2) how the estate plan advances the client s goals; (3) the general purposes of discretionary trusts; (4) how the trustees were selected; (5) which beneficiaries/generations have priority and why; (6) whether overall equality among beneficiaries is desirable and why; (7) the anticipated duration of any trusts; and (8) lifestyle maintenance-what type of lifestyle the client views as appropriate and contemplates for future generations. With a thoughtful statement of intent to provide context, neither beneficiaries nor trustees would have to deduce what objectives a grantor had in mind when establishing a trust and whether a grantor would have viewed a discretionary request as falling within the standard. Often, a summary of the grantor s philosophy is instructive. The role of wealth in life, the virtues of education, paid employment, pursuit of artistic or philanthropic endeavors, or family history and the creation of the family wealth are common themes. The Restatement (Third) recognizes that the most reliable guide for resolving questions about discretionary distributions are the underlying or general purposes of the trust. Accordingly rather than relying upon speculation about the import of specific details of fact or wording, it is often more instructive to analyze the variety of beneficial interests and other provisions of the trust as a whole, with

11 any other available evidence, in a broader effort to ascertain why the trust was created and what role the particular discretionary power was to play in the trust plan. D. Discretionary Standards-What Do They Encompass? The Restatement (Third) does note that all presumed meanings must yield to findings of actual contrary intention and may be affected by the context and more general purposes of the trusts and the estate plan. Again, determining the grantor s actual intent is the key. Most trusts now sound very much alike with trustees struggling to determine whether a particular distribution would have been contemplated by the grantor and adopting the constructional preferences outlined below by default. The following is a brief examination of the common interpretations of discretionary standards. 1. Support and maintenance. This is probably the most common standard found in trust instruments. Support and maintenance encompass distributions to beneficiaries for normal living expenses such as housing, clothing, medical care, food, and payment of taxes, premiums on life and property insurance and interest on debt. This standard is usually construed to include routine vacations and support of a beneficiary s dependents. This standard does allow for inflation adjustments and may permit increased distributions to meet increases in the beneficiaries needs. Courts have tended to view these terms as synonymous even when this results in the terms being treated as redundant. These terms are usually accompanied by a reference to a beneficiary s standard of living. Absent specific language in the trust these terms generally do not authorize distributions to enlarge the beneficiary s personal estate or to enable the making of extraordinary gifts. See comment d (2) of Section 50 of the Restatement (Third). 2. Health. This term includes routine items, such as annual physicals and medications as well as unusual items such as surgery, nursing care, hospitalization, psychoanalysis and rehabilitation. Arguably, plastic surgery for cosmetic purposes or travel to spas and health resorts would not be covered. Health is generally construed more broadly than medical needs. If the intention is to assure the beneficiary special health care such as in home care, additional language is advisable. The Restatement (Third) provides that expensive home care generally would not be included within the health standard absent further elaboration.

12 a. Suggestion: Consider addressing whether medical insurance premiums for a beneficiary as well as premiums for dependents should be covered. Does the grantor expect that a beneficiary will be employed and should first explore employer provided insurance or cover premiums from earned income? Should more non-traditional forms of medical care be covered or even experimental treatments that are not covered by insurance? How does the grantor view cosmetic surgery especially where it may be classified as reconstructive? 3. Education. This would include not only tuition, room and board, books and travel to school, but also other expenses such as tutors. Bogert, The Law of Trusts and Trustees, Section 181 (2d ed. rev. 1981). The Restatement (Third) provides: The term education without elaboration is ordinarily construed as extending to payment of living expenses as well as fees and costs of attending an institution of higher education or a beneficiary s pursuit of a program of trade or technical training, and the like, as may be reasonably suitable to the individual and to the trust funds available for that purpose. Courts have construed education to include education through college, but unless there is explicit language in the instrument it probably does not include professional or graduate study. See Bogert, The Law of Trusts and Trustees, Section 182 (2d ed. rev. 1981). In general, courts have reasoned that if a grantor intended to provide for a professional course of training beyond an undergraduate degree, the grantor would have included an express provision relating to distributions for graduate/ professional education. See also Restatement (Third), Section 50, comment (d) (3), Thus if the intention is to assure the beneficiary some special form of education. Further elaboration would be helpful. a. Sample Language: The term education as used herein may include, but shall not be limited to, (a) education at public or private nursery, elementary or high schools, including boarding schools, (b) undergraduate or graduate study in any and all fields whatsoever of a professional character or otherwise, at public or private universities, colleges or other institutions of higher learning and (c) any other activity, including travel, which shall tend to develop fully the talents and potentialities of the beneficiary of a trust. The expenses of education shall be deemed to include, but shall not be limited to, (a) tuition, books and incidental charges made by the school attended by the beneficiary for whom payment is made, (b) any travel costs to and from the institution attended by the beneficiary, (c) his or her room and board and (d) a reasonable amount of spending money.

13 b. Suggestion: This sample language while more comprehensive and detailed than the term education standing alone, does not address whether multiple degrees can be earned with trust funds, whether extras such as a lap top or other technology hardware are included or whether a basic level of education must be provided to all beneficiaries (college) before beneficiaries may expect that graduate degrees or non-degree program expenses will be paid from the trust. 4. Best interests and welfare. This is a much broader and less definite standard than maintenance and support. This standard permits payments for luxuries or enjoyment. This standard does not, however, permit a complete distribution of and termination of a trust. See Scott on Trusts, Section (4 th ed. 1987). The standard best interests and welfare is frequently used in larger trusts to authorize the trustee to accumulate or to distribute income among beneficiaries to achieve certain tax savings. The question often arises whether a best interests and welfare standard is broad enough to permit distributions to the beneficiary for the purpose of making gifts for estate planning purposes. The answer is unclear under existing case law. One Illinois Supreme Court case, Rock Island Bank & Trust Co. v. Rhoads, 353 Ill. 131, 187 N.E. 139 (1933), held that distributions to a life tenant under a comfort and satisfaction in life standard which enabled the beneficiary to make charitable gifts were permissible. In the Rock Island case, the Court focused on the grantor s pattern of gift giving and the beneficiary s desire to continue the gift program. But see Kemp v. Paterson, 4 A.D.2d 153, 163 N.Y.S.2d 245 (1967) (wherein the court held that distributions to the income beneficiary under a best interests standard for gifts to the natural objects of her bounty to avoid estate taxes were unauthorized under the terms of the trust). See also Dunkley v. Peoples Bank & Trust Co. 728 F. Supp. 547 (W.D. Ark. 1989) (surcharging trustee and requiring return of assets that had been distributed to allow indirect gifts to be made by discretionary beneficiary under support, reasonable comfort and best interests standard). 5. Gifting from Marital Trusts. Trustees frequently are approached to make discretionary distributions from marital trusts to enable a spouse to make gifts. This, of course, results in the marital trust being diminished and a lower estate tax at the surviving spouse s death. The rationale is that facilitation of the spouse s estate planning objectives is in the spouse s best interest or for the spouse s welfare. There is limited law on this issue as well. In Matter of Mandel, 46 Misc.2d 850, 261 N.Y.2d 110 (1995), the court refused to permit an invasion in a marital trust where the

14 will authorized invasions for the spouse or for her use. Similarly, in another case the court denied an invasion to enable the wife to make gifts to her children pursuant to a clause which authorized invasions of principal in the absolute discretion of my Trustee as shall be appropriate and to the best interest of my wife In re Estate of Howard, 236 S.E.2d 423 (1977). In Estate of Hartzell v. Commissioner, T. C. Memo (1994), the IRS argued that the exercise of an invasion power over property held in a general power of appointment marital trust was invalid and the surviving spouse s gifts of property should not be recognized. The will authorized invasions of principal for the comfort, maintenance, support and general well being of the spouse, or to continue the standard of living to which she is accustomed, or to aid her in living at a standard to which she is accustomed, or to aid her in the event of any accident, injury, illness or other emergency affecting her. The Tax Court ruled that the property removed from the marital trust was not improperly distributed to a third party and therefore not includable in the surviving spouse s gross estate. In Technical Advice Memorandum , the IRS determined that annual exclusion gifts made from a marital trust were improper because the marital trust was held for the spouse s exclusive benefit and distributions to facilitate estate planning objectives were not for the spouse s comfort (the applicable standard) and exclusive benefit. a. Suggestion: If the grantor believes that a spouse or other beneficiary should be able to make gifts to family members and/or charity with distributions from the trust specific language should be included. Who is included within the class of potential donees-are stepchildren, spouses or other collateral relatives permissible donees? Also determine if such gifts are limited to non-taxable gifts such as annual exclusion gifts or payments for tuition or medical expenses or whether larger taxable gifts by beneficiaries supported by trust funds are contemplated. Furthermore, should a beneficiary be required to use his or her own funds for gifts before making a distribution from the trust to facilitate gifting? Also consider whether any gift tax due could by covered by discretionary distributions from the trust. 6. Comfort. The term comfort standing alone can encompass a beneficiary s enjoyment, happiness, pleasure or satisfaction in life. The term authorizes distributions to a beneficiary beyond strict support or maintenance, and could include travel and certain luxuries. Frequently, however, the word comfort often accompanies a support or maintenance standard. Here the language adds nothing to the usual meaning of support for a beneficiary whose lifestyle is already at least reasonably comfortable. Such terms tend to elevate the standard for a beneficiary whose accustomed lifestyle has been more modest. See comment (d) (3)

15 of Section 50 of Restatement (Third). Several courts have interpreted the term comfort (which is different than comfortable support and maintenance ) as the equivalent to station in life. 7. Standard of living. Occasionally, standards will be expressed in terms of the beneficiary s standard of living or manner in which the beneficiary is accustomed to living. This standard is ambiguous unless the point in time to which the living standard relates is clearly stated. The Restatement (Third) takes the position that the term accustomed manner of living is ordinarily that enjoyed by the beneficiary at the time of the grantor s death or when the irrevocable trust is created. In addition, the Restatement notes that if a beneficiary becomes accustomed over time to a higher standard of living, that standard may become the appropriate standard of support if consistent with the trust s level of productivity and not inconsistent with an apparent priority among beneficiaries or other purpose of the grantor. Furthermore, distributions allowing an increased standard of living may be appropriate if the trust has increased in size to the point that the remainder beneficiaries would be favored over the current beneficiary to a degree unlikely intended by the grantor. In the case of a surviving spouse, the appropriate standard is likely to be that to which the beneficiary was accustomed while living with the grantor. See e.g. Barnett Banks Trust Company v. Herr, 546 So. 2d 755 (Fla. App. 1989). One Illinois case has held that the point in time at which the standard of living is determined is the date of execution of the instrument and not the grantor s subsequent death or the standard of living at the time of the request. See Hart v. Connors, 85 Ill. App.2d 50, 228 N.E.2d 273 (1 st Dist.1967). If there has been a change in the standard of living from the date of execution of the instrument until the grantor s date of death, the beneficiary could be locked into an unintended standard in some states. See also In re Estate of McCart, 847 P 2d 184 (Colo. App. 1992) (Colorado court of appeals found the accustomed standard of living distribution standard to be non-variable, yet the court focused only on the last three years of the settlor s life in determining the applicable standard of living ). 8. Distributions in the trustee s sole discretion. Many trust instruments attempt to grant unlimited discretion to the trustee either by omitting a standard of distribution or by granting the trustee sole, absolute and uncontrolled discretion. The Restatement (Third) adheres to the traditional view that it is contrary to sound public policy to relieve a trustee from all accountability for discretionary distributions. The Restatement (Third) views a grant of extended discretion through the use of terms such

16 as absolute as a manifestation of an intention to relieve a trustee of normal judicial supervision and control in the exercise of discretionary distributions. Both case law and commentary state that where there is no standard, courts will not interfere with a trustee s discretion if the exercise is made in good faith and consistent with the purposes of the trust. See Restatement of Trusts (Third), Section 50, comment c states: Once it is determined that the authority over trust distributions is held in the role of trustee, words such as absolute or unlimited or sole and uncontrolled are not interpreted literally. Even under the broadest grant of fiduciary discretion, a trustee must act honestly and in a state of mind contemplated by the settlor. Where a trustee is given sole and absolute discretion, the court will intervene only if the trustee acts arbitrarily or dishonestly. See Scott on Trusts, Section 187 (4 th ed. 1987). Similarly, under the Uniform Trust Code the use of terms such as absolute, sole, or uncontrolled require a trustee to act in good faith and in accordance with the terms and purposes of the trust and the interests of the beneficiaries. In Matter of Stillman, 107 Misc.2d 102, 433 N.Y.2d 701 (1980), the trustees refused to invade principal to support the grandsons of the grantor. The grandsons sued for abuse of discretion, and the court ordered the trustees to make discretionary distributions for support despite the instrument s grant of absolute and uncontrolled discretion to the trustees. See also PLR (distinguishing discretion from sole discretion ). 9. Discretion for support of dependents. If the discretionary trust is for the benefit of, for instance, the grantor s daughter, there is a split of authority as to whether that discretion also extends to the support of anybody who is legally dependent upon the beneficiary, such as a spouse or minor child. Section 50 of the Restatement (Third) provides that a support standard generally includes support of a spouse and minor children including suitable education of a beneficiary s children. The term dependents should be defined in the instrument. If distribution may be made to a beneficiary and those dependent upon him and if no definition is given, it is unclear whether payments be made (a) to those persons to whom the beneficiary has a legal obligation of support; (b) to those persons considered the dependents of the beneficiary for income tax purposes; or (c) to those persons who are, in fact, dependent upon the beneficiary. a. Suggestion: Dependents may extend beyond the classic spouse and minor children and frequently include adult children, parents, siblings or nieces and nephews. Does support include distributions for a dependent s college education?

17 10. Loans to Beneficiaries. In situations in which it may be unclear whether you can exercise discretion to make a particular payment, advisors will propose a loan as an alternative. The Restatement (Third) takes the position that the loan does not have to be a prudent investment if the document permits discretionary distributions to the beneficiary seeking the loan. See Section 50, comments d (6), and f and Section 90 of the Restatement (Third). Granting a trustee the ability to make loans from a discretionary trust can be quite practical and thus a specific grant of authority to make loans is advisable. It is optimal to grant the trustee to make such loans as it deems advisable and allow the trustee the latitude to make the loans on terms that differ from a commercial loan. In general, advisors should avoid running afoul of the rules under IRC Section 7872 and risking treatment of the loan as a below-market loan. a. Sample language: If the trustee determines that it is preferable to lend money from a trust to a beneficiary for any purpose described in this section instead of distributing principal to that person, the trustee may do so at such rate of interest (or without interest) and for such security (or no security) and on such terms for repayment as the trustee deems advisable and in the best interests of the beneficiary. The trustee shall require the borrower to execute a promissory note evidencing the loan, and shall take the steps that trustee deems necessary to make the repayment of the loan enforceable, but the trustee shall not be liable for any loss that may arise from making such a loan. 11. Distributions upon Fulfillment of Specified Conditions. Often the instrument will provide that a beneficiary is entitled to a distribution if he/she maintains sobriety or remains drug free. Such conditions are permissible provided they do not violate public policy. An example of a condition that violates public policy is to condition distributions upon a beneficiary s divorcing a particular individual. See Restatement of Trusts (Third), Section 76 (2003) ( a trust or a provision in the terms of a trust is invalid if enforcement of the trust or provisions would be against public policy, even though its performance does not involve the commission of a criminal or tortious act by the trustees ). Many trustees do not want to be in the position of being required to monitor a beneficiary s behavior (e.g. use of alcohol or drugs). In addition to issues of privacy, most trustees do not have the resources to conduct this type of monitoring. It is advisable for a family member or other third party to be given this responsibility or to certify to the trustee that a beneficiary satisfies the conditions. In addition, a trustee should be entitled to rely upon any third party representations as to a beneficiary s fulfillment of the specified conditions.

18 12. Advancements. It is critical to address whether the grantor wishes to treat extraordinary discretionary distributions as advancements against a beneficiary s ultimate share of the trust. Such distributions might include, for example, amounts required by a beneficiary for a down payment on a house, for a wedding or to start a business. If the instrument, however, does not expressly state that the distribution shall be treated as an advancement, it will not be treated as an advancement. In the absence of language in the document waiving interest, the beneficiary of an advancement is subject to an interest charge for the amount distributed. See Scott on Trusts, Section 255 (4 th ed. 1987). a. Sample Language. In addition to the foregoing payments of income or principal, the Trustee, bearing in mind my primary purpose of affording educational opportunities for each of my children, and providing for their support in reasonable comfort and health until they are able to do so themselves, in the Trustee s discretion, may pay to any such child of mine, from income or principal or both, of that child s separate trust, such sum or sums as that child may request if such child intends to marry and needs funds for a wedding, intends to purchase a home and needs funds for a down payment, needs funds for a business venture that the trustee deems sound, or any other reason deemed meritorious by the trustee. Distributions for a wedding, purchase of a home, or for a business venture shall be treated as advancements without interest against the respective shares hereinafter provided for each child. 13. Consideration of Other Resources. A critical factor in evaluating any discretionary distribution is request is the extent to which a trustee must consider the beneficiary s resources or ability for self-support. Again in the absence of a statement of intent, trustees must look only to the standard and any additional references to a beneficiary income or assets. Additional questions arise if a trustee is to consider a beneficiary s income or assets. Can a beneficiary be expected to sell assets to fund his or her lifestyle? What if the assets are not readily marketable or significant capital gains taxes would result from the sale? More importantly, did the grantor intend for his descendants to work and for the trust to provide only supplemental support or was it to intended to be the primary source of support? If wealth enhancement for future generations is the primary goal of the trust, it is imperative that statements be included in the trust making this intent clear. Additionally, if the grantor anticipates that the trusts should be used to provide temporary support during periods of hardship despite the primary goal of wealth enhancement this goal too should be stated.

19 In the absence of clear language, a trustee must then determine whether it is: (i) is required to take account of a beneficiary s other resources, (ii) is prohibited from doing so, (iii) is to consider the other resources but has some discretion in the matter. The Restatement (Third) view is that the trustee has the discretion to consider a beneficiary s other resources in the absence of specific language. The Restatement does set forth several qualifications to this general rule: (1) Where the beneficiary is entitled to part or all of the income or to an annuity or unitrust amount, in that case the trustee must take the mandatory distributions into account before making discretionary distributions. (2) Where the beneficiary is entitled to payments from another trust created by the same grantor or as part of a coordinated estate plan required distributions from the other trust and the purposes of the trusts must be considered. (3) Where the beneficiary was probably not expected to be self-supporting the trustee should not reduce or deny payments because of a beneficiary s personal resources. Where a trustee is required to take a beneficiary s other resources into account, resources normally includes the beneficiary s income and other periodic payments such as annuity payments. The Restatement (Third) states that a trustee is presumed to be required to take into account a parent s duty to support a minor child in the absence of express language in the trust instrument altering this presumption. For example, the general rule in Illinois traditionally had been that unless the governing instrument expressly requires that the beneficiary s own assets must be exhausted or considered before distributions may be made to him or her, the trustee is not required to consider the beneficiary s other assets or sources of income prior to making distributions. Two cases in Illinois have held that a trustee is precluded from (a) requiring that the beneficiary s assets first be exhausted; or (b) considering the beneficiary s own assets before making a discretionary distribution. See Nielsen v. Duyvejonck, 94 Ill.App.2d 244, 236 N.E.2d 743 (3rd Dist See also Hart v. Connors, 85 Ill.App.2d 50, 228 N.E.2d 273 (1 st Dist. 1967) and Bracken v. Block, 204 Ill. App.3d 23, 561 N.E.2d 1273 (1990). However, subsequent Illinois cases have held that the trustee could consider outside resources where the trustee has broad discretion to distribute income and principal as the trustee deemed necessary or advisable for the beneficiary s supplemental support and care. See Stein v. Scott, 252 Ill. App. 3d 611, 625 N.E.2d 713 (1 st Dist. 1993). There is a trend in other jurisdictions to follow this approach. See also, Nationsbank, N.A. v. Tegethoff, 18 S. W. 3d 22 (Mo. App. Ct. 2000) (court instructed trustee to consider beneficiaries private income where trust authorized principal invasions in such amounts as trustees considered reasonable and necessary under the circumstances for the purposes stated ). See Godfrey v. Chandley, 248 Kan. 975, 811 P.2d 1248 (1991) for a

20 discussion of several leading cases on the issue of consideration of a beneficiary s outside income and resources. a. Sample language: In determining what amounts are necessary for the support, health, maintenance and education of any person, the trustee shall take into account (1) his obligations, if any, to support others; (2) the obligation, if any, and the ability of others to support him; (3) other income available for his support so far as known to the trustee; and (4) any factors the trustee deems pertinent. b. Suggestion: Provide guidance as to what documentation will be required to substantiate a beneficiary s outside resources. If the grantor wishes to relieve beneficiaries of the burden of producing financial statements or tax returns in connection with a request for funds specific language should be included in the discretionary provisions. Moreover, the trustee should be permitted to rely upon a beneficiary s non verified statement as to the nature and extent of his or her resources. 14. Duty of Impartiality-Defining Priorities. Where there are multiple or successive beneficiaries of a trust, the trustee is under a duty to deal impartially with them. See Scott on Trusts, Section 232 (4 th ed. 1987). The comments to Section 50 of the Restatement (Third) state: Questions about the presumed meaning of standards and the significance of beneficiaries other resources are complicated when a trust has multiple discretionary beneficiaries, whether of the same or different generations. Difficulty of generalization through rules or preferences is aggravated by the number and interrelatedness of issues and alternative meanings to be considered, and by the diversity in the terms of these discretionary powers, in the purposes and size of trusts, and in the beneficiaries circumstances and their relationships to the settlor and to one another. The comments note that in many cases the structure and terms of interests may suggest a priority to be accorded various individuals or classes. There have been varying opinions as to whether the duty of impartiality implicitly precludes a trustee from making discretionary distributions which result in the exhaustion of trust assets at the expense of remainder beneficiaries. Some courts have interpreted the duty of impartiality to permit exhaustion of a trust if distributions are made in accordance with the standard set for the in the trust instrument. See e.g. Dial v. Dial 378 Ill.276, 38 N.E. 2d 43 (1941). Where a trustee holds multiple trusts for the same beneficiary, a trustee must exercise its discretionary distribution authority impartially among the trusts especially where the trusts have

21 different remainder beneficiaries. See e.g. Wiggins v. PNC, 988 S.W. 2d 498 (1999). The Northern Trust Formbook addresses priority among different classes of beneficiaries: In making discretionary distributions of trust property to beneficiaries the trustee shall consider the following: (a) Among current beneficiaries of the trust, the interests of an older generation beneficiary shall have priority over younger-generation beneficiaries, if the younger generation beneficiaries are descendants of the oldergeneration beneficiary. (b) The interests of a current beneficiary shall have priority over the remaindermen of the trust, if the remaindermen are descendants of the current beneficiary. The trustee may also consider the tax effects in making discretionary distributions of trust property to beneficiaries. a. Suggestion: If there are children from a first marriage consider addressing the priorities among the spouse and the children of the first marriage in more detail. Should the spouse be required to exhaust his or her assets before receiving distributions from the trust and would this include the sale of a vacation home or other non-investment assets? Should the spouse be entitled to maintain the same lifestyle he or she enjoyed with the grantor even if that diminishes the remainder interest? Can distributions be made to allow the spouse to make gifts even if those gifts will be made to non-descendants of the grantor (the spouse s children and grandchildren)? 15. Discretionary Authority to Terminate a Trust. It may be desirable to grant a trustee the authority to terminate a trust and distribute it outright to a beneficiary or a class of beneficiaries. The reasons for this may be because the trust is no longer economical due to its size and administrative costs or because the grantor s tax or other objectives cannot be fulfilled. The Northern Trust Company Formbook contains the following small trust termination provision: A corporate trustee in its discretion may terminate and distribute any trust hereunder if the corporate trustee determines that the costs of continuance thereof will substantially impair accomplishment of the purposes of the trust. The trustee shall terminate and forthwith distribute any trust created hereby, or by exercise of a power of appointment

22 hereunder, which is still held at the end of the period allowed by the applicable rule against perpetuities, if any. Distribution under this section shall be made to the persons then entitled to receive or eligible to have the benefit of the income from the trust in the proportions in which they are entitled thereto, or if their interests are indefinite, to those persons per stirpes if they have a common ancestor, or if not, then in equal shares. It may be desirable to allow termination of larger trusts due to circumstances unforeseen by the grantor. a. Sample language. Recognizing that conditions which I cannot forsee may arise in the future, if the trustee determines that one or more of the following has occurred, the trustee in its sole discretion may distribute such part or all of the trust to the beneficiary for whom it is then held or if there is more than one beneficiary, to those beneficiaries then living who are my descendants per stirpes, or if such beneficiaries are not my descendants, then in proportion to their income interests or if their interests are indefinite, then in equal shares: (1) A marked change in the needs or requirements of a beneficiary hereunder or to allow a beneficiary to assume responsibility for the management of his or her own affairs or to make provisions for his or her family if the trustee believes it to be in the best interests or for the well being of the beneficiary or his family and no useful purpose would be served by the continued existence of the trust; (2) Legislation or other court decisions detrimental to the trust or to any beneficiary; or (3) Other events which impair the intent and purpose of the trust. E. Conclusion. The drafting of trusts, especially of discretionary distribution provisions, has always been critically important to achieving clients missions in executing estate plans. By repositioning conversations with clients to go beyond the boilerplate, we gain the opportunity to learn more about our clients beliefs and biases surrounding wealth transfer, which in turn will help us clarify contradictions in their thinking and strike the delicate balance between protection and control through the use of discretionary trusts. By being aware of all of these issues upfront, our drafting can become more nimble and more client and family specific, and can facilitate the preservation of family wealth while affording trustees flexibility to meet the family s needs.

23 Section Three Putting Values into Your Standards: Moving Beyond Boilerplate 1 Stacy E. Singer Senior Vice President (312) ses7@ntrs.com 1 The author wishes to thank Laura Mandel, Senior Trust Administrator, Raymond C. Odom, Director of Wealth Transfer Services, and Patricia Sack, Senior Trust Administrator, for their thoughts and assistance in putting together these materials.

24 A. Introduction For most estate planners, the use of either precatory language, or language that goes beyond the scope of tax requirements and addresses values and intentions, has not been popular. Most planners have assumed that such language might muddy the water, and even lead to unnecessary litigation. In addition, for many, the drafting of such language moves into an area focused on clients feelings, goals, intentions and other soft topics that are both difficult to discuss and hard to justify in an hourly rate environment. However, our brave new world of estate planning, where taxes are so often not a primary driver of planning, is leading many planners and advisors alike directly into these conversations. What should we be discussing? How can we begin those conversations? And what should we do with the information we learn? B. A little history 1. Historically, documents have been rife with language expressing a grantor s hopes, wishes, suggestions and desires. For example, language suggesting I wish to provide for my spouse in the manner to which she is accustomed is most useful if the accustomed manner is defined which it rarely is. a. However, that language often failed to clarify whether there was an intention to create a legally enforceable trust, leading to a great deal of litigation over the grantor s intentions and the provisions that are to be enforced in such situations. i. In those circumstances, the courts generally looked at all of the provisions of the document to determine the grantor s intentions, as well as the family relationships involved. b. Often, however, the courts chose the opposite path, and refused to look very hard, instead determining that if the language was not clear in creating a trust, no trust was created. c. The uncertainty led many practitioners to avoid any kind of precatory language, and instead use only terms that are absolutely necessary and have clear meanings.