When creating your irrevocable trust and seeking (i) asset protection; (ii) current gift tax inclusion and (iii) subsequent estate tax exclusion, the most important decisions you will make is the level of discretion accorded the trustee in making distributions from trust.
The two most common distribution standards in an asset protection trust are “wholly discretionary” and “ascertainable standards” (meaning health, education, maintenance and support or “HEMS”). If you allow the trustee to make distributions pursuant to an “ascertainable standard,” you open the trust up to estate tax inclusion as the recent Massachusetts case of Pfannenstiehl v. Pfannenstiehl, 475 Mass. 105 (2016) illustrates. In that case the divorcing non-beneficiary spouse won at trial with the inclusion of the value of the beneficial interest held by her husband and from a reading of the appeal, made a good case for marital estate inclusion but won on the “expectancy” analysis. We strenuously oppose the HEMS standard in the context of an asset protection trust and, most particularly, in an asset protection, non-grantor trust seeking estate tax exclusion.
The ascertainable standard was created and refined by our judiciary through tax cases. The question being addressed was whether the trustee had too much “control” so as to include the assets of the trust in the taxable estate and whether the beneficiaries could influence that control. The court cases articulated the concept of an ascertainable standard so as to provide sufficient discretion and alleviate the potential for an adverse tax impact. The result was that HEMS became the standard of discretion for trustees.
After the passage of EGTRAA in 2001 and the grotesque expansion of the estate tax exemption, however, the HEMS standard for estate tax purposes applies to less than two out of 1,000 Americans. Since that is the case, why do lawyers still draft an asset protection trust to comply with restrictions required for .002 of all Americans. Answer: That’s the way we have always done it and God forbid we stray from an antiquated standard.
We recommend wholly discretionary distribution standards, as statutorily recognized by Wyoming law. The wording typically provides that “the trustee shall make distributions to any beneficiary in its sole, absolute and unreviewable discretion….” This assures that the discretion to make a distribution is held wholly by the trustee and there is less risk of the trust being invaded by outside sources.
Note that Wyoming law specifically excludes taxes from the HEMS standard, which is small comfort given the other demands of a beneficiary that could be made. We understand that a senior beneficiary residing in a nursing home with a HEMS distribution clause would risk the trustee being required to make distributions for the cost of that nursing home since this would be for the beneficiary’s health, maintenance or support. We just deliberately and knowingly walked through a trap door. Medicaid recovery would have a hey day with this standard. Wyoming also specifically provides that the discretionary standard is an “expectancy” and not a property right, which addresses estate inclusion not only for tax, but also for marriage, Medicaid and the like.
Use the discretionary distribution standard and forget HEMS.