In May 2016, the firm was honored by the Long Island Council of Churches for the pro bonolegal services they have provided the Council and its member churches.
Utilizing the Estate and Gift Tax Exemption Before It’s Too Late
Absent action from Congress, the federal estate and gift tax exemption will revert back to $1 million in 2013. Given this looming uncertainty, individuals should take advantage of the current $5.12 million exemption before the end of 2012 by making gifts. In addition, New York State does not currently impose a gift tax, making this an opportune time for New Yorkers to consider gifting strategies.
High-net-worth married couples often hesitate to make outright gifts for fear of losing income and control over assets. One technique couples can use to help alleviate these concerns is to create mutual lifetime credit shelter trusts for the benefit of each spouse. A lifetime transfer to a credit shelter trust would ordinarily be considered a taxable gift to the trust beneficiary, but because the gift is less than or equal to the exemption amount, the gift is a tax-free transfer. The ability to customize the trust instrument according to each spouse’s unique needs and desires, while also providing each spouse with some degree of control, is an attractive feature of the credit shelter trust.
For example, consider Jack and Jill, a husband and wife with a net worth of $20 million and two adult children. Theyare concerned about the possible loss of the current exemption, and would like to reduce the amount of estate taxes that their children will have to pay. Jack and Jill also wish to maintain their cash flow and control over their assets. This dual concern for financial security and control prevents them from currently making gifts to their children.
Lifetime credit shelter trusts might be the ideal instrument for such a couple. Credit shelter trusts allow for creativity and flexibility; the trust can be drafted in a way that ensures each spouse income during life, while still allowing the couple to take advantage of the current exemption. For example, Jack could fund a lifetime credit shelter trust for Jill’s benefit with $5 million of assets, a transfer that would be tax-free under the current exemption. All income would be paid to Jill for her life, with principal distributed according to an “ascertainable standard.” Upon Jill’s death, the trust funds would be available to their children and might be either distributed or held in further trust. In addition, assuming that Jack (the settlor) has not retained any prohibited powers over the trust, its value would not be included in his estate. The trust would also be drafted to avoid inclusion in Jill’s estate. Similarly, Jill could use her $5 million exemption to fund a lifetime credit shelter trust for Jack’s benefit.
Acting as Beneficiary and Trustee
One common question that arises when a couple wishes to retain control of their assets is whether a spouse can act as both beneficiary and trustee without incurring adverse tax consequences, such as inclusion of the trust assets in her estate. For example, perhaps Jill, as beneficiary, would like to retain a higher degree of control over the trust assets by participating as trustee. In Revenue Ruling 78-398, the IRS determined that a trust beneficiary who was also named as the sole trustee could have some discretion to make distributions of principal to herself. In that case, the trust assets were not included in her estate because her powers as trustee were limited by an ascertainable standard—namely, only as necessary for her “maintenance and medical care.” As described below, the Treasury Regulations are even more permissive.
This ruling was recently confirmed by Estate of Chancellor v. Comm’r (T.C. Memo 2011-172). In Chancellor, the surviving spouse acted as both beneficiary and trustee of a credit shelter trust created by her husband. The trust instrument provided that the trustee could distribute trust principal to the beneficiary-spouse for her “maintenance, education, health care, sustenance, welfare or other appropriate expenditures.” The Tax Court ruled that the spouse, as both beneficiary and trustee, could exercise her power to make distributions to herself without the trust being included in her estate because her power was limited by an ascertainable standard.
Traditionally, “ascertainable standard” has been defined by Internal Revenue Code (IRC) section 2041 and Treasury Regulations section 20.2041-1 as relating to the beneficiary’s “health, education, sup- port, or maintenance.” These are broad standards, and the Treasury Regulations also permit the trustee to exercise discretion to support the beneficiary’s “accustomed manner of living.” Use of these specific terms is not required, but caution is advised when using alternative terms.
For example, in Chancellor, the IRS asserted that the trustee-beneficiary’s estate should have included the trust because the standard did not relate solely to her health, education, support, or maintenance, but also considered the spouse’s “welfare and other appropriate expenditures.” After examining the settlor’s intent and the applicable state law, the Tax Court ultimately ruled that the power to invade was limited by an ascertainable standard and did not include the trust in the decedent’s estate. This case highlights the importance of careful drafting by illustrating that the IRS may take action if the trust instrument strays from using the exact language contained in the regulation.
An alternative to using an ascertainable standard is to appoint an independent trustee. The independent trustee could act as the sole trustee, or, if the couple wishes to retain more control, the independent trustee could instead act as a co-trustee with the beneficiary. As a co-trustee, the independent trustee could be empowered to make those discretionary distributions that beneficiaries might not be able to make without risking inclusion of the trust in their estates.
Returning to the example above, perhaps Jill feels constrained by a standard limiting her to distributions only for her health, education, maintenance, or support. She could instead, or in addition, appoint a trusted friend to act as an independent trustee. This friend could make those distributions that Jill feels she needs but would otherwise not be necessary for her health, maintenance, education, or support. By using an independent trustee, Jill would not be exercising a power that would risk inclusion of the trust in her estate. IRC section 674(c) generally describes independent trustees as persons who are not immediate family or subordinates or employees of the settlor or trustee. Consideration should be given to appropriate trustee appointment and removal powers.
A third consideration is to include a “five-by-five power.” Under a five-by-five power, as defined by IRC section 2041(b)(2), beneficiaries can retain limited withdrawal powers over principal without the entire trust being taxed in their estates. This ability to withdraw principal must be limited to an annual amount that does not exceed the greater of either $5,000 or 5% of the trust principal.
Reciprocal Trust Doctrine
Mutual lifetime credit shelter trusts do have a hidden danger: the IRS’s reciprocal trust doctrine. This danger can be avoided through careful drafting. Reciprocal trusts are those created by two individuals for the benefit of each other. Application of the reciprocal trust doctrine allows the IRS to “uncross” the trusts and to treat each as a self-settled trust, or one created solely for the settlor’s benefit. As such, the trust is included in the settlor’s estate, obviating one purpose for which the trust was initially created.
For example, if Jack funds a trust with $5 million for the benefit of Jill, and Jill funds an identical trust with $5 million for the benefit of Jack, such trusts would be reciprocal. The IRS could then use the reciprocal trust doctrine to uncross the trusts, deeming Jack to be the beneficiary of the trust that he created and Jill to be the beneficiary of the trust that she created, thereby resulting in estate inclusion.
According to the U.S. Supreme Court in U.S. v. Grace (395 U.S. 316, 324–25 ), the reciprocal trust doctrine applies when two trusts are interrelated and the settlors are left “in approximately the same economic position” as before the creation of the trusts. For example, in Grace, trusts created by a husband and wife for the other’s benefit were deemed to be reciprocal because each settlor was in the same basic economic position and because the trusts were “substantially identical in terms and were created at approximately the same time.”
The doctrine has also been applied when spouses held crossed trustee powers over identical trusts, but did not have an economic interest. In Estate of Bischoff v. Comm’r (69 T.C. 32 ), the couple executed identical trusts for the benefit of their grandchildren and named the other spouse as trustee. Distributions of principal and income were made in the sole discretion of the trustee. If such a power had been held by the settlor, the value of the trust would have been included in the settlor’s estate under IRC sections 2036(a)(2) and 2038(a)(1). Here, the Tax Court ruled that the trustee powers were reciprocal and uncrossed the powers, deeming the spouses to be the trustees of the trusts they created. Thus, each trust was deemed to be part of the settlor’s estate under IRC sections 2036(a)(2) and 2038(a)(1). In its decision, the Tax Court stated that it was not necessary for the settlor to have an economic interest in the property transferred in order for the reciprocal trust doctrine to apply; it was enough for the settlors to have crossed trustee powers.
To avoid the reciprocal trust doctrine, each trust must be materially different. The IRS does not define material differences, and careful drafting is essential. Although certainty is impossible, the following non-exhaustive list of examples of material differences might provide assistance:
- Different times of execution
- Different distribution schemes
- Different trustees
- Appointment of an independent trustee in one trust
- Different or additional beneficiaries
- Inclusion of a five-by-five power in one trust
- Inclusion of a limited power of appoint- ment in one trust
- Different remainder interests
- Different times of termination.
Each family situation is different and presents opportunities for innovation and creative drafting. For example, in an appropriate situation, one trust might appoint the spouse and children as trustees, whereas the other trust names only the spouse as trustee. Perhaps Jack’s trust allows Jill to invade principal for her health, maintenance, education, and support, whereas Jill’s trust grants Jack a more limited withdrawal power over principal. Alternatively, Jack’s trust might grant the remainder to the children outright, whereas Jill’s trust might hold the remainder in trust for their children and grandchildren, thereby utilizing her generation-skipping transfer tax exemption.
Case law indicates that material difference is not a particularly stringent standard, but prudence is always recommended. In Estate of Levy v. Comm’r (T.C. Memo 1983-453), the reciprocal trust doctrine did not apply to two trusts simultaneously created by a husband and wife because the trust terms were not identical; the trust instrument for the wife’s benefit granted her a special power of appointment, whereas the trust for the husband’s benefit granted him no such power. The wife’s special power of appointment was found to have “objective value” that resulted in the trusts having “very different legal consequences.”
Similarly, in Private Letter Ruling 200426008, the IRS chose not to apply the reciprocal trust doctrine to trusts executed by a husband and wife for the benefit of the other spouse and their child. Each trust contained a life insurance policy on the settlor’s life and named the other spouse as trustee. The trusts were similar in many respects, but also had several important differences. Under his trust, the husband could only receive distributions three years after his wife’s death and only when his net worth and income fell below specified levels. Under her trust, the wife could only receive distributions after the death of their child and only up to $5,000 or 5% of the trust principal. Furthermore, the wife was given a limited power of appointment that could only be exercised after their child’s death. Of course, like all private letter rulings, this decision was limited to the parties at issue and cannot be cited as precedent. The ruling does, however, highlight the types of differences that the IRS will examine in determining whether the reciprocal trust doctrine applies.
In the case of mutual lifetime credit shelter trusts, the parties should strive to avoid the reciprocal trust doctrine by including significant material differences between the trust instruments. These differences need not be arbitrary. Given the general flexibility of the credit shelter trust, material differences can be incorporated by tailoring each trust to the respective beneficiary’s needs. For example, if Jack is elderly or in poor health, Jill’s trust for his benefit might be funded with fewer assets or have a more restrictive distribution scheme. This technique likely has the dual benefits of adapting the trust to accommodate the couple’s unique situation and avoiding the reciprocal trust doctrine. Couples might also consider including a limited power of appointment in the trust that names the spouse and children as trustees. This will help protect the spouse and ensure that the children exercise discretion in their parents’ best interests. The key is to avoid estate inclusion and application of the reciprocal trust doctrine. Careful drafting will achieve both goals, while also protecting each spouse and providing a degree of control.
Another consideration might include drafting the trusts to utilize the generation-skipping transfer tax exemption. The trust may provide that the trust corpus remain in further trust for the benefit of the settlor’s children and grandchildren. The settlor might then allocate his generation-skipping transfer tax exemption to the trust. This will allow the trust assets and any future appreciation to ultimately pass to his grandchildren without imposition of the generation-skipping transfer tax. It is important to note that the current generation-skipping transfer tax exemption, which is equal to the estate tax exemption, is similarly scheduled to revert back to $1 million on January 1, 2013.
Lifetime credit shelter trusts are ideal ways to take advantage of the current estate and gift tax exemption. Their use allows married couples to make gifts while retaining some financial control and a source of income. Credit shelter trusts also allow for flexible and creative drafting, a characteristic that can help avoid inclusion of the trust in the beneficiary’s estate and avoid application of the reciprocal trust doctrine. Because the fate of the $5.12 million estate tax exemption hangs in the balance, couples should act before the end of the year.
New York State conducts residency audits to establish whether a taxpayer is a New York State resident, a nonresident, or a part-year resident in order to determine the correct amount of that taxpayer’s tax obligation.
If you live in more than one place and one of them is in New York, you should prepare for a New York State residency audit. The burden of proof generally is on you to support your claim that you are not a NYS resident. The same rules apply if you have a place in New York City and elsewhere in New York State, and you claim that you are not a New York City resident.
Understanding Your Residency
There are two ways to be a New York State resident: either you are domiciled in New York, or you are deemed to be a statutory resident of New York.
Domicile means a permanent home, or the principal establishment to which a taxpayer intends to return whenever absent.
A statutory resident is not domiciled in New York State but maintains a permanent place of abode there for substantially all of the taxable year, and spends in the aggregate more than 183 days of the taxable year in the state. For example, you might live in New Jersey, but commute to Manhattan on workdays and also own a house in the Hamptons to use on summer weekends. In that case, an auditor could argue you should be taxed as a New York resident.
Statutory residency is a separate consideration from domicile, which we’ll further discuss in a future post.
Scenario: Establishing New Domicile
Let’s say you are a native New Yorker who’s fortunate enough to own two homes, one in New York and the other in Florida; you spend the time between November and March enjoying the good weather in Florida, and the rest of the year in New York. The state considers you a New Yorker, and you’re subject to paying taxes on your worldwide income.
But if you were a nonresident of New York, you’d be subject to tax only on that portion of your income attributable to (“sourced to”) New York. Let’s say you spend more time in Florida than in New York and want your taxes to show that you are a Florida resident. Be careful: spending time in Florida is not enough. To establish a new status as a Floridian you must change your domicile, which involves simultaneously lessening your ties to New York and strengthening your ties to Florida. An auditor from the New York State Department of Taxation and Finance initially will consider five primary factors in determining your domicile. You can take steps that might sway the determination in your favor.
1. Home. Which residence is bigger or more expensive? Which is rented or owned? How much have you invested into their upkeep and maintenance? The numbers and dollars don’t lie. Usually, you’re going to put the money and effort into your primary home.
2. Active Business Involvement. If you’re still working, where are your active business interests? An auditor may not be persuaded that you are a Florida resident, if you remain deeply involved in your New York-based businesses.
3. Time. This is where most people get confused. The 183 days refers only to statutory residents. As a general guideline, you should be able to prove that you spend significantly more days out of New York and in your Florida home. If you spend five months in New York, three in Florida and four months traveling, the auditor will see your time in New York as the most prevalent. Documents like bills, phone records, receipts, and passports should support your claims.
4. Near & Dear. Where do you keep valuable items, like family heirlooms, jewelry, cars and art collections? An auditor will assume you’ll want to be in close proximity to the items that have monetary or sentimental value.
5. Family. Where does your family reside? Where do your minor children attend school? It may be difficult to show that a spouse, minor children or dependents have a separate domicile from yours.
Useful, But Not Determinative
You might think that obtaining a Florida driver’s license and voter registration will show a New York State auditor that you are no longer a New Yorker. While these can be helpful, they do not have the weight of the primary factors above and are not determinative. Other factors in this category include where your car or boat is registered, physical location of safe deposit boxes, and citation of domicile in legal documents such as a will or trust.
A Note On What Does Not Affect Your Residency
There are other misconceptions about residency audits that should be addressed.
● Your accountant’s location does not impact your status. He or she can have an office in New York even if your domicile is in another state.
● Your burial plot is also not a factor during a residency audit. Your eternal resting place will not be considered maintaining ties to New York.
● A passive interest in a New York partnership is not considered in evaluating domicile.
You’ll know that the State is looking at your situation if you receive a nonresident audit questionnaire in the mail. Unless you fully understand the rules, you should always consult a legal or tax professional before completing it.
There are other issues and circumstances that can influence an auditor when determining your residency and we can help you plan accordingly and mitigate tax risk. Contact Capell Barnett Matalon & Schoenfeld at (516) 931-8100 or visit here to schedule a consultation.
On May 11, 2017, Renato Matos and John Osborn presented a webinar on Negotiating Architect and Construction Contracts as part of the Faith-Based Webinar Series.
This article was co-written by Elder Law Partner Stuart Schoenfeld.
In order to qualify for Medicaid, an applicant is required to meet specific resource and income standards. For individuals applying for either nursing home or community Medicaid coverage in 2014, the resource threshold (the maximum amount of “non exempt” assets an individual can have in his or her name in order to qualify for Medicaid) is $14,550 in New York State. Certain assets, such as a home, are exempt assets provided that either the Medicaid applicant or his spouse occupy the premises as his or her primary residence.
The Deficit Reduction Act of 2005 (the “DRA”) imposed a five-year “look-back” for individuals applying for nursing home Medicaid coverage. As a general rule, asset transfers made by the applicant or his or her spouse during the five year period prior to the submission of the Medicaid application will result in a period of Medicaid ineligibility. It is important to note that under current New York law the Medicaid look-back rules apply only to nursing home Medicaid but not to applications for community care (i.e. an individual may transfer all of her assets on the 31st day of the month and be eligible for community Medicaid coverage on the 1st day of the following month). Because of Medicaid’s resource limits and five-year look-back rules, it is important that individuals who wish to protect and preserve their assets complete a Medicaid plan in a timely manner in order to prevent the imposition of a penalty should future nursing home care be required.
There are various planning techniques that can be utilized when creating an effective asset preservation plan. In evaluating when and how to transfer assets, it is crucial that the elder law attorney carefully consider both the tax and non-tax ramifications. This article evaluates various gifting techniques from the perspective of maximizing available tax benefits.
Gifting assets to children or other loved ones outright is the simplest method of transferring resources. However, this technique will frequently result in significant adverse tax consequences. As described in greater detail below, under IRC Section 1015(a), the donor’s basis in the gifted asset will carry over to the donee. The donee/child will be responsible for income taxes on the realized gain when the asset is sold. If the child is in a higher income tax bracket than the donor/parent, the ultimate income tax obligation could be substantially greater if the asset is sold by the child rather than the parent. This is especially important in light of the recent tax increases enacted by the American Taxpayer Relief Act of 2012.
There are additional concerns if the gifted asset is a residence. Transferring a residence by outright gift to a child may result in the loss of real estate tax exemptions such as the enhanced star, senior citizens or veteran’s exemptions. In addition, the child may not qualify for the IRC Section 121 exclusion which permits an individual to exclude $250,000 of profit upon the sale of a principal residence ($500,000 in the case of a married couple).
One of the most important issues to consider regarding an outright gift is the loss of the step-up in basis. Ordinarily, the tax basis of assets owned by an individual as of the date of his or her death is ‘stepped up’ or increased to the asset’s fair market value as of the date of death. Retaining the step-up in basis is a very powerful tax planning tool, as it can effectively eliminate any income tax liability if the asset is sold soon after the death of the parent. An asset that is gifted by the parent during his or her lifetime will retain the donor’s basis and will not qualify for a step-up in basis upon the parent’s death. As stated above, the child will be obligated to realize the gain upon the later sale of the asset based on the parent’s carryover basis.
A related strategy for creating an outright gift that is commonly utilized with respect to a residence is to transfer the property subject to a life estate reserved by the donor parent. Reserving a life estate allows the parent to retain the right to use and occupy the property for the rest of his or her life. It should allow the parent to retain many of the tax benefits discussed above such as available real estate tax exemptions and the basis step-up.
A key implication that must be considered is the gifted residence’s impact on the donor’s taxable estate. Due to the fact that the donor retains an interest in the house, the value of the house will be included in the taxable estate of the donor. Thus, although it will qualify for the step-up in basis, there will be an increase in the donor’s taxable estate which may result in increased federal and state estate taxes.
Furthermore, if the house is sold during the parent’s lifetime, the children will be responsible for the capital gains taxes on the profit attributable to the value of the remainder interest based on the difference in the sale price and the parent’s carryover basis. It is important to note that as the parent ages, the proportionate value of the life estate decreases and the proportionate value of the remainder interest increases. Accordingly, the taxes attributable to the profit resulting from a sale of the remainder interest will also increase. Selling the property during the parent’s lifetime could present a potentially significant financial burden for the children. Moreover, it is important to note that the Section 121 exclusion will be limited to the value of the life estate only. If the value of life estate is less than $250,000 ($500,000 in the case of a married couple) use of the Section 121 exclusion will be limited.
Although it is beyond the scope of this article, there are significant non-tax implications that must also be considered when transferring assets. There are a number of significant issues frequently overlooked when gifting an asset or transferring a house subject to a life estate. Creditor and bankruptcy issues of the child/donee, the unintended consequences of a child predeceasing the parent, divorce of a child/donee and the disability of a child or grandchild, are some of the issues that should be carefully considered prior to making the gift.
Irrevocable Medicaid Qualifying Trust
As with other gifting strategies, an Irrevocable Medicaid Qualifying Trust will permit the parents to protect and preserve their assets should long term community or nursing home care be required. With proper drafting, the gifted property held in the trust should remain eligible for available tax benefits and can also be protected in the event a child faces legal and/or financial difficulties. In order for the trust assets to be viewed by Medicaid as unavailable to the parent, (1) the trust must be irrevocable and (2) the parent/settlor may not serve as trustee. Furthermore, any principal or income that pursuant to the terms of the trust can be distributed by the trustee to the parents will be considered available for Medicaid purposes.
When creating a Medicaid Qualifying Trust, the goal should always be to protect assets while maximizing available income and estate tax benefits, such as the Section 121 exclusion, star exemption, and veteran’s benefits. In many situations, it may be beneficial to construct the trust in a manner that will allow the transfers to be treated as a completed gift for Medicaid purposes, but as an incomplete gift for tax purposes. In other situations, it might be beneficial to structure the transfer as a completed gift for both Medicaid and tax purposes. Such circumstances may include the scenario where the total value of the estate is in excess of the applicable state and/or federal estate tax exemption levels or where the basis of the transferred property is high, and a later sale utilizing the carryover basis would not result in significantly increased capital gains taxes. Another circumstance where a completed gift might be beneficial is where the asset generates significant income for the settlor, which could be detrimental in the event the settlor enrolls in Medicaid at some point in the future.
Individuals with significant assets may, with the aid of counsel, determine that it is beneficial to establish two or more trusts whereby certain assets, such as those with a high basis or those that generate significant income, are transferred out of their names for both estate tax and Medicaid purposes while other assets, such as a residence and those assets with a low tax basis remain part of their estate for estate and income tax purposes. The drafting attorney should also consider including other important estate tax planning techniques for inclusion in the trust, such as bypass/credit shelter provisions, if applicable.
Establishing a viable plan to protect and preserve assets involves the development of a comprehensive strategy both from an elder care and tax planning perspective. A plan cannot be designed and executed without consideration of both the tax and non-tax implications. In many situations, a properly drafted Medicaid Qualifying Trust will be the most effective way to achieve all of the planning objectives.
This article first appeared in the February 2014 edition of the Nassau Lawyer and is reprinted with permission by the Nassau County Bar Association.
This article was co-authored by Tax Partner Robert S. Barnett.
Asset protection is often an important goal in estate and financial planning. The central vehicle is often a family asset protection trust. In drafting such a trust, the settlor’s intent is of central importance and needs to be clearly presented. A discretionary trust may be the ideal method of providing increased coverage. The law regarding asset protection trusts is a changing area, as the Restatement (Third) of Trusts modifies the traditional approach long promoted by the Restatement (Second). Careful attention must be paid to the trust distribution provisions, and this article presents some practical considerations.
Discretionary Trusts – Generally
Generally, creditors can only reach those assets that have been distributed or to which a beneficiary has an enforceable right. In a pure discretionary trust, the trustee is granted absolute and complete discretion, thereby limiting the beneficiary’s rights. In a well-prepared asset protection trust, the trustee has discretion regarding the amount to distribute, the timing of a distribution, whether to make any distributions at all, and which beneficiaries, if any, will receive distributions.
A distribution provision in a pure discretionary trust might read: “So much, all, or none of the principal may be paid to any, all, or none of the beneficiaries at any time or from time to time, as the trustee, in his or her sole, absolute, and unfettered discretion may determine.” This language can be contrasted with that found in many trusts: “Income and/or principal shall be paid to the beneficiary for health, education, maintenance, and support.” This type of provision is referred to as an ascertainable standard and is less effective for asset protection purposes, due to the use of the word “shall” and due to the fact that a court may determine that beneficiaries or creditors have an enforceable right to a distribution.
In a pure discretionary trust, the beneficiary’s rights are more limited than in a trust with an ascertainable standard. If a beneficiary “shall” or “may for health, education, maintenance, and support” receive a certain amount of trust principal, a trustee could be compelled to make a distribution to a creditor. Conversely, if the beneficiary “may in the trustee’s sole and absolute discretion” receive trust principal, neither the beneficiary nor the beneficiary’s creditors can require that a distribution be made. Note, however, that New York Civil Practice Laws and Rules Section 5205(d)(1) provides that up to ten percent of trust income may be available to a creditor seeking satisfaction of a money judgment. Notwithstanding this ten-percent invasion right, under a pure discretionary standard, both the beneficiary’s and the creditor’s access to the trust fund is limited. It is recommended that the trust also contain provisions regarding the settlor’s intent that the trust not be invaded.
This was the approach long taken by the Restatement (Second), published in 1959. The Restatement (Second) provides that the extent of a beneficiary’s enforceable interest in the trust (and the extent of creditor protection) is determined by the amount of discretion granted to the trustee. Provided that the trustee is afforded “sole, absolute, and unfettered” discretion, the trust is likely to be classified as purely discretionary with complete asset protection.
The Restatement (Third), published in 2003, takes a new approach to discretionary trusts, which is of concern to asset protection planners. According to the Restatement (Third), even if the trust grants the trustee complete discretion, a standard of reasonableness or good faith may be imputed based on “the extent of the trustee’s discretion, the various beneficial interests created, the beneficiaries’ circumstances and relationships to the settlor, and the general purposes of the trust.” The Restatement goes on to state that even if the trustee has complete discretion, “it is rare [ ] that the beneficiary’s circumstances, the terms of the discretionary power, and the purposes of the trust leave the beneficiary so powerless” that a distribution could not be compelled.
The Restatement Third does not provide any absolutes with regard to asset protection, nor does it provide any instruction for drafting a pure discretionary trust in which a beneficiary has no enforceable interest. It is unclear to what extent the courts will interpret and apply this language, and different jurisdictions will likely take different approaches. If the court treats discretionary trusts as if they contain an ascertainable standard, asset protection may be negated or severely limited. Thus, in jurisdictions that have not enacted laws governing the issue, drafters may be advised either to grant the trustee absolute discretion or to draft the trust under the laws of a jurisdiction with a statute affording creditor protection to discretionary trusts. In all events, the settlor’s intent should be clearly established, as this may be a defining characteristic of asset protection trusts.
The Use of Discretionary Trusts in New York
New York has no statute on point with regard to asset protection and discretionary trusts, nor has it expressly adopted the approach of either Restatement (Second) or Restatement (Third). There is, however, ample case law on the subject.
When the trustee is granted complete and absolute discretion, the law “is clear that a creditor … cannot compel the trustee to pay any part of the income or principal to the beneficiary.” Vanderbilt Credit Corp. v. Chase Manhattan Bank, NA, 473 N.Y.S.2d 242, 245 (1984). However, if discretion must be exercised according to a specific standard, there may not be complete creditor protection and the beneficiary (or creditor) may have an enforceable interest.
If the discretionary trust contains an ascertainable standard, a creditor may be able to reach the trust assets. The settlor’s intent is often determinative when examining a beneficiary’s or creditor’s ability to compel a distribution. Take for instance, the case of Estate of Escher, 407 N.Y.S.2d 106 (N.Y. Surr. 1978), affirmed by 52 N.Y.2d 1006 (1981), in which the trust instrument granted the trustee discretion to distribute principal as needed for emergency situations. Here, the court determined, and the Court of Appeals affirmed, that a distribution could not be compelled, as the nature of the creditor’s claim did not constitute an “emergency situation,” as intended by the settlor. The court examined the settlor’s intent through the trust language, the relationships between the settlor and the beneficiary and between the settlor and the remaindermen, the identities of the remaindermen, and “any other pertinent facts indicative of intent.”
As illustrated by Escher, the settlor’s intent will be examined if the discretion is limited by an ascertainable standard. If the creditor can compel a distribution on behalf of a beneficiary, the creditor may be able to reach the trust assets, thereby negating any asset protection. Therefore, in situations where creditor protection is a significant concern, it is advisable to avoid the use of such standards and to grant the trustee complete discretion or, if a standard is insisted upon, to clearly express how the settlor intends for the discretion to be exercised. Additional consideration may be given to placing the trust situs in a jurisdiction that has not adopted the Restatement (Third) or has enacted statutes to enforce asset protection trusts.
In conclusion, the law regarding asset protection and discretionary trusts is currently in flux due to the changes set forth in the Restatement (Third). When asset protection is desired, it is recommended that the trust grant the trustee complete discretionary and clearly express the settlor’s intent to prohibit beneficiaries and creditors from compelling distributions.
This article first appeared in the January 2013 NYSSCPA newsletter.
Download the entire newsletter