Imagine you've created a trust naming your daughter as beneficiary. You expect that the trust will provide for her health, education, maintenance, and support. But exactly what does that mean? How would the trustee handle a discretionary payout for her wedding? To be sure you are creating an instrument that will anticipate all possible scenarios and provide tax-saving advantages, pay close attention to the written word.
Trusts can be extremely effective estate planning tools for minimizing taxes and ensuring your beneficiaries are cared for according to your wishes, both during and after your lifetime. When creating a trust, clients may assume their exact wishes will be carried out to the letter. While this often is the case, the complex language of trusts is not always black and white. The interpretation of the standards of distribution can be challenged in court when disputes arise between the trustee and the beneficiaries over disbursement of funds.
The language of a trust agreement must be carefully crafted to balance your wishes with the powers of the trustee and the needs of beneficiaries. Tax consequences must also be considered. Qualified attorneys specializing in trusts and estates will carefully weigh all the issues when drafting a trust document and will take time to understand your particular situation. Along with a basic understanding of some key terms, you and your attorney should be able to create a trust that will strike the perfect balance.
Too Much Discretion May Come at a Cost
Trust documents employ carefully crafted language to balance the wishes of the grantor with the tax consequences of the provisions. If provisions in the trust are so broad that trustees have too much discretion over distribution of funds, beneficiaries may be treated by the IRS as the owners of the trust property and taxed accordingly. On the flip side, standards left to interpretation by the courts may mean your beneficiaries are not cared for according to your wishes. Only a qualified attorney can determine the proper language to best meet your needs.
Some of the most tragic disputes arise when the trustee and beneficiaries are at odds over a distribution from the trust's principal assets. Such distributions are called "invasions of principal." With a greater understanding of some key trust terms, you may be able to steer clear of such disputes.
What Does the Trust Language Mean?
The standards of distribution set forth in a trust must be ascertainable. In other words, the standards must be clearly measurable. Some of the commonly accepted ascertainable standards include support, maintenance, education, and health. Other standards may include comfort, best interest, and emergency. Here is a brief explanation of how some of these standards may be interpreted:
Support and Maintenance
Support and maintenance encompass more than bare necessities. These terms include a beneficiary's normal living expenses, such as housing, clothing, food, and medical care, according to the beneficiary's customary standard of living.
Under the less restrictive standard of best interests, the trustee may make distributions allowing a beneficiary to enjoy a high standard of living, covering such niceties as extensive travel, a luxury automobile, or expensive jewelry.
Typically, the term education includes college education, but may not necessarily include graduate level or professional education unless specified. A client wishing to provide for a grandchild's pursuit of a medical degree, for example, should communicate those desires when the trust agreement is being drafted. Such considerations as travel expenses to and from school and a reasonable allowance for related expenses also should be clarified in the trust document, if so desired.
The term health includes all routine medical care, medication, surgery, and hospitalization, as well as nursing care and mental health expenses. This term is less restrictive than "medical care," which may not cover expenses for treatment of ailments not universally accepted as medical problems, such as addictions or psychological problems.
The term emergency may be determined by a court to be an ascertainable standard pertaining to unusual and unforeseen expenses, but may not be deemed an ascertainable standard by the IRS for tax purposes. To minimize confusion, the client may wish to specify the types of emergencies for which distributions are authorized, such as financial emergencies or those related only to health or maintenance.
While many factors determine the level of access beneficiaries will have to trust assets, understanding the difference between "support and maintenance" and "best interests," for example, will go a long way toward helping you communicate your wishes. Ultimately, choosing the provisions for distributions is a balancing act, with tax consequences on one side of the scale and the wishes of the grantor on the other side. Once you understand these basic principles, seeking the counsel of a qualified estate planning attorney is the next step in minimizing taxes while ensuring beneficiaries are cared for according to your wishes.
Updated: January 1, 2013
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.
© 2013 Wilmington Trust Corporation.