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By: Ian Weinstock, Kostelanetz & Fink LLP
LEXIS PRACTICE ADVISOR RESEARCH PATH: New York Business & Commercial > New York Estate Planning > Trusts > Practice Notes
A trust is a legal arrangement pursuant to which a grantor (a.k.a., settlor, donor, trustor) transfers property to a trustee to administer on behalf of one or more beneficiaries according to the terms of the instrument governing the arrangement. There are two fundamental characteristics of a trust. The first is the high degree of fiduciary duty expected of a trustee. The second, which is generally the least intuitive feature of trusts, particularly for non-lawyers, is the bifurcation of legal ownership and beneficial ownership.
In the trust context, the trustee is the legal owner of the trust assets. Although it is convenient to think of a trust as a separate legal entity, and particularly as a separate taxable entity for income tax purposes, at common law, a trust had no existence separate from the person of the trustee. So, for example, you will see property owned in the name of “X, as Trustee of the ABC Trust” rather than simply in the name of “the ABC Trust.” This can sometimes be a source of frustration if there is a change in trustees, when banks or other financial institutions may require that their accounts be re-titled to reflect the new trustee, or worse, when local property tax divisions insist that real estate be similarly re-titled. An argument can be made that this re-titling is not necessary because the trust still owns the property, but a counterargument can also be made that because the trustee is the legal owner, a change in trustee is an ownership change that needs to be reflected properly in the title. As a practical matter, you will almost always find that the path of least resistance—retitling the property—is the best course of action.
The trustee is the legal owner of, and is therefore tasked with administering, the trust assets, but the trustee does so only on behalf of the beneficiaries. The trustee can get no personal benefit from the trust assets (unless of course the trustee is also a beneficiary), though trustees are entitled to trustees’ commissions as compensation for their efforts. The trustee’s role is an active one, in contrast to that of the beneficiaries, which is primarily a passive one: merely to receive the benefits of the trust in the form of distributions when needed. Beneficiaries can play a more active role at times, however. They can enforce the trust by bringing a legal action against a trustee who is not administering the trust properly. And if the terms of the trust instrument provide them with authority to do so, they may have a role in certain aspects of the trust administration, for example, by exercising rights of withdrawal or other powers over distributions, or by naming successor trustees.
What about the settlor of trust; what role does he or she have? In fact, beyond creating the trust and transferring property to it, usually the settlor has very little role. As noted above with respect to beneficiaries, the terms of the trust agreement may provide the settlor with certain ongoing authority, for example in naming successor trustees. And with revocable trusts, the settlor typically reserves the unfettered right to amend or revoke the trust. But in most irrevocable trusts, the settlor has no authority to influence the administration of the trust, at least not directly. This can come as a surprise to clients, who often view the trust assets as “their money” even after they transfer those assets to a trust. The fact that settlors often misunderstand their role in a trust context gives rise to two key takeaways for you as attorneys. First, where you represent clients setting up irrevocable trusts, explain to them clearly and often that transfers of assets to the trusts are irrevocable, and once they transfer assets, they do not own those assets anymore. And second, where you represent trustees who are being pressured by settlors to act in a certain way, advise them that if they allow the settlor to influence them to act in a manner contrary to the best interests of the beneficiaries, they may be personally liable to those damaged beneficiaries. That can be very tricky, because the settlor usually chooses the trustee, and often chooses a particular trustee because of that trustee’s loyalty to the settlor; yet, once the trustee accepts his or her office, legally, his or her sole loyalty must be to the beneficiaries. No one ever said being a trustee was easy!
A brief word about terminology: what is the difference between a trust and a trust agreement? A trust is the actual legal arrangement among the parties described above. A trust agreement (or, more broadly, a trust instrument) is the written document that sets forth the conditions under which the trust is to be administered. It is easy to be imprecise in this regard: you may, for example, hear people ask to see a copy of the trust, when what they really want to see is a copy of the trust agreement.
A trust agreement is sometimes referred to as a contract. That is not technically correct; a trust agreement is an agreement, but it is not a contract. One party to a contract does not, unless expressly stated, owe fiduciary duties to another, whereas, as noted above, fiduciary duty is a hallmark of the trustee/ beneficiary relationship. Also, a contract may create ongoing obligations among the parties, but it does not create a separate legal/taxable entity. A robust discussion of all of the subtle differences between a trust agreement and a contract are beyond the scope of this practice note, as are the differences between trusts and other arrangements, such as escrows. (It is, after all, more important to know what a trust is than what it is not.) But being precise in your terminology can help your clients make sense of what can be a particularly confusing landscape.
Trusts can be classified according to a number of different criteria, one of which is revocability. A trust is revocable if the settlor has under the trust agreement retained the right, either unilaterally or with the consent of another party, to revoke the trust and reclaim the trust assets. Revocable trusts are typically also amendable by the settlor, even if not expressly stated to be so, for the obvious reason that the settlor could always revoke the trust and re-settle the trust assets into a different trust, so the settlor should be able to achieve the same result by just amending the first trust. An irrevocable trust is, not surprisingly, a trust that does not fit the definition of a revocable trust. Under New York’s Estates Powers and Trusts Law (EPTL), a trust that does not specify whether or not it is revocable is irrevocable. See NY CLS EPTL § 7-1.16. That said, to avoid doubt, every trust should expressly state whether it is revocable or irrevocable, which can be done fairly simply:
or
Unless otherwise provided in the trust agreement, a revocable trust becomes irrevocable on the death of the settlor, though a revocable trust can still be revoked by a specific provision under the settlor’s Will. See NY CLS EPTL § 7-1.16.
Note that even if the trustee has discretion to distribute all of the trust’s assets back to the settlor, the trust would not thereby be classified as revocable. Revocability is determined by the settlor’s authority, not the potential for the settlor to receive the trust assets back based on a third party’s decision. Similarly, if the settlor has a reversionary interest in the trust, such that, for example, the assets of the trust would be distributed back to the settlor if he or she is living at the death of the beneficiary, that would have no impact on the classification of the trust as revocable or irrevocable because it does not implicate the settlor’s authority.
Though not legally required, the settlor is generally the sole beneficiary of a revocable trust during the settlor’s lifetime, and is often the sole trustee as well while he or she retains capacity. It may therefore seem that revocable trusts are not very substantial arrangements: if the settlor is the sole beneficiary as well as the sole trustee, and can take back the trust assets at will, what has the settlor really accomplished by transferring those assets to the trust? In fact, the trust laws of many offshore jurisdictions do not expressly contemplate revocable trusts for that very reason. And even in the United States, revocable trusts are typically treated as non-entities for creditors’ rights purposes and tax purposes. See, e.g., NY CLS EPTL § 7-3.1; 26 USCS § 676; 26 USCS § 2038. Nonetheless, revocable trusts play a key role in probate avoidance and incapacity planning, as will be discussed below in the section titled, Reasons for Creating a Trust.
Another criterion by which a trust can be classified is the instrument under which it is created. An inter vivos trust, as the name implies, is one created between living people; in other words, it is created via a separate agreement between a living settlor and the trustee. (It is worth noting that under certain circumstances an inter vivos trust can be established via a declaration by the trustee that he or she holds certain assets in trust for the beneficiaries; there would therefore be no stated settlor and, technically no “agreement” because the trustee is the only signatory to the document. Declarations of trust are generally seen where the settlor and the trustee are the same person, or where a trustee of one trust exercises his or her discretion to set up another trust.) In contrast, a testamentary trust is one that is created under a decedent’s Will; there is no separate trust agreement but rather the terms of the Will itself govern the trust, so the Will is the trust instrument. An inter vivos trust can be revocable or irrevocable; a testamentary trust is always irrevocable.
Testamentary trusts in New York suffer from a particular disadvantage: New York is among only a handful of states that require trustees of testamentary trusts to obtain authorization—called Letters of Trusteeship—from the court supervising the administration of the decedent’s estate before they can serve as trustee. See NY CLS SCPA § 103(21); NY CLS SCPA § 701; NY CLS SCPA § 724. For the initial trustees of a testamentary trust, this is not a huge burden, because they can apply for Letters of Trusteeship as part of the same proceeding by which the Will is admitted to probate and the executors are granted Letters Testamentary. However, where a subsequent change in trustees of a testamentary trust is required, a separate proceeding must be brought in Surrogate’s Court for new Letters of Trusteeship, which is both time-consuming and relatively costly in terms of legal fees. Therefore, you should consider setting long-term trusts up as inter vivos trusts rather than as testamentary trusts.
It is worth noting that the Surrogate’s Court has jurisdiction over inter vivos trusts as well as testamentary trusts, see NY CLS SCPA § 207, but the requirement for Letters of Trusteeship does not apply to the former.
Although not germane to this article, it is worth noting that there are other kinds of trusts besides personal trusts. There are corporate trusts such as pension plans and bond indentures. (Interestingly, the value of assets held in corporate trusts utterly dwarfs the value held in personal trusts, yet there is comparatively little law applicable to corporate trusts relative to personal trusts.) There are business trusts, which are entities created under the laws of certain states—such as Massachusetts, but not New York—that function more like corporations, with transferable shares. There are constructive trusts, which are remedies fashioned by courts of equity to prevent unjust enrichment. And there are resulting trusts, pursuant to which assets are held in trust by the recipient under circumstances where the transferor could not have intended the recipient to have beneficial ownership of them yet neglected to establish an express trust.
Probably the most common reason Americans create trusts is probate avoidance. Certain states have very expensive or tedious probate processes (i.e., judicial proceedings to administer the assets of a decedent) so it is common in those states for people to use revocable trusts as their primary estate planning document. The revocable trust is most useful in those states if it is fully funded; that is, if the client transfers all of his or her assets to the trust during life, so there are no assets left in his or her own name that would require probate for proper disposition. But even if the client does not actually re-title all assets into the name of the trust, in certain jurisdictions (notably, California), it may be possible to avoid probate merely by listing assets among the assets of the revocable trust on a schedule to the trust instrument, as those assets can be re-titled into the name of the trust after the client’s death without the requirement of going through probate.
Revocable trusts have traditionally not been as popular in New York as they have been in certain other jurisdictions such as California and Florida. One explanation for the revocable trust’s comparative lack of popularity in New York is, no doubt, reluctance on the part of the New York T & E bar to adapt to new concepts. But in fairness to T & E attorneys in New York, because the probate system here is not unduly expensive or tedious, there has not been as much of a need for revocable trusts: probate avoidance is, after all, a lower priority where probate is less onerous. In addition, New York actually requires assets to be formally re-titled in the name of the trust for a transfer to be effective, see NY CLS EPTL § 7-1.18, making probate avoidance rather more cumbersome in New York than in states where, as noted above, merely listing the assets as owned by the trust can serve the required purpose. However, unfunded revocable trusts, used in conjunction with a pourover Will that names the revocable trust as the sole beneficiary of the decedent’s estate, are growing in popularity in New York, even though probate is not avoided at all if the revocable trust is unfunded. That popularity growth can presumably be attributed to certain advantages of revocable trusts becoming increasingly evident to drafting attorneys: (i) privacy— probated Wills are public documents, while revocable trusts are not—and (ii) obviating the need for Letters of Trusteeship.
Another widely touted benefit of trusts is creditor protection, with the most common creditors of beneficiaries being divorcing spouses. Assets of an irrevocable trust for the benefit of third parties (i.e., those other than the settlor or the trustee) are generally exempt from the claims of the beneficiaries’ creditors for the very basic reason that the beneficiaries do not legally own those assets. However, if the beneficiaries can freely alienate their beneficial interests in the trust, the fact that creditors cannot directly access the assets of the trust may not matter much, as the creditors can obtain the beneficiaries’ beneficial interests in the trust, and obtain indirectly what they could not obtain directly. The default law in New York is that trusts are “spendthrift” trusts—where beneficial interests are inalienable—only as to income, not principal, unless specified otherwise in the trust instrument. See NY CLS EPTL § 7-1.5. Therefore, it is generally advisable to include express spendthrift language in trust instruments to make beneficial interests in principal inalienable as well:
A so-called self-settled trust, one in which the settlor is a beneficiary, does not offer any creditor protection under New York law. See NY CLS EPTL § 7-3.1. New Yorkers who want to create asset protection trusts, (i.e., self-settled trusts that cannot be reached by the settlor’s creditors) need to do so in an offshore asset protection jurisdiction, such as the Cook Islands, or a domestic asset protection jurisdiction such as Delaware or South Dakota. The efficacy of domestic asset protection trusts is a much-debated issue, and beyond the scope of this article, but suffice it to say that if you are contemplating drafting such a trust, it is advisable to obtain advice from local counsel in the given jurisdiction to make sure that the trust adheres strictly to the requirements of that jurisdiction’s asset protection laws.
What about a trust where the trustee is a beneficiary? Unlike a self-settled trust, a trust does not cease being a spendthrift trust merely because a trustee is a beneficiary. Nonetheless, a trustee with discretion to make distributions to him or herself could arguably be compelled by creditors to exercise that discretion to the greatest extent permitted under the trust instrument. For maximum creditor protection, it may therefore be prudent to name only non-beneficiaries as trustees, or to restrict a beneficiary-trustee from exercising discretion over distributions.
A robust discussion of creditors’ rights issues is beyond the scope of this article, but one additional point is worth making. Setting up and funding a trust to protect against claims of the beneficiaries’ creditors is a different matter entirely than setting up and funding a trust to place assets beyond the reach of the settlor’s creditors. Clients facing creditors’ claims may ask you to create irrevocable trusts for the benefit of their family members so the clients can transfer their assets to those trusts and thereby frustrate the claims of the clients’ creditors. Those transfers would likely be voidable as fraudulent conveyances, and if the client is in bankruptcy, could be deemed bankruptcy fraud. Moreover, your participation in the drafting process could expose you to claims of aiding and abetting that fraud. You should therefore be clear on your clients’ overall financial picture before assisting them with their trust planning.
Use of trusts for creditor protection can basically be described as saving beneficiaries from third parties, but often clients are more interested in using trusts to protect beneficiaries from themselves. For young beneficiaries, paternalism is relatively easy to justify: how many 18-year-olds or even 21-year-olds are mature enough, either emotionally or financially, to handle a large inheritance? As beneficiaries get older, however, balancing out paternalism with encouraging autonomy becomes more complex. Some beneficiaries may never be sufficiently mature, emotionally or financially, to handle significant wealth, but many are quite responsible by age 30 or 35. Moreover, receiving some assets outright may actually help beneficiaries become financially mature by requiring them to manage their own money. (Alternatively, allowing beneficiaries to become co-trustees once they reach a certain age can have similar benefits from a financial education perspective.)
For various reasons, some T & E attorneys routinely recommend trusts to last for the lifetimes of all beneficiaries, but that might not be appropriate for all clients. The best course of action for you as an attorney is to discuss in detail with clients when they think their children/grandchildren ought to receive assets outright. Factors you should consider include the amount of wealth at stake—massive wealth militates in favor of keeping assets in trust—and how well the clients know their beneficiaries. You could, for example, draft a client’s Will or revocable trust to include lifetime trusts for their children when their children are very young and their financial maturity is inherently unknowable, but if the children seem to be maturing normally, and assuming the clients are still alive and still have capacity, revise the Will or revocable trust later on so that the trusts end at age 35, or in stages at ages 30, 35, and 40, for example. Or you could keep the lifetime trusts but encourage the clients to suggest to the trustee that she/he exercise her/his discretion to distribute assets liberally to the beneficiaries, including all of the assets of the trust, if the beneficiaries are financially mature enough to handle it.
One aspect of paternalism where New York has not gone as far as certain other jurisdictions concerns so-called “silent trusts.” In some jurisdictions, including Delaware, clients have the option of incorporating into trust instruments provisions specifically prohibiting the trustee from informing the beneficiaries about the existence of, or assets in, the trust. Presumably the clients are concerned that mere knowledge of the trust could discourage beneficiaries from leading productive lives. New York does not permit silent trusts, as the basic fiduciary duty to keep the beneficiaries informed, and the resulting ability of the beneficiaries to enforce the trust to keep the trustee “in line,” is presumably deemed more important than not spoiling the beneficiaries. See NY CLS SCPA § 2306.
A client may not be particularly concerned about protecting a beneficiary from creditors or from the beneficiary’s own financial mismanagement but may merely feel that a trustee would do a better job managing assets than the beneficiary would do herself or himself.
As a corollary, a client may create and fund a revocable trust for his or her own benefit primarily so that if/when he or she becomes incapacitated, the successor trustee named in the trust agreement can assume the role of trustee and commence managing the assets of the trust for the settlor’s benefit. There are, of course, other ways of addressing asset management in case of incapacity; for example, a legal guardian could be appointed for the client, or an attorney-in-fact under a power of attorney could manage the client’s assets. But a guardianship proceeding is time-consuming and expensive, and an attorney-in-fact does not have the same fiduciary duties as a trustee. (An attorney-in-fact is a fiduciary, and therefore, when acting, must act in the best interests of the principal. However, an attorney-in-fact is not compelled to act, while a trustee is under an affirmative obligation to administer the trust’s assets.) Consequently, incapacity planning, which is analytically a sub category of asset management, is an oftencited benefit of revocable trusts.
Asset management can be an important objective for irrevocable trusts as well. For example, a settlor may want assets that would otherwise pass to multiple beneficiaries to be managed as a single pool. That can be particularly important where the assets consist of real property used by multiple family members or interests in a family business, where the centralized management afforded by a single trust could be advantageous.
New York law facilitates efficient asset management, though it is far from unique in that regard. For example, New York, like most jurisdictions, permits trustees to employ custodians, including broker-dealers, and to maintain securities in the “street name” of such broker-dealers rather than in registered form. See NY CLS EPTL § 11-1.10. New York also permits trustees to delegate investment discretion. See NY CLS EPTL § 11-2.3. Trustees can therefore open accounts with brokers, bankers, or investment advisors, and thereby access more or less the entire range of asset management options the financial services industry has to offer.
Tax benefits are a frequently cited reason for the creation of certain irrevocable trusts. (Revocable trusts, as noted above in Classification of Trusts, afford no direct tax benefits.) A robust discussion of the numerous and varied tax benefits afforded by trusts is beyond the scope of this article, but suffice it to say that a wide range of opportunities can be obtained through different types of irrevocable trusts. Trusts can qualify for a charitable income tax deduction. Trusts can permit the deferral of estate taxes until the death of a surviving spouse. Trusts can help make maximum use of the federal and state estate tax exemptions of both spouses. Trusts can facilitate the deferral of capital gains taxes. Trusts can permit leveraged gifting, where future appreciation on assets can be transferred to lower generations at little or no gift or estate tax cost. And trusts can allow parents essentially to pay the income taxes on income earned for the benefit of lower generations, thus allowing the assets set aside for those lower generations essentially to grow income tax-free.
There is no universally accepted definition of estate planning, but for purposes of this discussion, you can view estate planning generally as organizing one’s assets and circumstances so that one’s wishes with respect to those assets and circumstances will be implemented when one is no longer capable of implementing them oneself. With that broad definition, most, if not all, of the issues discussed above would fall within the ambit of estate planning. However, there is one rather fundamental aspect of estate planning that has not yet been touched upon, namely, making sure that assets actually get to one’s intended beneficiaries, where trusts can be important.
For example, if you have a married client who has children from a prior marriage, the client may well want to provide for his or her spouse (assuming the spouse survives) for the balance of the spouse’s life, but will ultimately want assets to pass to his or her children from the prior marriage. But if the client leaves all of his or her assets to the spouse, the spouse is free to do with them what he or she wishes, which may not involve the deceased spouse’s prior children at all. You can instead advise the client to create a qualified terminable interest property (QTIP) trust, a type of marital trust, where the spouse would be the sole beneficiary until the spouse dies, but the remaining trust assets pass to the deceased spouse’s prior children thereafter. And even if there is no prior marriage, if the client fears that, if he or she dies, his or her spouse could re-marry and disinherit their joint children in favor of the new spouse, a QTIP trust can assuage those fears.
One point about QTIP trusts and New York law, though. New York has a fairly detailed statute, see NY CLS EPTL § 5-1.1-A, setting forth a surviving spouse’s right of election, that is, the right to receive an “elective share” of the deceased spouse’s assets instead of what the deceased spouse provided for via Will or otherwise. The basic idea behind the right of election is to ensure that a deceased spouse makes adequate provision for the surviving spouse, but because the computation of the elective share is fairly involved, elective share issues tend to be quite complicated. A full discussion of those issues is beyond the scope of this article, but the relevant point in this context is that an interest in a QTIP trust does not qualify as making adequate provision, so a surviving spouse could, in theory, elect to take a portion of the deceased spouse’s estate outright instead of enjoying the benefits of the QTIP trust. Often, that is a bad deal economically because the QTIP trust provides access to the whole estate, whereas exercising the right of election nets the surviving spouse only a fraction of the estate. Spouses can also waive their rights of election in advance, either through a prenuptial or postnuptial agreement or a standalone right-of-election waiver, and some T & E attorneys incorporate such waivers into every QTIP-based estate plan. That may be overkill, however, particularly as guaranteeing that a waiver is enforceable necessitates considerable financial disclosure and documentation. You should be aware of the issue, however, because in the right circumstances, obtaining such a waiver may be what saves the estate plan.
A trust may have similar estate planning benefits where children and grandchildren are concerned. A client may want to provide primarily for his or her grandchildren, but may not want to leave assets directly to them just in case his or her children might need access to those assets during their lives. Again, a trust can solve the problem by providing that both children and grandchildren are beneficiaries while the children are alive, but after the children are gone, the assets are distributed outright to the grandchildren.
And, as a corollary to the last point, while some clients want to strictly divide assets equally among their beneficiaries in a given generation, some clients are more concerned that different beneficiaries may have different needs. The hedge fund manager child may not need money, while the inner-city school teacher child does. In that case the client could simply provide more for the latter child, but that could be seen as harsh. Instead, you could advise the client to create one trust for both children; the trust would presumably benefit mostly the poorer child, but on its face it would not be discriminatory, and in any event the trust’s assets would be available for the other child as well if, say, her hedge fund collapsed.
To be a good drafter, you must attempt to address as many contingencies as possible, within reason, of course. (For example, you may make a conscious decision, when drafting a Will for an unmarried client with no children, to provide for the possibility that he or she will get married but not for the possibility that he or she will have children, simply because you expect that he or she will update the Will when and if that happens.) Some contingencies are less obvious than others, but thinking about what can go wrong should generally get you to the right place.
One basic issue that you should always consider is survivorship. Simply providing “I give $100,000 to X” is all well and good, but what if X is not then living? New York has a so-called “anti-lapse” statute, NY CLS EPTL § 3-3.3, such that a bequest to a child or a sibling of the testator who predeceases the testator will pass to the predeceased beneficiary’s issue, per stirpes. But what if the beneficiary is not a child or sibling? And what if the client does not want that gift-over to issue, per stirpes? You should never rely on the anti-lapse statute, but instead you should draft the gift-over specifically:
Survivorship must be considered not just with respect to the client, but with respect to other beneficiaries. Let us say the client wants to create a testamentary trust for the benefit of a sibling during the sibling’s life, with the remainder to the sibling’s children. First, the trust should only be created if the sibling survives the testator—that is one contingency to plan for. But what if a child predeceased the sibling? You should draft for that contingency as well:
An alternative phrasing to “then-living issue” could be “the issue who survive my said sibling,” but either way you should be defining the class of issue with survivorship in mind.
Taking survivorship issues to an extreme, you should generally provide for an “ultimate disaster” clause to address the disposition of assets if all of the beneficiaries are no longer living. Collateral relatives who would not otherwise be beneficiaries could be the remote contingent beneficiaries, as could charitable organizations.
There may be circumstances, such as where the client has numerous children and grandchildren, in which you deem the odds of an ultimate disaster scenario as too remote to worry about, particularly because it is a topic that clients do not like to consider. But those cases are rare.
And when thinking about survivorship, consider that A could survive B, B could survive A, or A and B could die simultaneously. You should therefore always include a comprehensive “common disaster” clause in your documents, to apply whenever people die in quick succession:
New York has a survivorship statute, NY CLS EPTL § 2-1.6, but it only applies to deaths with 120 hours, and that may be too short a period.
One other point about survivorship bears mention. Say you are drafting mirror image documents for two spouses, and in each document you provide for a cash bequest to some third party, but only if the spouse predeceases, because the intent is to pay that bequest at the death of the second spouse. However, if under the survivorship clause of each document, each spouse is deemed to predecease the other if they die in a common disaster, that cash bequest could end up being paid twice. You may therefore need to draft a special carve-out for that bequest, such that in one document but not the other, the spouse is deemed to survive for purposes of that bequest. (There could be other circumstances where a reversal of the presumption of survivorship is warranted as well.)
Another contingency to consider besides survivorship is new members of a class being born or adopted into the class. New York has a statute to address afterborn (“pretermitted”) children, NY CLS EPTL § 5-3.2, but it only applies to children, not afterborn members of other classes. To the greatest extent possible, therefore, you should draft with reference to classes of people defined in relation to each other rather than with reference to specific individuals. So, for example, instead of a disposition of the remainder of a trust one-half to named child X and one-half to named child Y, consider a disposition to then-living issue, per stirpes, or, if the client prefers the share of a predeceased child to get re-allocated among the other children rather than to pass to that child’s descendants, to then-living children, per capita.
What if nobody dies or is born unexpectedly, but rather the client’s assets change after the drafting of the document? If a Will disposes of Blackacre, but the testator no longer owns Blackacre at death, the bequest of Blackacre is said to “adeem.” New York law provides for different consequences in the event of an ademption depending on the circumstances of how the property came to no longer be owned. See NY CLS EPTL § 3-4.3; NY CLS EPTL § 3-4.4; and NY CLS EPTL § 3-4.5. In some cases the beneficiary may receive nothing and in others the beneficiary may receive the value of the adeemed property. To avoid having to determine which circumstances apply and what the consequences are, a disposition of a specific item should always be qualified with “if I own it at my death” or “if it then constitutes part of the principal of the trust.”
Specific assets may not be the problem, but rather the overall level of a client’s wealth could change. Dispositions of cash amounts could prove to be a larger percentage of the client’s wealth than intended if the client spends down his or her wealth during life. That can be solved by providing for a disposition of a percentage of the trust assets instead of a cash bequest, but under different circumstances, a percentage of the trust assets could end up being more money than the client intended to give away if his or her wealth increases substantially. One solution is to provide for the lesser of the cash amount or a specified percentage of the trust assets.
Another contingency to think about is divorce. New York law has a fairly comprehensive statute, NY CLS EPTL § 5-1.4, providing that divorce will automatically revoke dispositions to the decedent’s spouse under a Will, revocable trust, or beneficiary designation, and will also automatically revoke fiduciary appointments. But as comprehensive as it is, the statute does not apply to irrevocable trusts, and it also does not cover circumstances where other people besides the settlor/ testator get divorced. So, for example, if a client appoints a child-in-law as a fiduciary, it may make sense to condition the appointment on the child-in-law being married to the child at the time of appointment, and to further provide that the childin- law shall immediately cease to act if he or she gets divorced from the child.
Clients may want to benefit particular charities in their documents. But what if a charity ceases to exist, or loses its charitable status? For major charities that have been in existence for decades or centuries, that is probably not a significant risk, but it certainly can and does happen to smaller, newer charities. You might therefore want to condition a bequest to a charity accordingly:
And what if the bequest fails? Should there be a gift-over to a different named charity? Or to a charitable organization of the trustee’s choosing? Or should the bequest simply lapse? If the client has general philanthropic intent, the gift-over will probably be her or his choice, whereas if the client just wanted to benefit that particular charity, maybe she or he will want the bequest to lapse if that charity no longer qualifies. (One unrelated point about naming charities in your documents: to avoid the risk of litigation over an improperly named charity, you should always look up the exact name and location of the charity on its website or the IRS’ online list of tax-exempt organizations and describe it as such in the documents you draft.)
A trustee can have little or no discretion under a trust instrument, or can have very extensive discretion. Traditionally, trusts provided for all income to be distributed to the current beneficiary but no principal. Then someone had the great idea to give the trustee discretion to invade principal, since a beneficiary might need more money than just the income could provide; as a result, the role of the trustee became much more complicated! And then, building on that earlier innovation, the next great idea was to make both income and principal discretionary, because the beneficiary might not in fact need all of the income; the trustee’s role then became even more complicated. Sometimes the degree of discretion you should provide in a trust instrument is driven by tax considerations, but often it is a function of the client’s preferences, which you ought to discuss early in the drafting process.
It might be helpful to address a few relevant tax concepts at this point. First, a non-grantor trust is subject to income tax at the same rates as an individual, but the brackets are far more condensed, such that a trust hits the top marginal income tax rate at a far lower level of income than for an individual. Second, without getting into all of the nuances of fiduciary income tax, as a general rule, non-grantor trusts get to deduct income distributions to beneficiaries, and the beneficiaries then have to pick those distributions up into income. Consequently, unless the beneficiaries are already in the top marginal income tax bracket, it will often be taxefficient to distribute income from a non-grantor trust because the income will be taxed at a lower rate in the hands of the beneficiary than it will in the hands of the trust. And third, if a trustee who is also a beneficiary has unlimited discretion to make distributions, the trustee will be deemed to have a general power of appointment over the trust, with substantially adverse potential gift and estate tax consequences, whereas if the beneficiary/trustee’s discretion is limited by an ascertainable standard—for example, only for health, education, maintenance, or support—none of those adverse consequences typically arise.
If tax consequences were all that were relevant, you would tend to draft trusts so that income could be accumulated in grantor trusts but would be distributed in non-grantor trusts, and you would tend to incorporate extensive discretion in trusts where beneficiaries were not trustees but ascertainable standards where beneficiaries were not. (On that second point, to a large degree you can do both, by drafting different standards for beneficiary/trustees than for non-beneficiary/trustees.)
But sometimes clients want to limit discretion for nontax reasons. For example, as discussed above in “Estate Planning” in Reasons for Creating a Trust, a client might want to provide primarily for grandchildren in a particular trust, but nonetheless name children as secondary beneficiaries just in case the children run out of money. Perhaps in that trust the trustee could be given extensive discretion to make distributions to grandchildren but could be given limited discretion to make distributions to children only for emergency needs. Or perhaps a client wants to put a cap on aggregate distributions to some or all of the beneficiaries, either as a dollar amount or as a percentage of the trust assets. (If there is a dollar amount cap on distributions, it might make sense to build in an inflation adjustment provision, though, particularly in a long-term trust.)
There are other areas besides distributions where trustees can have different degrees of discretion. For example, in the decanting context, trustees can essentially rewrite a trust. You could go so far as to give the trustee the power to decant to a trust with entirely new beneficiaries. (Alternatively, you could draft a trust to permit the trustee to add beneficiaries without decanting. As the power to add beneficiaries is one way to make a trust a grantor trust, it is not uncommon to see trusts where the trustee has the power to add charitable organizations as beneficiaries.) Many clients would be uncomfortable granting a trustee such broad discretion, but some would not, so that is another topic of conversation you ought to raise with the client early in the drafting process.
One further point on discretion: you can give a trustee extensive discretion in the trust itself, but then give a trustee some guidance on how to exercise that discretion in a separate letter of wishes from the settlor. That letter is not part of the trust, and is not even legally binding—and you should expressly state as much in the text of the letter—but the client may well feel better by providing the trustee with some insight into the settlor’s preferences, and the trustee may also feel better by having a better sense of the settlor’s intent. Why not put that guidance in the trust itself? Mainly because the letter captures the settlor’s wishes at a moment in time. The settlor’s views and circumstances could change, and it may therefore be unwise to “hard-wire” limitations into the trust. It is easier, after all, for you to draft an updated letter of wishes if circumstances change than it is to decant the trust.
Because the future is inherently uncertain, you do not know what assets a trust may hold in the future, or what sorts of investments a trustee may find it prudent to make. Consequently, it is often best to provide for very broad investment authorization among the powers provisions you incorporate into a trust. Fortunately, most boilerplate powers provisions already incorporate broad investment powers, as well as broad powers to borrow, lend, improve real property, remediate environmental issues, and deal with a myriad of other issues as well. All other things being equal, providing more authority to a trustee is a positive: if the trustee never needs to use the authority, no harm done, but if the trustee might need to use it, at least the trust instrument empowers the trustee to do so.
However, all other things may not be equal. In particular, you have a client to deal with, and if the client gets a 50- page trust replete with detailed provisions on administering S-corporations, life insurance, art portfolios, commercial real estate, etc., when all the client actually owns are a few mutual funds, the client may not be happy. Moreover, some clients, including sophisticated ones, can be alarmed by broad authorizations to lend, borrow, buy alternative investments and derivatives, etc., because they envision the trustee using the full extent of his or her authority. You therefore need to balance the client’s concerns, as well as a nearly universal bias that less is more when it comes to boilerplate language, with the benefits of broad authorizing provisions. One approach is to leave in the standard boilerplate powers provisions but only add separate life insurance, S-corporation, etc., language where you think there is a real likelihood that those provisions will be needed. But for particularly skittish clients, or ones particularly concerned with the length of the document, you could actually delete the powers provision entirely and instead include merely a cross-reference to the default New York law:
Many instances of drafting to retain flexibility have already been discussed elsewhere in this practice note. Incorporating decanting language into a trust is a particularly important way to preserve options for dealing with unanticipated future developments. Similarly, broad authorizing language and extensive distribution discretion provide trustees the flexibility to deal with changed circumstances. A few additional concepts warrant mention, however.
First, it is almost always prudent to provide a mechanism for removal of the trustee. Individual trustees can age, develop substance abuse problems, lose mental capacity, or otherwise simply become distracted. Corporate trustees can go through reorganizations, budget cuts, etc., that may result in a diminution of service levels. Or the relationship between the trustee and the beneficiaries can deteriorate for a host of other reasons. On the other hand, you may not want to make it too easy for a beneficiary to remove and replace a trustee, because then the trustee may be overly beholden to the beneficiary, which could result in a loss of objectivity on the part of the trustee, potentially jeopardizing some of the goals of the trust. As a middle ground, the settlor, or the settlor’s spouse, or a majority of the adult beneficiaries (if there are at least a few) could be empowered to remove a trustee, or you could designate a separate trust protector whose sole function is to remove and replace the trustee. (You then need to deal with trust protector succession as well, but you could simply provide that the trust protector can appoint his or her own successor.)
Second, you should try to preserve a certain amount of flexibility in the tax status of the trust as well. If a trust is a grantor trust, incorporate language to “de-grantorize” the trust by permitting a release of the powers that trigger grantor trust treatment. For example, if the trust is a grantor trust because the settlor has retained the power to substitute assets for assets of equal value, draft in a mechanism for the settlor to irrevocably waive that power. Or, alternatively (or in addition), authorize the trustee to reimburse the settlor for the tax obligations of the trust; that provision should not, by itself, result in inclusion of the trust in the settlor’s estate for estate tax purposes, though if the trustee actually uses that authority regularly, the result could be different. On a separate note, it is not uncommon in the international trust context to see provisions in the trust mandating that the trust be a foreign trust for U.S. income tax purposes, but that may well be the wrong approach, because if circumstances change in the future, it may make sense for the trust to convert into a U.S. trust. It may well be best, therefore, not to “hard-wire” the tax status into the trust instrument but allow it to be changed if circumstances warrant such a change.
Third, you should incorporate a “vesting-in-minors” clause into your documents. Assets may become payable outright to a person who is a minor at the time he or she is to receive the assets, and in the absence of a better option, the trustee may insist that a legal guardian for the minor’s property be appointed by a court before the trustee will pay over the assets. The vesting-in-minors provision gives the trustee other options, such as paying the assets directly to the minor, or to the parents of the minor, or to a custodian under a Uniform Transfers to Minors Act or Uniform Gifts to Minors Act, or even to a separate trust for the minor.
Finally, you may want to consider multi-generational trusts incorporating powers of appointment. A power of appointment is essentially a mechanism to give someone else the power to determine the disposition of the remainder of a trust. The idea behind the power of appointment is that, when the remainder of a trust is to be distributed, someone with knowledge of the prevailing circumstances at that time may make better decisions than the settlor would have made many years in advance. A power of appointment is said to be general if it can be exercised in favor of the powerholder, his or her creditors, his or her estate, or the creditors of his or her estate; otherwise, the power is said to be limited. Assets over which a person holds a general power of appointment are includible in that person’s estate for estate tax purposes, while assets over which a person holds a limited power are generally not. Note that a limited power could be very broad—exercisable in favor of anyone in the world except the powerholder, his or her creditors, his or her estate, or the creditors of his or her estate—or it could be quite narrow, exercisable only in favor of the powerholder’s descendants.
To be specific on terminology, the person who creates the power of appointment—the settlor of the trust, generally—is referred to as the donor of the power; the powerholder is referred to as the donee of the power; the class of people in whose favor the power can be exercised are referred to as potential appointees; and the class of people who would receive the assets that are the subject of the power to the extent the power is not exercised are referred to as takers in default of appointment. You should always include takers in default of appointment when you draft, to account for the contingency of the power not being exercised. Note that a power of appointment can be exercised in favor of a continuing trust for the potential appointees as well as to them outright. A sample provision granting a power of appointment is as follows:
There are a few provisions that you should include in New York trusts to address specific issues of New York law. One is the socalled virtual representation provision:
NY CLS SCPA § 315 is New York’s virtual representation statute, and it addresses who must receive service of process in a judicial proceeding. For example, it is only necessary to serve the current members of the class of interested parties. In general, the provisions of the statute are automatically effective, but in one instance, “horizontal” virtual representation of a person with a disability by another party with the same interests, the governing instrument must authorize it. Without a provision like the one above, it could be necessary to have a guardian ad litem appointment to represent a minor beneficiary, whereas with the provision, an older sibling who is an adult and is a party to the proceeding anyway could represent the minor beneficiary without the cost and delay of having a guardian ad litem appointed.
Another provision is part of the vesting-in-minors clause. As noted above in the section, Retaining Flexibility, the vestingin- minors clause is designed to give the trustee flexibility to deal intelligently with property that would otherwise be payable outright to a minor. It is important in the vesting-inminors clause to expressly authorize payment to a custodian under a Uniform Transfers to Minors Act or Uniform Gifts to Minors Act, because NY CLS EPTL § 7-6.6 provides that in the absence of such an authorization in the governing instrument, only amounts up to $50,000 can be paid over to a custodian.
You should also include a tax clause in any Will or revocable trust you draft. Under EPTL Sec. 2-1.8, estate taxes are apportioned against the property generating the estate tax obligation. That is rarely what clients want: when a client wants to give $50,000 to his or her sister, he or she generally does not want the sister to have to pay estate taxes on that $50,000, and is expecting that estate taxes will be paid out of the residue of the estate or trust. But apportionment must be specifically overridden by a provision in the governing instrument; hence, you need to include a tax clause to direct, for example, that estate taxes be paid from residue. Of course, it may be that under different circumstances you may want to direct that taxes be paid from a different source. In fact, there are a number of issues you may want to consider, including whether or not the tax clause covers only property passing under the instrument. A robust discussion of the nuances of tax clauses is beyond the scope of this article, but even a very basic tax clause that does no more than override apportionment will generally be a good addition to your documents.
Finally, you should include a bond waiver, at least in Wills. Fiduciaries are generally required to post a bond to secure the performance of their duties before they can receive Letters, see NY CLS SCPA § 708, unless the governing instrument waives the requirement. Consequently, to spare a testamentary trustee the time and expense of obtaining a bond, you should include language such as the following in Wills:
In fact, it cannot hurt to incorporate that language (absent the reference to the Executor) into inter vivos trusts as well, just in case a beneficiary would otherwise try to make a trustee’s life difficult.
For additional coverage of New York Trusts, please review the complete practice note in Lexis Practice Advisor.
Ian Weinstock is a partner with Kostelanetz & Fink, LLP in New York City. He is the head of the firm’s Trusts and Estates practice and works extensively in the areas of trust administration, estate administration, and domestic and international estate and tax planning.