DRAFTING TRUST DISTRIBUTION CLAUSES: HEALTH, EDUCATION & MAINTENANCE First Run Broadcast: December 2, 2015 Live Replay: June 1, 2016 1:00 p.m. E.T./12:00 p.m. C.T./11:00 a.m. M.T./10:00 a.m. P.T. (60 minutes) One of the most problematic areas of trust planning is defining the distribution powers of a trustee. Drafting broad discretionary distribution powers or tightly defined powers each come with their own challenges. Broad discretionary powers are the often the source of dispute and litigation as beneficiaries challenge trustee decisions. Tightly defined powers, however, often fail to accommodate changing circumstances economic, tax, life circumstances of beneficiaries becoming too inflexible to be functional. Incorporation of HEM or health, education and maintenance standards is helpful but still fall short of providing a clear guide to trustees and being dispute-proof. This program will provide you with a real-world guide to drafting distribution clauses in trust documents, the practical tradeoffs and risks of each approach, and common traps to avoid. Drafting distribution provisions in trusts tradeoffs, risks, and traps Statutory and common law framework for discretionary distributions Discretionary powers how to provide flexibility without fostering disputes Limits and risks of drafting narrow distribution powers shifting law, economics, and life circumstances Interpreting trust documents to discern objective, measurable standards for discretionary distributions Understanding HEM health, education and maintenance standards and how they operate in practice Balancing the tension between income beneficiaries and beneficiaries with remainder interests Speakers: Daniel L. Daniels is a partner in the Greenwich, Connecticut office of Wiggin and Dana, LLP, where his practice focuses on representing business owners, corporate executives and other wealthy individuals and their families. A Fellow of the American College of Trust and Estate Counsel, he is listed in The Best Lawyers in America, and has been named by Worth magazine as one of the Top 100 Lawyers in the United States representing affluent individuals. Mr. Daniels is co-author of a monthly column in Trusts and Estates magazine. Mr. Daniels received his A.B., summa cum laude, from Dartmouth College and received his J.D., with honors, from Harvard Law School.
PROFESSIONAL EDUCATION BROADCAST NETWORK Speaker Contact Information DRAFTING TRUST DISTRIBUTION CLAUSES: HEALTH, EDUCATION & MAINTENANCE Materials provided by: Jeremiah "Jere" W. Doyle, IV BNY Mellon Wealth Management (o) (617) 722-7420 jere.doyle@bnymellon.com Blanche Lark Christerson Deutsche Asset & Wealth Management - New York City (o) (212) 454-1039 blanche.christerson@db.com Presentation by: Blanche Lark Christerson Deutsche Asset & Wealth Management - New York City (o) (212) 454-1039 blanche.christerson@db.com William Kalish Akerman Senterfitt, LLP Tampa, Florida (o) (813) 223-7333 william.kalish@akerman.com Jeffrey Gad Akerman LLP Tampa, Florida (o) (813) 223-7333 jeffrey.gad@akerman.com
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Blanche Lark Christerson Managing Director, Senior Wealth Planning Strategist Tax Topics 2015-11 11/30/15 Trusts and divorce Trusts can offer creditor protection to beneficiaries. Yet the extent of that protection can depend on various factors, including the terms of the trust, where the beneficiary lives and the nature of the action against the beneficiary. Pfannenstiehl v. Pfannenstiehl, a recent decision from the Appeals Court of Massachusetts dealing with the division of property in divorce, is a case in point (88 Mass. App. Ct. 121, August 27, 2015). The facts. H and W married in early 2000. They had two children, both with special needs (one child was dyslexic and had attention-deficit disorder, and the other had Down syndrome); W was the primary homemaker and caretaker of the children. Dad, H s father, and B, H s twin brother, ran very successful forprofit colleges through several closely held corporations (H worked as an assistant bookstore manager at one of the colleges, earning $170,000 a year). In 2004, Dad created a trust to benefit his descendants a class that would grow as more descendants were born (at the time in question, Dad had three children (including H) and eight grandchildren, or 11 descendants in all). Dad funded the trust chiefly with shares from the companies, which generated substantial income through tuition payments. B and the lawyer who had represented Dad and the companies for 30+ years were the trustees. The trustees could make discretionary distributions of income or principal to a beneficiary, in equal or unequal shares, for a beneficiary s comfortable support, health, maintenance, welfare and education, and could consider a beneficiary s other sources of funds in determining whether to make a distribution; distributions were income-tax free since Dad was responsible for paying the trust s income taxes (yes, this was a defective grantor trust). The trust had a spendthrift provision that was designed to preclude a beneficiary from assigning or pledging trust property, as well as shield the property from attachment, execution, garnishment or other seizure under any legal, equitable or other process. The trustees only made distributions to Dad s three children: from May 2009 through March 2012, H s brother and sister received varying amounts, generally monthly, totaling $1.13 million and $1.18 million, respectively; in 2008, H received a single distribution of $300,000, and from May 2009 through August 2010,
received varying amounts, generally monthly, totaling $500,000. When H filed for divorce in September 2010, he received nothing further from the trust. Divorce proceedings lower court. H s divorce trial lasted eight days in early 2012. The proceedings were complicated, and intensely litigated. A key question was whether the trust was part of the marital estate. Under Massachusetts law, the Probate and Family Court judge had considerable latitude in ascertaining that estate and its division. She concluded that the trust, which she valued at nearly $25 million, was part of the marital estate, and that H, as one of 11 possible beneficiaries, had a 1/11 interest in the trust. The judge valued the entire marital estate at $4.3 million, and allocated 60% to W and 40% to H (in the final calculation, W received $2.33 million and H received $1.97 million). To effect the transfers to W, the judge ordered H to pay W nearly $50,000 per month for 24 months. Thanks to loans from Dad, H was able to make about five payments; when those loans ceased, H wrote to the trustees requesting distributions from the trust so that he could comply with the judgment. The trustees denied his request, and W filed a contempt proceeding: H had not paid her from January through April 2013. H was found guilty, and ordered to jail for 60 days unless he paid what was owed (over $200,000, with interest). H appealed the contempt judgment, stating that he had no independent ability to make the payments and therefore could not be held in contempt; he also appealed the holding the trust was part of the marital estate. Appeals Court. The Appeals Court vacated the contempt judgment, noting that H had tried to satisfy the monthly payments by borrowing from his father, and by asking the trustees for distributions after the loans ceased. Although one could question the genuineness of all these machinations given the bias of the two trustees and the husband s father, it was not proved by clear and convincing evidence that H willfully and intentionally violated a clear and unequivocal order. The Appeals Court affirmed that the trust was part of the marital estate. Some of the factors the court looked at included the following: The spendthrift provision was being invoked as a subterfuge to mask the husband s income stream and thwart the division of the marital estate in the divorce. The cutoff of distributions to H on the eve of divorce was a deliberate manipulation to erase a major component of the husband s annual income and to silence his interest in the trust. The trust s standard for distributions to beneficiaries comfortable support, health, maintenance, welfare and education was ascertainable; H s income stream was therefore not too remote or speculative for inclusion in the marital estate. H had an enforceable right to trust distributions to support his lifestyle, his interest in the trust was vested in possession, and he was likely to receive distributions once the divorce was over. The 60/40 split between W and H was also appropriate, given that W was the primary homemaker and caretaker of the two children and spent extraordinary amounts of time addressing their needs; H s substantial income distributions from the trust for support, maintenance and welfare were woven into the fabric of the marriage. A dissenting judge (with whom another judge joined) said that H s interest was too remote and speculative, too dependent on trustee discretion, and too elusive of valuation to have been included in the Tax Topics 11/30/15 2
marital estate for purposes of division. Here, the trust was not solely for H, but had an open class and multiple beneficiaries, in different generations, to whom the trustees owe fiduciary duties. In addition, the trust s ascertainable standard could not be read in isolation. The trustees had discretion regarding the amounts and timing of distributions, and could take into account a beneficiary s funds from other sources in determining whether to make a distribution; indeed, the trustees made distributions in some years, and not in others. In short, the husband s interest in the trust stands on different footing from a party s interest in cases where interests are more clearly fixed and certain. The fractional share methodology used by the judge in the lower court produced an arbitrary result. Although the majority of the court noted what it considered machinations on the part of the trustees to discontinue payments to H on the eve of his divorce filing so as to paint his interest as remote and speculative where it never had been previously the primary focus should be the terms of the trust instrument itself, not how those terms may be or have been manipulated. In other words, consideration of such manipulation must be secondary to the terms of the trust instrument itself. Comments. H has appealed to the Supreme Judicial Court of Massachusetts (the highest court in the state). In the meantime, what to make of this case? Several thoughts come to mind. First, in the words of the majority opinion, Massachusetts divorce law takes an expansive view of the marital estate, which can include a beneficial interest in trust; in determining that marital estate and its division, a judge is allowed to weigh many factors, including the length of the marriage, the conduct of the parties during the marriage, the age, health, station, occupation, amount and sources of income, vocational skills, employability and needs of each of the parties. Other jurisdictions, however, may have less expansive views. Accordingly, the divorce law to which the beneficiary is subject (typically, where the beneficiary lives) will affect which of the beneficiary s property interests are available for purposes of dividing the marital estate notwithstanding language in the trust that attempts to limit a creditor s access to the trust property. Second, because the trust had an ascertainable standard for distributions ( comfortable support, health, maintenance, welfare and education ), the trust property was more accessible than it would have been if the trustees had full discretion for distributions, and no ascertainable standard. In this case, however, full discretion would have been problematic since H s brother was a trustee/beneficiary: for him to be able to participate in decisions regarding trust distributions and avoid adverse tax consequences (such as the trust property being includible in his estate), the ascertainable standard was necessary. (Note that when family members are trustees and beneficiaries, there are often trade-offs in terms of the flexibility and potential creditor protection the trust can provide; as with so much in the planning area, it is a balancing act.) Third, it was clear that the court s sympathies lay with W, and not H (W had made significant employment sacrifices to take care of their children, in particular, their Down-syndrome daughter). To illustrate, the court commented unfavorably on for-profit colleges, and repeated many of the probate judge s tart observations regarding H and his family, including how the proverbial family wagons circled the family money when H s divorce began, describing H s $170,000 salary as an assistant bookstore manager as inflated and flowing from familial relations (the court said that a normal incumbent in this position would earn $50,000-$60,000 a year), and noting the machinations that were designed to silence H s interest in the trust. As the old saying goes, however, bad facts make bad law. That is, putting the human factor to one side, it seems surprising that the court concluded that H had a fixed right to distributions, given that distributions were discretionary (albeit subject to an ascertainable standard); it also seems surprising that the court agreed that as one of 11 current beneficiaries, H had a 1/11 interest in the trust: this fractional approach overstates H s interest assuming more descendants are born, and understates his interest if the class suddenly contracts because beneficiaries die. Tax Topics 11/30/15 3
In addition, notwithstanding the court s dim view of how the trust was administered and the perceived manipulations of H s family, the trustees had a fiduciary obligation to the other trust beneficiaries. If they had agreed to H s request for distributions so that he could fulfill the court-ordered 24 monthly settlement payments to W, those distributions arguably would have fallen outside of the scope of the trust s ascertainable standard for distributions (again, "comfortable support, health, maintenance, welfare and education ). Furthermore, whether a trustee is an independent third-party or a family member or friend, that trustee is no less vulnerable to a potential suit from a disgruntled beneficiary. Here are a few takeaways from this case: 1) full discretion on the part of trustees (as opposed to discretion that is subject to an ascertainable standard) offers more potential creditor protection to beneficiaries; 2) depending on the jurisdiction, a divorce court may be more willing to consider a beneficiary s discretionary trust interest as a divisible part of the marital estate; and 3) before they wed, beneficiaries of means may want to consider having a pre-nuptial agreement, as unromantic as such agreements can be. No more $100,000,000 checks! On September 7, 2015, the IRS issued Announcement 2015-23. IRS personnel were told that effective January 1, 2016, the IRS cannot accept checks over $99,999,999, as checks in excess of that amount must be processed by hand, which can lead to errors. If a taxpayer owes more than that amount, the taxpayer must use two or more checks or pay by Fed Wire. Good to know. December 7520 rate The IRS has issued the December 2015 applicable federal rates: the December 7520 rate remains at 2.0%, where it was in November. The December mid-term rates are: 1.68% (annual), 1.67% (semiannual and quarterly) and 1.66% (monthly). The November mid-term rates were: 1.59% (annual), 1.58% (semiannual and quarterly) and 1.57% (monthly). Blanche Lark Christerson is a managing director at Deutsche Asset & Wealth Management in New York City, and can be reached at blanche.christerson@db.com. The opinions and analyses expressed herein are those of the author and do not necessarily reflect those of Deutsche Bank AG or any affiliate thereof (collectively, the Bank ). Any suggestions contained herein are general, and do not take into account an individual s specific circumstances or applicable governing law, which may vary from jurisdiction to jurisdiction and be subject to change. No warranty or representation, express or implied, is made by the Bank, nor does the Bank accept any liability with respect to the information and data set forth herein. The information contained herein is not intended to be, and does not constitute, legal, tax, accounting or other professional advice; it is also not intended to offer penalty protection or to promote, market or recommend any transaction or matter addressed herein. Recipients should consult their applicable professional advisors prior to acting on the information set forth herein. This material may not be reproduced without the express permission of the author. "Deutsche Bank" means Deutsche Bank AG and its affiliated companies. Deutsche Asset & Wealth Management represents the asset management and wealth management activities conducted by Deutsche Bank AG or its subsidiaries. Clients are provided Deutsche Asset & Wealth Management products or services by one or more legal entities that are identified to clients pursuant to the contracts, agreements, offering materials or other documentation relevant to such products or services. Trust and estate and wealth planning services are provided through Deutsche Bank Trust Company, N.A., Deutsche Bank Trust Company Delaware and Deutsche Bank National Trust Company. 2015 Deutsche Asset & Wealth Management. All rights reserved. 022613 113015 Tax Topics 11/30/15 4
Discretionary Trust Distributions from Trusts Jeremiah "Jere" W. Doyle, IV BNY Mellon Wealth Management (o) (617) 722-7420 jere.doyle@bnymellon.com
Discretionary Distributions Planning stage Educating the client about the various standards and the tax and non-tax implications Administration stage Determining if a distribution is appropriate
Discretionary Distributions References: The trust instrument, any amendments and settlement agreements The Internal Revenue Code and applicable regulations Bogert, Law of Trusts Scott on Trusts Restatement (Second) of Trusts Restatement (Third) of Trusts Uniform Trust Code Loring, A Trustee s handbook Case law
Discretionary Distributions Distribution standards What is the settlor s intent? What does the trust language mean? What factors must be taken into account before making a distribution? Beneficiary s lifestyle, other resources? Why is the distribution standard not expressed in detail? Too expensive to have attorney spend hours drafting customized distribution provisions. What are the tax considerations in adopting distribution standards? A trustee who has the discretionary power to distribute trust property to himself as a trust beneficiary possesses a general power of appointment unless the discretionary power is limited by an ascertainable standard related to his health, education, maintenance or support. 2041(b)(1)(A); 2514(c)(1). Interpretation of distribution standards are governed by state law. The meaning of a particular term may be more or less restrictive, depending on the law of the state that governs the language of the trust. As a general rule, if the trustee uses its judgment and makes a reasonable decision to make a discretionary distribution, a court will not reverse the trustee s decision unless the distribution was made in bad faith or is deemed to be an abuse of discretion. If the trustee s discretion is absolute or uncontrolled, a court will give the trustee s decision more deference. The fiduciary duty of impartiality overlays every distribution decision Alternate provisions to provide guidance Creditor protection issues
How is the distribution to be made? Discretionary Distributions To beneficiary directly To beneficiary s guardian To be applied for the benefit of the beneficiary To third person for the benefit of the beneficiary To custodian for minor beneficiary
Ascertainable Standard Not a general power of appointment no estate tax inclusion Health, education, maintenance and support Constitutes an ascertainable standard if the power is reasonably measurable in terms of the beneficiary s needs for health, education or support. A power to use property for the comfort, welfare or happiness of the holder of the power is not limited by the requisite standard. Regulations under Section 2041 provide that a power is limited by an ascertainable standard if the words health, education, support and maintenance appear in connection with the granted discretionary power. Examples of powers that are limited by the requisite standard are powers exercisable for the holder s: Support Support in reasonable comfort Maintenance in health and reasonable comfort Support is accustomed manner of living Education including college and professional education Health Medical, dental, hospital and nursing expenses and expenses of invalidism
Support and Maintenance Means more than bare subsistence Includes the beneficiary s normal living expenses, such as housing, clothing, food and medical care depending on the standard of living enjoyed by the beneficiary during the settlor s or testator s lifetime Includes regular mortgage payments, property taxes, suitable health insurance or care, life and property insurance, vacations, family and charitable gifting In many states, if a trustee may distribute principal for a beneficiary s support, the trustee may also distribute principal for the support of the beneficiary s spouse and children If the settlor wants to allow the trustee to make distributions to spouses of the settlor s descendants, he or she should include a specific provision in the trust document Drafting attorney: Help out the trustee - Define what you mean by the term
Comfort Generally, comfort is broader than support or maintenance and includes the beneficiary s enjoyment, pleasure, happiness, satisfaction or peace of mind. Drafting attorney: Help out the trustee - Define what you mean by the term
Best Interest or Best Interest and Welfare Allows the trustee to make distributions to allow the beneficiary to enjoy a high standard of living, including extensive travel or the purchase of expensive cars and jewelry. Best interests standard allows distributions for broader purposes than a support standard but the best interest standard is less easy to define. This could be interpreted to allow the trustee to distribute the entire principal of the trust. Drafting attorney: Help out the trustee - Define what you mean by the term
Education Includes college, but generally does not include graduate or professional education unless specifically provided by the trust instrument Includes living expenses as well as fees and other costs of attending an institution of higher educations Drafting attorney: Help out the trustee - Define what you mean by the term
Health Includes routine medical care, medication, surgery and hospitalization, extended nursing care and mental health Settlor may want to expressly allow home health care over nursing home care Does it cover emergency medical treatment, psychiatric treatment, psychological treatment, routine health exams, dental care, eye care, eye glasses/contact lenses, elective cosmetic surgery, cosmetic dental work, lasik surgery, health insurance, dental insurance, unconventional medical treatment, home health care (round the clock nurses), gym memberships, day at the spa, golf club memberships, vacations to relieve tensions and stress, an expensive car with more comfortable seats to relieve back pain? Drafting attorney: Help out the trustee - Define what you mean by the term
Emergency Courts interpret this term narrowly Authorizes distributions only for the beneficiary s unusual and unforeseen expenses IRS takes the position that the term emergency does not create an ascertainable standard for federal estate and gift tax purposes. However, some courts take the opposite view i.e. that the term emergency is an ascertainable standard for tax purposes. Drafting attorney: Help out the trustee - Define what you mean by the term
Sole and Absolute Discretion Trustee may make distributions for any purpose or withhold distributions as long as the trustee does not act in bad faith or arbitrarily Restatement 2d of Trust states that the trustee s decision to distribute or withhold distributions does not need to be reasonable. However, most courts will impose a standard of reasonableness even where the standard for principal distributions is the absolute and uncontrolled discretion of the trustee If the settlor wants the trustee to have complete latitude and the beneficiaries to have no enforceable rights against the trustee, the language of the standard should be explicit that that is the settlor s desire. Drafting attorney: Help out the trustee - Define what you mean by the term
Standard of Living If there is a concern about changing standards of living, the time to which the standard refers should be made clear. Example: Beneficiary s standard of living at the time of the settlor s death v. beneficiary s standard of living at the time of the distribution. The beneficiary s standard of living may change between the time the trust is drafted and the date of the testator s death or the beneficiary s standard of living at the time the distribution is made Specify at what time the standard of living should be measured. Drafting attorney: Help out the trustee - Define what you mean by the term
Making Gifts Does a standard of distribution (e.g. distribution in the best interests of the beneficiary) allow a trustee to make distributions to a beneficiary so the beneficiary can make gifts? Annual exclusion gifts Charitable gifts Use of lifetime gift tax exemption (e.g. $5,120,000 for 2012) Trust language which defines best interests of a beneficiary as including distributions for the benefit of the beneficiary s descendants would allow the beneficiary to make gifts of trust property. Best to have language in the trust document that specifies that the trustee may make distributions to the beneficiary for the purpose of making gifts and the type and amount of such gifts.
Priorities Among Beneficiaries Unequal distributions If trust has multiple beneficiaries and the trustee is not given discretion to make unequal distributions, the presumption is that the beneficiaries should receive equal distributions Presumption is based on the trustee s duty to treat beneficiaries impartially. If the settlor wants to give the trustee the power to make unequal distributions or to favor one beneficiary over another, the trust instrument should state specifically that unequal distributions are allowed. An alternative is that trust may permit unequal distributions but have them be treated as an advancement Settlor may wish to establish priorities among beneficiaries Example: primary concern is for child and trustee need not consider the interest of any other beneficiary in making distributions to the child. Example: spouse should be given first priority and children second priority
Taking Beneficiary s Other Assets into Consideration Unless the trust instrument states otherwise, the general rule is that the trustee need not consider the beneficiary s other assets in determining what assets are required for support of the beneficiary. The beneficiary has the right to look to the trust assets first for his or her support. Consider the tax consequences it may be better from a tax point of view to take other sources of income into account before making distributions from a trust Example: take spouse s rights to distributions from a marital trust into consideration before making distributions from a credit shelter trust Example: take non-skip person s other sources of income, especially those from a non-exempt generation skipping trust, before making distribution from a generation skipping exempt trust.
Taking Beneficiary s Other Assets into Consideration Distributions conditioned on need In some states, if a distribution from a trust is conditioned on need, the beneficiary s outside assets and income must be considered. Boston Safe Deposit and Trust Company v. Boynton, 443 N.E. 2d 1344 (Mass. App. 1983). Even if the trust directs the trustee to consider the beneficiary s other assets, there is a question as to which assets the trustee must consider. Income, liquid assets, beneficiary s entire estate including illiquid assets? What about taking into consideration the income tax consequences to the beneficiary if the beneficiary must liquidate his own assets.
Fiduciary Guidance Advisable to give the trustee discretion to consider the beneficiary s personal characteristics e.g. does the beneficiary have a job, is he or she a spendthrift or a substance abuser, can he or she handle money? The general rule is that the trustee cannot take the beneficiary s personal characteristics into account unless specifically authorized by the trust instrument.
Professional Trustee Decisions made by trust committee Trust officer presents facts of case to trust committee who, in turn, decides if a discretionary distribution should be made. Trust committee usually has a form that the trust officer must complete about the trust to aid the trust committee in making a decision.
Creditor Claims Generally, purely discretionary trusts are not subject to creditor s claims Creditor may not attach a beneficiary s discretionary distribution interest until it is distributed to the beneficiary A beneficiary of a purely discretionary trust cannot compel the trustee to make distributions. Right in a discretionary trust is not a property interest it is a mere expectancy To the contrary: Restatement (Third) of Trust and Uniform Trust Code Restatement (Third) give trust beneficiaries a right to force a distribution pursuant to ambiguous terms Restatement (Third) position is that a reasonableness standard of review should be applied to most discretionary trusts, regardless of whether or not the trustee is grantor sole, absolute, or unfettered discretion. Restatement (Third) creates an enforceable right and a property interest in almost all discretionary trusts that contain a standard. Some states have enacted statute codifying the Restatement (Second) approach that creditors may not attach a beneficiary s interest in a discretionary trust.
Creditor s Claims Some states have not adopted the Uniform Trust Code s authority allowing a creditor to attach a discretionary interest. Solution for estate planners seeking to prevent creditors from attaching an interest in a discretionary trust: Forum shop choose a state that has codified the discretionary trust law under the Restatement (Second)
Conclusion Discretionary trusts have administration issues, tax issues and creditor claims issues There are a number of issues the trustee must consider in making discretionary distributions. The role of a trustee, whether an individual or corporate, of a discretionary trust is not an easy task.