Mandatory and Discretionary Trusts
A trust has assets that are usually distributed over time to the beneficiaries of the trust. Trusts can be classified by how much discretion is given to the trustee to distribute either principal or income to the beneficiaries.
A mandatory trust gives the trustee no discretion, but must distribute its income or principal according to a schedule set by the trust document. A mandatory trust usually has a limited lifetime, because the trustee must distribute income and principal according to a set formula. A mandatory trust can give out all of the property at one time, or at staged intervals so that the beneficiaries do not squander a lump sum payment. So, for instance, the trust can pay out a quarter of its assets every 5 years while investing the assets in the meantime.
A drawback of the mandatory trust is that the trust pays out the money regardless of the beneficiaries' needs, tax situation, or their credit situation. For instance, unless the trust document specifies otherwise, a beneficiary may assign his right to receive income from the trust to a creditor, so that he can receive all of the money right away in the form of a loan. Even if the trust document specifies that the beneficiary cannot assign his rights in the trust, a creditor may attach her rights through a court order, and demand that the trustee pay the creditor instead of the beneficiary.
A unitrust is a special type of mandatory trust that pays a life beneficiary a set percentage of the total worth of the trust periodically. The trustee can make investments that will yield mostly capital gains rather than income, but he must pay the beneficiary a fixed percentage, even if some of the money must be paid out from the trust's principal. A unitrust allows a greater choice of investments, since the trustee can choose investments with the highest yield, without worrying about whether the increase in value is classified as income or capital gains. When a trust has both income and residual beneficiaries, residual beneficiaries may feel cheated if the trustee selects investments that yield mostly income, while income beneficiaries may feel cheated if most of the investments yield capital gains. Hence, unitrusts avoid that conflict, while allowing the trustee to select the best investments.
A mandatory trust is inflexible; the trustee cannot respond to future events that may minimize taxes, increase the total payments to the beneficiaries, or protect the beneficiary's interest from creditors. The trust may be optimized by giving the trustee discretion in managing the trust and paying out its benefits.
The trustee of a discretionary trust has the discretion to pay income or principal to the beneficiaries. Although the discretion is limited by the guidelines of the trust document and the trustee's fiduciary duty to the beneficiaries, it would be wise for the settlor to choose someone that they can trust completely. Even so, the courts have consistently ruled that a trustee must act in good faith in regards to both the purpose of the trust and to the beneficiaries.
Many trusts—called support trusts—are set up for the comfortable support and maintenance of the beneficiaries in a manner in which they have been accustomed or for their education. Since the guidelines for the discretion often depends on the status or needs of the beneficiary, the trustee has a duty to get the information needed so that he can determine if any payments should be made, and how much. If the trustee fails to diligently inquire of the beneficiaries' condition, then courts may find that the trustee failed to exercise his discretionary power. The trustee must act reasonably and in good faith. Good faith means that the trustee thought that what he did was in the best interest of the beneficiaries.
A major drawback to a discretionary trust is that beneficiaries who are not satisfied with the payout may challenge the trustee in court, which will reduce the assets in the trust, since money will have to be spent defending itself. This can be prevented by inserting a no-contest clause in the trust document, which will terminate the beneficiary's interest in the trust if they contest it. However, a no-contest clause will only be effective if the beneficiary is receiving income from the trust—otherwise, the beneficiary would have little to lose by contesting the trust.
To prevent legal problems for the discretionary trustee, some settlors have added specific language—such as that the trustee will have absolute, sole, or uncontrolled discretion—in the trust document to nullify the reasonableness requirement, but the courts still require that the trustee have good faith; otherwise, the trustee would have no fiduciary duties to the beneficiaries, which contradicts the purpose of a trust. If the trustee had absolute discretion, then the trust would be a precatory trust, which, legally, is no trust at all.
In giving the trustee discretion, the settlor usually stipulates an objective or standard to be used by the trustee in exercising his discretion. The courts can enforce the trust or replace the trustee if the trustee fails to exercise his discretion in accordance with the objectives stipulated by the settlor.
Sometimes the settlor will intend to provide a minimum of an income to a beneficiary. In these cases, the trustee will consider the other resources of the beneficiary in deciding whether to pay the beneficiary and how much. However, unless it is expressly stated in the trust document, most courts have found that the beneficiary's other resources are not to be considered in the trustee's decision.
To reduce lawsuits by disappointed beneficiaries, the trust document may have exculpatory clauses that protect the trustee against any exercise of discretion that is not willful neglect. Exculpatory clauses are generally upheld, except where the trustee had a confidential relationship with the settlor that may have been abusive or where the trustee had undue influence. Courts will also disregard exculpatory clauses if there has been willful neglect, or the trustee exhibited bad faith or reckless disregard for the purpose of the trust or for the beneficiaries. U.T.C. §1008
Exculpatory clauses in trust documents that were drafted by the trustee are viewed with suspicion by the courts. In these cases, there is a danger that the settlor did not adequately understand the disclosure. In prior cases[i], proof that the trustee abused his fiduciary relationship with the settlor was required. However, the modern trend, as evidenced by U.T.C. §1008(b) and the Restatement (Third) of Trusts §96, is that there is a presumption of abuse unless the trustee can prove that the exculpatory clause was fair and that its contents were adequately disclosed to the settlor.
To determine if the exculpatory clause was fair, the courts will look at the following:
- the scope of the clause and the reason for inserting it;
- the prior relationship between the settlor and trustee;
- the sophistication of the settlor in business and legal matters;
- and whether the settlor received independent advice.
There is a strong presumption that if the settlor was represented by an attorney who was not also the trustee, then the settlor or the attorney was adequately informed of the exculpatory clause.
Types of Discretionary Trusts
Discretionary trusts are sometimes classified according to their objectives, the most common being the spendthrift trust, support trust, sprinkle trust, and perpetual trust.
The spendthrift trust usually pays money to the beneficiary only as needed either for support and maintenance or for an education. Because the beneficiary has no right to a minimum income, no creditor can force the trustee to pay for the beneficiary's debts, so the beneficiary's right cannot be alienated. Additionally, the trust document will also have a spendthrift provision, whereby any beneficiary interest in the trust cannot be assigned, alienated, pledged, attached, or otherwise subject to the claims of creditors of the beneficiaries.
A support trust pays the beneficiary for her health, support, maintenance, and education. Often, a support trust is created for surviving spouses.
A sprinkle trust (aka sprinkling trust, spray trust) is a discretionary trust that sprinkles, or sprays, its assets to the beneficiaries. The trustee must distribute the income, but can chose whom to pay, and how much, among the intended beneficiaries. Generally, the trustee tries to increase the income of the trust from investments and sprinkles a certain amount periodically to the beneficiaries.
However, the trustee of a sprinkling trust cannot also be a beneficiary. Otherwise, because the trustee has almost complete control of the funds in the trust, the IRS will consider the trust funds to be part of her property, and therefore, part of her estate when she dies, which may expose the trust fund to an estate tax.
A perpetual trust is one whose lifetime depends on some other event, such as the life of a beneficiary. The abandonment of the Rule Against Perpetuities by many jurisdictions allows the creation of the perpetual dynasty trust, where, typically, the trustee invests the principal and distributes the income to the settlor's descendants. A perpetual trust is, by necessity, a discretionary trust, since investment returns are highly variable. Furthermore, to maintain a certain income for the beneficiaries, the trustee may have to invest enough to increase the value of the trust over time, since, usually, the number of beneficiaries will gradually increase.
[i] Marsman v. Nasca, 573 N.E.2d 1025 (Mass. App. Ct. 1991) and Rutanan v. Ballard, 678 N.E.2d 133 (Mass. 1997)