Take-Away: The capacity to execute a non-probate instrument is different than the capacity to execute a Will, which can lead to inconsistent standards that are applied

Background: I recently reviewed a trust instrument where the provision pertaining to the settlor being removed as initial trustee referred to the settlor’s physician determining the settlor’s ‘lack of competency.’ While capacity and competency are frequently used interchangeably, they are not the same. As a medical determination, capacity is found by physicians and psychiatrists, and it is best understood as existing on a continuum. Capacity can range from high to average to low and may vary based on context. Competency is a legal determination that is made by the probate court, which exists as binary- the individual is either competent or is incompetent. 

Capacity to Make a Will: Dementia, standing alone, does not render an individual incapacitated for purposes of making a Will. Most states, including Michigan, hold that proof of a particular illness or condition, like schizophrenia, Alzheimer’s disease, or drug addition, does not preclude the existence of testamentary capacity.

Standard to Determine Capacity: For an individual to possess capacity to make a Will, he/she must understand the nature and extent of his/her property, the natural objects of his/her bounty, and the contents of his/her estate plan. Courts frequently point out that the minimum level of mental capacity required to make a Will is less than that necessary to make a deed or a contract.

Elements of Testamentary Capacity: Testamentary capacity merely requires that the individual  (i) understand the nature of the business in which he/she is engaged; (ii) recall the property he/she means to dispose of; (iii) knows the persons who are the natural objects of his/her bounty; and (iv) knows the manner in which the property is to be distributed between or among them.

Capacity to Make a Contract: According to the Restatement of Contracts [Section 15 (1)(A)] contractual capacity requires the high standard that the contracting individual have the ability to understand the consequences of the transaction. Thus, it is much easier for an individual with cognitive, intellectual, or developmental disabilities to satisfy testamentary capacity than it is to satisfy the capacity standard to execute a contract or a deed.

Higher Contractual Capacity Rationale: The judicial rationale for having a higher capacity requirement for contracts is that it protects individuals who may have cognitive or developmental disabilities from depleting their assets during their lifetime. However, with a Will, it does not impact property until the testator’s death, and thus the testator does not need to be protected from the depletion of his/her asset during lifetime. Apparently, society is not as concerned with a mentally incapacitated individual making bad choices that take effect at his/her death as it is with them making decisions that deplete their assets during lifetime.

Non-probate Transfers: The question then becomes what is the correct standard of capacity to be used when an individual uses a non-probate transfer mechanism like a revocable trust, life insurance, IRA beneficiary designations, or transfer-on-death beneficiary arrangement? While these wealth transfer devices are contract-like in nature, or they are actual contracts, they are frequently called “will substitutes” because they are functionally indistinguishable from a Will. Yet it should come as no surprise that probate courts often diverge on whether to resolve a contest over a non-probate transfer device under either the standard for contractual capacity or for testamentary capacity.

Michigan Trust Code: The Michigan Trust Code is modeled on the Uniform Trust Code, which provides that “the capacity required to create, amend, revoke, or add property to a revocable trust, or to direct actions of the trustee of a revocable trust, is the same as that required to make a will.” [MCL 700.601.] This section thus seems to treat a revocable trust, which may have been intended to avoid probate, i.e., a non-probate transfer device, as a Will and not a contract. It is not so clear cut when it comes to a TOD beneficiary arrangement.

Example: Brad created a revocable trust in which he named his adult children as discretionary beneficiaries along with himself during his lifetime. Brad’s trust instrument provides that upon his death the trust is to terminate and all trust assets are to be distributed to Brad’s children in shares of equal value. Brad has dementia. Brad recently amended his trust to name his ex-wife as an additional discretionary beneficiary of his trust, and an equal ‘outright’ remainder beneficiary with Brad’s children on Brad’s death. Brad also executed a new IRA beneficiary designation in which he named his ex-wife as a beneficiary of his IRA along with his children, entitling her to an equal share of the IRA balance on Brad’s death.

When Brad’s children learn of his trust amendment and his change to his IRA beneficiary designation, the children file an action in the probate court to challenge Brad’s lifetime changes to his trust (assuming that the children have legal standing to do so under state law), seeking to void the amendment in which he named his ex-wife as a discretionary and remainder beneficiary along with his children. Brad children also seek to invalidate the change to his IRA beneficiary designation in which he named his ex-wife as one of the primary beneficiaries along with Brad’s children. Brad’s children assert that Brad lacked the high level of capacity required to make the changes to his trust and IRA beneficiary designation.

Under the Michigan Trust Code, Brad should be able to amend his trust, due to the lower capacity standard the statute authorizes; Brad’s freedom to make testamentary decision if at all possible despite his lower level of capacity. However, Brad’s efforts to change the beneficiary designation of his IRA, a contractual relationship, might be set aside since the higher capacity standard is used with regard to contracts, arguably protecting Brad during his lifetime from depleting his retirement assets. In sum, two separate capacity standards will be used by the probate court to deal with the children’s challenges to Brad’s actions.

Rhetorical Question: If a revocable trust is used as a ‘Will substitute’ then it stands to reason why MCL 700.601 would apply the lighter testamentary capacity standard when adopting or amending the trust. However, sometimes a revocable trust is used for capacity planning, meaning it is used to replace the need for a probate court appointed conservator. If the purpose of the revocable trust is to protect the individual’s assets, via the presence of a successor trustee, while avoiding the publicity attendant to a court appointed conservator, should not the higher contractual capacity standard be applied, if that is the revocable trust’s purpose is so that the settlor does not deplete his/her resources and therefore diminish their quality of life.

Conclusion: Capacity and Competency are not the same, nor are they determined in the same manner. Additionally, there are different standards used to determine an individual’s capacity, with testamentary capacity setting a very low bar, in contrast to contractual capacity which requires proof that the individual understands the consequences of the transaction. Confused yet?