Upjohn Rule Explained

Take-Away: I was recently asked why a provision regularly appears in irrevocable trusts that ties the hands of the trustee in making distributions. I explained that the regularly recurring provision that elicited their question is called the Upjohn provision that is intended to avoid trust assets being included in an individual trustee’s taxable estate. This rule also serves to protect trust assets from the trustee’s personal creditor claims. In an era of free-basing we probably need to reconsider the use of an Upjohn provision in some trusts, if there is no estate tax exposure faced by the individual trustee, along with a corresponding goal to expose trust assets to an income tax basis adjustment on the trustee’s death.

Background: Often trusts are funded with a individual beneficiary designated as the trustee. An example would be grandparents who create an irrevocable trust for the benefit of their son and their son’s children, i.e. the settlors’ grandchildren, with the son named as the trustee whose discretion is subject to an ascertainable standard, e.g. HEMS.

• General Power of Appointment: If the individual trustee/beneficiary has a legal obligation to support another trust beneficiary, e.g. the trustee’s minor children, who are also trust beneficiaries, and that support obligation could be satisfied by a distribution from the trust in the trustee’s discretion, the trustee’s discretionary distribution power is treated as a general power of appointment. This will be the case even if that trustee’s discretion is limited by an ascertainable standard that relates to the health, education or support of the beneficiary. [Treas. Reg. 20.2041-1(c) (2).]
• Tax and Creditor Exposure: If the trustee is deemed to hold a general power of appointment over the trust assets, the value of the trust assets are included in the trustee’s taxable estate on death, and creditors of that general power of appointment holder may access the assets over which the holder can exercise the power of appointment.

Upjohn Provision: An Upjohn provision is intentionally  included in the trust instrument to prohibit the individual trustee from making distributions that would discharge that trustee’s legal obligations of support. Upjohn, 30 AFTR2d 72-5918 (DC Mich 1972.)

• UTC: The Uniform Trust Code, Section 814(b)(2), contains a similar prohibition: “A trustee may not exercise a power to make discretionary distributions to satisfy a legal obligation of support that the trustee owes another person.”
• MTC: Michigan adopted this same rule at MCL 700.7815(3)(b). Note, however, that this is a default rule, which means that a trust instrument can be drafted to expressly disavow the Upjohn rule. [See 700.7105(2), where MCL 700.7815(3)(b) is not mentioned as one of the few MTC rules that cannot be overcome by a trust instrument.]

Grantor Trust: Moreover, trust income may be taxable to the grantor, e.g. the trust is classified as a grantor trust for income tax reporting purposes, if the trustee has discretion to distribute the income for the support or maintenance of a beneficiary who the grantor is legally obligated to support or maintain, and the trustee actually makes such a distribution to that beneficiary. [IRC 677(b).] This legal support obligation is normally associated with distributions to or for the benefit of a minor trust beneficiary, but it can also extend to the legal obligation to support a spouse.

Example Upjohn Provision:  No trustee may (i) make any distribution to or for the benefit of a beneficiary of this Trust that would discharge such Trustee’s legal obligation to support such beneficiary; or (ii) participate in the exercise of any discretionary power to distribute income or principal to or for the benefit of himself or herself, unless it is subject to an ascertainable standard.

Conclusion: An Upjohn provision is normally found in most irrevocable trusts where the trustee is an individual. The purpose of the provision is to minimize the trust assets to federal estate taxation on the individual trustee’s death. If a trust does not contain such a provision, and minor children are trust beneficiaries, it might be wise to decant the trust’s assets to a new trust where the Upjohn provision is added to limit the trustee’s discretion, even when that discretion is already limited to the HEMS standard. If free-basing is the goal, then a decanting of the trust’s assets to a new trust instrument without an Upjohn provision might be warranted, but that seems like a fairly aggressive move in light of the possible exposure to a 40% federal estate tax, if the individual trustee’s death occurs after 2025.