Welcome to the first “Drafting Do’s and Don’ts” column. As a senior wealth strategist at UBS, each year I review estate planning documents prepared by hundreds of law firms from across the country. Most of those documents are well-crafted, but some are not quite up to snuff. This column will explore why the language chosen in a particular situation was sub-optimal, hypothesize about why mistakes were made, and offer suggestions for how that drafting could have been improved.
Despite authoring this column, I do not hold myself out as especially gifted in the realm of legal prose. In fact, I approach this project with humility and a certain amount of trepidation. By critiquing the work of others, I am essentially begging the reader to point out every mistake I make.
Drafting is a learned skill that we continue to hone throughout our careers. My sincere hope is that over time this column will help you think critically about your own documents and improve your drafting skills just a little more quickly than you otherwise would have. As you read this column, I urge you to do so with a critical eye. Do you agree with my philosophy, and if not, why? How can you take the language I offer and improve it even further?
This inaugural column begins with a discussion of defined terms. Using defined terms can be an elegant way of drafting. It can significantly shorten a document and ensure consistency. It can also make a trust more readable for clients and nonprofessional trustees. That said, if a word is defined with a surprising or novel meaning, it can almost guarantee the trust will be improperly administered. This is particularly true when the trustee is a relative or family friend who is inexperienced in trust administration. In my experience, having a professional trustee is very much the exception, so it is important that the trusts we create are as “user friendly” as possible.
A Defined Word Does Not Mean What You Think It Means
I recently reviewed a trust that authorized distributions for “education,” which is a pretty common provision. Most often that term is not defined at all. When a definition is provided, it emphasizes the breadth of the concept. That is, “education” is defined expansively to include pre-schools, private schools, boarding schools, trade schools, and graduate programs, in addition to the traditional four-year college degree.
In this particular trust, however, the definition of education was limited to four years of college. I was surprised to find such a narrow definition of education hidden in the back of the document. The operative provision gave no indication that the term “education” had anything other than its ordinary meaning. I would view this as a trap for both professional and less experienced trustees. An experienced trustee may see the term “education” and assume he knows what it means. A less experienced trustee is simply unlikely to look for the definition of such a common term.
How could this be improved? I will assume the narrow definition was consistent with the intentions of the grantor, so we should draft the operative provision in a way that puts our trustee on notice. If the trust authorized distributions for the “health, maintenance, support, or college expenses” of a beneficiary, the trustee would be far more likely to look up the definition of “college expenses.” That is a phrase that does not have an obvious meaning. It could include tuition, room and board, lab fees, book costs, fees for sports teams or clubs, a monthly stipend, and other expenses. A good defined term can both communicate the client’s intention and alert the trustee of the need to take extra care to ensure a distribution is appropriate.
Defined Term— Disappearing Discretion
About a year ago I saw another trust in which a critical term had an unexpected definition that was hidden deep in the document. Reading through the substantive provisions, it appeared that both a credit shelter trust and a trust for children granted the nonbeneficiary trustee absolute discretion for making distributions, but that turned out not to be true.
The credit shelter trust said:
[M]y Trustees shall pay as much of the net income and principal of this trust, even to the extent of all or none, at any time and from time to time as my Trustee, other than my husband, shall determine in such Trustee’s discretion to any one or more persons within a group consisting of my husband and my issue in any degree of consanguinity living from time to time.
The trust for children was generally consistent with the language of the credit shelter trust, “my Trustees shall pay to the beneficiary as much of the net income and principal of the trust, even to the extent of all or none, at any time and from time to time as my Trustee shall determine in the exercise of absolute discretion.”
I would read both provisions as creating an absolute discretion standard. They state that the trustees can pay out “all or none” of the principal. The credit shelter trust prohibits the surviving spouse trustee from participating in a distribution decision, which is a required provision when you have an absolute discretion standard unless you want the surviving spouse to have a general power of appointment. See IRC § 2041.
Note that there is a small inconsistency in that the credit shelter trust simply says distributions can be made in the “Trustee’s discretion,” whereas the trust for children says “absolute discretion.” That inconsistency is something to avoid because it implies the distribution standard for the two trusts is different, although the nature of the difference is unclear. The larger problem with this particular trust, however, is that despite all the evidence, both the credit shelter trust and the trust for children are in fact subject to a health, education, maintenance, and support standard. To understand how that is possible you must read all the way to Article Ten.
Article Ten: In exercising his or her discretionary powers to pay or accumulate income and to pay principal of the trusts under this Will, my trustee other than my husband (i) shall make such distributions only to the extent that such Trustee deems them necessary or advisable for the health, education, maintenance and support in reasonable comfort of the eligible recipient(s) thereof. . . .
Given that the distribution standard in the operative sections of the trust so clearly appears to be an absolute discretion standard, I question how many trustees would find this limitation in Article Ten. This is significant, because a trustee could be held liable if a distribution is made for any purpose outside this ascertainable standard. Instead of hiding such an important provision, it would have been better for the credit shelter trust and each child’s trust to limit distributions to health, education, maintenance, and support in reasonable comfort. Although a definition should add clarity and consistency, it created confusion in this case.
As a final critique of this provision, because this is an ascertainable standard within the meaning of IRC § 2041, the husband, as trustee, could participate in deciding whether to make a distribution from the credit shelter trust without risking any adverse estate tax consequences. The restriction on the husband’s participation in distribution decisions was unnecessary and probably not consistent with the goals of the settlor.
Definitions for Powers of Appointment
To end on a more positive note, I’ve observed an increasing number of attorneys who define a limited power of appointment and use that definition throughout a document. This concept can be implemented in a number of ways.
For example, the dispositive provisions of a trust could say, “Upon the Beneficiary’s death, the property held in his trust shall be distributed as the Beneficiary may appoint through his Limited Power of Appointment. To the extent any such property is not so appointed . . . .” A later article of the trust would provide that “the following provisions shall apply in each instance under this Trust Agreement in which a Beneficiary is empowered to appoint trust property through a Limited Power of Appointment. . . .” The document would then proceed to define to whom property could be distributed to and what formalities were required to exercise the power of appointment. As a variation, some attorneys simply provide that a power of appointment can be exercised in favor of the “Eligible Appointees” and define that term in a subsequent article.
It is quite common for a surviving spouse to have a power of appointment under both a marital trust and a credit shelter trust. Children and grandchildren are often given a power of appointment as well. Consolidating the provisions that govern the operation of those powers into a single article in a trust can be an efficient and elegant way to draft.
In a similar vein, it has become more common to grant beneficiaries a contingent general power of appointment over assets that are not exempt from the generation-skipping transfer tax. Typically, these provisions are drafted so that a beneficiary only has a general power of appointment to the extent the existence of the power will reduce the overall transfer taxes (federal and state) paid on a beneficiary’s death. The language used to create a contingent general power of appointment can be quite technical and lengthy. If you include such a provision in your trusts, consider including language such as, “Upon the Beneficiary’s death, the property held in his trust shall be distributed as the Beneficiary may appoint through his Limited Power of Appointment or his Contingent General Power of Appointment. To the extent any such property is not so appointed . . . .” A subsequent article can then define Contingent General Power of Appointment and the conditions under which the beneficiary may exercise that power.
Coming Up Next
My next column will review several more drafting examples that did not fully achieve the client’s goal, including a discussion of provisions that contain inflation adjustments.
Did you find this column helpful? Disagree with some of the advice given? Have an example of drafting (good or bad) you would like to share? E-mail me at Stephen.Liss@ubs.com. n