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

22-Jan-20

Ascertainable Standard(s)

Take-Away:  Most of us are familiar with the use of the ascertainable standard , i.e. distributions limited to a beneficiary’s health, education, support or maintenance  (HEMS) used in trusts. As something of a surprise, the HEMS standard appears in three separate provisions of the Tax Code, two that deal with the taxation of the exercise of powers of appointment and a third that deals with regard to the taxation of a grantor trust. While HEMS is commonplace in many trust instruments and used as a limiting distribution directive to the trustee, its source in the Tax Code is for something different from what state common law contemplates.

Background: A power of appointment is treated as a general power of appointment if the power can be exercised in favor of the power holder, his or her creditors, his or her estate, or the creditors of his or her estate. The release of a general power of appointment will be treated as a taxable transfer by the power of appointment holder. If the power of appointment is otherwise limited by an ascertainable standard, then the power holder is not treated has holding a general  power of appointment, and thus the negative transfer and income tax consequences of merely holding such a power are avoided.

Lifetime Power of Appointment- IRC 2514(c) (1):  As a generalization, the exercise of a general power of appointment is deemed a transfer of property by the individual who possesses the power of appointment. Consequently, the lifetime exercise of a general power of appointment is considered a taxable gift by the holder of the power of appointment. However, the definition of a general power of appointment excludes: “A power to consume, invade or appropriate property for the beneficiary or the possessor which is limited by an ascertainable standard relating to the health, education, support or maintenance of the possessor shall not be deemed a general power of appointment.”  [IRC 2514(c) (1).]

  • Example: Decedent establishes a credit shelter trust for the benefit of his widow. The widow is named as trustee and lifetime beneficiary of the credit shelter trust. The widow, as trustee, is considered to hold a general power of appointment over the credit shelter trust. However, if the widow’s exercise of discretion as trustee is limited to making discretionary distributions for her own health, education, support, or maintenance, then she is treated as not holding a general power of appointment over the credit shelter trust. Note, however, if the widow possesses the right to receive all credit shelter trust income, and the widow exercises a lifetime-limited power of appointment over the credit shelter trust corpus, she will be deemed to have made a taxable gift of the value of the income interest in the assets that are appointed by her. Estate of Regester v. Commissioner, 83 Tax Court 1 (1984)..
  • Definition: The Treasury Regulations, after referring to health, education, support or maintenance by the power holder then state: As used in this subparagraph, the words ‘support’ and maintenance are synonymous and their meaning is not limited to the bare necessities of life. A power to use property for the comfort, welfare, or happiness of the holder of the power is not limited by the requisite standard. Examples of a power which are limited by the requisite standard are powers exercisable for the holder’s ‘support’ ‘support in reasonable comfort’, ‘maintenance in health and reasonable comfort,’ ‘support in his accustomed manner of living,’ ‘education, including college and professional education,’ ‘health’ and ‘medical, dental, hospital and nursing expenses and expenses of invalidism.’ In determining whether a power is limited by an ascertainable standard, it is immaterial whether the beneficiary is required to exhaust his other income before the power can be exercised.” [Treas. Reg. 25.2514(b)-(2).]

Testamentary Power of Appointment- IRC 20141(b) (A): If an individual dies holding a general power of appointment over assets, the value of those assets subject to that power of appointment will be included in the individual’s taxable estate, whether or not the power of appointment is actually exercised. This estate inclusion rule with regard to assets subject to a general power of appoint excepts from the definition of a general power of appointment: “A power to consume, invade, or appropriate property for the benefit of the decedent which is limited by an ascertainable standard relating to health, education, support, or maintenance of the decedent shall not be deemed a general power of appointment.” 

  • Example: Decedent was the trustee of a credit shelter trust established by her late husband. She was the sole trustee of that trust and the sole lifetime beneficiary of that trust. The decedent possessed the authority under the credit shelter trust to make discretionary distributions from the trust for her own, health, education, support, and maintenance. On the decedent’s death, she will not be treated as holding a general power of appointment over the credit shelter trust assets. Consequently, the value of none of those credit shelter trust assets will be included in the decedent’s taxable estate. Therefore, those trust assets will not cause any estate tax liability for the decedent’s estate, nor will those credit shelter trust assets receive an income tax basis adjustment on the decedent-beneficiary’s death under IRC 1014.
  • Definition: The Treasury Regulation’s definition of when a  decedent’s power of appointment is not treated as a general power of appointment due to the existence of an ascertainable standard is the same as under IRC 2514(c)(1) reiterated above. [Treas. Reg. 20.2041-1(c) (2).]

Grantor Trust- IRC 674(b) (5):  The settlor or grantor of a trust is not taxed as the trust’s owner if:  (i) such grantor or a nonadverse person (or both) possesses a power to distribute trust corpus to or for a beneficiary or beneficiaries or for a class of beneficiaries (whether or not income beneficiaries), provided the power is limited by a reasonably definite standard that is provided in the trust instrument. [IRC 674(b)(5)(A)]; or (ii) to or for any current income beneficiary, provided that the distribution of corpus must be chargeable against the proportionate share of corpus held in trust for the payment of income to the beneficiary as if the corpus constituted a separate trust. “A power does not fall within this power if any person has a power to add to the beneficiary or beneficiaries or to a class of beneficiaries designated to receive income or corpus, except where such action is to provide for after-born or after-adopted children.” [IRC 674(b) (5).]

  • Reasonably Definite Standard: The Treasury Regulations that explain what is a reasonably definite standard, used to describe when a trust will not be taxed as a grantor trust, is also described as an ascertainable standard which includes the following powers retained by the grantor: the power to distribute corpus for the education, support, maintenance or health of the beneficiary; or for the beneficiary’s reasonable support and comfort; or to enable the beneficiary to maintain his accustomed standard of living; or to meet an emergency of the beneficiary.” [Treas. Reg. 1.674(b)-1(b) (5) (i).] Thus, while reasonably definite standard under this Code section might be viewed as something different from an ascertainable standard, the Regulations say they are the same thing.
  • ‘Comfort’: While the grantor trust Regulation contemplates distributions for a beneficiary’s reasonable support and comfort, the two transfer tax Regulations note that a power of appointed to use property for the comfort of the power holder is not limited by the requisite standard. This discrepancy between the two definitions may be a small matter, or it resolved with the use of the conjunctive and.
  • Precaution: Usually it is better to completely avoid the use of the word comfort when creating an ascertainable standard and make sure that the slightly more permissive grantor trust definition that contains and comfort is not used when the intent is to use the ascertainable standard as a limitation to avoid transfer taxation to the holder of the power of appointment.

Tax Code v. Practice: All of the Tax Code sections that are described above deal with the taxation of the holder of a power of appointment (the trustee) or assigning the taxation of an irrevocable trust’s income. Yet the HEMS standard is commonly used in trust instruments to establish boundaries of the trustee’s discretion to make discretionary trust distributions, even when there are no transfer or income tax implications to the trust’s settlor. By using the HEMS standard, though, the settlor is assured that there will be an objective balance maintained by the trustee between the prevention of discretionary distributions for extravagant purposes by the trust beneficiary, thus jeopardizing the trustee’s duty of impartiality to all trust beneficiary, and meeting the current beneficiary’s actual needs.

HEMS Defined: But what does health, education, support and maintenance actually mean if the Tax Code’s definitions seem to be narrowly defined?

  • Common Law: Unfortunately, the specific definition of each term used within the HEMS distribution standard varies from state-to-state. Each state has its own construction of each HEMS term under its case law.
  • Michigan Trust Code: The Michigan Trust Code (MTC) defines an ascertainable standard as “a standard relating to an individual’s health, education, support or maintenance within the meaning of section 2041(b) (1) (A) or 2514(c) (1) of the Internal Revenue Code.” [MCL 700.7103(b).] Consequently, the MTC definition is not much of a guide as it refers back to the Tax Code.
  • This definition is also used with regard to a power of withdrawal under the Michigan Trust Code- “Power of withdrawal means a presently exercisable general power of appointment other than a power that is either of the following: (i) exercisable by a trustee and limited by an ascertainable standard.” [MCL 700.7103(f) (i).]
  • An ascertainable standard also appears when the Michigan Trust Code provides the following limitation: “A person other than a settlor who is a trust beneficiary and trustee of a trust that confers on the trustee a power to make distributions pursuant to a discretionary trust provision to or for the trustee’s benefit may exercise the power only in accordance with an ascertainable standard. [MCL 700.7815(3) (a).] The Reporter’s Commentary to this section notes that this statutory limitation is intended to ensure that a general power of appointment for transfer tax purposes has not been inadvertently created.
  • Restatement (Third) of Trusts: If some objective standard is desired when a trustee is to follow a HEMS discretionary distribution standard, then it might be helpful for the trust instrument to direct the trustee to refer to the Restatement (Third) of Trusts (2003) and in particular Section 50, when guidance is sought as to the settlor’s intent behind the use of the HEMS distribution standard. That Section provides essentially three separate categories of what is generally included within a HEMS distribution directive: (i) what is generally included; (ii) what might be included:  and (iii) what is expressly not included within a HEMS distribution directive. Examples from the Restatement follow:
  • Generally Included: Regular mortgage payments; property taxes; health insurance; maintenance of existing life and property insurance; continuation of existing pattern of vacations; continuation of family gifting patterns; and continuation of charitable gifting patterns.
  • Might be Included:  Reasonable additional comforts or luxuries; and special vacations that the trust beneficiary has never taken before.
  • Expressly Excluded: Payments unrelated to support, which merely contribute to the beneficiary’s contentment or happiness; distributions that enlarge the beneficiary’s personal estate; and distributions that enable the beneficiary to make extraordinary gifts.

Conclusion:  A HEMS distribution standard is commonly used in many trust instruments. However, its origins are derived from the Tax Code’s use of an ascertainable standard, which provides a narrow interpretation to those four (actually three if we ignore maintenance) words. The Michigan Trust Code’s definition of HEMS only relies on the Tax Code’s narrow definitions. Either a trust instrument should provide its own definitions, or examples, to guide the trustee, or the trust instrument should direct the trustee to refer to the Restatement (Third) of Trust’s more expansive examples to guide a trustee.