What Are the Pros and Cons of a Beneficiary-Controlled Trust?
Would you like to provide your children or loved ones with an inheritance while protecting them from some of the risks that may accompany a large windfall?
A beneficiary-controlled trust may provide that balance. The primary beneficiary can have significant rights, benefits, and control over the property held in the trust. At the same time, the trust may help protect the inheritance from creditors, lawsuits, divorce, or estate taxes.
However, a beneficiary-controlled trust is not appropriate for every beneficiary. The amount of protection it provides depends on the trust’s terms, applicable state law, and how much authority the beneficiary receives.
What Is a Beneficiary-Controlled Trust?
A beneficiary-controlled trust is a trust in which the primary beneficiary has a significant degree of control over the inherited property.
The beneficiary may be named as the sole trustee. Another option is to name the beneficiary as a co-trustee with an independent trustee who controls distributions.
If a co-trustee is named, the beneficiary may be given the authority to remove that co-trustee and select a successor. The trust may also include a broad, nongeneral power of appointment. This can allow the beneficiary to determine how the trust property will ultimately pass to other beneficiaries without giving the beneficiary unrestricted ownership of the property.
The exact amount of control given to the beneficiary should reflect the beneficiary’s financial experience, judgment, circumstances, and need for protection.
What Are the Benefits of a Beneficiary-Controlled Trust?
If you want to leave an inheritance to a mature child or loved one whom you trust to make prudent financial decisions, a beneficiary-controlled trust is a strategy worth considering.
Even beneficiaries who handle money wisely may encounter situations in which their money and property become vulnerable to:
- Creditors’ claims
- Divorce
- Lawsuits
- Estate taxes
A properly designed beneficiary-controlled trust may help protect the property held in the trust from some of these risks.
The trust document can limit the beneficiary’s involvement and control where necessary. Even with those limitations, the beneficiary may still have considerable authority over the inheritance and how it is used.
The Beneficiary Can Serve as Sole Trustee
One option is to name the beneficiary as the sole trustee of their trust.
Under many states’ laws, most creditors may not be able to reach the beneficiary’s interest or compel the trustee to make a distribution when distributions are left to the trustee’s discretion.
When the beneficiary is also the trustee, that discretion may be limited by an ascertainable standard. One commonly used standard permits distributions for the beneficiary’s health, education, maintenance, and support, often abbreviated as HEMS.
Maryland law defines an ascertainable standard as one related to an individual’s health, education, support, or maintenance.
A beneficiary serving as trustee also has a fiduciary duty to follow the trust’s requirements. If the trust permits distributions only for the beneficiary’s HEMS, the trustee must determine whether a requested distribution satisfies that standard.
The trustee is not generally permitted to make a distribution directly to satisfy a beneficiary’s creditor when doing so would violate the trust’s terms. However, once money or property is properly distributed to the beneficiary, a creditor may be able to reach it.
A HEMS Standard May Provide Estate Tax Benefits
Limiting the beneficiary’s distribution authority to a HEMS standard may also provide an estate tax benefit.
Under the Internal Revenue Code, a power to use trust property for the beneficiary’s own benefit is generally not treated as a general power of appointment when it is limited by an ascertainable standard related to health, education, support, or maintenance. The IRS explains this distinction in its guidance on powers of appointment.
When properly drafted and administered, this limitation may help prevent the trust property from being included in the beneficiary’s gross estate for federal estate tax purposes.
The outcome depends on the trust’s complete terms and the beneficiary’s actual powers. Merely placing the words “health, education, maintenance, and support” in a trust does not guarantee a particular tax result.
A Sole-Trustee Structure May Reduce Costs
Naming the primary beneficiary as the sole trustee may also reduce the cost of administering the trust.
If there is a relatively low risk of creditor claims or lawsuits and the beneficiary can responsibly manage the property, the trust may not need to pay the fees associated with an independent co-trustee.
This arrangement allows the beneficiary to manage and invest the trust property while making distributions under the HEMS standard.
How Does a Beneficiary-Controlled Trust Work With a Co-Trustee?
Another option is to name the beneficiary as a trustee with authority to manage and invest the trust’s assets while appointing an independent co-trustee to control distributions.
This independent co-trustee is sometimes called a distribution trustee.
An Independent Trustee May Provide Greater Protection
The independent trustee may be given sole discretion to make distributions to the beneficiary. This structure is more complicated and may be more expensive because an additional trustee is involved. However, it may provide greater protection for the property held in the trust and, indirectly, for the primary beneficiary.
Unlike a beneficiary serving as sole trustee, the independent trustee may not need to be limited to distributions for the beneficiary’s HEMS. Depending on the trust’s terms, the independent trustee may distribute property to the beneficiary for other reasons without necessarily reducing the same level of asset protection.
The actual protection will depend on applicable law, the trust language, and the circumstances surrounding each distribution.
The Beneficiary May Retain Some Control Over the Trustee
The beneficiary may still retain a significant amount of control—not directly over the timing or amount of distributions, but over who serves as the independent trustee.
For example, the trust may allow the beneficiary to remove and replace the independent trustee. The replacement must satisfy the independence requirements contained in the trust and applicable tax law.
The original article referred to a person who is not a related or subordinate party under Internal Revenue Code Section 672(c). The IRS defines related and subordinate parties to include certain relatives, employees, and other individuals whose relationship may affect their independence.
If the beneficiary faces a heightened risk of lawsuits, divorce, or creditor claims, the trust may also allow the beneficiary to resign as trustee and appoint an independent trustee in their place. This may provide additional protection for the trust’s property.
What Are the Disadvantages of a Beneficiary-Controlled Trust?
A beneficiary-controlled trust can provide flexibility and protection, but it also has limitations. Those limitations should be considered before deciding how much authority to give the beneficiary.
It May Not Protect the Inheritance From Every Creditor
A beneficiary-controlled trust may help protect inherited property from many creditor claims, but the protection is not absolute.
Trust and creditor laws vary by state. Certain claims may receive special treatment, and creditors may be able to reach property after it has been distributed to the beneficiary.
Maryland law, for example, addresses when a court may allow a creditor or assignee to reach a beneficiary’s interest and instructs courts to consider the needs of the beneficiary, a spouse or former spouse, and dependent children. See Maryland Estates and Trusts §14.5-501.
Whether a particular creditor can reach trust property depends on:
- The terms of the trust
- Whether distributions are mandatory or discretionary
- Whether the trust contains a valid spendthrift provision
- The beneficiary’s authority over distributions
- The type of creditor or claim
- The law governing the trust
No trust should be described as providing complete protection from every possible claim.
It May Give Some Beneficiaries Too Much Control
A beneficiary-controlled trust may not be the best estate planning strategy for a beneficiary who is not skilled at managing money or who has demonstrated poor judgment.
The trust document will state the beneficiary’s fiduciary responsibilities. Even so, this type of trust can give the beneficiary considerable control over the inheritance.
For example, a beneficiary who is also the sole trustee may be permitted to make distributions to themselves for health, education, maintenance, and support. To a large extent, the beneficiary must determine whether a particular distribution satisfies that standard. This may give the beneficiary substantial leeway in deciding how the trust’s money or property is spent.
If you are concerned that a beneficiary cannot responsibly handle the duties of a trustee, another trust structure may provide greater oversight and more peace of mind.
An Independent Trustee Can Increase Costs and Complexity
Adding an independent distribution trustee may provide stronger protection, but it also makes the trust more complicated to administer.
The independent trustee may charge professional fees. The beneficiary must also coordinate with that trustee when requesting distributions. This can reduce the convenience and direct control that make a beneficiary-controlled trust attractive.
The decision involves balancing three competing considerations:
- The beneficiary’s control
- The inheritance’s protection
- The cost and complexity of administering the trust
Is a Beneficiary-Controlled Trust Right for Your Family?
A beneficiary-controlled trust may be appropriate when you want to leave an inheritance to a responsible child or loved one without giving that person unrestricted ownership of the property.
It can provide the beneficiary with meaningful control while offering some protection from creditors, lawsuits, divorce, and estate taxes. However, it may provide too much control for some beneficiaries, and it cannot protect trust property from every possible claim.
The trust should be designed around the beneficiary’s maturity, financial skills, personal circumstances, and exposure to potential claims.
If you would like to learn whether a beneficiary-controlled trust will work for you and your family, call Andre O. McDonald, a Howard County, Montgomery County, and District of Columbia estate planning, special needs planning, and Medicaid planning attorney.
Call 443-741-1088, 301-941-7809, or 202-640-2133 to schedule an appointment. We can help you design a beneficiary-controlled trust that reflects your goals and protects the inheritance you want to leave to family members and loved ones.
DISCLAIMER: THE INFORMATION POSTED ON THIS BLOG IS INTENDED FOR EDUCATIONAL PURPOSES ONLY AND IS NOT INTENDED TO CONVEY LEGAL, INSURANCE, OR TAX ADVICE.
