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George F. Bearup, J.D. Senior Legal Trust Advisor

1-Aug-18

Qualified Dispositions in Trust Act Ambiguity – Caution on the Settlor’s Retained Powers

Take-Away: If an individual considers the adoption of a Qualified Dispositions in Trust, aka Michigan’s version of an asset protection trust, the trust instrument may need to restrict the settlor’s retained rights to only direct trust investments or veto trust distributions among the other rights that the settlor may retain in their qualified dispositions trust.

Background: While Michigan adopted the Qualified Dispositions in Trust Act in 2017,  few trusts have been adopted since its arrival. It is possible, however,  that many preexisting irrevocable trusts have been decanted to convert those trusts to qualified dispositions trusts to protect the trust beneficiaries. A qualified dispositions trust is a stark departure from Michigan’s common law that prohibited a self-settled spendthrift trust to shelter assets from the settlor’s creditors. As such, it must adhere to all statutory formalities and limitations.

Requirements: There are only a few requirements to establish a Michigan qualified disposition trust: (i) the trust must be irrevocable; (ii) the trust must be subject to Michigan law; (iii) someone other than the settlor must be the independent trustee; and (iv) the trust must include spendthrift language that is specified in the Act which includes a restriction on transfers as contemplated by Section 541(c)(2) of the federal Bankruptcy Code in order to shield the assets held in the trust from creditors.

Settlor’s Retained Rights: A settlor who creates and transfers assets to a Michigan qualified dispositions trust can retain several rights in the trust while still protecting those assets from the settlor’s future creditors. The rights or powers that a settlor can retain in a Michigan qualified dispositions/asset protection trust include the following:

  • The power to direct the investment decisions. MCL 700.1044(2)(a);
  • The power to veto a distribution from the trust. MCL 700.1044(2)(b);
  • The right to exercise a testamentary limited power of appointment over the trust’s assets,  exercised on the settlor’s death. MCL 700.1044(2)(c).
  • The right to receive income from the trust, i.e. the ability to receive discretionary distributions made by the trustee. MCL 700.1044(2)(d).
  • The right to receive income or principal from a charitable remainder annuity (a CRAT) or unitrust (a CRUT). MCL 700.1044(2)(e).
  • The right to receive income or principal from a grantor-retained annuity trust (a GRAT). MCL 700.1044(2)(f).
  • The right to withdraw, annually, up to 5% of the initial value of the trust’s property. MCL 700.1044(2)(f).
  • The  right to receive or use of trust principal, but only if the potential or actual receipt or use of the trust asset by the settlor is the result of the trustee’s discretion; MCL 700.1044(2)(g).
  • The right to remove a trustee. MCL 700.1044(2)(h).
  • The right to use real property if it is held in a qualified personal residence trust (a QPRT.) MCL 700.1044 (2)(i).
  • The use of trust income or principal to pay the income taxes due on the trust’s income, e.g. it is a grantor trust for income tax reporting purposes on which the settlor must otherwise pay the income taxes. MCL 700.1044(2)(j).
  • The trustee may also use trust assets to pay the settlor’s estate administration expenses, and any estate or inheritance tax imposed on the settlor’s estate caused by the value of the trust’s assets included in the settlor’s estate. MCL 700.1044(2)(k); and
  • The settlor’s actual or potential receipt of required minimum distributions from retirement benefits that are paid to the trust. MCL 700.1044(2)(l).

While that is an impressive list of rights or powers that the settlor is authorized to retain in a qualified dispositions trust, a few misstatement of a couple of retained powers could end up being a trap for the settlor, caused by ambiguities in the Qualified Dispositions Trust Act definitions. Since the Act is a stark departure from Michigan’s common law, most courts will interpret its  provisions narrowly and require strict adherence to what the statute requires and what it permits in order to protect assets from creditor claims.

Statutory Ambiguities: Most individuals who establish a qualified dispositions in trust will want to retain as much control over the assets as possible. This retained control normally extends to controlling investment decisions of the trustee and controlling the trustee’s distributions from the trust. Unfortunately,  the Act creates confusion when it applies statutory definitions to the manner of the settlor’s control over trust investments and distributions.

Investment Decisions: As indicated above, the Act permits the settlor to retain ‘the power to direct investment decisions of the trust.’ MCL 700.1044(2)(a). The confusion comes when the Act provides a definition of advisor and the requirements for a qualified disposition.

Advisor: Advisor means a person who is given authority by the terms of a trust instrument to remove, appoint, or both, 1 or more trustees to direct, consent to, approve, or veto a trustee’s actual or proposed investment or distribution decisions. A person is considered an advisor even if the person is denominated by another title, such as trust protector. Any person may serve as advisor. MCL 700.1042(a).

Qualified Disposition:  A disposition is NOT A QUALIFIED DISPOSITION if a transferor [settlor] or any person that is related or subordinate to the transferor [settlor] within the meaning of section 672(c) of the Internal Revenue Code may act as an advisor. For the purposes of this subparagraph, act as an advisor does NOT INCLUDE THE POWER TO DIRECT THE INVESTMENT DECISIONS OF THE TRUST, THE POWER TO VETO A DISTRIBUTION FROM THE TRUST, OR THE RIGHT TO REMOVE A TRUSTEE OR ADVISOR AND TO APPOINT A NEW TRUSTEE OR ADVISOR. (Emphasis in CAPITAL letters.) MCL 700.1042(p)(iii).

Restated, the settlor or someone related to the settlor cannot act as an advisor of the trust, other than with regard to the three excepted powers- direct investments; veto distributions; remove a trustee.

By combining the definition of advisor and the limitations under qualified dispositions the settlor and persons related to the settlor may only retain the power to direct  investment decisions. Thus, if the settlor is to retain any power over investment decision, the trust instrument should provide that the settlor may direct the investment decisions of the trustee; do not  give to the settlor the power to consent, approve or veto the trustee’s investment decisions.

Distribution Decisions:  The Act permits the settlor to retain the power to veto a distribution from the trust. MCL 700.1044(2)(b.) But with the Act’s definitions of advisor and qualified disposition [see above], a combined reading of the two definitions means that the settlor, and those who are related or subordinate to the settlor, may veto a distribution; do not  give to the settlor the power to direct, consent or approve distribution decisions made by the trustee.

Rule of Thumb: While the temptation may be to combine in the Michigan qualified dispositions trust instrument the power to both ‘veto and direct’ in the same authorized retained powers by the settlor, they are not the same: the settlor may only (i) retain the power to direct investments, and (ii) veto trustee distributions.

Conclusion: While this recommendation may seem to be overly cautious, most judges when first confronted with a Michigan qualified dispositions trust are more likely to remember what they learned in law school, which is that Michigan does not permit a self-settled asset protection trust. The Qualified Dispositions in Trust Act is a radical departure from Michigan’s long-standing common law and public policy. It would not surprise me if a trial judge went out of his/her way to find that the statute, and what it permits, was not ‘followed to the letter’, with the result that the spendthrift protections intended by the Act will be ignored by a court.  In sum, stick with the exact language required by the statute to make sure that the asset protection trust will be respected by the courts.