| OVERVIEW
RELEVANCE
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.
FUNDAMENTAL ISSUES
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.
PIVOTAL POINTS
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.
PRACTICE APPLICATIONS
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.
COMMENTARY
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.
PRACTICE ALTERNATIVES
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.
THE LAW
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)
ADDITIONAL REFERENCES
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
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