Discretionary Trusts: Providing Guidance to the Trustee

Take-Away: Trusts that give the trustee the discretion to spray income among a group of trust beneficiaries is a highly flexible tool in which to reduce that income’s exposure to high federal income tax rates imposed on irrevocable trusts. That extraordinary flexibility can, however, cause tension for both the trustee and among trust’s beneficiaries. Clearly describing what factors the trustee must, or should, take into account in making discretionary distributions of trust income will help to mitigate that tension.

Background: Current popular estate planning strategies include dynasty trusts designed to avoid federal estate taxation over multiple generations, with multiple trust beneficiaries, and discretionary income spray or sprinkle trusts among multiple current beneficiaries which is designed to avoid excessive federal income taxes otherwise faced by the trust.

Income Spray Provision: An income spray provision is designed to avoid income accumulating in an irrevocable trust. Income that is distributed to trust beneficiaries is taxed to the trust beneficiary and not the trust. Trust income that is accumulated and not distributed is taxed at the 37% federal income tax rate in excess of $10,950 a year. Additionally, undistributed trust income will probably be exposed to the 3.8% net investment income tax. Add to those tax rates state income taxes, and it is possible for a trust to be paying a combined income tax rate around 45% on undistributed income. By distributing income to a trust beneficiary who is in a low, or no, marginal income tax bracket avoids the confiscatory federal income tax rate(s) otherwise faced by the trustee.

Trustee Tension: While an income spray provision might appeal to individuals who like simplicity of such a trust e.g. one family, one document, one trust instrument with the trustee paying close attention to all the trust beneficiaries’ needs, such a trust is not simple for a trustee to administer. The trustee has a fiduciary duty of loyalty to all trust beneficiaries, not to mention a fiduciary duty of impartiality to both the current and the remainder trust beneficiaries. The trustee’s duty of loyalty also requires, though, that the trustee avoid unwarranted disclosure of information acquired in the course of the fiduciary relationship, particularly when the trustee knows, or should know, that disclosure would be detrimental to a beneficiary. Restatement (Third) of Trusts, Section 78 (comment i.) Consequently the trustee has a balancing act to contend with, treating all trust beneficiaries fairly and honestly, while arguably expected to hold back from all beneficiaries sensitive matters associated with regard to just one trust beneficiary.

Duty of Impartiality:  The Michigan Trust Code provides: [T]he differing interests for which the trustee must act impartially include those of the current beneficiaries versus those beneficiaries holding interests in the remainder and among those currently eligible to receive distributions. [MCL 700.7803.] See also Restatement (Third) of Trusts, Section 79.

Waiver: The duty of impartiality can be expressly waived in a trust instrument under the Michigan Trust Code, but not the trustee’s duty of loyalty, for which a trustee cannot be excused. [MCL 700.7105.]

Beneficiaries Tension: One of the practical problems with a trust’s income spray provision is that it often does not address what a trustee must consider in the exercise of the trustee’s discretion to make a discretionary distribution of income.

Multiple Ages: More to the point, many irrevocable trusts might have multiple generations of trust beneficiaries, e.g. a discretionary income spray credit shelter trust is established for a surviving spouse and the settlor’s descendants, where the widow is age 93, her children are ages 72 and 70, her grandchildren are ages 50 and 45, and her great grandchildren are in their 20s, all with different needs, means, and lifestyles.

Multiple Families: Consider the current phenomena of children from multiple marriages as the pool of current beneficiaries of a discretionary trust, e.g. the settlor describes the current trust income beneficiaries to whom distributions may be made as ‘my descendants.’ These age differences, or step-sibling relationships arising from blended families, all tend to promote tension among the trust beneficiaries who may bring with them resentments from their parent’s failed marriage to their other parent.

Duty to Communicate and Inform: The trustee’s duty to annually report to the trust beneficiaries with regard to the distributions made from the trust can also result in tension. In the absence of silent trusts in Michigan (so far, but the Probate and Estate Planning Council is looking at some form of silent trusts) most current trust beneficiaries will be made aware of the amount of distributions made to other trust beneficiaries, which can lead to resentment or friction among them and sometimes anger with the loss of an expection of privacy when the purpose for a discretionary distribution is made known to others.

Facilitating the Trustee’s Trust Administration: Some provisions can be added to a trust income spray provision to assist the trustee to deal with these inherent tensions.

1. Waiver of Impartiality: If the settlor intends that one current beneficiary’s needs will take priority over other current beneficiaries’ needs, then that should be expressly stated.

Example: In making discretionary income distributions under this trust, the trustee shall first make whatever distributions are necessary to meet the health and support needs of my surviving spouse, prior to considering or making income distributions to other current trust beneficiaries such as my children or more remote descendants. My surviving spouse’s needs shall be met first prior to any distribution of trust income to any other trust beneficiary.   

2. Address Priorities: Similarly, if the needs of the current beneficiaries are to be weighed more heavily by the trustee than those of the remainder beneficiaries, again that should be clearly stated in the trust instrument. Current income beneficiaries usually want income while remainder beneficiaries usually want trusts invested for capital growth. Current income distributions means, obviously, fewer assets to be held or distributed to the trust remainder beneficiaries. The Restatement (Third) of Trusts, Section 90 (comment c) notes that “the divergent economic interests of trust beneficiaries give rise to conflicts of interest of types that simply cannot be prohibited or avoided in the investment decisions of typical trusts.” A trust should anticipate and seek to expressly deal with these conflicts of interest.

Example: In investing trust assets and making discretionary distributions under this trust, the trustee shall initially take into consideration only the needs of the current beneficiaries of this trust, even to the extent that the trust corpus might ultimately be exhausted  which I acknowledge would leave nothing to be distributed to the remainder trust beneficiaries.Such a potential situation is something that I have contemplated and accept as a possible outcome of the administration of this trust which places a priority on meeting the needs of the current trust beneficiaries.

3. Consideration of Other Resources: As has been covered in the past, this is an area where the common law of trusts, as summarized in both the Second and Third Restatements of Trust diverge from one another, which in turn gives a trustee considerable anxiety. The Second clearly stated that if a trust instrument is silent, the trustee is to make discretionary distributions to a trust beneficiary without taking into consideration any other financial resources then available to that trust beneficiary. The Third provides the opposite obligation, which is that if the trust instrument is silent, then the trustee must first take into consideration any other financial resources then available to that trust beneficiary. If an income sprayprovision is added to the trust in order to avoid the high income tax burden of an irrevocable trust, and the trustee is required to consider the beneficiaries’ external resources, it is possible that all income will be distributed to the trust beneficiary who is not financially successful with his or her own efforts compared to the other trust beneficiaries.

Example: An income spray trust is administered for the settlor’s two adult children. The son is a successful dentist. The daughter is a social worker. Will all the income distributed from the trust in order to avoid the high income tax rates imposed on trusts be to the daughter, given her lack of income, compared to her brother’s? Is that what the settlor wants? Should income distributions by the trustee to the beneficiaries be in equal amounts to avoid animosity and resentment between the children? Should income distributions in order to save income taxes be equal among the current trust beneficiaries, and any other discretionary distributions only then take into consideration other resources? Again, this is a situation where the trust instrument can direct that the trustee shall take into consideration other resources, or the trustee may take into consideration those other resources, or that the trustee may may completely disregard any other resources then available to the current trust beneficiary. These directions would be both helpful to the trustee while also indicating to the trust beneficaries’ the trust settlor’s purpose and intent with regard to including the provision in the trust.

Aside #1: Some courts take the other resources consideration to an extreme level, which may be inconsistent with the settlor’s intent. As an example, a Connecticut court held that a trustee should look at outside resources, even to the point of potentially exhausting those resources before exercising its discretionary distribution authority. Guaranty Trust Co. v. New Yourk City Cancer Commission, 144 A.2d 535, 547 (1958.)

Aside #2: Often an income spray provision is used in conjunction with the Tax Code’s ascertainable standard, health, education, maintenance and support (HEMS.) Treasury Regulations that attempt to define those words interpret them to allow for a trust beneficiary’s reasonable expenses and not just the ‘bare necessities.’ [Treasury Regulation 25.2514-1(c)(2.)] Bare necessities for one current beneficiary may appear to be luxuries to another trust beneficiary.

4. Address Privacy Expectations: As noted early, a trustee must balance the obligation to provide meaningful information to the trust beneficiaries in order to enable them to enforce the terms of the trust to protect their interests under the trust, against unwarranted disclosures of a private nature that arise from a trust distribution. The trust instrument should provide some examples of what the trustee is relieved from disclosing in an annual accounting to trust beneficiaries.

If ever adopted in Michigan, like it is in Delaware, a trust instrument might be drafted in a manner to make use of a notice recipient who would receive sensitive information with regard to a trust distribution, e.g. the cost of an abortion; alcohol rehabilitation, in lieu of providing that information to all current trust beneficiaries.

Conclusion: Discretionary trusts that give the trustee the authority to spray trust income among a group of trust beneficiaries are a highly flexible tool to meet the needs of multiple individuals and in particular to minimize the onerous income tax liability imposed on an irrevocable trust. However, they tend to create a considerable of tension, both for the trustee and also among the trust beneficiaries. Anticipating those tensions by including some of the trust provisions just noted can go a long way to assist in the efficient and effective administration of a discretionary spray trust and perhaps minimize strain in family dynamics.