Discretionary Trusts: What to Look For

Take-Away: When you review a proposed discretionary trust, there are several key provisions or definitions to look for when you conduct that review to avoid second-guessing the settlor’s intent. A trust’s discretionary distribution provision should give clear guidance to the trustee when asked to make a distribution, while at the same time clearly identify the settlor’s intent when beneficiaries are not to have enforceable rights with regard to distributions. If the trust’s discretionary distribution provision does not address both of these concerns, then the drafting attorney should be asked by the trustee to amend the provision to add a clear expression of the settlor’s intent which will give the trustee true insight into the scope of its discretionary distribution power.

Background: Trust officers will continue to review more and more discretionary trusts when asked to serve as the professional fiduciary of that trust instrument. They can expect to see more discretionary trusts due to changes in the law (tax and creditor protection), and in-vogue trust strategies that include the Michigan Qualified Dispositions in Trust Act (asset protection), spousal lifetime access trusts (SLATs), and the prevalence of dynasty-type trusts that are designed to avoid federal estate and generation skipping transfer taxation for multiple generations of family members. The inherent problem often stems from the fact that attorneys draft trust instruments, but they do not administer the trusts that they draft, such that there is often a disconnect between the words used in the trust instrument and the day-to-day reality of that trust’s administration.

Discretionary Trust Provision: The Michigan Trust Code provides an expansive definition of this term:

“..means a provision in a trust, regardless of whether the terms of the trust provide a standard for the exercise of the trustee’s discretion and regardless of whether the trust contains a spendthrift provision, that provides that the trustee has discretion, or words of similar import, to determine 1 or more of the following:

Whether to distribute to or for the benefit of an individual or a class of beneficiaries the income or principal or both of the trust.
The amount, if any, of the income or principal or both of the trust to distribute to or for the benefit of an individual or a class of beneficiaries.
Who, if any, among a class of beneficiaries will receive income or principal or both of the trust.
Whether the distribution of trust property is from income or principal or both of the trust.
When to pay income or principal, except that a power to determine when to distribute income or principal within or with respect to a calendar year or taxable year of the trust is not a discretionary trust provision if the distribution must be made. [MCL 700.7103(d).]

When a trust is determined to be a discretionary trust, it is not as a consequence a support trust, which is defined at MCL 700.7103((k). However, these statutory definitions do little to help the trustee ascertain the settlor’s actual intent as to the scope of the trustee’s discretion to administer the trust. When a trust instrument is reviewed, considerable attention needs to be given to the discretionary distribution provisions and corresponding definitions, if any, so that the trustee clearly understands how that provision should be interpreted and implemented consistent with the settlor’s purposes that led to the creation of the trust. [Restatement (Third) of Trusts, Section 50(2) (2012).] This effectively means that the words used by the settlor in the trust instrument will be construed in accordance with their normal usage. But as noted earlier, lawyers, not settlors, usually draft the trust instrument. [“Notwithstanding any other provision to the contrary,” or “hereinbefore” or “ henceforth” or “to wit” are not normal.]

Trustee’s Exposure to Liability: You will recall that the Michigan Trust Code makes it clear that despite the use of such terms as absolute, sole, or uncontrolled discretion, a trustee will be found to have abused its discretion in its exercise or its failure to exercise a discretionary power if the trustee fails to exercise its judgment in accordance with the terms and purposes of the trust instrument. [MCL 700.7815(1)(c).] Which then leads to several questions surrounding the words that are used in a trust instrument and which reveal the settlor’s purposes for creating that trust.

Questions to Ask Yourself When You Review a Trust Instrument:

Definitions: Does the trust instrument contain definitions of key words used in a discretionary distribution provision, like health (does this include cosmetic surgery?) or education (does this include computers and software, travel to and from college, or studies or sabbaticals abroad?) or need (does this word implicitly include ‘only after all other available resources have been exhausted by the beneficiary’) or necessary (is this restricted to unexpected emergencies?)
Material Purpose Clause: Often trust instruments do not contain a statement of the settlor’s material purposes why he/she created the trust, despite the prevalence of that terminology and concept periodically appearing in the Michigan Trust Code. [Examples: MCL 700.7111(2) nonjudicial settlement agreement must not defeat a material purpose of the trust; or 700.7411(1)(a) a judicial modification cannot alter a trust’s material purpose.] When you read the trust instrument and its discretionary distribution provisions, can you clearly identify the settlor’s material or even primary purpose with regard to the trust? Can minor purposes, e.g. avoid probate, hedge against future addictions, protect an inheritance from a divorce, be distinguished from material purposes, e.g. deal with a child’s spendthrift tendencies?
Internal Inconsistencies: Often a trust instrument, which is to be considered as a whole, will contain internally conflicting provisions. This results when a mandatory direction is used in conjunction with a discretionary distribution provision. Example: “The Trustee shall distribute to my daughter so much of the net income and/or principal of her trust share as the trustee, in the trustee’s sole and absolute discretion, determines necessary for my daughter’s health, support and maintenance..” With this simple provision we are faced with a mandatory directive shall that is coupled with an advisory delegation sole and absolute discretion, which advisory delegation, in turn, is then curtailed by the term
Statutory Presumptions: Much of the Michigan Trust Code applies to a trust instrument if the trust instrument is silent on a technical point or question, meaning the Michigan Trust Code provides a default set of rules that will apply when the trust instrument is silent. The Michigan Trust Code is in large measure based on the Uniform Trust Code which, in turn, took many of its provisions from the Restatement (Third) of Trusts. That Restatement cites a presumption that when a trustee exercises its discretion to make a trust distribution, the trustee should take into consideration other financial resources then available to the trust beneficiary who seeks the distribution. [Restatement (Third) of Trusts, Section 50, comment e., which is a reversal from the position taken in the Restatement (Second) of Trusts.] How many settlors’ are aware of, or agree with, this presumption that the trustee must take into consideration the trust beneficiary’s other available financial resources? Does this obligation imposed on the trustee include the use of non-financial resources, or the ability to access illiquid resources of the beneficiary like obtaining a second mortgage on the beneficiary’s home equity? Should the trustee consider the beneficiary’s personal and economic circumstances prior to making a discretionary distribution, like the number of children the trust beneficiary then has in college, even though there is no legal obligation to support those children?
Multiple Beneficiaries of the Same Trust: With a dynasty-type of trust, often there are multiple beneficiaries who are potential distributees of the same trust. Example: “The Trustee may pay to or for the benefit of my child or my child’s descendants such amount of trust income or principal as the trustee, in its sole and absolute discretion, deems advisable.” While there are no conflicting mandatory and advisory powers in this authorization, does the trustee know if a child is to be given priority over the child’s descendants when the trustee makes a discretionary distribution? Under what circumstances should a distribution be made by the trustee to the child’s descendants? Is there an expectation that all trust beneficiaries of the same trust will be treated equally, effectuated when and through an implied advancement when the trust finally terminates, or is the trustee authorized to treat trust beneficiaries unequally?
Standard of Living: When the trustee is directed to make distributions consistent with the beneficiary’s accustomed standard of living beneficiary’s, is that concept defined anywhere in the trust instrument, or a benchmark that is provided to measure that standard, or when that standard of living is to be identified? If that concept is not defined in the trust instrument it will be presumed to be at the time when the trust became irrevocable, e.g. the settlor’s death, not when the trust was signed by the settlor. [Restatement (Third) of Trusts, Section 50, comment d (2).] Is that what the settlor wants?
Tax Consequences: The trustee will normally take potential tax consequences into account when it exercises its discretion in making a distribution from the trust. But whose tax consequence is to be considered? The beneficiary’s or the trust’s or the trust’s remainder beneficiaries?

Letters of Wishes: While it is easy to say that if the trust instrument is weak in the level of guidance that it provides to the trustee in the exercise of its discretion, the trustee should feel free to contact the drafting attorney to seek greater clarity in the trust instrument. But the reality is that when it is submitted to the trustee, the trust instrument will already be signed by the settlor and the trustee will be expected to simply sign the Acceptance of Trust ‘as is’ and not attempt to alter its terms. In that situation the trustee should request a non-binding letter of wishes from the settlor to assist the trustee. [ Restatement (Third) of Trusts, Section 87.] But even a letter of wishes can be problematic if it contains inconsistencies, it conflicts with the trust instrument, or a dispute arises when trust beneficiaries demand copies of that letter of wishes which is not, technically speaking, susceptible to the trustee’s duty to communicate and furnish information with regard to the trust’s administration.

Conclusion: Without clear guidance from the trust instrument, a trustee may be reluctant, at least without the protection of a probate court authorization, to make liberal trust distributions if the settlor’s purposes and intended scope of discretion given to the trustee are not clear. In that situation its more likely a conservative distribution will be made by the trustee, but such a conservative approach to the trust and its administration may not be consistent with the settlor’s intent that the beneficiary to whom the settlor intended the trust to be most generous. Exercising discretion is a challenge all by itself. An ambiguous trust instrument, or one that is internally inconsistent, impedes the trustee’s administrative responsibilities even more. While both trustee and drafting attorney serve the same individual, the trustee should not be reticent to ask the drafting attorney for clarification, examples, or detailed definitions to assist in the administration of a discretionary trust.