Traditional trust law permits parents to leave funds for their children and grandchildren in a way that protects the inherited assets from creditors, double estate taxation, in the event of divorce, and from being lost to in-laws if a child dies. Depending on which of these goals the the grantor of the trust seeks to achieve, the trust must have one or more features that restrict access and control by the beneficiaries.
In short, there's something of a trade-off between the amount of protection a trust provides and the amount of control it affords the beneficiaries. Parents and children may be more or less comfortable with the restrictions. The following chart is meant as a guide to help clients and attorneys determine how each trust, which we call "Family Protection Trusts" in our practice, should be drafted.
|Estate Taxes||HEMS Standard|
|Death (keep it in the family)||No restrictions|
The most protective trusts are those managed entirely by independent trustees with complete discretion whether and when to make distributions to beneficiaries. They provide complete protection from creditors of the beneficiaries and are the most protective if a beneficiary divorces. Divorce is the most difficult situation in which to provide complete protection because probate courts have significant discretion and are likely to take into account the use of the trust during the marriage. For instance, they will be more likely to include trust property as part of marital assets if the trust funds have been used for the couple's support during their marriage. But they will also look at control, and a trust in which the beneficiary has no control will be more protective than one in which she has or shares in decision-making.
While most people do not need to be concerned about it, federal estate taxes have a threshold at $11.58 million (in 2020), many more people would like to reduce state estate taxes for which the threshold in Massachusetts is $1 million. A parent can leave funds in trust for children that will not be taxed when the children die by using an independent trustee or by limiting distributions of principal to purposes related to the health, education, maintenance, and support ("HEMS"—in other words, for necessities, not luxuries such as Maseratis, vacations, and second homes).
Using the HEMS standard, children can be trustees of their own trusts, have free access to the income generated by the trust, and still have the estate tax protection offered by Family Protection Trusts. However, by limiting principal distributions to the discretion of independent trustees, they would lose creditor and divorce protection.
If the purpose of the Family Protection Trust were limited to keeping the trust assets in the family upon the death of a child—rather than have them pass to a surviving spouse and other chosen recipients during subsequent decades—the beneficiary could serve as trustee and have complete discretion over distributions of principal. But drafting the trust in this fashion would mean the loss of the creditor, divorce and tax protections typically provided by a Family Protection Trust.
We typically draft our Family Protection Trusts to require that any principal distributions be made by an independent trustee, but to permit sons and daughters to manage their trusts as long as they do not need to draw on the principal. They are able to manage the trust investments as they see fit and to withdraw the trust income—dividends and interest. But if they ever needed access to principal, they would have to appoint an independent trustee. The son or daughter beneficiary could continue to serve as co-trustee and be involved in the trust management, but all decisions regarding principal distributions would have to be the sole province of the independent trustee.
The idea behind this approach is to balance control and protection, and for the trust to be seen as a reserve. One hopes that sons and daughters will be able to can stand on their own two feet, but life happens and this is not always possible. The Family Protection Trust will be there when needed by a child or grandchild if they lose a job, go bankrupt, become ill, or become disabled. With respect to potential disability, the Family Protection Trust also acts like a Special Needs Trust, permitting beneficiaries to be eligible for public benefits, despite the funds set aside in trust for their benefit.
The risk of this approach is what could happen if the son or daughter trustee doesn't follow the rules of the Family Protection Trust. The rules say that the trustee cannot distribute principal to himself and, if he were to do so, he would be legally at risk of lawsuit by the remaindermen, who will receive what's left in the trust upon his death. However, the remaindermen are probably his children and unlikely to sue. If the trustee plays fast and loose and starts withdrawing principal, he will destroy it as a creditor, divorce, and, potentially, tax protection tool. In this way, Family Protection Trusts are no different from other trusts. They can offer significant protections, but they are simply written documents. The trustee may risk legal liability if she does not follow the terms of the trust, but more importantly, the trust will not achieve the purposes for which it was created if its terms are not followed.