Pot Trusts

Take-Away: Many trust instruments these days, especially dynasty-type trusts, use a pot trust approach in order to give the trustee considerable latitude to spread taxable income generated by the trust over several trust beneficiaries who may be in low, or no, income tax brackets. Along with the flexibility that comes with a pot trust are a host of other problems that often cause conflict among the several trust beneficiaries.

Background: Trust distribution provisions can be drafted in several ways. One predictable approach is to direct the trustee to divide the trust estate into separate shares of equal value, one share for each of the settlor’s children. Each trust share is thereafter administered separately as its own trust. The other less common approach is for the settlor to direct that the trustee administer the trust estate as a single trust for multiple beneficiaries, known as a pot trust, i.e. one pot feeds multiple beneficiaries. If a client starts talking about how to best distribute their wealth upon their death from their trust, it is critical to appreciate the nuances of administering a pot trust. Some ‘pros and cons’ of administering a pot trust follow:

Advantages of a Pot Trust:

1. Better Investment Opportunities: Many investments require investors to meet accredited investor standards, which means that they must possess a minimum investment net worth. Small trusts, i.e. separate share trusts, may be unable to meet these threshold net worth amounts. In addition, it may be much easier to diversify the trust’s investment corpus if sufficient assets are available to permit the desired diversification. Individual securities can be purchased. If the size of the trust corpus is too small, the use of mutual funds may be the only practical option available to obtain the required diversification. And with mutual funds, there may come higher fees and unpredictable capital gains to be reported at year end.
2. Lower Administrative Costs:  Many fiduciary fees are charged on a sliding scale. With a larger size of trust corpus associated with a pot trust the result might be a lower fee paid for trustee services, investment advice, and similar economies of scale.
3. Fewer Administrative Burdens:  If accountings, tax reporting, and other administrative burdens are required for only one source, the pot trust, the relative administrative burden is reduced for the trustee.
4. More Flexibility to Meet Beneficiary Needs: In many family situations one individual may require large distributions from the trust to respond to their extraordinary needs, e.g. medical crises; disabilities; addiction treatment. With a pot trust it is easier for the trustee to meet these extraordinary needs by accessing a larger pool of assets held in a single trust. If a separate share trust had been created for the trust beneficiary who presents extraordinary needs, it is possible their entire trust share would be depleted to meet those needs. Consequently, the trustee possesses greater ability to consider and weigh the needs of each beneficiary to determine what is appropriate without being constrained by a smaller amount held in a separate share trust.
5. Address Beneficiary Age Differences: If the settlor’s trust divides after a designated event, e.g. “when my youngest child attains the age of 23”  the pot trust can more equitably address beneficiary expenses prior to the division of the pot into separate shares. Example: Parents have three children. Parents pay for the college education of their older two children, but parents die prior to their youngest child graduating from college. The pot trust could be used to pay to complete the youngest child’s college education, arguably permitting the youngest child to receive more distributions from the pot trust until their college education is completed than the older siblings. Only after all the children have had their college educations paid for (either by parents while alive, or from the pot trust after their deaths) will the remaining trust corpus then be divided into separate shares of equal value, one share created for each child. This use of a pot trust to address this perceived inequity among children works well, unless there is a dramatic age difference between the children, as the older children may receive very few (if any) distributions from the pot trust waiting for their younger sibling to complete college, before the separate shares are finally created.
6. Beneficiary’s Divorce: If one of the beneficiaries is facing a divorce, it is much more difficult for a divorce court to treat the beneficiary’s interest in the pot trust as part of the beneficiary’s divisible marital estate. Most pot trusts give the trustee the discretion to pay income or principal to or for the benefit of multiple trust beneficiaries. As a result, it is difficult for a divorce court to find that one of the beneficiaries of a pot trust has any exclusive right to receive either trust income or trust principal. Moreover, the other beneficiaries of the pot trust might actually intervene in the other trust beneficiary’s divorce proceeding and argue that any effort by the divorce court to award an interest in the trust to a beneficiary’s former spouse would arguably be an invasion of that intervening trust beneficiary’s interest in the pot trust.
7. Reduce Income Tax Liability: We know that irrevocable trusts face the highest marginal income tax bracket of 39.6% on accumulated trust income in excess of $12,500. Rather than pay an income tax at that high rate the trustee will often distribute income from the trust to the beneficiaries, with a resulting income tax deduction. The income distributed to the trust beneficiaries will be taxed at their presumably lower marginal income tax rate. Income can be distributed by the trustee to some beneficiaries who have no other taxable income, which means that some of the income distributed by the pot trust can be intentionally sprayed to those taxpayer-beneficiaries who are in lower (or no) tax brackets. The more beneficiaries there are for the pot trust, the more the trust income can be disbursed among beneficiaries with less income tax erosion.

Disadvantages of a Pot Trust:

1. No Privacy: There will be little or no privacy regarding distributions made to beneficiaries from the pot trust. Even if a trustee’s accounting contains vague descriptions of what a distribution was made for from the trust to the beneficiaries, the recipient beneficiary may not want others to see what or to whom the distribution was made, e.g. payment of a psychiatric counseling bill.
2. Beneficiary Resentment: Since all of the beneficiaries of a pot trust will be able to see in the accountings exactly how much other beneficiaries have received in trust distributions, that disclosure easily devolves into a perceived unfairness, if needs vary significantly from one beneficiary to another. Thus the likelihood  of conflict among trust beneficiaries increases.  Example: One trust beneficiary just went through her third substance abuse rehabilitation. The other trust beneficiaries become resentful that that afflicted beneficiary demonstrates no self-discipline or willingness to change behavior, arguably at their expense.
3. Unequal Beneficiary Needs: Not all beneficiaries are alike. If the pot trust anticipates disproportionate distributions to beneficiaries on the basis of identified needs, some beneficiaries will inevitably need more financial assistance than other beneficiaries. If one beneficiary is a fully employed neurosurgeon, arguably that beneficiary will have few needs that cannot be met through his/her own earnings. Another beneficiary of the same trust may be a social worker who lives very modestly and thus the social worker may have more occasions to ask the trustee for a distribution from the pot trust. Consequently,  distributions from a pot trust to a beneficiary who has immediate financial needs will always be to the detriment of other trust beneficiaries whose needs are not current or immediate, but who nonetheless intend to look to or rely on the pot trust at a future point in time.
4. Proof of Need: Because most pot trusts are structured to give the trustee broad discretion to make disproportionate distributions based upon a beneficiary’s demonstrated need, the trust instrument often will use narrower distribution standards that require actual proof of need; these ‘tighter’ distribution standards can cause additional administrative expenses (and delays) associated with the trustee requiring proof to establish need, or perhaps more expense borne by the requesting beneficiary to document their need.
5. Trustee Litigation: The probability of litigation brought by trust beneficiaries against the trustee is increased with a pot trust. Some beneficiaries who may become resentful that other beneficiaries are receiving more benefit from the trust than themselves are more likely to question the trustee’s exercise of discretion to make disproportionate distributions to the one beneficiary.
6. Duty of Impartiality: Under Michigan’s Trust Code the trustee has a duty of impartiality to all trust beneficiaries, both present trust beneficiaries and remainder trust beneficiaries. It is a challenge for a trustee to fulfill that duty of impartiality to administer a pot trust and balance the interests of all beneficiaries at the same time. Responding to the disparate needs of multiple trust beneficiaries, combined with the larger pool of remainder trust beneficiaries that often accompanies a pot trust or dynasty-type trust,  makes distribution decisions, or the amount to be distributed from the trust,  far more challenging for the trustee.

Conclusion: Obviously how a trust is to be administered after the settlor’s death is dependent upon the settlor’s wishes, reflecting their goal and priorities, and to a degree the age and maturity of their primary beneficiaries. If a pot trust is considered by the settlor, it would be advisable to review with them both the advantages and disadvantages of using a pot trust.