Take-Away: While the settlor’s spouse can hold several powers over a trust created for his/her benefit, holding too much power over the trust for his/her benefit, such as the power to remove and replace the trustee, can bring unexpected estate tax problems for the spouse.

Background: Many trusts are created these days for the settlor’s spouse, prompted by the 2026 sunset of the $12.06 million applicable exemption amount, i.e. spousal lifetime access trusts (SLATs), where the goal is to use the settlor’s large applicable exemption amount while it still exists. With the settlor’s perpetual goal of “let’s keep it simple,” it is common to find the spouse-beneficiary being given substantial powers over the trust created for his/her benefit, including the power to remove and replace the acting trustee of the trust, if the spouse is not named as trustee, or if the spouse is named with another as co-trustees of the trust.

Spouse as Sole Trustee: A spouse can act as the trustee of his/her own trust, and not have any estate tax exposure, but only if the spouse-trustee’s discretion  is limited to an ascertainable standard.

  • Ascertainable Standard: An ascertainable standard limits the trustee’s discretion to make distributions from the trust for the beneficiary’s health, education, maintenance, and support, a so-called HEMS standard. Going beyond an ascertainable standard to make discretionary distributions creates an unnecessary risk that leads to estate inclusion, since the spouse-trustee will be treated as holding a general power of appointment over the trust’s assets. [IRC 2041(a)(2).] Moreover, in some states, the spouse-trustee’s creditors might have access to the trust’s assets to satisfy claims when the spouse acts as the sole trustee of the trust, even if the spouse-trustee’s discretion to make distributions is limited to an ascertainable standard.

Spouse’s Power to Remove and Replace Trustee: To provide comfort to the spouse-beneficiary of the trust, when an independent trustee is named, the spouse is often given the power to remove and replace the acting trustee of his/her trust. For a long time, this power posed  a major risk which caused estate inclusion of the spouse-beneficiary. This was due to an unfortunate IRS Revenue Ruling. In Revenue Ruling 79-353 the risk identified was that if the spouse could remove and replace a corporate trustee at will, then the powers of the corporate trustee were attributed to the spouse-beneficiary, thus leading to estate inclusion, i.e. the equivalent of the spouse-beneficiary holding a general power of appointment over the trust assets. [IRC 2041(a)(2).] Fortunately, the Revenue Ruling was subsequently repealed.

  • Risk: However, despite the repeal of Revenue Ruling 79-353, the remove and replace power is not without its own limitations. The Regulations provide that a beneficiary’s power to remove a trustee and appoint oneself “may be a general power of appointment” if the powerholder [spouse] can become a trustee through the exercise of such power of removal, and the trustee possesses an unascertainable distribution standard.

Independent Trustee: Under the Tax Code, only an independent trustee can possess discretion to make distributions under an unascertainable standard. This is why many trust instruments limit the ability of the trust beneficiary to appoint a successor trustee to one who is not disqualified under IRC 672(c), i.e. one who is neither related nor subordinated to the person who possess the power to remove and replace a trustee. Restated, IRC 672(c) identifies disqualified persons who are excluded from the category as an independent trustee.

  • Related or Subordinated Party:  This exclusion provides a pretty broad cross-section of family members. This disqualified person category includes the powerholder’s: spouse, father, mother, issue, brother, sister or employee. [Apparently nephews and nieces and cousins are all okay.] The prohibited class also extends to a corporation in which stock holdings of such person and the trustee are significant from the viewpoint of voting control, and also any employee of that corporation, and a subordinate employee of the corporation in which such person is an executive.

Generalizations: Distilling these rules to a list of do’s-and-don’ts, consider the following:

  1. Only an independent trustee can hold discretion to make distributions under an unascertainable standard.
  2. If a spouse acts as sole trustee of a trust for his/her own benefit, their discretion to make distributions must be limited to the health, education, maintenance and support ascertainable standard. That limited distribution power is not treated under the Tax Code as a general power of appointment over the trust’s assets.
  3. Caution should be used if a trust starts out using an independent trustee whose discretion is not limited by an ascertainable standard, and the spouse-beneficiary is given in the same trust instrument the unilateral power to remove and replace the independent trustee. If that remove-and-replace the power is not restricted, it will be viewed by the IRS as the spouse possessing the ability to name themselves as successor trustee holding an unascertainable power of distribution, i.e. general power of appointment.
  4. If a spouse and independent trustee are named as co-trustees of the trust, and the settlor wishes to give the spouse the authority to remove an replace the independent trustee then the spouse’s remove-and-replace power should be limited only to qualified persons. The spouse-co-trustee should be prohibited from naming a disqualified person under IRC 672(c). Perhaps a savings clause should be included in the trust to prohibit the exercise of any power to remove and replace a trustee that would cause the spouse beneficiary to hold a power under IRC 2041.
  5. Variations implementing these rules can also be used. For example, a trust instrument can provide the spouse-beneficiary with an unrestricted right to remove and replace trustees when the distribution provisions then specify that distributions by a non-independent trustee are limited to an ascertainable HEMS standard, but may be made for the beneficiary’s “welfare and best interests” (or another unascertainable standard, like happiness) by an independent trustee if one is acting, i.e. dual distribution standards depending upon who is then acting as trustee.

Conclusion: Giving a trust beneficiary the power to remove and replace a trustee is considered to add considerable flexibility to a trust instrument. If that is the goal, then it is important to either restrict the replacement trustees to independent trustees, or limit the distribution standard the non-independent trustee must follow.