Early predecessors of modern trusts appeared in connection with land conveyances in England. Prior to the Statute of Wills, enacted by Parliament in 1540, it was impossible for a landowner to devise title in land to heirs. Moreover, under the harsh common law rules of primogeniture, if a landowner died without living relatives, his land would escheat to the Crown. To avoid these difficulties, title was often conveyed to a third person “to the use” of the owner during his life, and then to the beneficiary. The “trustee” of this passive trust had no duty except to hold and convey title.
Modern trust law also developed in England, in the 12th and 13th centuries. For practical reasons (i.e., payment of taxes), landowners leaving to fight in the Crusades might convey title in land to another person. However, English law did not recognize the claim of the returning Crusader forced to sue if the legal owner refused to revest title in the original owner. Turned away at courts of law, some Crusaders then petitioned the King, who referred cases to the Courts of Chancery. These equitable courts often compelled the legal owner (the “trustee”) to reconvey the land back to the Crusader, (the “beneficiary” or cestui que trust) who was deemed to be the equitable owner.
Equitable remedies first recognized by Chancery Courts exist today in the form of injunctions, temporary restraining orders, declaratory judgments, which remedies may be sought where there is no remedy at law. Despite the formal merger of law and equity in New York in 1848, the Court of Appeals has observed that “[t]he inherent and fundamental difference between actions at law and suits in equity cannot be ignored.” Jackson v. Strong, 222 N.Y. 149, 118 N.E. 512 (1917).
The principles of recognition and enforcement of trusts enunciated by Courts of Chancery form the basis of modern trust law. A trust is thus a fiduciary relationship with respect to specific property, to which the trustee holds legal title for the benefit of one or more persons, who hold equitable title as beneficiaries. Thus, two forms of ownership — legal and equitable — exist in the same property at the same time. [Restatement of Trusts, §2]. Trustees are responsible, inter alia, for ensuring that trust property is made productive for beneficiaries. The trust instrument defines the scope of discretionary powers conferred upon the trustee. With respect to discretion involving distributions, the trust may grant the trustee (i) no discretion; (ii) discretion subject to an ascertainable standard; or (iii) absolute discretion. The scope of discretion granted has profound tax and non-tax consequences, especially if the trustee is the grantor.
B. No Discretion
The trust may provide that the trustee “distribute to Lisa annually the greater of $1,000 or all of the net income from the trust.” In this situation, the grantor (also known as the trustor, settlor, donor, or creator) of the trust could name himself as trustee with no adverse estate tax consequences, since he has retained no powers which would result in the property being considered part of his gross estate. (However, if Lisa were given a limited power to appoint income to which she would otherwise be entitled to another person, a gift tax could result.)
Obviously, eliminating trustee discretion with respect to distributions provides certainty to beneficiaries, and reduces the chance of conflict. However, the trustee will be unable to increase or decrease the amount distributed in the event circumstances change. Another problem arises: Some jurisdictions, such as New York and Delaware, authorize a trustee to appoint trust property in favor of another trust. These “decanting” statutes permit trustees to “decant” trust assets into new irrevocable trusts drafted with dispositive provisions which reflect changed circumstances. However, EPTL § 10-6.6(b) provides as a statutory prerequisite that the trustee must have unfettered power to invade the principal of the trust. A trust granting the trustee no discretion with respect to distributions could not avail itself of the “decanting” statute.
C. Absolute Discretion
At the opposite end of the spectrum lie trusts which grant the trustee unlimited discretion. If the grantor were trustee this trust, estate inclusion would result under IRC §2036 — even if the grantor could make no distributions to himself — because he nonetheless would have retained the proscribed power in IRC §2036(a)(2) to “designate the persons who shall possess or enjoy the property or the income therefrom.”
Disputes among beneficiaries (or between beneficiaries and the trustee) could occur if the trustee possesses absolute discretion with respect to trust distributions. However, by adding the term “unreviewable” to “absolute discretion,” the occasion for court intervention would appear to be limited to those extreme circumstances where the trustee has acted unreasonably or acted with misfeasance.
The “decanting” statutes in all states which have enacted them, including New York, permit the creation of new irrevocable trusts where the trustee has been granted absolute discretion with respect to distributions. One significant advantage of utilizing a decanting statute is that no beneficiary consent is required and no court supervision is necessary in order to create a new trust. Nor is there is a need to demonstrate a change in circumstances.
D. Ascertainable Standard Discretion
In the middle of the spectrum lie the most common trusts, which grant the trustee distribution discretion limited to an ascertainable standard. As is the case with trusts granting no discretion to the trustee, if the trustee’s discretion is limited by an ascertainable standard, no adverse estate tax consequences should result if the grantor is named trustee. Since this degree of discretion affords the trustee with some flexibility regarding distributions without adverse estate tax consequences, most grantors find this model attractive.
Although no adverse estate tax are likely if the grantor is trustee, adverse income tax consequences are nevertheless possible. For example, if the trustee determines that no distribution is required for the beneficiary’s health, education, maintenance and support, trust income will be taxed at compressed income tax rates. This problem might be minimized by creating another class of contingent beneficiaries, to whom the trustee, guided by the same ascertainable standard, could shift income. However, such an arrangement may occasion disputes among beneficiaries.
Despite the flexibility afforded by trusts whose distributions are determined by reference to an ascertainable standard, issues may arise as to what exactly is meant by that term. Is the trustee permitted to allow the beneficiary to continue to enjoy his or her accustomed standard of living? Should other resources of the beneficiary be taken into account? The trust should address, for example, with some specificity, what the accustomed standard of living of the beneficiary is, when invasions of trust principal are appropriate, and what circumstances of the beneficiary should be taken into account in determining distributions pursuant to the ascertainable standard. If the trust fails to address these issues, the possibility of disputes among current beneficiaries, or between current and future beneficiaries, may increase.
“Decanting” statutes in some jurisdictions, such as Delaware and Alaska, permit the appointment of irrevocable trust assets into a new trust where the trustee has significant — but not absolute — discretion with respect to distribution of trust assets. However, EPTL §10-6.6(b) requires that the trustee have unfettered power to invade principal in order to vest trust assets in a new irrevocable trust. Therefore, an “ascertainable standard” trust established in New York could not avail itself of the decanting statute.
E. Investment Discretion
Investment of trust assets is also an important consideration of the grantor. While the grantor may be content with delegating discretion for distributions to the trustee, he may have an investment philosophy which he wishes to be employed by the trustee. Unless otherwise stated in the trust instrument, the trustee is granted broad discretion with respect to the investment of trust assets. New York has not enacted the Uniform Prudent Investor Act. However, New York has enacted its own rule, found in EPTL §11-2.3, entitled the “Prudent Investor Act.” Under the Act, the trustee has a duty “to invest and manage property held in a fiduciary capacity in accordance with the prudent investor standard.” The prudent investor standard comprehends the philosophy that the trustee will exercise reasonable care in implementing management decisions for the portfolio, taking into account trust provisions. The trustee should pursue a strategy that benefits present and future beneficiaries in accordance with the “risk and return objectives reasonably suited to the entire portfolio.” If the grantor believes that the named trustee can make distribution decisions, but requires assistance in investing trust assets, the instrument may authorize the trustee to engage a financial advisor to provide professional guidance in making investment decisions.
F. Trust Protectors
Some jurisdictions permit the use of trust “protectors” to provide flexibility in the administration of trusts. This is particularly important given the state of flux in the estate tax. The Uniform Trust Code recognizes the principle that an independent person may be vested with the authority to direct the trustee to perform certain actions. Powers granted to the protector could include the power to (i) remove or replace a trustee; (ii) direct, consent or veto trust distributions; (iii) alter, add or eliminate beneficiaries; or (iv) change trust situs and governing law. To avoid adverse tax consequences, a trust protector should not be a member of the grantor’s family. Attorneys, accountants, siblings or friends could be named as a trust protector. Corporate fiduciaries may not be a good choice, since their ability to exercise authority may in practical terms be constrained by the institution.
Various avenues exist for disgruntled beneficiaries to challenge the manner in which a trust is being administered. Problems may arise where a beneficiary is also serving as co-trustee with an independent trustee. The most drastic step is to remove the trustee. In fact, discretionary trusts often provide for removal of the trustee, and replacement by the grantor or trust beneficiaries. However, the retention by the grantor of the power to remove the trustee may imbue the trust with tax problems. Rev. Rul. 79-355 stated that a retained power by the grantor to remove a corporate trustee and appoint another corporate trustee was in essence the retention by the grantor of the trustee’s powers. The retained power would constitute an “incident of ownership,” and would cause the entire life insurance trust to be included in the grantor’s estate.
However, the IRS in TAM 9303018 opined that the removal of a trustee “for cause,” would not result in the power being attributed to the grantor. Some of the removal “for cause” powers cited include (i) the legal incapacity of the trustee; (ii) the willful or negligent mismanagement of trust assets; (iii) the abuse or inattention to the trust by the trustee; (iv) an existing federal or state criminal charge against the trustee; or (v) a relocation of the trustee.