Trust Distribution Standards May Be Very Broad

Trust distribution standards may be very broad. In fact, the trustee could be given the authority to distribute to the beneficiary in the trustee’s sole discretion. This type of discretionary trust can provide asset protection if the trustee isn’t the beneficiary. However, if the beneficiary is the trustee, it would subject the trust assets to the beneficiary/trustee’s creditors (at least in most states). It would also cause inclusion in the beneficiary/trustee’s taxable estate. After all, the trustee would have a “general power of appointment” under Section 2041 of the IRC because the trustee could appoint the assets to themself as beneficiary. Conversely, if the beneficiary isn’t the trustee, they’d have no way to force any distributions by the trustee, which is why such a trust typically provides asset protection. Typically, a creditor stands in the shoes of the debtor.

However, the regulations to Section 2041 carve out an exception when the trustee is acting under an “ascertainable standard.” Certainly, if the trust mandated the trustee to distribute $1,000 per month to themself as beneficiary, that would not be a general power of appointment because it would be “ascertainable.” However, the limits of ascertainability are far broader.

Treas. Reg. 20.2041-1(c)(2) provides “a power is limited by [an ascertainable] standard if the extent of the holder’s duty to exercise and not to exercise the power is reasonably measurable in terms of his needs for health, education, or support (or any combination of them).” The regulation goes on to provide that the terms “support” and “maintenance” are synonymous. Many trusts are drafted with this “safe harbor” language from the regulations, “health, education, maintenance and support,” sometimes referred to as the “HEMS” standard. While the HEMS standard is an ascertainable standard according to tax law, it’s still very flexible and it’s difficult to say exactly what is required. But, it would allow a beneficiary to go to court to enforce the standard.

Let’s look at a typical example of the difference between a fully discretionary standard and a HEMS standard. Mary is the trustee of a trust and John is the beneficiary. If the trust provides for Mary to make distributions to John in her sole discretion, she would not be required to distribute anything to John. On the other hand, if the trust provides a HEMS standard, then Mary would need to make distributions to or for John’s benefit at least for a minimum level. But, Mary could decide to provide that minimum or more. For example, Mary could determine that John only needs a studio apartment in a working-class neighborhood. Conversely, she could determine John needs a larger home in a nicer neighborhood. Mary would have a similar level of discretion in other areas, as well. She could distribute enough for John to scrape by or enough for him to live more comfortably.

A HEMS standard, while ascertainable, isn’t specific. It provides a range in which the trustee may operate. If a dispute arose over the limits of that range, the court would be the final arbiter.

More to follow . . .