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Estate Planning Shades of Grey

Estate Planning Shades of Grey

Giving discretion to a trustee may be more complicated than you think

Trustee discretion is given for the best of purposes: to provide flexibility in addressing changing needs and situations of beneficiaries.  But, given in a variety of circumstances and expressed in a variety of ways, discretion has as many shades of meaning as there are shades of grey, with consequences to boot.


Types of Discretion

Consider the most common types of discretion given to trustees. 

First, a trustee may be: (1) directed to distribute income to the beneficiary, or (2) given discretion to pay income to the beneficiary or to accumulate it.  Immediately, for income tax purposes, this distinction renders the trust either as a “simple” trust under Internal Revenue Code Section 651, or a complex trust under IRC Section 661. 

Second, a trustee may be given discretion to distribute trust principal to a beneficiary.  Often, power to invade principal is given to provide for “health, education, maintenance and support,” known as the HEMS standard. HEMS is recognized as an “ascertainable standard” for federal estate and gift tax purposes, as described at IRC Section 2041(b)(1)(A), on the basis that a state court can determine the amounts required to be distributed.  Or, discretion may be given to invade principal for broader purposes, such as general welfare.   Typically, giving trustee discretion to invade for only HEMS or for general welfare won’t change the estate and gift tax treatment of the trust.


If Beneficiary is Trustee

When the beneficiary is a trustee, these powers over income and principal may create significant differences in the tax treatment of the trust.  If the beneficiary/trustee has the power to accumulate income or to distribute it to himself, then the portion of the trust attributable to the accumulated income will be treated as a grantor trust vis-à-vis the beneficiary under IRC Section 677.  And if the beneficiary has a discretionary power to distribute principal to himself not limited by an ascertained standard of HEMS, the trust will be included in his estate under IRC Section 2041. 

Still, having a beneficiary act as a sole or a co-trustee can be very useful for many reasons. To avoid the adverse estate tax consequence of Section 2041, many states have adopted statutes that limit a beneficiary/trustee from making any distributions to himself for a purpose other than HEMS, avoiding at least the estate tax issue under Section 2041.


Grantor Trust Status

Discretion may intentionally be given to create desired tax consequences, such as grantor trust treatment for property gifted during lifetime, so that the grantor/donor may enhance the value of the gift by continuing to pay income taxes on the property transferred.  Common provisions used to create grantor trust status include authorizing the donor/grantor to substitute property of equivalent value or to borrow at adequate interest but without adequate security.  Giving a trustee who has no beneficial interest in the trust, a so-called “non-adverse” trustee under IRC Section 672, power to add a beneficiary to the trust will also result in grantor trust status under IRC Section 674. 

If the donor/grantor acts as trustee and has certain powers over the timing or the allocation of distributions to and among beneficiaries, grantor trust status will also result under Section 674.  Because such powers are also likely to result in an incomplete gift under Treasury Regulations Section 25.2511-2 or estate tax inclusion under IRC Section 2036 and Section 2038, a donor/grantor typically doesn’t hold such powers as a trustee.  However, for grantor trust purposes, a grantor is deemed to hold any powers held by a spouse.  If the grantor’s spouse as trustee holds a discretionary power to accumulate or pay income to a beneficiary after attaining age 21, the discretion results in grantor trust treatment for income tax purposes under Section 674.  If the goal is to avoid grantor trust status, then discretion must be limited by requiring that the fiduciary accounting income of the trust be distributed to the beneficiary during lifetime or at his estate at death.  (Treas. Regs. 1.674(b)-1(6)(i)(a)).


Grantor’s Income Taxes

Grantor trust status raises the further issue of who pays the income taxes on the trust’s income.  If the trustee’s discretion includes power to pay the grantor’s income taxes, then the property may be subject to estate taxes on the death of the grantor on the grounds that the ability to satisfy a debt of the grantor renders the trust subject to the claims of the grantor’s creditors.  However, if state law precludes creditors from being able to claim the trust assets as a result of this discretionary trustee power, then the trust will avoid estate tax inclusion.  (Revenue Ruling  2004-64).  Several states, including New York, Florida and New Jersey, have adopted statutes limiting the rights of creditors so that trustees may be given this discretion without risk of estate tax inclusion.  (See N.Y. E.P.T.L. Section7-3.1 (d)).


Importance of Language Used

The language used to create discretion not only has an impact on tax consequences, but also on the rights and claims of parties interested in the trust.  When the governing document states that the trustee “shall” distribute principal to provide for HEMS, the language may be construed as a direction requiring that distributions be made, even when discretion is given to determine the actual needs for health, education maintenance and support.  To make clear the discretionary nature of the trustee’s authority, the use of the permissive “may” is preferable.

Grantors may also set forth factors to be considered in exercising discretion, such as the other resources available to the beneficiary or the preference of one beneficiary to the exclusion of any one or more other beneficiaries, either current or future.  The authority may be stated to extend to the termination of the trust, because it’s no longer practical to continue because of its size or the lack of tax benefits or for no specific reason set forth in the trust instrument. 

Broad discretion to invade trust principal may also be relied on to decant trusts into new trusts for the same beneficiaries, with more desirable provisions, either under the common law of the seminal Phipps case in Florida, or statutory authority in states like New York, N.Y.E.P.T.L. Section10-6.6(b).


Limits on Discretion

Discretion may also be expressed in extended terms, such as absolute or uncontrolled.  While such expressions may encourage deference by courts to determinations made by trustees, discretion necessarily has its limits.  It can’t go so far as to authorize irresponsible or unreasonable behavior.  The grant of discretion can’t vitiate the basic duties of a trustee to invest and distribute the trust res in the nature of an exoneration clause.  In all events, the trustee is required to remain accountable.  (See Restatement (Third) Trusts, Section 50, Comment c).


Grantor’s Intent

The greatest protection for trustees and beneficiaries alike in avoiding differences over the scope of discretion and the manner of its exercise lies in the expression of the grantor’s intent.  (See generally, Restatement (Third) Trusts, Section 49).  The more thoroughly expressed the intent in creating discretion, the more likely that discretion will be exercised for the purposes it was created.         



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