Distribution Requests: Why So Many Questions?
One of the more common questions that a trustee receives from beneficiaries is what information is needed for the trustee to approve a distribution request. Sometimes, the beneficiary is surprised that the trustee has even asked any questions into the intended purpose and reason for the distribution request or requested documentation related to such purpose. While not all inclusive, this post will summarize some of the many considerations a trustee must examine when deciding whether to approve a beneficiary’s distribution request.
The Evolving Role of Trustees
When a corporate trustee has discretion over making a distribution to a beneficiary, there is a certain amount of due diligence and analysis that must be conducted to ensure that they are following the specific terms of the trust along with general fiduciary principles, such as treating all beneficiaries of the trust fairly. Many years ago this was a much simpler process, when families lived near each other and there was a trustee from the local bank down the street that had been working with the family for generations. In those instances, the parties had very specific knowledge of the family needs based upon an intimate knowledge of the family history.
Over the years it’s become much more complex. Trustees today are administering trusts for the benefit of beneficiaries located all around the world, offering fewer opportunities to meet in person. This limits a trustee’s knowledge of the family and the needs of individual beneficiaries to phone and email conversations. Moreover, trustees often change over the years, making their knowledge of family history limited. In short, corporate trustees today must be more diligent in asking questions that allow them to become familiar with the family needs, and create a record to rely on as to the trustees’ thought processes and the supporting documentation when deciding whether to approve or decline a beneficiary distribution request. The result is that trustees must collect more documents and ask additional questions in response to the documentation collected.
Distribution Considerations
A trustee starts by examining the specific distribution terms in the trust agreement. The trust itself establishes a foundation as to the types of factors to be considered and the grantor’s intent as to when the trustee is to make a distribution to a beneficiary. Each trust is different when it comes to distribution terms. Some may be very broad and liberal, and not put any conditions on when a distribution can be made. For example, the distribution provision may simply state that the trustee may make a distribution to or for the benefit of the beneficiary per the trustee’s absolute discretion. When this occurs, a trustee may be more likely to approve the requested distribution so long as it is reasonable based upon the trust’s current fair market value.
As mentioned previously, a trustee must consider the needs of all of the beneficiaries of a trust and not just the specific beneficiary requesting a distribution. Therefore, a trustee must consider the amount of the distribution request as compared to the trust’s overall value. This is to ensure that the trust is not diminished too rapidly and that it can continue to exist and support the needs of each of its current beneficiaries and remainder beneficiaries for as long as the trust’s existence was intended by the grantor, which under Delaware law can be perpetual.
When performing this analysis for a current beneficiary of the trust, a trustee will examine how much income the trust assets are generating and whether the distribution requested falls within the amount of income being produced or if, by making the distribution, it will reduce the principal of the trust. Some trusts negate this consideration by directing the trustee to favor the current beneficiaries’ needs over providing for the next generation of beneficiaries. As every trust is unique, the actual provisions of the trust are just the starting point for a trustee when deciding whether to approve a distribution request.
Understanding the HEMS Standard
Most of the time, a trust will not be so liberal regarding distributions, but rather the trust will have some provisions that provide a framework with limitations as to the types of distributions to be made to a beneficiary. The most common such ascertainable standard is “HEMS,” which is an acronym for Health, Education, Maintenance and Support. HEMS is a standard that is expressly referenced in the Internal Revenue Code, along with subsequent Treasury Regulations, state laws, and trust documents themselves. Generally, this standard is more predictable to both trustees and beneficiaries.
Health Distributions
Health and education are fairly easy terms to summarize. Examples of a distribution for a beneficiary’s health include, but are not limited to distributions such as for emergency medical treatment, psychological treatment, routine exams, and dental work. However, a gray area does exist when the request is to cover an unconventional type of treatment, or spa treatments to relieve stress, which a trustee may be less hesitant to approve under this standard, unless the trust specifically includes these within its definition of health. When such a gray area does arise, the distribution may not be denied outright, but it will likely prompt a trustee to ask additional questions or to ask for further documentation from the beneficiary before approving the distribution request. In these instances, the decision is driven by the specific facts and circumstances affecting that beneficiary and the family overall.
Education Distributions
Distributions for education typically include distributions such as for a beneficiary’s tuition, room and board. These distributions can also be made for technical school or career training. For both health and education distributions, a trustee will generally ask for the beneficiary to provide a copy of the bill or invoice as support for making the distribution and to verify the amount requested is the same as the amount to be paid to the third party provider. For reasons that will be discussed below, another reason a trustee may ask for a copy of the invoice is so that the amount can be paid directly to the third party education provider, rather than making the distribution directly to the beneficiary.
Maintenance and Support Distributions
Distributions for a beneficiary’s maintenance and support are not as clearly summarized, but are typically considered to allow for distributions to cover such beneficiary’s accustomed living expenses and additional reasonable comforts that are within the means of a similar person of like station in life. Similarly, support can include payments to provide for a beneficiary’s minor dependent children that he or she is legally obligated to support, unless other provisions in the trust prohibit such distributions. What is not included in maintenance and support distributions are payments that merely contribute to the beneficiary’s happiness, or are made to enlarge a beneficiary’s personal income or estate, or to enable the beneficiary to make extraordinary gifts.
Specific examples of typical maintenance and support distributions include, but are not limited to, paying suitable health insurance premiums, paying property taxes, and utility payments. Distributions for maintenance and support typically require a clear explanation in the beneficiary’s reason for the request and should include any additional documentation which evidences a reasonable connection between the distribution amount requested with the reason for the request.
Considering Other Available Resources
Another common provision found in trust agreements relates to whether or not a trustee should consider a beneficiary’s other available resources before making a distribution. Sometimes the provision is very clear, such as one that states that the trustee shall not consider the other available resources or income available to a beneficiary, or one that states that the trustee must consider a beneficiary’s other available resources. However, more often the provision states that a trustee “may,” but need not, consider a beneficiary’s other available resources. This leaves the discretion with the trustee as to whether to ask for this information or not.
Some trustees may automatically ask to receive additional information, while another trustee will only request such information predicated on the occurrence of certain conditions. At a minimum, a trustee will likely ask for this information in situations where there has been an increased number of distribution requests from one beneficiary, or where there is a change in the pattern of a beneficiary’s typical requests, such as a significantly larger amount requested. In addition, if the principal of a trust is being diminished by the distributions, a trustee would be more likely to inquire into the other available resources of a beneficiary in order to preserve the trust’s corpus so that it will be available to fulfill the needs of other beneficiaries. Generally, the type of information requested will be a copy of the beneficiary’s most recent tax return along with an annual budget of their expenses. This information is used to determine whether the beneficiary could otherwise pay for the expense that he or she is asking to be covered by a distribution from the trust.
GST Tax Implications
While there are many other considerations a trustee will need to examine before approving a distribution, one of the other more common concerns is whether there are any generational skipping transfer tax (“GST”) implications to the trust and beneficiary triggered by making the distribution. GST can be fairly complex, and the following is a very high level summary of the area.
Overall, GST is a federal tax imposed on every “generation skipping transfer.” There are three types of generation skipping transfers, the first is a taxable distribution to a skip person, the second is a taxable termination, and the third is a direct skip. The type of transfers applicable to a trust is taxable termination which can occur when a trust is terminating and being distributed to beneficiaries that are skip persons. The other applicable transfer to a trust is a taxable distribution to a beneficiary who is a skip person.
There are a few ways a person can be a “skip person,” and of course exceptions to the definitions, but the easiest example of a skip person is a grandparent/grandchild relationship. Basically, if a grandparent or higher generation makes a gift to a grandchild, it is called a direct skip transfer, which would be subject to GST tax. As it applies to a trust, a taxable distribution to a skip person is when a trust, created by a grandparent, makes a distribution to a grandchild. For trusts, this occurs when a trust is not exempt from GST tax, which means that no GST tax exemption was allocated by the person that created or contributed property to the trust. As applicable to distributions to a beneficiary, if a trustee does not have a gift tax return or other documentation on file evidencing the allocation of such GST tax exemption, then a trustee should always consider whether there are any GST tax implications with approving a beneficiary’s distribution request with added scrutiny.
If GST tax does apply, then the next logical question is who pays the tax and how much would it be? The answer to these questions depends on which of the three types of GST transfers listed above is relevant. In the event of taxable termination from a trust to skip persons, the trustee has the duty on behalf of the trust to pay the GST tax due and file the relevant tax returns. This will have the effect of lowering the amount of the final distribution to beneficiaries. In the event of distribution from a trust to a beneficiary that is a skip person, the beneficiary is the one who has the burden of paying the tax. In either case the taxable amount is determined by a formula. If there has been no GST tax exemption allocated the applicable tax rate (currently at 40%) is multiplied by the amount of the distribution.
As this results in a high taxable rate, most beneficiaries would wish to avoid this outcome. Therefore a trustee will consider whether there are ways to avoid such an outcome where the beneficiary is considered a skip person, but no GST tax exemption has been allocated to the trust. As briefly noted above, one option a trustee may have is to pay a medical or educational provider directly, rather than making an outright distribution to a beneficiary. The reason that this option may be proposed to a beneficiary is because no GST tax will be due when making the distribution directly to a third party medical or educational provider as it is considered a qualified transfer under the Internal Revenue Code, and not a taxable gift for gift tax or GST tax purposes. Therefore, while the beneficiary may have initially requested an outright distribution, a trustee may ask additional questions when there are GST tax implications to explore whether the trustee can help the beneficiary avoid having to pay GST tax by exploring other distribution options.
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As one can see, there are many different factors that a trustee must consider when deciding whether to approve a distribution request from a beneficiary. At Commonwealth Trust Company we encourage open communication with the beneficiaries of trusts that we administer. Our team of professionals are always available to help answer any questions a beneficiary may have regarding the process.
Commonwealth Trust Company is pleased to provide this article as a guide. Commonwealth Trust Company is not engaged in the practice of law and is not providing legal advice by the provision of these materials. Commonwealth Trust Company recommends that clients seek the opinion of their attorney regarding the specific legal and tax issues addressed in this article.