Flexible Trusts

Take-Away: The ‘name of the game’ in drafting trusts these days is flexibility, in order for the trust to be able to adjust to the constantly changing tax laws. In addition, flexible trusts address future changes in the circumstances of both beneficiaries and fiduciaries which is critical with a dynasty type trust that is expected to continue for multiple generations into the future. Flexiblity can be enhanced through thoughtful trust provisions, but too much flexibility might cause unanticipated tax consequences during the trust’s administration.

Background: In a recent article in Trusts & Estates noted estate planning attorneys Marty Shenkman, Kim Kamlin and Lou Harrison, and Jerry Horn’s comments at this year’s Notre Dame Tax and Estate Planning Institute, identified a handful of techniques in how a trust can be made more flexible to adjust to constantly changing environments, along with a couple of cautionary remarks when flexible trusts should not be used. While not necessarily a ‘check-list’ to be included in every trust, these observations can provide some helpful insights to make a trust more flexible, while also attuned to when a flexible trust might go awry. Some of the following suggested  provisions were also added by me, so use them with caution!

Use a Neutral Gender: Avoid gender pronouns like husband and wife. Instead use spouse which covers same-sex marriages.

Broadly Define Children: Expand the definitions of child or children and descendants to encompass other forms of assisted reproductive technologies (ART) like in-vitro fertilization, surrogacy, genetic manipulation, and the fact that individuals (future trust beneficiaries) may be born long after their genetic parent’s death, especially when class gifts e.g. “my descendants” are used in a Will or trust.

Add Powers of Appointment to Enable Free-basing: In an era where the emphasis is on obtaining a step-up in the income tax basis for inherited assets, consider giving to each generation of  trust beneficiaries a testamentary general power of appointment to pay their creditors at death, which will expose all of the trust assets to an income tax basis adjustment (which power can always be released within a few years of the beneficiary’s death if the concern is that this power then creates a future estate tax liability). Similarly, even if income tax basis manipulation is not the goal, consider giving each generation a testamentary limited power of appointment to a group of appointees which is broader than just the appointer’s descendants in order to be able to create future trusts for more remote beneficiaries who may need the protections of a trust, e.g. “my parents’ descendants.”

Enhance a Beneficiary’s Creditor Protection: Use discretionary trust distribution provisions rather than support trust distribution provisions. Trust beneficiaries may live all over the country and each state applies its own rules with regard to whether the beneficiary’s interest in the trust can be reached by judgment creditors or divorce courts. Support trusts, g. health, education, support and maintenance,  are generally more vulnerable to creditor claims or are treated as property interests in a divorce court setting. Not so much in Michigan where the law is pretty clear (or at least I hope it is clear to judges, but who knows for sure) but trust beneficiary’s may reside in other jurisdictions where a court may decide to ignore Michigan’s interpretation of a support trust. Note too, that in some states where the trustee’s discretion to make distributions is limited by the HEMS ascertainable standard, the creditors of the trust beneficiary in that other state may be able to access the assets held in trust to satisfy their judgments.

Use Grantor Trusts: Give a trust protector or director the ability to add grantor trust powers to the trust settlor over an irrevocable trust. If the irrevocable trust is a grantor trust then a couple of opportunities arise: (i) the settlor then pays the trust’s income taxes, which is the equivalent of making a gift-tax-free gift to the trust beneficiaries; and (ii) if the settlor can substitute assets of equivalent value with the irrevocable trust, the settlor can swap assets with the trust, bringing low-basis assets back into the settlor’s name prior to death, which then exposes those low-basis assets to an income tax basis adjustment on the settlor’s death, thus avoiding capital gain exposure in the hands of the inheritors when those assets are later sold.

Trust Protectors: Use trust protectors, now called trust directors in Michigan, as just noted, to convert a non-grantor trust to a grantor trust for income and gift tax savings purposes. A trust director can also be given the power to remove and replace trustees, as a ‘check and balance’ especially in revocable trusts where there may be a concern of financial abuse by the acting successor trustee over the elder settlor of the trust. Even broader trust amendment powers can be given to a trust director to adapt the trust to future changes in the tax law without having to petition the probate court for a formal trust modification.

Special Power Holders: While a trust director could be given the broad power to amend a trust to add or remove trust beneficiaries, or confer grantor trust powers on the settlor,  the problem, at least in Michigan, is that the trust director serves in a fiduciary It is hard to imagine a trust director, who acts in a fiduciary capacity, exercising the power to add or change beneficiaries to whom that director owes a fiduciary duty. But a person who is named in the trust as a special power holder to add or remove grantor trust powers, or to add or remove trust beneficiaries is not technically a fiduciary, just a ‘mere’ special power of appointment holder. While not too many settlors will be eager to give someone the ability to change beneficiaries of the settlor’s trust, if the settlor is willing to provide this scope of power, then consider naming a special power of appointment holder for that limited purpose instead of giving that type of power to a trust director. Maybe this is just a matter of semantics and a judge would treat the special power holder as a fiduciary trust director, but it is worth a shot.

Trust Situs: Since trust beneficiaries are highly mobile these days, so should the trust that is established for their benefit. The situs of the trust, and its governing laws, should be easily changed either by the trustee or better yet the power should be exercised by the trust director. Such changes in trust situs are used to respond to  state income taxation of accumulated trust income, the need to provide better creditor protection for the trust beneficiaries, or in order to limit a trust beneficiary’s access to information about the trust (a silent trust.)

Trust Decanting: Since not all states have decanting statutes, consider intentionally giving to the trustee the power to decant the trust assets to a new, and presumably improved trust instrument, perhaps without some of the restrictions or conditions often found in state decanting statutes. Expressly giving the trustee the power to decant the trust’s assets could also mitigate claims by trust beneficiaries who are unhappy with the terms of the new decanted trust who assert that the trustee abused its fiduciary duties exercising a decanting power. For example, if the trustee decanted the trust assets from a grantor trust to a non-grantor trust, the trust beneficiaries will be unhappy that their trust will now have to pay its own income taxes; expressly giving the trustee the decanting power to change the tax status of the irrevocable trust would probably protect the trustee if it, in fact, exercised its decanting power in such a manner to eliminate the grantor trust

Add Charitable Beneficiaries: Consider giving a person the right to add charitable beneficiaries to a grantor irrevocable trust. This would reduce the amount available to the non-charitable beneficiaries, but it would reduce the settlor’s income tax liabilities with regard to the trust (the charitable deduction that arises from such distributions is passed through to the settlor.) If the trust is a non-grantor trust, distributions to a charity from the trust is the equivalent to a 100% charitable deduction by the settlor which might not otherwise be available to the settlor due to the recently increased standard deduction amounts.

Anticipate State Estate Taxes: While Michigan does not impose an estate tax, many states still do, states where Michigan residents may still own property, thus exposing those assets to state estate taxes. If that is the case,  since most state estate tax exemptions are not portable, the minimization of state estate taxes will require the continued use of a credit shelter trust even when there is no federal estate tax exposure. Some states, but not all, permit a type of state-QTIP election, so it is possible that a federal QTIP trust, a state QTIP trust, and possible a conventional credit shelter trust will be required depending on the location of trust assets and their values.

Income vs Unitrust: Consider the use of annuity and unitrusts instead of using a ‘pay all trust income to’ directive to the trustee. Those distribution concepts (annuity; unitrust) are probably more consistent with the modern-portfolio theory of trust investments.

Beware the Hidden Gift Tax: An individual who holds a special or limited power of appointment over trust assets can be found to have made a taxable gift if they were also the lifetime income beneficiary of the appointed assets when the limited power of appointment is exercised. The beneficiary-power holder is treated as having made a gift of the income that the appointed assets would have generated had the assets remained held in the name of the trust. Rev. Ruling 79-327; Estate of Regester vs. Commissioner, 83 Tax Court 1 (1984.)

Anticipate Use of the GST Exemption: While we have the concept of portability of a deceased spouse’s unused federal estate tax applicable exemption amount, often overlooked is that the deceased spouse’s GST exemption amount is not portable. Thus, if the estate plan is to establish on the surviving spouse’s death a dynasty-type of trust for the benefit of children, grandchildren and more remote descendants, only the surviving spouse’s GST exemption can be applied to that dynasty-trust. That is when it might be advisable for the surviving spouse to disclaim to a credit shelter trust the amount of the deceased spouse’s unused GST exemption, so that it can be applied to the credit shelter trust and later dynasty-type trust after the survivor’s death. The credit shelter trust can then be merged into the survivor’s own GST exempt dynasty trust on the survivor’s death

Expand Trustee Discretion: Consider authorizing the trustee of a discretionary trust to distribute ‘what the trustee believes the settlor, if serving as trustee, would make as a trust distribution, including the entire distribution of the entire trust estate’ which in effect would terminate the trust. This expanded discretion permits the trustee to include the trust estate in the gross estate(s) or one or more beneficiaries and addresses the portion of the trust corpus that may be GST exempt, while also permitting the trustee to possibly avoid multiple incidences of GST taxation of trust distributions or terminations. The exercise of this extraordinary fiduciary discretion to ‘empty’ the trust also permits the trustee to engage in free-basing under IRC 1014.

Beneficiary-Trustee: There is a lot of interest in establishing non-grantor trusts with a trust beneficiary also serving as trustee of the trust. So long as the trustee’s discretion is limited to an ascertainable standard, the exercise of that discretion (which is a general power of appointment) is not treated as a taxable gift. [Treas. Reg. 20.2041-1(c)(2); 25.2511-1(g)(2).] An additional issue is whether the beneficiary-trustee has a legal obligation to support a distributee under the trust. If the trust instrument permits the trustee to pay or distribute trust property to any one or more among a particular child and their descendants for their health, education and support (HEMS) the child can serve as trustee. But if the HEMS standard includes the requirement that the trustee must consider other resources available to the distributee (and that is the default rule under the Michigan Trust Code when the trust instrument is silent) and other resources exist, that will deprive the trustee of all ability to use trust property to provide for the support of that minor child, and might invite challenges from other trust beneficiaries to that exercise of the trustee’s discretion. It has been suggested that a distribution standard used in a trust instrument explicitly limit both the right to exercise the power (of distribution) and the right to not exercise the right (of distribution.)

Conclusion: All of these provisions or considerations are not appropriate for every trust. Some may even be dangerous, e.g. giving a special power of appointment holder the ability to add beneficiaries would destroy a marital deduction trust which can only have the surviving spouse as the marital trust lifetime beneficiary. But the point is that in our fast-moving society change is now the by-word, and more and more states are inclined to change their trust laws with the goal of attracting more trust-business, thus making the ability to change trust provisions more and more relevant. Accordingly, there are plenty of good reasons to intentionally add flexibility to most trust instruments both from the beneficiaries’ perspective as well as the efficient administration of the trust by the trustee.