Beneficiary Can be Trustee Without Estate Tax Inclusion
When my clients want to make substantial outright bequests, I encourage them to switch from an outright bequest to a trust with the beneficiary as the trustee. The trust provides the beneficiary with creditor protection, divorce protection, and estate and inheritance tax protection. Occasionally, I hear questions from my clients or their advisors concerning whether the trust will be included in the beneficiary/trustee’s estate for estate tax purposes.
The beneficiary can be a trustee of a trust for his or her benefit if distributions to the beneficiary are limited to an ascertainable standard, as defined by the IRS. The IRS definition of ascertainable standard is defined as health, education, maintenance, or support. If the purposes for which the beneficiary/trustee can make distributions are limited to these categories, the trust will not be included in the beneficiary’s estate upon the beneficiary’s death.
Occasionally, someone uses a slightly different standard and the IRS will attack the standard. In Estate of Ann R. Chancellor, T.C. Memo 2011-172, the decedent was a trustee and beneficiary of a trust that allowed corpus distributions for “necessary maintenance, education, healthcare, sustenance, welfare or other appropriate expenditures needed by the beneficiaries… taking into consideration the standard of living to which they are accustomed.” The IRS argued that this was not an ascertainable standard. The Court undertook an analysis of Mississippi law and determined that the standard was ascertainable. Therefore, the trust was not subject to estate taxes.
Even though the taxpayers won this case, they incurred stress and unnecessary legal fees due to the trust using language that did not track the IRS definition of an ascertainable standard. In my opinion, the more expansive language did not accomplish anything.
Tennessee law, as well as the law of most other states, has interpreted the phrase “health, education, maintenance, and support” to include expenditures to maintain the beneficiary’s standard of living to which they are accustomed. Therefore, expanding the distribution standard to refer to “accustomed standard of living” does not increase the purposes for which distributions can be made. However, the more expansive language may invite unnecessary IRS scrutiny.
If you are concerned that an ascertainable standard is too restrictive, you can also give the beneficiary the right to withdraw up to 5% of the trust per year for any reason. I recommend limiting the withdrawal right to one day each year. If the beneficiary dies on the day that you have chosen (typically December 31), 5% of the value of the trust will be included in the beneficiary’s estate. However, if the beneficiary dies on any other day during the year, the 5% withdrawal power will not cause any portion of the trust to be included in the beneficiary’s estate.
In summary, rather than leaving significant bequests outright, you should leave them in trust with the beneficiary as trustee. The standard for distributions should be limited to health, education, maintenance, and support. You should also give the beneficiary the right to withdraw up to 5% of the trust for any reason. If you follow these guidelines, your beneficiaries will thank you and you will avoid creating estate tax issues for your beneficiaries.
