Discretionary Distribution Terms – Redux

Take-Away: A helpful reminder is that state law determines a property interest, while the federal law determines how to tax those property interests. Words used in the Tax Code may have a much different meaning when those same words are used in a trust’s discretionary distribution provision.

Background: Considerable time is spent looking that the words and definitions that are used in the Tax Code and its Regulations. Sometimes we are hung up on what those words mean, well beyond their tax implications, when we start looking at the scope of a trustee’s discretion. It is important to remember that the words used in the Tax Code may not have the same meaning as the words used in a trustee’s discretion to make distributions from a trust. Key points behind this principle include:

State law determines property rights and interests.

Federal law determines how to tax those state-created property rights and interests. United States v. Rogers, 461 U.S. 677 (1983).

It is state law, not the Tax Code that will be used to interpret the language of a trust instrument.

The Tax Code and its Regulations will be used only to determine how the tax laws apply to the property interests that the trust’s language creates or the interest that is transferred.

The definitions of the property interests created will usually be found in the state’s common law.

A fairly recent Michigan Court of Appeals decision found that the probate judge properly examined traditional dictionary definitions of the word health and found health to include such concepts as mental health, and the health of one’s mind and spirit and even their However, that appellate Court panel was unwilling to extend that concept of health to “anything that makes a person ‘feel good.’” In re Brooks, 2014 Mich App. LEXIS 2046 (2014).

Ascertainable Standard: Surprisingly, the ubiquitous health, education, support, and maintenance (HEMS) standard that is used in many trust instruments finds its origins in Tax Code with regard to the taxation of powers of appointment and grantor trusts. A trustee is treated as holding a general power of appointment over trust assets for transfer tax purposes if the power may be exercised for the trustee’s direct and or indirect benefit. Yet the transfer by the power holder, i.e. the trustee, will not be treated as a taxable transfer if that power is restricted by an ascertainable standard relating to the health, education, support or maintenance of the power holder. Accordingly, if the trustee is also a trust beneficiary, it is customary to see the ascertainable standard used to prevent the taxation of trust assets in the trustee/beneficiary’s estate. That said, the same HEMS ascertainable standard is regularly used in trusts when the trustee is not, and never will be, a trust beneficiary.

Powers of Appointment: These statutory definitions of powers of appointment, both found in IRC 2041 (b) (estate taxes) and IRC 2514 (c) (gift taxes) are identical. They have the same meaning when it comes to defining HEMS as an ascertainable standard. [Reg. 20.2041-1(c) (1) and 25.2514-1(b) (1) and Revenue Ruling 75-351, 1975-2 CB 368.]
Definitions: As an additional surprise, one would assume that if two separate Tax Code sections expressly refer to health, education, support and maintenance as an ascertainable standard used to prevent a power of appointment holder from paying gift, estate or GST taxes, that the Regulations would contain exhaustive definitions and helpful definitions.
Health: Neither in the Regulations [20.2041-1(c) (2)] nor the Restatement (Third) of Trusts, Section 50, comment (d) (3) define the term health or give any examples.
Education: Similarly, the Regulations do not define the term The Regulations only state that education is an ascertainable standard. In regard to education, the Restatement at least provides some guidance, stating: “education usually means the payment of living expenses, fees, and other costs of attending an institute of higher education.” [Restatement (Third) of Trusts, Section 50, comment (d) (3).]
Maintenance: Surprisingly, the Treasury Regulations expressly say that maintenance is synonymous with support, which redundancy is repeated in thousands of trust instruments each year.
Support: The Regulation’s only helpful guidance is the observation that with a “support or maintenance standard, their meanings are not limited to the basic necessities of life.” [Regulation 20.2041-1(c) (3); Restatement (Third) of Trusts, Section 50, comment d (2).]

Practical Observations: Since federal law, as indicated by the Regulations, does not provide much guidance to interpret the ubiquitous HEMS ascertainable standard, a trust instrument should include its own definitions of health, education, and support (overlooking maintenance as a ‘redheaded stepchild’) to explicitly reflect the settlor’s intent when the HEMS standard is used. In addition, the settlor should be prepared to include additional definitions in the trust, using some of the following questions to better identify the scope of the single word used:

Does support mean that the trust beneficiary is entitled to distributions sufficient to support the beneficiary himself and also his spouse and minor children?
If support extends to the beneficiary’s family members by association, they are not technically beneficiaries of the trust. Should they be considered beneficiaries, or merely relevant factors used by the trustee to determine the amounts required to maintain the designated beneficiary in his accustomed standard of living?
Does education indicate the level of education intended, and whether other types of training, or other types of broadening experiences, e.g. an exchange student, are to be included?
If distributions are for a beneficiary’s education, how long should those educational benefits continue?
Does a distribution for the beneficiary’s education contemplate distributions directly to the educational provider, rather than directly to the beneficiary himself?
Does education mean the payment of living expenses, fees, and other costs of attending an institute of higher education, including computer hardware and software?
Does support mean the beneficiary’s normal living expenses, or is support expansive enough to cover accustomed patterns of behavior, like annual vacations, gifts, and expenses related to the maintaining the beneficiary’s accustomed standard of living?
Does health mean expenditures only to address emergency situations?
Does health include non-necessary medical expenditures, e.g. face-lifts; tattoo removal expenses; liposuction,?

Conclusion: If individuals (or more likely their attorneys by habit) continue to use the HEMS ascertainable standard in trusts, they need to be encouraged to provide detailed definitions, if not examples, in the trust instruments to guide the trustee administering a discretionary trust. In the absence of helpful definitions, the trustee may not know exactly what those terms mean, and which could cause some uncertainty (and delay) with regard to the circumstances under which the trustee may exercise discretion to make the distribution.