Review By: Lena S. Barnett, Howard M. Lang, Roger McClure, and Samuel T. Swansen
Reprinted from Conspectus Current, Inaugural Issue 1998.
Copyright 1998 by Esperti Peterson Publications, LLC. All rights reserved.
Source: 50 The Tax Lawyer 489 (1997). Author: Richard W. Harris.
A thorough understanding of the intricacies of ascertainable standards as applicable in the realms of estate, gift and income taxation is crucial for all estate planning professionals.
Whether or not a trustee is limited to an ascertainable standard in making distributions is critically important to determining the income, estate, and gift tax consequences to the trustee, the grantor, and the beneficiaries.
An "ascertainable" standard is one that is sufficiently determinable and enforceable to entitle a beneficiary to compel the trustee to make or refrain from making a distribution. In some situations, the standard must relate to the health, education, support, or maintenance of a beneficiary to avoid adverse estate and gift tax implications.
ESTATE TAX
Generally, if a donor transfers assets into an irrevocable trust and possesses the right to enjoy or exercise control over the assets at the donor's death, those assets are includible in the donor's gross estate. Thus, if the donor is to serve as trustee, the trustee's discretion over beneficial enjoyment of income and principal must be subject to an ascertainable standard.
A donor's gross estate will also include the assets of an irrevocable trust to the extent that the donor/trustee may use the trust to fulfill any of his or her legal obligations, such as an obligation under state law to support a child or spouse, even though the trustee's discretion is subject to an ascertainable standard.
The gross estate of a trustee who is also a beneficiary will include the value of the trust if, at the trustee's death, the trustee can distribute property to himself or herself under a non-ascertainable standard, as such a power constitutes a general power of appointment. If the discretion of a beneficiary/trustee is subject to an ascertainable standard related to health, education, maintenance, and support, however, the power will not be a general power of appointment.
A trustee is subject to an ascertainable standard in distributing trust property when the trustee's authority is sufficiently determinable and enforceable to permit the beneficiaries to compel the trustee, through judicial action if necessary, to make or refrain from making a distribution. An ascertainable standard often defines the permissible reasons for making a distribution, e.g. education or medical care; or sets some other measuring rod by which to judge a distribution. For example, instructing a trustee to make a distribution to maintain a beneficiary in "his accustomed standard of living" generally constitutes an ascertainable standard, because a court can assess the beneficiary's past standard of living and compare it to his or her present situation and needs.
Over the years, courts have reviewed countless trust investments to determine whether the grantor intended to impose enforceable limits on the trustee or whether the grantor intended to give the trustee complete discretion in making distributions. The results turn on the precise language of the governing instrument, and, often, one or two words can make the difference in the outcome.
Terms such as "happiness," "care," "well-being," "welfare," or "comfort" may not constitute ascertainable standards under state law. Likewise, authorizing a trustee to act "in his sole and absolute discretion" may undo an otherwise ascertainable standard, because this language limits judicial review of the trustee's decisions.
The regulations implementing Section 2041 state that a trustee's power to distribute property to himself or herself must be subject to "an ascertainable standard relating to the health, education, support, or maintenance of the possessor," or the power will be a general power of appointment. The grantor's failure to incorporate this language in the trust agreement has caused much litigation.
GIFT TAX
As a general rule, if a transfer of property constitutes a completed gift for gift tax purposes, the property is not includible in the donor's gross estate. Similarly, if a gift is incomplete for gift tax purposes, the property is typically included in the donor's gross estate. The estate and gift tax rules are not, however, completely symmetrical. Clearly, it is possible for a donor to make a completed gift of property, yet the property is includible in the donor's gross estate under either Section 2036 or Section 2038.
If a third-party trustee, acting under an ascertainable standard, can make distributions to the donor from an irrevocable trust, no gift occurs to the extent of the ascertainable standard of the grantor's right to receive distributions. If the trustee is not limited to a fixed standard, however, the gift may be incomplete in its entirety, depending on whether the grantor can compel the trustee to make distributions.
If a trustee is also a beneficiary, and can make distributions to himself or herself under a non-ascertainable standard, the trustee makes a gift whenever he or she makes a distribution to another beneficiary.
If a trustee who is a beneficiary wants to make a "qualified disclaimer" of his or her interest in a trust, the trustee's power to control distributions must be subject to an ascertainable standard. Thus, if a surviving spouse who is both a trustee and a beneficiary of a bypass trust disclaims property from the marital trust to the bypass trust, the trustee must be subject to an ascertainable standard.
INCOME TAX
Even though a donor makes a completed gift for gift tax purposes, the donor may remain liable for the income taxes the property thereafter generates in accordance with the so-called "grantor's trust" rules in Sections 673 to 677. For example, if the grantor retains a beneficial interest in the trust's income or names his or her spouse as an income beneficiary, the grantor is liable for the taxes on the income the trust property earns.
The grantor is also subject to taxation on the trust's income if the grantor or the grantor's spouse holds the power to make discretionary distributions of trust income, even if that power is subject to an ascertainable standard. The grantor is also taxed on the trust's income if a trustee other than the grantor or the grantor's spouse has the discretion to distribute income among the beneficiaries, unless that trustee's discretion is subject to a "reasonably definite external standard."
On the other hand, a grantor is not subject to taxation on the trust's income merely because he or she can distribute principal to other beneficiaries - so long as the grantor is subject to an ascertainable standard.
If the surviving spouse is to be both a trustee and a beneficiary of the credit shelter trust, limit the spouse's right to make distributions to himself or herself as an ascertainable standard relating to health, education, support, and maintenance.
Avoid using terms such as "happiness," "care," "well-being," "welfare," or comfort," as they do not always constitute ascertainable standards. Use the phrase "support, maintenance, health, and education" to impose an ascertainable standard.
When establishing a custodial account under the Uniform Gifts (or Transfers) to Minors Act for a child of a donor, do not permit either parent to serve as custodian; if the parent/custodian dies before the account is completely distributed, it will be included in his or her gross estate. Likewise, a donor, regardless of his or her relationship to the child, should not serve as custodian.
Consider making the trust a "defective" grantor trust. Given the compressed tax brackets for trusts, it may be less costly if the grantor pays the tax.
To avoid giving a beneficiary/trustee a general power of appointment, for estate tax purposes, the drafting attorney must limit the trustee's discretion over disposition of income and principal to an ascertainable standard relating to the health, education support or maintenance of the distributes.
Deviating from this safe harbor standard generates obtuse, difficult, inconsistent, and challenging tax issues, as documented in the article's 232 footnotes.
The decision to impose an ascertainable standard can also significantly affect the rights of the beneficiaries. A non-ascertainable standard grants the trustee broad powers and leaves beneficiaries with little recourse if the trustee is stingy or too free in making distributions. On the other hand, a trustee operating under a fixed standard may find it necessary to spend trust funds on legal fees defending his or her decisions in court.
The special valuation rule of Section 2702 has virtually stopped grantors from retaining income or similar interests in trusts other than qualified annuity or unitrust interests.
Clients wanting to provide beneficiaries with predictable sources of income should consider a total return trust. Donors wanting to retain beneficial interests in trust property should consider a grantor retained annuity trust or unitrust.
Nothing in this discussion should indicate approval of using the grantor as a trustee of an irrevocable life insurance trust. The "incidents of ownership" rules of Section 2042 are far broader than Sections 2036 and 2038.
SS 674, 677, 2036, 2039,
2041, 2511, 2514, 2518
Treas. Reg. SS 1. 674(d)-1,
20.2041(c)(2), 25.2511-1(g)(2), 25.2514-1(c)(2)
Rev. Rul. 59-357, 1959-2
C.B. 212
Rev. Rul. 56-484, 1956-2
C.B. 23
Jennings v. Smith,
161 F. 2d 74 (6th Cir. 1947)
Strite v. Meginnes,
330 F. 2d 234 (3rd Cir. 1964)
Digby. What Powers Can a Donor Retain Over Transferred Property?, 24 ESTATE PLANNING 318 (1997).
Frackelton. Careful Restriction of Power Avoids Inclusion in Estate, 54 TAXATION FOR ACCOUNTANTS 79 (1995).
Weinstein. Avoiding Estate Tax from Powers of Appointment, 22 TAXATION FOR LAWYERS 332 (1994).
Bittker and Lokken. FEDERAL TAXATION OF INCOME, ESTATES AND GIFTS (Warren, Gorham & Lamont, 2d ed. 1993).
Stephens, Maxfield, Lind, and Calfee. FEDERAL ESTATE AND GIFT TAXATION (Warren, Gorham & Lamont, 7th ed. 1996).
BOTTOM LINE
