Maria Worthington McKenna
What You Need to Know About Beneficiary-Controlled Trust
Would you like to provide your children or loved ones with an inheritance but protect them from the risks that may accompany a large windfall? If so, you can create a beneficiary-controlled trust in which the person you name as the trust’s primary beneficiary has rights, benefits, and control over the property held by the trust, but with important protections. In a beneficiary-controlled trust, you can name the primary beneficiary as the sole trustee, or if you name a co-trustee, the beneficiary can be given the authority to remove the co-trustee and select a successor co-trustee if they choose. In addition, a beneficiary-controlled trust may include a broad, nongeneral power of appointment that enables a beneficiary who is also trustee to limit the ability of other more remote beneficiaries to enjoy the property held by the trust.
What Are the Pros?
If you want to provide an inheritance to a mature child or loved one that you trust to make prudent financial decisions, a beneficiary-controlled controlled trust is a strategy that you should consider. Even beneficiaries who handle money wisely could encounter situations in which their inheritance or money and property are vulnerable to creditors’ claims, divorce, lawsuits, or estate taxes: a beneficiary-controlled trust can protect the property held in the trust against those claims. Although you can include terms in the trust document that limit the degree of involvement and control you would like the beneficiary to have, a beneficiary-controlled trust can still enable the beneficiary to have a considerable amount of control over their inheritance and how it is used.
Beneficiary as sole trustee. Under most states’ laws, even if a beneficiary is the sole trustee, most creditors may not reach the beneficiary’s interest in the trust or compel the trustee to make a distribution if the trustee is not required, but has the discretion, to make distributions based on an ascertainable standard, for example, distributions for the beneficiary’s health, education, maintenance, and support (HEMS). Also, even if a beneficiary is the sole trustee, the trustee has a fiduciary duty to adhere to the trust’s requirement to make distributions only for the beneficiary’s HEMS and is not permitted to make distributions to the beneficiary’s creditors. However, once the trustee makes a distribution to themselves as a beneficiary, the creditor may then be able to reach the funds.
This type of provision provides two additional benefits. First, the HEMS standard provides a safe harbor under the Internal Revenue Code (I.R.C.), and its use will prevent the value of the inheritance or money and property in the trust from being included in your beneficiary’s gross estate for estate tax purposes. Second, depending upon the unique circumstances of each beneficiary and if there is low risk of creditors’ claims or lawsuits, naming the primary beneficiary as the sole trustee, along with the HEMS standard for distributions, may reduce expenses during administration of the trust because the fees required for an independent co-trustee would not be incurred.
Beneficiary as co-trustee. Another option that provides enhanced protection for the trust’s assets such as money and property is to name the beneficiary as a trustee authorized to manage and invest the trust’s assets, and to name an independent co-trustee (sometimes called a distribution trustee) who is responsible for making discretionary trust distributions to the beneficiary. Although it is more complicated and expensive to include an additional independent trustee empowered to make distributions in their sole discretion, it provides a greater degree of asset protection for property held by the trust and for the primary beneficiary indirectly. In addition, the independent trustee does not need to be limited to distributions according to the HEMS standard. Rather, the independent trustee may distribute trust property to the beneficiary for any reason without reducing the level of asset protection. Typically, the trust’s terms still provide the beneficiary with a significant degree of control, not directly over the amount or timing of distributions, but over who serves as the independent co-trustee. The beneficiary is permitted to select the independent trustee as long as that trustee is actually independent—not a related party or a person subordinate to the beneficiary as defined by I.R.C. § 672(c)—and still avoid having the property held by the trust included in their estate for estate tax purposes. In addition, the beneficiary may replace the independent trustee at any time and for any reason. If the beneficiary is facing a heightened risk of lawsuits, divorce, or creditors’ claims, they could resign as the trustee and appoint an independent trustee to serve in their place, providing additional protection for the trust’s assets.
What Are the Cons?
May not protect against all creditors. Some states’ laws provide exceptions that preclude beneficiary-controlled trusts from being used to protect trust assets from claims by certain creditors, for example, a former spouse’s claim for alimony or a claim for child support. In those states, the creditor may be able to reach the trust’s property to satisfy those claims or to compel a distribution that it can then use to satisfy the claims.
May provide too much control for some beneficiaries. For beneficiaries who are not skilled at managing money or have poor judgment, a beneficiary-controlled trust may not be the best estate planning strategy. Although the trust document will specify the beneficiary’s responsibilities as a fiduciary, a beneficiary-controlled trust provides the beneficiary with considerable control over their inheritance. Even if a beneficiary who is also the sole trustee may only make HEMS distributions to themselves, to a large extent, it is up to them to determine if a particular distribution meets that standard, permitting them substantial leeway in how the money or property held by the trust is expended. If you are concerned that a beneficiary will not be able to handle the responsibility of also being a trustee for a beneficiary-controlled trust, other estate planning solutions may provide you with more peace of mind.
If you would like to find out more about whether a beneficiary-controlled trust is a strategy that will work for you and your family, give us a call to set up an appointment. We can help you think through how to design your beneficiary-controlled trust in a way that achieves your goals and protects the inheritance you want to leave for family members and loved ones.