I have written in the past about designing Trusts for children. Indeed, you can see under the "Most Popular Posts" section of my blog, a post devoted to the subject.
In planning for children, the question always comes up: upon the death of the second parent, how do I protect the children so that they have what they need but not so much it saps the children’s motivation to lead a productive life? As the prior posts describe, most Trusts address this objective with "ascertainable standards." Ascertainable standards provide parameters for Trustees to utilize in deciding what is appropriate for the Trust beneficiaries. When a client names an institutional Trustee or a third party Trustee, these standards protect the independent Trustee so that the beneficiary cannot compel extravagant distributions. At the same time, those standards ensure the beneficiary receives necessary distributions and the Trustee is not acting arbitrarily.
Ascertainable standards are also important for estate tax purposes. Sometimes the client creates a "Dynasty" Trust for the child’s lifetime where the child is the beneficiary and also is named as the sole Trustee. Despite serving in these dual roles, the Trust assets would not be taxed in the child’s estate upon the child’s death if the Trust is governed by ascertainable standards. In other words, provided the client trusts the adult child to spend Trust assets wisely, the child can serve as beneficiary and the sole Trustee and avoid estate tax inclusion at the child’s death. However, if the Trust does not have ascertainable standards, these estate tax advantages are lost. (By the way, these same ascertainable standards allow the client to name a surviving spouse as the beneficiary and Trustee without triggering tax in the surviving spouse’s estate.)
So what are ascertainable standards? As described in prior posts, they are defined as "health, maintenance, support and education." These terms, ostensibly common and innocuous, have deeper meaning in the Trust world. These terms are accepted by the Courts and IRS as providing sufficient guidelines for Trustees in administering Trusts. On the other hand, when drafters stray outside of these four words, the tax advantages may be lost. Such was the case in a recent Tax Court decision, Estate of Chancellor v. Comm’r, T.C. Memo. 2011-172, where the IRS argued that the inclusion of the word "welfare" jeopardized the advantages of the Trust because "welfare" was not an ascertainable standard. Although the IRS ultimately lost and the Tax Court did not subject the Trust assets to estate tax in the beneficiary’s estate, it required a Tax Court case to reach that conclusion. Chancellor teaches us that clients and their attorneys are well advised to stay within the well accepted "health, maintenance, support and education" standards in designing their Trusts.