DRAFTING SPECIFIC DISPOSITIVE AND ADMINISTRATIVE PROVISIONS. A. Granting Trustee(s) Discretionary Dispositive Power with "Sprinkling Trust" Provisions

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1 DRAFTING SPECIFIC DISPOSITIVE AND ADMINISTRATIVE PROVISIONS A. Granting Trustee(s) Discretionary Dispositive Power with "Sprinkling Trust" Provisions The term sprinkling trust or sprinkle trust is broadly applied to any trust that gives the trustee discretion over how to distribute principal, income, or both. One of my instructors used to call it a spigot trust, because you could turn distributions on or off like a faucet. The term actually seems most appropriate when there is more than one beneficiary, as in a family pot trust or perhaps an education trust for the grandchildren. Giving the trustee discretionary powers here allows the trustee to pick and choose who will receive a sprinkle from the trust, perhaps because of differing need or maybe because different beneficiaries are in different tax brackets to minimize the income tax paid on a distribution. Even in a sprinkle trust you can designate that one or more trustees are to have primary consideration when the trustee is deciding to make a distribution. SAMPLE LANGUAGE: SPRINKLE PROVISIONS RELATING TO INCOME: During the lifetime of the Grantor's wife, MARY SAMPLE, the Trustee may distribute to, or for the benefit of, the Grantor's wife and children so much of the net income from the Family Trust as the Trustee (other than the Grantor s wife), in its sole discretion, deems necessary for the following purposes. To the extent that the funds in the Trust Estate are

2 considered by the Trustee to be sufficient for such purposes, the Trustee may distribute funds to allow MARY A. SAMPLE or a child of the Grantor to: (a) Obtain a college or university education or pursue other types of education or higher learning; (b) Assist in establishing, operating, or maintaining a business or profession; (c) (d) Assist in the acquisition of a home; Assist in the event of a financial emergency; (e) For any other purpose that will, in the sole discretion of the Trustee, further the best interest of any beneficiary. I request that my Trustee consider the respective needs of my beneficiaries, as well as other income and resources available to my beneficiaries. When making distributions from the Family Trust, my Trustee may exclude any of the beneficiaries or may make unequal distributions among them. SPRINKLE PROVISIONS RELATING TO PRINCIPAL: During the lifetime of the Grantor's wife, MARY A. SAMPLE, if the income from the Family Trust, together with the receipts from other sources known to the Trustee, and at the Trustee s sole and absolute discretion, shall be insufficient for the needs of the Grantor's wife and children, then the Trustee (other than the Grantor's wife) is authorized to pay to the Grantor's wife, or for her benefit, and for the benefit of the

3 Grantor s children, so much of the principal of the Family Trust as may be deemed necessary for such purposes. PROVIDING FOR A PRIORITY BENEFICIARY IN A SPRINKLE TRUST: In making distributions under this Article, my Trustee shall give consideration first to the needs of my husband and only thereafter to the needs of my descendants and the remainder beneficiaries. My husband is the Primary Beneficiary of the Family Trust. In making discretionary distributions under this Article, my Trustee should bear in mind that my primary concern and objective is to provide for the well-being of my husband, and the preservation of principal is not as important as this objective. IF SPRINKLED DISTRIBUTION IS TO BE CONSIDERED AN ADVANCEMENT: Provided, however, that any such payments, other than payments for the education of any beneficiary, shall be deducted from such beneficiary's proportionate share, if any, of the Trust Estate. IF SPRINKLED DISTRIBUTION IS NOT TO BE CONSIDERED AN ADVANCEMENT: A distribution made to a beneficiary under this Article is specifically not an advancement, and is not to be charged against the share to which the beneficiary may be entitled under other provisions of this trust.

4 IF SPRINKLED DISTRIBUTION MAY BE, BUT NOT NEED BE, AN ADVANCEMENT: My Trustee shall designate any distribution made under this Subsection as an advancement. A determination by my Trustee as to whether a distribution is for an advancement under this Subsection or is a distribution under Subsection a) is conclusive on all persons. USING HEMS STANDARD TO AVOID ESTATE INCLUSION FOR TRUSTEE WHO IS A BENEFICIARY: If the Trustee is serving as a sole Trustee and is also a beneficiary or potential beneficiary of the Trust, the Trustee may distribute to, or for the benefit of, the Grantor s wife and children, only so much of the net income or principal from the Family Trust as the Trustee deems necessary for the health, support, maintenance, and education of the Grantor s wife and children. DRAFTING TIP: Consider leaving support out of your typical HEMS provision. It usually does not add much where there is a friendly trustee. And where there is an unfriendly trustee it can create a claim by the spouse of a right to distributions from the trust even if his support needs can be met elsewhere. And, by extension, the spouse may be able to qualify for means-tested benefits if the trust is not obligated to support him.

5 B. Incentive Trust Provisions Incentive Trust provisions refers to trust language that requires or encourages a Trustee to use distributions as a means to encourage or discourage certain behaviors. Many clients want to avoid creating trust fund babies that may suffer from the following: Loss of motivation due to sufficient wealth. Lack of self-sufficiency. Loss of self-esteem. Spendthrift lifestyle. Addictive and self-destructive behavior. Incentive trusts can use the carrot or stick approach. The carrot approach permits distributions or bonus distributions when the beneficiary s behavior/activities are in line with the grantor s values and goals. The stick approach enacts a penalty, such as a reduction or cessation of distributions, when the grantor wishes to discourage certain actions by the beneficiary. Incentive trusts are sometimes criticized for being inflexible. For example, where a sum of $100,000 upon graduation from college may seem princely at one point, it may not be very motivational as inflation or other costs erode the dollar s buying power. Clients and their attorneys may also be unable to foresee all the possible things that can go wrong with an incentive. For example, it might be inequitable and contrary to the client s goals to punish a beneficiary who is disabled, but that can be the result if the beneficiary is required to attend classes, for example, to receive trust distributions.

6 In a few instances, incentive trust provisions can be deemed invalid as against public policy, such as provisions that encourage divorce or penalize a beneficiary from marrying outside his or her religion, although an incentive that gives a bonus for marrying a certain person or class of person may be permissible where a court may invalidate a provision that takes away a distribution if a beneficiary marries outside the preferred class. But there is also the middle ground, where an incentive trust was upheld where it conditioned distributions on the beneficiary not convert to her husband s faith. United States National Bank of Portland v. Snodgrass, 275 P.2d 860 (Or. 1954) SAMPLE EDUCATION-RELATED PROVISIONS: Distribution Upon Entering College. At any time after a beneficiary has commenced a course of study at an accredited college or university with the objective of obtaining a bachelor s degree in a subject which the trustees, in their discretion, deem reasonably likely to prepare the beneficiary for financial self-sufficiency, the trustees may make a single, lump-sum distribution to the beneficiary from his or her trust of an amount not to exceed FIVE THOUSAND DOLLARS ($5,000). The trustees may also make this one time distribution to a beneficiary who does not satisfy the foregoing requirements, but who has commenced a course of study or training which the trustees, in their discretion, determine to be reasonably equivalent to the pursuit of a bachelor s degree in light of all of the facts and circumstances, including the beneficiary s abilities or disabilities and the beneficiary s career goals. The distribution described in this paragraph may be made to the beneficiary no more than once during his or her lifetime. Annual Award for Academic Performance. At the end of each academic year that a beneficiary is engaged in a course of study at an accredited college or university with the objective of obtaining a bachelor s degree in a subject which the trustees, in their discretion, deem reasonably likely to prepare the beneficiary for financial self-sufficiency, if such beneficiary has maintained a

7 grade point average of at least 3.0 on a grading scale that provides a 4.0 for an A average (or the equivalent on a different grading system), and if such beneficiary is pursuing his or her education on a full time or substantially full time basis, the trustees may make a lump-sum distribution to the beneficiary of an amount not to exceed TEN THOUSAND DOLLARS ($10,000). In determining the amount distributed under this paragraph, the trustees may take into consideration, for example, the quality of the educational institution, the difficulty of the beneficiary s curriculum, and any special challenges the beneficiary may have faced during the academic year. Distribution Upon Receiving a Bachelor s Degree. At any time after a beneficiary has received a bachelor s degree from an accredited college or university, or such other degree or certification as the trustees, in their discretion, shall deem reasonably equivalent to the attainment of a bachelor s degree in light of all of the facts and circumstances, including such beneficiary s abilities or disabilities, or the beneficiary s career goals, and if the beneficiary has completed his or her education with a final grade point average of at least 3.0 on a grading scale that provides a 4.0 for an A average (or the equivalent on a different grading system) the trustees may make a single, lump-sum distribution to the beneficiary from his or her trust of an amount not to exceed TWENTY-FIVE THOUSAND DOLLARS ($25,000). In determining the amount to be distributed under this paragraph, the trustees may take into account, for example, the degree of difficulty of the beneficiary s curriculum, the beneficiary s grade point average, any academic honors received by the beneficiary, and any special challenges faced by the beneficiary. The distribution described in this paragraph may be made to the beneficiary no more than once during his or her lifetime.

8 Distribution Upon Receiving an Advanced Degree. At any time after a beneficiary has received an advanced degree (such as a master s degree, a PhD, an MBA or a professional degree) from an accredited university, or such other educational achievement as the trustees, in their discretion, shall deem reasonably equivalent thereto in light of all of the facts and circumstances, including such beneficiary s abilities or disabilities, the trustees may make a single, lump-sum distribution to the beneficiary from his or her trust of an amount not to exceed THIRTY-FIVE THOUSAND DOLLARS ($35,000). The distribution described in this paragraph may be made to the beneficiary no more than once during his or her lifetime. INFLATION INDEXING: Wherever a specified dollar amount is referred to in this Article in connection with a distribution to or for the benefit of a beneficiary, such amount shall be increased by the same percentage as the percentage of increase, if any, shown by the All Items Consumer Price Index for Urban Wage Earners and Clerical Workers published by the U.S. Department of Labor, Bureau of Labor Statistics, for the San Diego Area for the month in which this trust agreement is executed, as compared with the most recently published index on the first date that such gift takes effect or such distribution becomes permissible. If such index is no longer published, the trustees, in their discretion, shall select an appropriate index for the purpose of adjusting such amounts for the effect of inflation since the date this trust agreement was executed. SAMPLE INCOME-MATCHING PROVISIONS: Distributions to Match the Beneficiary s Earned Income. The trustees may distribute to a beneficiary on a quarterly, annual, or other basis, as much as one dollar of the net income, and, to the extent the net income is insufficient, the principal, of the trust for each dollar of

9 income earned by such beneficiary. The trustees determination of the amount of income and principal distributable to the beneficiary under this paragraph, if any, shall be absolute and binding upon all persons interested in the trust estate. The trustees may, for example, equate the income earned by the beneficiary to his or her adjusted gross income for federal income tax purposes, reduced by investment or passive income (such as rents, dividends, and interest), income from relief of indebtedness, capital gains, and government benefits, if any, and such other adjustments as the trustees deem appropriate under the circumstances. The trustees may make interim distributions to a beneficiary prior to their final determination of such beneficiary s earned income based upon such documentation of earnings as the trustees deem appropriate, including, without limitation, the beneficiary s W-2 forms, pay stubs, business profit or loss statements, or draft tax returns. No reimbursement shall be required of any beneficiary who has received a distribution under this paragraph based upon an estimate of his or her adjusted gross income if such adjusted gross income for the year in question is subsequently determined to be less than that estimated, or if such adjusted gross income is reduced as a result of an audit of, or amendment to, the beneficiary s federal income tax return, provided, however, that the trustees may, in their discretion, reduce distributions in subsequent years to such beneficiary pursuant to this paragraph to reflect such prior overpayment. The distributions authorized under this paragraph shall be made to the beneficiary as soon as practicable after the amount of such distribution, if any, has been determined by the trustees. In no event shall the distributions to a beneficiary under this paragraph exceed ONE HUNDRED THOUSAND DOLLARS ($100,000), collectively, in any calendar year. OTHER PROVISIONS TO ENCOURAGE BEHAVIOR: Distributions to Assist in the Purchase of a Residence. At any time after a Current Beneficiary has attained at least twenty-three (23) years of age, upon the request of the Current Beneficiary, the Trustees may contribute to the Current Beneficiary's maintenance and support, but are not required to do so, by making a reasonable down payment for the purchase of an appropriate primary residence for the Current Beneficiary. Prior to making any such distribution to or for the benefit of the Current

10 Beneficiary, the Trustees, or persons selected by the Trustees, shall meet or otherwise confer with the Current Beneficiary to determine what constitutes an appropriate residence for purposes of this Section based upon the Current Beneficiary's ability to pay expenses related to such residence, including mortgage service, property taxes, utilities and maintenance from resources outside of the trust. The Trustees are discouraged from making the distribution authorized under this Section to any Current Beneficiary who fails to cooperate with the Trustees in performing this analysis. Distributions to Assist in Starting a Business. At any time after a Current Beneficiary has attained at least twenty-five (25) years of age, upon the request of the Current Beneficiary, the Trustees may contribute to the Current Beneficiary's maintenance and support, but are not required to do so, by assisting the Current Beneficiary to commence a business or profession in which the Current Beneficiary will be employed on a full-time or a substantially full-time basis, alone or with others. Prior to making a distribution to or for the benefit of the Current Beneficiary for purposes of commencing a business or profession, the Trustees, or persons selected by the Trustees, shall meet or otherwise confer with the Current Beneficiary to establish a realistic business plan for the proposed endeavor in order to determine the likelihood that the Current Beneficiary will become financially self-supporting through the proposed endeavor, the timing and amounts of distributions from the Current Beneficiary's trust that would be required to insure the success of the proposed endeavor, and whether such amounts would be reasonable in light of the risk of failure of the proposed endeavor, the remaining assets of the trust, and any other factors which the Trustees deem reasonable under the circumstances. The Trustees are discouraged from making the distribution authorized under this Section to any Current Beneficiary who fails to cooperate with the Trustees in establishing a realistic business plan for the proposed endeavor. PROVISIONS TO DISCOURAGE BEHAVIOR: Withholding Distributions to a Beneficiary Not Engaged in Productive Activities. Notwithstanding any provision of this Trust Agreement to the contrary, the Trustees may withhold any distributions of income or principal to, or for the benefit of, any beneficiary of a trust administered under the provisions of this Article who is engaged in unproductive activities or to whom a distribution would otherwise be unwise. In reaching such a determination, the Trustees may consider, for example: (a) whether the Current Beneficiary is seriously pursuing an education which will enable the beneficiary to obtain gainful employment commensurate with his or her abilities;

11 (b) whether the Current Beneficiary is working to support himself or herself in a manner commensurate with his or her abilities (even if such Current Beneficiary's chosen career does not produce substantial income but makes a productive contribution to the community); (c) whether the Current Beneficiary is working in the home as a parent in the care of such Current Beneficiary's children or other family members; (d) whether the Current Beneficiary is free of substance abuse or other negative addictive behavior; (e) whether the Current Beneficiary is capable of managing money in a responsible manner as demonstrated by past conduct; (f) whether distribution to the Current Beneficiary would serve to benefit such Current Beneficiary's creditors, including former spouses, rather than the Current Beneficiary; and (g) if the circumstances warrant, whether the Current Beneficiary is involved in activities which promote the welfare of others or of the community as a whole. The Trustee's determination as to whether distributions should be withheld as to a particular Current Beneficiary pursuant to the provisions of this Section shall be final and binding upon all persons interested in the trust estate. The Trustees shall not be liable to the Current Beneficiary or to anyone else for the Trustees' decision to make or withhold any distribution to a Current Beneficiary. Distributions to Substance Abusers. Without limiting the generality of Section 15 above, in making distributions to or for the benefit of any Current Beneficiary whom the Trustees believe may have substance abuse problems, we request that the Trustees limit distributions to such Current Beneficiary to those which the Trustees deem necessary to insure that such Current Beneficiary's basic living requirements are met. In making distributions for the basic health and maintenance needs of a Current Beneficiary with substance abuse problems, the Trustees are requested, to the extent practicable, to make payments directly to persons or organizations who are furnishing housing, utilities, health care (including health care insurance), and other basic goods and services to the Current Beneficiary, rather than make distributions directly to the Current Beneficiary.

12 C. Principal/Income Estate planners must understand the interplay between their state s version of the Uniform Principal and Income Act, the Prudent Investor Act, and the IRS regulations. Most state laws will allow a trustee to follow specific trust provisions regarding the determination of principal and income and the manner in which trust assets are invested in regards to pursuit of growth and not just income. However, the IRS will disregard a trust provision that departs significantly from traditional concepts of principal and income. See Treasury Regulations section 1.643(b)-(1). Where the income beneficiary and principal or remainder beneficiaries are different, there can be a strong conflict between the beneficiaries on whether trust revenue or assets should be treated as income or principal. The drafter should work to minimize these conflicts, but that can be done either by seeking a great deal of specificity or by giving the trustee broad discretion as to how to allocated principal and income. Some principal/income questions can have income tax implications for the trust and the beneficiaries. For example, generally capital gains are not included in Distributable Net Income (DNI) and are not considered paid or distributed to any beneficiary. They are therefore taxed to the trust and not to the beneficiaries; however, capital gains may be included in DNI if the trust permits it and the Trustee elects it. Tax issues also arise with distributions from qualified retirement plans and annuities, especially where distributions of principal may result in penalties. Even where income tax rules are not impacted, in some instances the allocation of income and principal can jeopardize the marital deduction where the Trustee can or does make a distribution that the IRS considers to be income to a non-spouse. SAMPLE PROVISION CONCERNING DETERMINATION OF PRINCIPAL AND INCOME: My Trustee shall determine how all Trustee fees, disbursements, receipts, and wasting assets will be credited, charged, and apportioned between principal and income in a fair, equitable, and practical manner. My Trustee may allocate capital gain to income rather than principal. My Trustee may set aside from trust income reasonable reserves for taxes, assessments, insurance premiums, repairs, depreciation, obsolescence, depletion, and the equalization of payments to or for the beneficiaries. My Trustee may select appropriate accounting periods for the trust property.

13 Notwithstanding the preceding provisions of this trust or applicable law to the contrary, my Trustee shall treat distributions from any qualified retirement account to any trust established under this trust in any given year as income to the extent the distribution represents income generated or treated as generated by any qualified retirement account for that year. (a) Annuity and Other Periodic Payments Annuity and other periodic payments refers to distributions made to my Trustee over a fixed number of years or during the life of one or more individuals because of services provided or property transferred to the payor in exchange for future payments. This includes payments made in money or property from the payor s general assets or from a separate fund created by the payor, including a private or commercial annuity, individual retirement annuity, pension, profit-sharing plan, stock-bonus plan, stock-ownership plan, or similar arrangement. My Trustee shall treat annuity and other periodic payments to any trust established under this trust in any given year as income to the extent the distribution represents income generated and treated as generated by the annuity or other periodic payment for that year. If income information is not available, then my Trustee shall apportion the annuity and other periodic payments between principal and income in a fair, equitable and practical manner under the guidelines set forth in this Section. To the extent an annuity or other periodic payment is characterized as interest, dividend, or other item of income, or an annuity or other periodic payment is made instead of interest, dividend, or other item of income, my Trustee shall allocate the payment to income. My Trustee shall allocate to principal the balance of the annuity or other periodic payment as well as any other payment received in the same accounting period that is not characterized as interest, dividend, or other item of income. To the extent annuity and other periodic payments are made and no part of the payments are characterized as interest, dividend, or other item of income, my Trustee shall use the present value of the annuity and other periodic payments as finally determined for federal estate tax purposes, and the Internal Revenue Code Section 7520 rate used to determine the value for federal estate tax purposes to prepare an annuitization table to allocate the payments between income and principal. If the amounts of annuity and other periodic payments change because of changes in the investment markets or other changes, my Trustee shall allocate the change in the amount of the payments between income and principal in a fair, equitable, and practical manner.

14 (b) Protection of Estate Tax Marital Deduction If, to obtain an estate tax marital deduction for a trust established under this trust, my Trustee must allocate more of a payment to income than provided for by this Section, then my Trustee shall allocate to income the additional amount necessary to obtain the marital deduction.

15 D. Formula Distributions Clauses Formula clauses most often come into play in the context of marital deduction planning, generation skipping tax planning, or split-interest charitable trust planning. 1. Marital Deduction Formulas Marital deduction formulas are divided into two types: pecuniary and fractional. A pecuniary formula funds a specific dollar amount. For example, a pecuniary formula would direct the trustee to distribute to the marital trust the smallest amount that, if allowed as a marital deduction, would result in the least possible federal estate tax. The credit shelter trust would receive the balance. A fractional formula funds the marital and credit shelter trust proportionally with each asset. For example, if the trust a fractional formula would direct the trustee to allocate a portion of the assets to the marital trust ($15,750,00/$21,000,000 = 75%) and credit shelter trust ($5,250,000/$21,000,000 = 25%) in the proportion that each trust bears to the total value. There are a variety of pecuniary formulas available. Some formulas fund the marital trust first -- the credit shelter is the balance ("up front marital"). Other formulas fund the credit shelter first -- the marital trust received the balance ("reverse marital"). SAMPLE PECUNIARY FORMULA: I give the smallest pecuniary amount of my residuary estate that, if allowed as a federal estate tax marital deduction, would result in the least possible federal estate tax being payable by reason of my death. SAMPLE FRACTIONAL FORMULA: My Trustee shall allocate to the Marital Share a fractional share of the remaining trust property calculated as follows. (1) The Numerator Assuming the value qualifies for the federal tax marital deduction, the fraction s numerator will equal the minimum value sufficient to reduce all death taxes imposed because of my death by federal, state, or local authorities to the lowest possible amount. In computing the numerator, my Trustee shall take into account my transfers, including transfers treated as made by me, and all deductions,

16 exclusions, credits, and reductions in value allowed in computing this tax. But any state death tax credit must be taken into account for this purpose only to the extent that it does not increase the amount of state death taxes payable. If the federal estate tax is repealed at the time of my death or is otherwise inapplicable, as finally determined for federal estate tax purposes, but there is a state death tax applicable to my estate, then the fraction s numerator will equal the minimum value sufficient to reduce all state death taxes imposed because of my death to the lowest possible amount, assuming the value qualifies for the state death tax marital deduction. In computing the numerator, my Trustee must take into account my transfers, including transfers treated as made by me, and all deductions, exclusions, credits, and reductions in value allowed in computing the tax. (2) The Denominator The denominator will be the value of the remaining trust property as finally determined for federal estate tax purposes. The Marital Share must carry its pro rata share of the income, but the Marital Share must not receive less income than that required to be paid to my wife under applicable state law. (c) Creation of the Non-Marital Share My Trustee shall allocate the balance of the trust property to the Non- Marital Share. SAMPLE PICK AND CHOOSE PROVISION (FRACTIONAL FORMULA): My Trustee has complete authority to satisfy the fractional gift by cash contributions, by in-kind contributions, by a combination of cash and inkind contributions, or by undivided interests in property. If there are insufficient assets qualifying for the federal estate tax or state death tax marital deduction to fully fund the Marital Share, my Trustee shall reduce the funding to the Marital Share accordingly. I acknowledge that the funding amount may be affected by actions by my Trustee and by my Personal Representative in making certain tax elections. Once calculated in this way, the fraction is fixed, and may not vary with changes in the property value after the valuation date used for federal estate tax purposes. Because the fractional gift is not intended to be a specified dollar amount or pecuniary in nature, my Trustee shall apply the fraction to the trust assets at their actual value on the effective allocation

17 date, so that the actual value resulting from the application of the fraction will reflect fluctuations in the trust property s value. My Trustee may fund the fractional share on a non pro rata basis if the funding is based on the total fair market value of the assets on the allocation date. My Trustee s allocations of assets are limited as set forth below. (1) Ineligible Assets My Trustee may only allocate property and the proceeds of any property to the Marital Share that qualify for the federal estate tax or state death tax marital deduction. (2) Tax Consequences of Certain Allocations I request that my Trustee always consider the tax consequences of allocating or distributing to the Marital Share any insurance policy that insures my wife s life, property subject to the foreign death credit, property on which a tax credit is available, or property that is income in respect of a decedent under the Internal Revenue Code. (3) My Wife s Interest in Community Property My Trustee shall allocate any interest my wife has in community property that is or becomes trust property at my death to the Marital Share, even though it is not included in my gross estate for federal estate tax purposes or in the computation for the fractional share. My wife has the absolute right to withdraw all of the net income and trust principal consisting of her community property. After determining the type of formula clause, the drafter must also specify which metric will be used to value the assets in applying the formula. For example, will you use the date of death, the date of distribution value, or a value which is fairly representative of appreciation and depreciation. If all assets retained the same value from date of death to date of distribution, the choice of formula would be unimportant. However, where the use of a fractional formula has appreciation and depreciation proportionately allocated among the shares, a pecuniary formula essentially freezes the value allocated to one of the shares and any increase or decrease in value of the assets affects only the amount allocated to the residuary share. While a pecuniary formula guarantees that there won t be any overfunding or underfunding of the first to fund share, there can be adverse income tax consequences because the gain or loss is often realized at trust tax rates. There is generally no gain or loss recognized for income tax purposes when assets are distributed according to a fractional formula.

18 Although you cannot use a one size fits all approach to marital funding formulas, many practitioners have a default approach they use most of the time unless specific circumstances, such as a large proportion of assets in a business or retirement account, would dictate deviating from the default. For example, a fractional pick and choose formula allows you to get the income tax benefits of a fractional formula while choosing which assets to fund into which trusts to get the best estate tax benefits. LAW CHANGE NOTE: With the permanent applicable exclusion amount at $5,250,000 and the introduction of portability, many practicioners are revisiting their marital deduction clauses to avoid funding the credit shelter amount first and instead funding the marital deduction amount first to take advantage of the asset protection of marital trusts without losing the stepped-up basis on the death of the second spouse. In order to provide the most flexibility, some practitioners then allow for a reverse QTIP election carving out that property that would otherwise qualify for the QTIP election but allocating it to the credit shelter share instead. SAMPLE REVERSE QTIP CLAUSE: My Trustee shall allocate all of the remaining trust property to the Marital Share. But if my Trustee or my Personal Representative chooses not to elect the federal estate tax marital deduction as to any property that would otherwise qualify for the QTIP election and not to elect the same property for any state death tax marital deduction under any state s law that would otherwise qualify for the state QTIP election, my Trustee shall allocate that portion of the trust property to the Non-Marital Share. RESOURCES: For more detailed discussion of marital deduction clauses, see /materials/rpte_step_2012_07_11_husbands.authcheckdam.pdf Or 2. Generation Skipping Transfer Tax Formula - SAMPLE (d) Division into Exempt and Non-Exempt Trusts My Trustee shall divide the property of the otherwise partially-exempt trust into two separate trusts, the exempt trust and the nonexempt trust. The exempt trust will consist of the largest fractional share of the otherwise partially exempt trust s total assets that will permit the exempt trust to be entirely exempt from generation-skipping transfer tax. The

19 nonexempt trust will consist of the balance of the otherwise partially exempt trust s total assets. To compute the fractional share, my Trustee will use asset values as finally determined for federal estate tax purposes. My Trustee must then apply the fraction to the assets at their actual value on the effective date or dates of distribution so that the actual value of the fractional share resulting from the application of the fraction will include fluctuations in the trust property s value. I request that my Trustee allocate the value of any Roth IRAs payable to my trust to the exempt trust to the extent possible.

20 E. Trust Expenses It is useful to have both general and specific provisions concerning what is a valid trust expense and how such expenses are allocated between income and principal beneficiaries. SPECIFIC EXPENSE PROVISIONS: LAST ILLNESS OF GRANTOR: My Trustee may pay from the trust property: expenses of my last illness, funeral, and burial or cremation, including expenses of memorials and memorial services; legally enforceable claims against me or my estate; expenses of administering the trust and my estate; and court-ordered allowances for those dependent upon me. These payments are discretionary with my Trustee. My Trustee may make decisions on these payments without regard to any limitation on payment of the expenses and may make payments without any court s approval. No third party may enforce any claim or right to payment against the trust by virtue of this discretionary authority. If payment would decrease the deduction available to my estate, my Trustee may not pay any administrative expenses from assets passing to an organization that qualifies for the federal estate tax charitable deduction. Likewise, if payment would decrease the deduction available to my estate or violate the provisions of Treasury Regulation Section (b)-4(d), my Trustee may not pay any administrative expenses from the net income of property qualifying for the estate tax marital deduction. My Trustee shall pay death taxes out of the trust property s principal, as provided in Section But if a probate estate is opened within six months after the date of my death, my Personal Representative shall pay any outstanding claims and expenses as authorized by the Personal Representative, as well as any death taxes from my probate estate to the extent that the cash and readily marketable assets in my probate estate are sufficient. LAST ILLNESS/FUNERAL OF INCOME BENEFICIARY Upon the death of an Income Beneficiary, my Trustee may pay the funeral expenses, burial or cremation expenses, enforceable debts, or other expenses incurred due to the death of the beneficiary from trust property. This Section only applies to the extent the Income Beneficiary has not exercised any testamentary power of appointment granted to the beneficiary under this trust.

21 My Trustee may rely upon any request by the deceased beneficiary s Legal Representative or family members for payment without verifying the validity or the amounts and without being required to see to the application of the payment. My Trustee may make decisions under this Section without regard to any limitation on payment of expenses imposed by statute or court rule and without obtaining the approval of any court having jurisdiction over the administration of the deceased beneficiary s estate. MANAGEMENT OF PERSONAL PROPERTY Until property distributed in accordance with this Article is delivered to the appropriate beneficiary or his or her Legal Representative, my Trustee shall pay the reasonable expenses of securing, storing, insuring, packing, transporting, and otherwise caring for the property as an administration expense. Except as otherwise provided in my trust, my Trustee shall distribute property under this Article subject to all liens, security interests, and other encumbrances on the property. GENERAL EXPENSE PROVISION: Except as otherwise provided in this trust, my Trustee may pay any property taxes, assessments, fees, charges, and other expenses incurred in the administration or protection of the trust. All payments will be a charge against the trust property and will be paid by my Trustee out of income. If the income is insufficient, then my Trustee may make any payments of property taxes or expenses out of the trust property s principal. My Trustee s determination with respect to this payment will be conclusive on the beneficiaries.

22 F. What to do if the Trust Underperforms One of the reasons to provide maximum flexibility in a trust is to allow for the possibility that the investments and other assets in the trust will underperform and the trust will not be able to fulfill the goals of the grantor or the trust obligations to the beneficiaries. For that reason, in addition to allowing for the use of trust protector and decanting provisions discussed below, it is wise to allow for early termination of the trust, as well as indemnification of the Trustee for good faith actions. SAMPLE PROVISION TO TERMINATE UNDERPERFORMING/SMALL TRUST My Independent Trustee may terminate any trust created under this trust at any time, if my Independent Trustee, in its sole and absolute discretion, determines that administering a trust created under this trust is no longer economical or is otherwise inadvisable, or if my Independent Trustee determines that terminating the trust is in the best interest of my beneficiaries. Once distributed, my Trustee will have no further responsibility with respect to that trust property. My Trustee will distribute the trust property from a terminated trust in this order: to me, if I am then living; if I am not then living, to my wife, if then a trust beneficiary; if I am not then living and my wife is not then a trust beneficiary, to the beneficiaries then entitled to mandatory distributions of the trust s net income, in the same proportions; and then if none of the beneficiaries are entitled to mandatory distributions of net income, to the beneficiaries then eligible to receive discretionary distributions of the trust s net income, in the amounts and shares my Independent Trustee determines. SAMPLE PROVISION TO INDEMNIFY TRUSTEE FOR POOR ASSET PERFORMANCE (especially useful in ILITS) The Trustee may rely, without inquiry or independent investigation, on the representations of any person selling, or in any way associated with the marketing, promotion or sale of, a given life insurance policy regarding the relative quality of such policy (as compared to other available policies) or regarding the absolute quality of such policy (without regard to other available policies). Specifically (but not by way of limitation), the Trustee shall have no duty: (i) To verify that any particular life insurance policy satisfies the requirements for a life insurance contract under Section

23 7702 of the Code; (ii) To compare the performance or pricing or the projected performance or pricing of a particular life insurance policy with the performance or pricing or the projected performance or pricing of any other life insurance policy that then may be available from any source; (iii) To assess the appropriateness of purchasing or retaining any life insurance policy as an investment for the trust as compared to other then available investment vehicles that are not life insurance policies; and (iv) To investigate the strength or solvency of the company that issued or is offering a given life insurance policy. The Settlor acknowledges that the Trustee is not a guarantor of any life insurance policy held in the trust, whether purchased by, or transferred to, such Trustee. The Trustee shall not be liable to the Settlor or to any present or future beneficiary of the trust for any loss or damage suffered in connection with the performance, or failure to perform, of any life insurance policy or the insolvency of any life insurance company.

24 G. Trustee Removal/Resignation and Successor Trustees While every trust should have provisions for removing and replacing the Trustee, these provisions should not be considered standard boilerplate that is the same for every trust. Depending on the client s goals, some Trustees may be easily removed while others may only be removed for the most serious of reasons and perhaps only by a court. In some instances, it may be appropriate to have the parties removing the Trustee appoint the successor, while other times it may be better to have the successor Trustees defined in the document even if the vacancy is the result of removal. SAMPLE TRUSTEE RESIGNATION PROVISION: A Trustee may resign by giving written notice to me. If I am incapacitated or deceased, a resigning Trustee must give written notice to the trust s Income Beneficiaries and to any other then-serving Trustee. SAMPLE TRUSEE REMOVAL PROVISION (Beneficiary Removal): may A majority of the Income Beneficiaries of any trust created under this instrument may remove a Trustee of the trust at any time, with or without cause. The right to remove a Trustee under this Subsection is not to be interpreted as granting the person holding that right any of the powers of that Trustee. A minor or incapacitated beneficiary s parent or Legal Representative act on his or her behalf. Notice of removal must be in writing and delivered to the Trustee being removed and to any other then-serving Trustees. The removal becomes effective in accordance with its provisions. FILLING TRUSTEE VACANCY: If the office of Trustee of a trust created under this instrument is vacant and no designated successor Trustee is able and willing to act as Trustee, my husband may appoint an attorney, certified public accountant or corporate fiduciary that is not related or subordinate to the person or persons making the appointment within the meaning of Section 672(c) of the Internal Revenue Code as successor Trustee. If my husband is unable

25 or unwilling to act, the trust s Primary Beneficiary may appoint an attorney, certified public accountant or corporate fiduciary that is not related or subordinate to the person or persons making the appointment within the meaning of Section 672(c) of the Internal Revenue Code as successor Trustee. Any beneficiary may petition a court of competent jurisdiction to appoint a successor Trustee to fill any vacancy lasting longer than 30 days. The petition may subject the trust to the jurisdiction of the court only to the extent necessary to make the appointment and may not subject the trust to the continuing jurisdiction of the court. A minor or incapacitated beneficiary s parent or Legal Representative may act on his or her behalf. NOTE: All of these powers (to accept resignation, to remove a Trustee or appoint a Successor) may also lie with the Trust Protector, either in addition to or instead of the grantor, beneficiaries, or court.

26 H. Trust Protectors Trust Protectors are growing in popularity, but as a consequence they are undergoing greater scrutiny. While some scholars opine that a trust protector can serve in a non-fiduciary position, many of those who practice trust litigation are of the opinion that a trust protector will always be held to the standard of a fiduciary. The powers of a trust protector are determined almost entirely by the document. As a result, the role of the trust protector can be very small or very large depending on how the document is drafted. Provisions for Trust Protector The Trust Protector s purpose is to direct my Trustee in matters concerning the trust, and to assist in achieving my objectives as expressed by the other provisions of my estate plan if needed. Any Trust Protector must be a corporate fiduciary or an individual who is not related or subordinate to me, while I am still living, or to any beneficiary within the meaning of Internal Revenue Code Section 672(c), and must not be an adverse party within the meaning of Internal Revenue Code Section 672(b). Neither I nor my spouse, nor any trust beneficiaries, nor any person who has contributed to the trust may serve as a Trust Protector at any time under this instrument. Article 1.2 Designation of Trust Protector Any Trust Protector authorized or required to act with respect to this instrument must be appointed by MARY SAMPLE, a successor appointed by her, or a certified public accountant or enrolled agent selected by the Trustee. The Trust Protector must be a corporate fiduciary or individual of a type described in Section The court acting to appoint a Trust Protector will acquire jurisdiction or authority over the trust only to the extent necessary to make the appointment and may not subject the trust to the continuing jurisdiction of the court. A minor or incapacitated beneficiary s parent or Legal Representative may act on his or her behalf. The Trust Protector s authority is conferred in a fiduciary capacity. Article 1.3 Removal and Replacement of a Trust Protector Any Trust Protector may be removed for cause only as determined by Mary Ellen Denomy, a successor appointed by her, or a certified public accountant or enrolled agent selected by the Trustee. The party removing a Trust Protector may appoint one or more successor Trust Protectors to immediately replace the removed Trust Protector. The court acting to remove and replace a Trust Protector will acquire jurisdiction or

27 authority over the trust only to the extent necessary for the removal and replacement of the Trust Protector. Article 1.4 Resignation of a Trust Protector A Trust Protector may resign by giving written notice to me. If I am deceased, a Trust Protector may resign by giving written notice to the trust s Income Beneficiaries and the then-serving Trustee. Resignation will take effect on the date set forth in the notice, but not earlier than 30 days after the delivery date of the notice of resignation, unless an earlier effective date is agreed to by me or by the trust s Primary Beneficiary. A resigning Trust Protector is not liable or responsible for the act of any successor Trust Protector. Article 1.5 Incapacity of a Trust Protector If any individual Trust Protector becomes incapacitated, the incapacitated Trust Protector need not resign as Trust Protector. Any then-serving Trust Protector or the immediately eligible successor Trust Protector may provide a written declaration that a Trust Protector is incapacitated. The written declaration of the Trust Protector s incapacity, if supported by a written opinion of incapacity by a physician who has examined the incapacitated Trust Protector, will terminate the Trust Protector s service. If the Trust Protector designated in the written declaration refuses to sign the necessary medical releases needed to obtain the physician s written opinion within 10 days of a request to do so, the Trust Protector s service will be terminated. The provisions of Section 10.05(i) of this instrument govern the determination of a Trust Protector s incapacity, except that a single physician may make the determination of incapacity instead of two physicians. Further, Section 10.05(i) governs the Trust Protector s obligations to submit to examination and provide necessary releases. Article 1.6 Authority of Successor Trust Protectors Any successor Trust Protector has all the authority of any predecessor Trust Protector, but is not responsible for the predecessor s acts, omissions, or forbearances. Article 1.7 Trust Protector Standard of Conduct The Trust Protector has no general duty to monitor or remain informed about the trust. Specifically, the Trust Protector has no duty to investigate the Trustee s actions or inactions, to audit the trust s books, to review the trust s investments, or to evaluate the trust portfolio s performance, unless a trust beneficiary or some other interested party: files a written complaint with the Trust Protector alleging a breach of trust and detailing the matters the Trust Protector should investigate, audit, review, or evaluate; or