By Stephanie E. Donaho
As estate planners work on sophisticated wills and trusts for their clients, they usually emphasize complex tax considerations. This emphasis is natural, considering the dizzying pace of change in the estate and gift tax laws over the last 20 years. Nevertheless, estate planning documents continue to be some of the most important documents that will govern title to property. It is a cause for concern that the provisions of estate documents addressing the relative rights and remedies of beneficiaries sometimes receive much less attention than those provisions governing the rights and remedies of the IRS.
Two significant trends make it increasingly more important to draft carefully when addressing the relative rights of beneficiaries and others with an economic stake in the property. The first trend is the increase in blended families and second marriages, where there is a natural tension among possible recipients of property. The second trend is the increased emphasis on long-term trusts, both for generation-skipping transfer tax (GSTT) planning reasons and to deal with marital property rights and creditor protection.
This article is intended to act as a catalyst for careful reflection by drafters on how the drafting decisions in tax-dominated estate planning documents can in fact either increase or decrease the likelihood of conflict between those with an economic stake in the property. Virtually every provision in a will or trust can affect the goal of minimizing conflict, and the scope of this article must necessarily be limited. The article addresses only drafting decisions for structure and substantive provisions, and not for administrative provisions. Needless to say, much of the conflict in estate and trust administration comes from administrative provisions, such as debt and tax allocation, tax elections, treatment of income and appreciation before funding, income and expense allocation and similar types of provisions. The failure to address these topics in this article does not minimize in any way their importance in the drafting process.
Structure of Trusts-Spray Trusts
While testators are alive, a family is generally a single unit and there is little concern about whether benefits provided to one child are greater than those provided to another. As a result, clients sometimes wish to create trusts in their wills in which all children are beneficiaries and each can receive distributions in accordance with need without regard to equality of distribution. Unfortunately, although these trusts permit great flexibility, a family seldom operates as a unit after the death of the patriarch and matriarch. It is human nature for a child to consider that he or she has a "share" of the estate. Inequal distributions can generate conflict and destroy relationships between siblings. As a result, this author recommends using a single spray or pot trust for siblings only when estates are relatively small and the primary use of the funds will be to house, clothe and educate the children. Even then, the spray trust concept should be used for the shortest period only, after which the trust assets can be segregated into separate trusts if the testators still wish the protection of a trust for children until they are older.
A variation of a spray trust involves the creation of separate trusts for each beneficiary (e.g., each child of the testator), which permit distributions to be made not only to that child but also to his or her descendants. The advantage of tiered beneficiaries is that, if a primary beneficiary has little or no need for the funds, the trust assets can be diverted to younger generation beneficiaries without making them wait until their parent dies. These provisions are even more attractive as life expectancies increase, especially in families of great wealth or when a trust is exempt from GSTT. This concept is also frequently used in standard bypass trust planning, at least for larger estates.
The primary disadvantage is the inevitable conflict that can occur when more than one person has access to the same fund of money at a single time, as highlighted in the description of spray trusts. Although there will likely be less conflict when the additional beneficiaries are the named beneficiary's descendants (rather than siblings), the possibility of conflict is nonetheless very real. These beneficiaries frequently consider themselves to be "entitled" to the trust assets because their parent probably created the trust, which is often named for them. The length of the trust can be many decades and the ability of a beneficiary's descendants to receive distributions can create the potential for inequality among the younger generation over a long period of time.
If tiered beneficiaries are being considered, the following are possible ways to reduce the likelihood of conflict.
- Prioritization of beneficiaries. An estate planner should prioritize the needs of the named beneficiary versus those of the younger beneficiary. The named beneficiary is frequently considered to be the primary beneficiary- the one whose lifetime needs should be considered ahead of the children's needs. Nonetheless, most instruments drafted with tiered beneficiaries fail to specify this requirement.
- Access limits. Consideration could be given to limiting the use of the funds for younger generation beneficiaries (e.g., for health or education) so that there is no "reward" for those beneficiaries who fail to be self-sufficient. Alternatively, access could be limited to specified dollar amounts or percentages of the trust.
- Distribution standard. A very broad distribution standard, such as "best interests," would permit the trustees to impose equality of distribution among younger generation beneficiaries if appropriate. If a health, education, maintenance and support (HEMS) standard is used, a wealthier, younger generation beneficiary may have no legal standing to object when a less successful (and perhaps less diligent) sibling takes significant distributions from the trust year in and year out. If a standard broader than the HEMS standard is used, careful consideration must be given to trustee selection to avoid adverse estate tax consequences.
- Inter vivos power of appointment. One method to reduce conflict is to avoid making the younger generation current beneficiaries, but instead to make them possible appointees under a special inter vivos power of appointment of the named beneficiary. This power of appointment allows the named beneficiary to provide for equality (or inequality, as the case may be) of distribution without regard to fiduciary considerations. If this option is selected, careful consideration must be given to whether exercise of the inter vivos power would constitute a taxable gift. The IRS has taken this position in some circumstances. See, e.g., Estate of Register v. Commissioner, 83 T.C. 1 (1984); Rev. Rul. 79-327; TAM 9419007; PLR 9451049.
- Veto power. A drafter can also contemplate giving the named beneficiary the power to veto any distributions by the trustee to his or her descendants. This would permit a named beneficiary to help maintain control over his or her descendants in a nonfiduciary capacity.
- Separate trusts. Another method to reduce conflict is to create separate trusts for the children of a beneficiary, and reduce the gift to the elder generation, rather than making everyone the beneficiary of the same trust.
- Equitable adjustments. Most tiered beneficiary scenarios give the trustee spray power among the younger generation and specifically provide that there will be no adjustments on the named beneficiary's death. Nevertheless, an estate planner should consider including a clause directing equalization if the trust is likely to continue for a long period of time and the testator's intent is for overall equality.
- Remote descendants. A drafter may wish to avoid more than two generations of beneficiaries at the same time. Most tiered beneficiary situations permit distribution among the named beneficiary and "his or her descendants." As a named beneficiary ages, he or she is likely not only to have children, but also to have grandchildren and perhaps great-grandchildren. Although conflict may be avoidable between a named beneficiary and his or her children, the inclusion of cousins, aunts, uncles or other relatives in a distribution mix is likely to cause friction in many families.
- Income only. The income only model is frequently used in second marriage situations or in other situations in which the primary beneficiary of the funds is to be the remainderman. The advantage of this standard is that, on its surface, it is predictable and clear. The disadvantage is that the asset allocation of a trust will automatically determine the amount of its income, creating a conflict between the income beneficiary (who may seek an income oriented asset allocation) and the remainder beneficiary (whose best interests may be served through a growth oriented investment strategy that might minimize income). Recent developments in the stock market (where interest rates, and therefore ability to earn income, have been fairly low, while the S&P 500 has done well) have exaggerated these conflicts. The asset allocation decision will thus have a significant impact on the ultimate rights as between the beneficiaries. Because of this impact, planners should generally use income only trusts in situations in which the trust is to be of fairly short duration (and therefore the impact caused by asset allocation will be minimized) or in which the income beneficiary's need for income is fairly insignificant and is unlikely to result in conflict.
- HEMS standard. One of the most common standards for distribution is the HEMS standard. This standard is considered to be ascertainable under the tax law, allowing the beneficiary to serve as a trustee or co-trustee. Although the general perception among drafters (including the author) is that this standard is quite broad and will permit most types of distributions, it nonetheless can produce controversy when remainder beneficiaries believe that the current beneficiary receiving HEMS distributions has adequate resources of his or her own.
- Broad discretion. A standard that permits distributions to be made at the trustee's complete discretion, at the trustee's discretion for the "best interests" of a beneficiary or for the "comfort and welfare" of the beneficiary is the one most likely to permit distributions to be made (or withheld) without fear of liability. Trustees can consider a wide variety of factors, including how a distribution would affect relationships among various beneficiaries. The fact that it is difficult for a beneficiary to challenge an exercise of discretion in distribution in and of itself helps reduce conflict, because it will similarly help reduce feelings of entitlement among beneficiaries. Nevertheless, such a broad standard also greatly limits the identity of the trustees because of Code § 2041 concerns. Likewise, although potential for conflict between beneficiaries may be less, it is a great act of faith for a trustor or testator to create such a broad standard. The welfare of his or her family members lies totally within the trustee's discretion. In a long-term trust, the ultimate identity of trustees is seldom known. As a result, the broad distribution standard should be used with great care, not only for tax considerations (which are significant), but also because it requires careful consideration of the identity of trustees and the methods for removing and replacing trustees and selecting successor trustees.
- Unitrust concept. Increased attention has been given to using a distribution standard similar to a charitable unitrust as an alternative to mandating income distributions. The primary motivation is to align the current beneficiary and the remaindermen by removing the incentive of the current beneficiary to seek high income at the expense of growth. In a unitrust concept, the financial interests of both the current beneficiary and the remaindermen are in the growth of the overall trust fund, and their investment objectives are more likely to be aligned. This use of a unitrust distribution in the noncharitable field is a very attractive option, although it is not yet common practice and the possible detriments are not fully known.
- 5-and-5 withdrawal rights. One way to reduce conflict between a current beneficiary and remaindermen over distributions is to give a current beneficiary the right to withdraw a certain percentage of the trust each year, irrespective of whether the beneficiary meets a standard for distribution. It is possible to do this without significant adverse tax consequences if the beneficiary is given a "5-and-5" distribution right, which is an exception to a taxable power of appointment under Code § 2041(b)(2). If such a standard is included in an instrument that is not designed to be subject to estate taxation at the beneficiary's death, a number of tax considerations must be taken into account.
- Consideration of beneficiary's other resources. Whatever the standard of distribution, it becomes important that an instrument address whether and to what extent a trustee must, should or can consider other resources. Sometimes the challenge is not deciding what type of standard to use but rather recognizing that a standard appropriate in one situation may create significant conflict in another. For example, there may be little or no controversy when a QTIP trust provides for net income distributions to a spouse and access to principal for health, education, maintenance and support. If the spouse remarries, there is a significant potential for conflict over health, education and maintenance distributions that the children believe may inure partially to the benefit of the second spouse. A planner should discuss with testators whether they want to alter a distribution standard on a beneficiary's remarriage. Another option includes adding an independent trustee to administer the distribution standard.
Obviously, one family situation with the greatest potential for conflict is the estate of a testator who has children from a first marriage and a second wife or husband. Generally speaking, it is almost impossible to draft around the problem. Instead, the best solution is typically one of structure.
It is usually preferable, particularly when the children from the first marriage are not that much younger than the second spouse, to provide for the children of the first marriage immediately on the death of their parent, as opposed to making them remainder beneficiaries of QTIP or other trusts for the surviving spouse. The separation of assets at death can be handled in one of several ways.
- Probate assets to children. In a fairly short second marriage, it is probably preferable to leave the household furnishings and personal effects to the second spouse and the remainder of the probate assets (many of which were co-owned by the testator and his or her prior spouse) to the children of the first marriage. As discussed below, the inheritance of the second spouse can be augmented through life insurance and pension benefits.
- Probate assets to spouse. In a longer second marriage, the reverse is usually true. The second spouse is familiar with and feels proprietary about the probate assets. In community property jurisdictions, there may be significant commingling. As a result, it is usually preferable to provide for the second spouse through the probate estate and to provide for the children of the first marriage through a life insurance trust (which is a tax-efficient vehicle as well) and, in larger estates, through the estate tax exemption and lifetime gifting. Of course, the existence of family run businesses, farms or ranches can complicate this scenario.
- Division of assets. In situations in which the estate is large enough, or in which life insurance is not an option due to insurability or cash flow concerns, the best alternative may be for the testator to make the difficult decision as to how to divide assets between the children of the first marriage and the surviving spouse. Tax considerations should be secondary to family considerations, even if this results in some estate tax being incurred on the death of the first spouse. In addition, it is extremely important that the testator be encouraged to communicate his or her intentions to the family, to minimize the conflict that occurs when people are surprised by how they were treated.
- QTIP trust. In some situations, there will be no alternative to creating a QTIP trust, with the children from the first marriage as remaindermen. In that case, independent trustees, unitrust distributions (if greater than income) and other techniques may reduce conflict. The testator must understand the inevitability of tension in such a structure.
The situation becomes even more complex in a second marriage when there are children from both spouses' previous marriages. In many instances, these children grew up together and the testators want to treat all children as being children of both of them. If this is the case, the testators usually want a standard estate plan, except that the remainder beneficiaries in both wills are the children of both marriages, rather than each testator's own children. Although this approach appears to be fair and inclusive on its surface, there is a significant potential for conflict. It is more common than not for events after the first spouse's death to lead the second spouse to change his or her will to include only his or her own children, or otherwise to exclude some or all of the first spouse's children.
This change may be a natural outgrowth of the fact that the common denominator in everyone's lives has died. Although the moral obligation of the second spouse is strong for a number of years, it tends to fade over time, particularly as distance and time may cause the second spouse to see less and less of his or her deceased spouse's children. The net effect may be that the will of the first spouse to die divides everything between the blended children, while the will of the second spouse to die leaves everything only to his or her own children. One way to avoid this is to draft a "cutback clause" in the will of each spouse. If he or she is the first to die, the remaindermen under his or her will change to the extent that the second spouse does not follow the original estate plan.
Powers of Appointment
One of the reasons to use testamentary powers of appointment is to ensure that the use of trusts (often dictated primarily for tax concerns and not necessarily from a desire to limit access to funds) does not give too many rights to the putative remainder beneficiaries. The fact that a parent who is a beneficiary of a trust can disinherit any one or more of his or her children is an effective tool to reduce conflict. It greatly reduces a beneficiary's incentive to challenge distributions to the parent, his or her selection of fiduciaries or other items of flexibility that exist.
Most powers of appointment are drafted to be broad, at least within a line of descent. A beneficiary is usually given the right to change any and all provisions on how the remainder of the trust will pass at his or her death, so long as the appointees are within one or more designated classes (e.g., descendants, descendants and charity). This is certainly the easiest to draft for and provides the most flexibility in terms of taking into account later circumstances.
Unfortunately, although a tool to accomplish great good, a very broad power of appointment can also be a tool to permit unfairness. It can pit siblings against each other in vying for a parent's favor. A broad power of appointment can also increase conflict by taking away from putative remaindermen something to which they feel entitled, as opposed to failing to leave them something to which they had no legal entitlement (e.g., not including them in a will).
To reduce the potential for conflict, a drafter should consider various alternatives in granting powers of appointment. For example, a power of appointment can allow a beneficiary to change how a remainderman receives his or her inheritance, but not the share. That power of appointment could be used to change terms of a trust, lengthen a trust, shorten a trust and make changes to the distribution standard or to the identity of the trustees, but could not be used to eliminate a beneficiary entirely. Another alternative is to provide that the power of appointment cannot be exercised in any instrument executed after the beneficiary reaches a certain age.
No Contest Clauses
In terrorem or "no contest" clauses may not reduce conflict but frequently prevent conflict from erupting into expensive litigation. Issues to consider in no contest clauses include what types of behavior will trigger the clause and who should be disinherited. For example, is it only the filing of a contest that will trigger the clause, or will providing any financial support to others who are seeking a contest similarly trigger the clause? If a person is disinherited, should his or her children be able to step into his or her shoes? In many situations, if a person is disinherited and his or her share passes to his or her children, the no contest clause does not act as a significant disincentive. On the other hand, disinheriting the children of a contestant may be unfair when those children and the contestant are adverse to each other.
Specific Bequests and Special Assets
- Household furnishings/personal effects. Most practitioners see greater conflict over the division of personal effects than in other areas. Drafters should be careful that their form language is clear on these gifts. In addition, a will should specifically address whether or not purchase money indebtedness should follow a specifically bequeathed asset. It is also a good idea to clarify that the executor (or some other appointee) has the power to specify the method of division, to liquidate and distribute items that the executor believes are subject to dispute and to divide the proceeds.
- Expensive assets. Sometimes testators own assets that have great sentimental value but are cash flow drains, such as valuable recreational property. Due to their sentimental value, these assets are likely to produce conflict. Generally speaking, testators should carefully consider any estate plan whereby they are leaving assets to their children that the children may not be able to afford to maintain. In an estate dominated by valuable recreational property, the estate tax may eliminate most if not all of the liquid assets, saddling the children with property that is expensive to maintain. Beneficiaries who use the property frequently and have their own resources might consider such an inheritance a boon. Beneficiaries who are unable to visit the property, or cannot properly afford to maintain their share, are frequently left at a disadvantage. The resulting conflict can tear a family apart. Therefore, a testator must carefully consider the nature of the assets and try to plan for sufficient liquidity to ensure that all children can afford any special family or vacation property. In situations where it is unlikely that children can afford the assets, the testator must face the need for liquidation.
As a general rule, an estate is less likely to have controversy if there are ample liquid assets. Planning for liquidity, whether through a liquidation of assets over time, through life insurance or otherwise, is a significant component in avoiding conflict.
- Closely held businesses. Interests in closely held businesses are a likely source of conflict, particularly if one or more children are active in the business while others are not. The potential problems, as well as potential solutions, are numerous and beyond the scope of this article. A buy-sell agreement can be of great assistance, although the enactment of Code § 2703 has eliminated the ability of families to use specified formulas that would provide some certainty of valuation, as opposed to appraisal methods. When a buy-sell agreement is used and is funded with life insurance, a testator must understand that the child who receives the business (and usually gets his or her pro rata share of the estate as well) may be receiving a much greater share of the estate than is fair. The testator's view may change, based on whether the child was a true moving force behind the success of the business or is merely the testator's remote hope for someone to succeed him or her. Needless to say, many clients are in denial on this issue. In this era of IPOs and frequent company acquisitions, the child whom the testator wanted to own the business so as not to lose his or her job may in fact flip the company shortly after the testator's death for a huge premium.
- Separate property vs. community property. A problem unique to community property jurisdictions is determining what is separate property and what is community property. In a second marriage situation, this can become a task that is rife with conflict. Estate planners should identify where there might be conflict. In the event that commingling may have occurred, so that there will be no conflict, the parties may want to consider a postnuptial agreement to the effect that certain assets are separate property. Separate counsel for the husband and wife may be necessary. Another alternative is to give one-half of the testator's separate property to the spouse, to eliminate any incentive to dispute the executor's decision. If this route is selected, drafting care needs to be taken to consider not only assets, but debt as well.
It is obviously presumptuous, as well as naïve, for any planner to believe that drafting decisions alone can eliminate family conflict. Nonetheless, there is no doubt that estate planners can do a better job of carefully considering how some standard tax planning practices will affect family dynamics. Even then, one cannot underestimate the need for clear, concise and unambiguous expression of those decisions in the drafting process.
Stephanie E. Donaho is a partner with Locke Liddell & Sapp LLP in Houston, Texas.Probate & Property Magazine is published six times annually and is included in section members' annual dues.