Mark B. Edwards
Poyner & Spruill, L.L.P.
Charlotte, NC 28202
İMark B. Edwards 1999 (Version 101599)
OUTLINE OF TOPIC
- How We Got Where We Are
- The First Paradigm - The Real Estate Model
- The Second Paradigm - The Tax Model
- Why Do We Have To Embrace A New Paradigm
- The Change In The Nature Of Wealth
- The Change In The Management Of Wealth
- The Change in the Taxation of Wealth
- The Change In The Manager Of Wealth
- Dealing With The Challenge Of Total Return Investing
- Rely Upon The New Uniform Principal And Income Act
- Give Discretionary Powers To Trustee
- Use Unitrust Payment Formula
- The Private Unitrust - Design Considerations
- The Distribution Amount In The Ordinary Unitrust
- A Variation - The Percentage Unitrust
- The Mandatory Percentage Unitrust
- The Withdrawal Percentage Unitrust
- Qualification For The Marital Deduction
- Additional Discretionary Distributions
- Source Of Distributions
- The Other Challenge - Providing A Trustee
- What Is The Problem
- A Statement of the Purpose
- The Power To Remove And To Replace The Trustee
- The Trust Protector ( Or Special Trustee Or Trust Advisor}
- Who Can Be The Trust Protector
- A Word Of Caution
What estate planners do today is largely centered on using
trusts to reduce wealth-transfer taxes. And we do a fine job
of it; the trusts we draft are carefully structured to comply
with all requirements of the Internal Revenue Code and the regulations
interpreting it, while at the same time meeting all those rules
about trust law that we learned in law school.
In most of these trusts the distribution pattern is the same,
save for minor variations:
The trustee shall hold the trust corpus and pay the income
therefrom to A during A's lifetime. Upon A's death, the trustee
shall divide the trust into two equal shares and pay over one
share to B and one share to C.
True, in some instances the trustee may be given discretionary
power to pay income or principal to one or more beneficiaries.
But even so the common pattern is someone receiving something
now, and a different or additional someone receiving what is
For the 35 years of my full-time law practice, I drafted trusts
this way. Then I left the practice to be a private trustee,
serving under documents that, for the most part, I had prepared.
Chefs will tell you that you never enjoy your own cooking. How
true that is! I find that I do not enjoy serving under some
of the documents I so proudly drafted. Not that they are wrong
in any legal sense, mind you. Not at all. But they do not, I
now believe, respond properly to the need of the trustee and
the beneficiary in today's financial environment.
The thesis of this paper, based upon the experience of "eating
my own cooking," is that we must change our way of drafting
these trusts in the future. We must have a new model, a new
paradigm, around which to fashion the provisions of the trusts
we draw. We must spend more time and creative energy developing
trust operating plans which comply with the requirements of
the tax law. We must permit the trust to invest its assets in
a manner consistent with modern investment practices and modern
trust law, and enable the trust to meet the human needs and
desires of both the grantor and the beneficiary.
- How We Got Where We Are.
Before we look at a new paradigm for our trusts, it will be
helpful to see what has brought us to this place in the history
of the trust.
A. The First Paradigm - The
Real Estate Model
Long ago, in medieval England, wealth and land were synonymous.
The nobles controlled all land, and used it to buy or reward
lesser nobles who assisted them. Upon the death of these lesser
nobles, the land reverted to its original owner who then used
it to replace the deceased individual. To avoid the loss of
land upon death and to avoid some of the other incidents of
the feudal system, some bright conveyancer of land conceived
of transferring land to one or more persons "for the use
of another." Since the multiple holders of the use never
completely died, there was no reversion, and since the land
user did not "own" the land, no feudal duties were
Uses became very popular and, according to one estimate, by
the early 1400's, the majority of real estate in England was
held "for the use of " someone other than the title
holder. This removal of the land from the feudal system became
intolerable for the Crown, so two of our favorite rules of law
- The Statute of Uses and the Rule Against Perpetuities - were
developed to curtail uses.
Out of this conflict, however, came the equitable concept of
the active trust, which was the forerunner of the trusts we
use today. This first kind of trust was conceived of and implemented
as a way to hold title of real estate in one person for the
use or benefit of another. This was the First Paradigm.
B. The Second Paradigm - The
The Second Paradigm originated in 1916 when the estate tax
was reintroduced to help finance World War I, and it has blossomed
ever since.. It is a new view of the trust as a device primarily
for tax purposes, to reduce wealth transfer tax, to manage income
tax, and to avoid generation-skipping tax. This tax-centered
Second Paradigm is added to and melded with the First Paradigm
of the trust as a property-owning, probate-avoiding way to own
The focus of the Second Paradigm is on the act of severing
the title of the property from the client and transferring it
to the trust in a manner that excludes the property from the
transferor's estate and sometimes even from the estate of the
beneficiary. We focus on the creation of a trust to reduce taxes
at the moment of the grantor's death. And that is where we stop!
We give little thought to how that trust will operate for the
next 25 years. We simply say to the trustee and to the beneficiaries:
"Bon Voyage! Have a nice life with the tax money I have
saved for you."
But now we need the Third Paradigm for the trust, a paradigm
that takes the elements of the first two models and adds to
them a forward-looking concern for the operation of the trust
after its execution and funding. This new paradigm will focus
on implementing the client's wishes with respect to the enjoyment
and management of the property that remains after the tax is
paid, rather than the tax consequences at the moment of the
grantor's death. It will be a trust driven by investments, not
- Why Do We Have to Embrace a New
The move from the First Paradigm to the Second was caused by
the imposition of particular taxes - wealth transfer taxes - by
the government in 1916 to finance the First World War. This event
caused a change in the way trusts were viewed. The paradigm shifted!
Now it is again external forces that require us to rethink the
way we look at and deal with trusts, and compel us to move to
the Third Paradigm. These forces are broad currents within our
society, and they are four in number - the change in the nature
of wealth, the change in the management of wealth, the change
in the taxation of wealth, and the change in the manager of wealth.
- The Change in the Nature of Wealth
During the formative years of the trust concept, wealth was
represented by land. The fruit of the land - the crops - could
be consumed or traded away while the land remained to produce
another crop. The land was "principal," and the
crops were "income." "Income" was disposable;
"principal" was not. Today, however, the nature
of wealth has changed; wealth is now represented primarily
by financial instruments. Crop rotation has become asset allocation!
Because of the long-term influence of the First Paradigm,
even as the nature of wealth changed, we comfortably moved
to the concept that these financial assets could be "rented"
just like farm land. That is, we could rent our money to Duke
Energy, for example, by buying some of its shares. In return,
we receive a "crop" of dividends. We call the value
of the shares "principal," and we call the dividends
"income." We consider these two elements as two
distinct things just as the trustee in the First Paradigm
did. But in doing so we have ignored that inescapable fact
that there is a qualitative difference between the land and
the crops of the First Paradigm. Land and wheat are different.
In the world of financial assets, however, there exists no
such difference. As one commentator has so pithily noted:
Property is property. Money is fungible. Accretions to wealth
derived by the owner from cash payments made by the issuers
of securities (interest and dividends) have no essential characteristic
that distinguishes them from those derived from cash payments
made by the purchasers of securities sold by the owner (realized
capital appreciation). And, absent the antiquated model and
associated slogans, no one in her/his right mind would ever
have thought otherwise.
In other words, since wealth is now represented largely by
financial capital rather than real property, we must move
away from the artificial distinction between income and principal
found in the First and Second Paradigms. We must move to the
- The Change in the Management
The change in the nature of wealth has lead to a change in the
management of wealth, and this new form of wealth management is
called "total return investing." This simply means the
investing of funds for maximum return, regardless of whether the
return is in the form of accounting income or capital appreciation.
This form of wealth management has been accepted by the financial
community for several reasons:
- The seemingly unending increase in the price of equity securities;
- The disappearance of meaningful yields on those same securities;
In 1974, Congress passed the Employee Retirement Income Security
Act (ERISA). This Act and subsequent follow-up statutes have created
a multitude of accounts for individuals under profit sharing plans,
401(k) plans and IRAs. All of these accounts share a common trait:
no distinction is made between "income" and "principal."
Because of this, the account holder does not track his income
or her capital gains. Instead he or she simply looks at the account
and compares its total value today to the total value at the start
of the period. In other words, they have embraced total return
In recognition of this movement, fiduciary law is changing (or
perhaps I should say, has changed) to embrace total return investing
as the standard for fiduciaries. The logic of this adoption goes
like this. A basic tenet of trust law is that a trustee must deal
with all beneficiaries of the trust impartially. However, the
artificial distinction between principal and income inherently
favors one class of beneficiaries - either the current income
beneficiaries or the remainder men - over the other. Therefore,
both the Uniform Prudent Investor Act and the Restatement (Third)
of Trusts have explicitly adopted total return investing as the
standard for proper fiduciary conduct.
But if trusts continue to be drawn in a way that divides income
and principal into two distinct piles of money and provides a
separate treatment for each pile, a problem is created for the
trustee. Let me summarize this investment problem created by the
First Paradigm mode of drafting trusts:
- The trustee must act with impartiality considering the needs
of the current beneficiaries and the anticipated needs of the
- Attorneys draw trusts requiring all income to be distributed
to one set of beneficiaries and the principal to be held for
- The higher the needs of the current beneficiaries, the greater
amount of the trust assets must be invested in income-oriented
securities, and these are the investments that are least able
to meet the needs of the future beneficiaries
- The beneficiaries are thus disappointed with impartiality.
The income beneficiaries feel that the income produced is inadequate,
while the remaindermen feel the trustee has not produced sufficient
This investment dilemma and the new fiduciary standards lead,
I believe, to the conclusion that trustees must move to the new
way of total return investing and that the trust documents under
which they serve must facilitate, not impede, this new investment
methodology. In short, there must be a move to the Third Paradigm.
- The Change (?) in the Taxation of Wealth
The Second Paradigm for trusts was begun in 1916 with the
permanent enactment of wealth transfer taxes. With the estate
and gift taxes now reaching a marginal rate of 55% at the
relatively low level of $3,000,000 and with a generation-skipping
tax of 55% applying to many typical trust dispositions, the
defining force in trust drafting became the desire to minimize
But what happens if this defining force disappears? The tax
bill recently passed by Congress contains provisions which
would ultimately eliminate the wealth transfer taxes by 2009.
While the President vetoed this legislation, it does seem
that Congress is serious about doing something to lessen the
burdens caused by these levies. Pundits surmise that at the
least we are likely to see an increase on the applicable exclusion
amount to, say, $1,500,000 per person and perhaps an increase
in the annual exclusion amount under §2503 to $20,000. Changes
of this magnitude would remove wealth taxes as an estate planning
consideration for many people. Of course, there will always
be persons with more, but they become fewer and fewer as the
exempt amount increases. We cannot sell tax-driven trusts
to the multitude of these people, but investment-driven trusts
would be of interest to all.
- The Change in the Manager
of the Wealth
Even as the changes in the nature, management and taxation of
wealth have been occurring around us, another change has been
taking place in the world of trusts. Every trust must have a trustee,
and that trustee must be sophisticated in fiduciary matters, disinterested
in the financial results of the trust and sufficiently long-lived
and stable to render the necessary services for the life of the
trust. In other words, the trustee should be a professional trustee.
And this normally means a corporate trustee!
Throughout the early years of my law practice, the use of corporate
trustees was very common. In recent years, however, there has
been increasing reluctance on the part of many of my clients to
utilize their service. Part of this reluctance, I believe, relates
to the unfulfilled expectations of many trust beneficiaries, for
which our trust documents bear some responsibility. Tales of these
disappointments, told across the table at the Wednesday bridge
club or around the lockers at the golf course, have been a powerful,
negative influence on my clients and their willingness to use
a corporate fiduciary.
Part of the reluctance, however, is brought about by the banks
themselves. Banks are bigger and more impersonal. Customers interact
with them by use of ATMs, toll free phone numbers and the Internet.
The image of the banker as a personal financial advisor has faded
away. Often in today's bank, there is no "Trust Department;"
banks now have their "Capital Management Division."
The name presumably reflects the priorities of the institution!
The primary mission of the corporate trustee as defined by their
literature, their advertising and their presentations seems to
be to provide asset management, not to offer wise counsel to sometimes
immature and argumentative beneficiaries nor to exercise considered
discretion in difficult circumstances.
We must also look again to ERISA for another factor at play here.
The movement to individual accounts started by ERISA empowers
the individual to control his or her financial future. These accounts
have also brought many new players into the market as financial
advisors - mutual fund families, brokerage houses, and insurance
companies. Many of these institutions possess trust powers through
subsidiaries and aggressively offer trust services to their clients,
positioning themselves as facilitators and helpers for the client's
trust beneficiaries just as they were for the client during life.
The result of these changes is a widening gulf between corporate
fiduciaries and the people who need them. More and more often
the client wishes to choose individual trustees even though they
are less qualified than available corporate fiduciaries. Again
it is time for the Third Paradigm trust, which would be drafted
with a view toward bridging the gulf between grantor and professional
trustee, and increasing the willingness to use the best qualified
entity as fiduciary.
- Dealing with the Challenge
of Total Return Investing
How are we to handle the challenge of facilitating the use of
total return investing? How do we address the problems created
by the artificial distinction between income and principal? Remember
that the adoption of the Uniform Prudent Investor Act may authorize
total return investing, but the trust language must also permit
it and facilitate it. There appear to be three options - rely
upon the new principal and income act, give broad powers to the
trustee to make things right, or eliminate the distinction entirely
by using a non-charitable, private unitrust. Each is worthy of
a closer look.
- Rely Upon the New Uniform Principal and Income Act
There are three sources which seek to bring total return investing
into the mainstream of fiduciary law. We have already mentioned
two of them - the Restatement (Third) of Trusts and the Uniform
Prudent Investor Act. The third is the Uniform Principal and Income
Act of 1997 (hereinafter referred to as the "1997 Act").
One purpose of this act is to modernize many of the default rules
governing accounting for trust investments, such as the treatment
of distributions from pass-through entities such as S corps, partnerships
and limited liability companies.
Another purpose of the 1997 Act, the key purpose for our discussion,
is stated as follows:
The other purpose is to provide a means for implementing
the transition to an investment regime based on principles
embodied in the Uniform Prudent Investor Act, especially the
principle of investing for total return rather than a certain
level of "income" as traditionally perceived in
terms of interest, dividends and rents.
The 1997 Act seeks to implement total return investing through
Section 104. This section authorizes a trustee to make adjustments
between principal and income when necessary if the income portion
of the trust's total return is too small or too large because
of the investment decisions made by the trustee under the Prudent
One response to the challenge of total return investing would
be to continue to draft trusts using tried and true First Paradigm
language. We could then rely upon passage of the 1997 Act to furnish
the trustee with the tools to do the job we expect. This course
of action would probably be a mistake for a number of reasons:
- The 1997 Act has been adopted in less than eight states, and
sometimes without Section 104.
- Several states have considered, and rejected, the 1997 Act,
primarily because of opposition from professional trustees to
- The New York study commission considering the Act has proposed
to define the word "income" in the phrase "pay
the income of the trust to A" to mean a 4% unitrust interest.
- There can be no assurance what action, if any, your state
will take on this legislation.
We must deal head-on with the challenge of total return investing.
Our duty to our clients indicates that we must act, not wait for
our legislature to take care of the problem in a satisfactory
- Give Broad Discretionary Powers
Another solution to the artificial distinction between income
and principal is to give the trustee a broad discretionary power
to ignore that distinction. The trustee could be given total discretion
to distribute income and principal among the beneficiaries of
the trust. For example:
The trustee, in its sole discretion, may pay amounts of income
or principal to or for the benefit of A during A's lifetime.
Upon A's death, the trust shall be paid over to B.
The problem with this solution to our principal/income problem
lies in two areas:
- It gives the trustee broad discretion to act, but this makes
the client very nervous.
- It gives the beneficiary no framework upon which to build
As we have stated before, clients today tend to view professional
trustees as big, impersonal, amorphous blobs, not as talented
individuals. Many clients cringe at the suggestion that the trustee
be given total discretion over what their beneficiaries may get
from the trust. True, the grantor may give guidelines to the fiduciary,
whether in the trust instrument or in a letter accompanying it.
But the grantor still may question who will interpret those guidelines
in the years to come. There may be situations such as spendthrift
trusts where discretion is the only answer, but it is not the
answer preferred by most clients and their families.
The creator of the trust may use it for tax reasons; he may use
it to control the property and its ultimate disposition; he may
use it to protect the beneficiary from his own judgmental errors.
In each of these situations, however, the grantor does provide
for one or more beneficiaries about whom he cares and whose happiness
is at least one of his motivating forces. Rarely does the grantor
use a trust with the intention to make the beneficiaries unhappy.
The expectations of the trust beneficiaries are important in determining
if they are happy with the trust, and those expectations arise
from the trust instrument. (And those expectations are also heavily
influenced by the concept of total return investing, as we have
already seen.) The totally discretionary trust gives the beneficiaries
no framework for their expectations. The beneficiaries are placed
in what they perceive to be an adversarial relationship with the
trustee. Make the trustee mad, or even fail to make the trustee
happy, and you may receive nothing.
- Use a Unitrust Payment Formula
Another alternative for implementing total return investing in
the Third Paradigm trust, the best alternative I believe for the
majority of trusts, is to use a unitrust payment formula. Such
a formula would require the trustee to pay to the beneficiary
a specific percentage of the value of the trust assets each year,
just as in the case of a charitable remainder trust under §664
or a grantor retained unitrust under §2702. The benefits of such
a trust would be as follows:
- The expectations of the beneficiaries are clearly defined
in the document.
- The trustee is relieved of concerns about the duty of impartiality,
for both the current beneficiary and the remainder beneficiary
share in the funds' growth (or loss). The beneficiaries are
- The trust can invest in any asset without regard to what it
produces as "income" or "capital appreciation."
Like any broad statement, there are exceptions to the rule; the
unitrust form of payout cannot be used blindly in every case.
Four types of trust in particular are not well suited for the
unitrust payout formula:
- A credit shelter trust where the surviving spouse is the beneficiary
and is alive. Any mandatory distributions would remove assets
from the shelter of the trust and subject any unspent portion
to tax in the estate of the surviving spouse.
- A generation skipping trust which provides for distributions
to a non-skip person for life and then to the skip beneficiaries.
The mandatory unitrust formula would be contrary to good tax
planning, for any unspent portion of the mandatory distributions
to non-skip persons would be taxed earlier than necessary.
- A spendthrift trust designed to protect assets from the claims
of creditors. A mandatory unitrust interest would be reachable
by creditors under the laws of most states.
- A trust funded largely with non-financial assets such as real
property or with non-liquid assets such as interests in a closely-held
business. The unitrust formula would produce an inappropriate
result of requiring payments in kind or requiring forced sale
of some of the assets.
The unitrust provision should be strongly considered, however,
in the vast number of ordinary trusts used in estate planning.
This would include irrevocable life insurance trusts after the
maturity of the policy, credit shelter trusts where the spouse
is not a beneficiary or where the trust continues after the death
of the surviving spouse, generation skipping and dynasty trusts
where no non-skip person is a beneficiary, and the typical protection
trust that holds assets for X until he or she attains the desired
Some commentators have pointed out that the terms of the unitrust
require a payout from the trust even if the beneficiary does not
need the money. Two points should be made. First, because of the
compressed income tax brackets applicable to trusts, all trust
income over $8,900 is taxed at 39%. Distribution of these amounts
to the beneficiaries generally results in a reduced income tax
burden for the family group. As for the estate taxes, any funds
not needed by the recipient could be given to objects of bounty
using annual exclusion gifts.
Secondly, very few people who are the current income beneficiaries
of a trust will be content to allow all income and gain to be
accumulated in the trust, whether they "need" it or
not. They want something distributed to them, and they will find
the "need" for it. Given this aspect of human nature,
the use of a unitrust payout formula imposes no real financial
hardship on the trust or its beneficiaries.
- The Private Unitrust - Design Consideration.
A private unitrust would closely resemble the charitable remainder
unitrust with which we are all familiar. Let us look at selected
provisions of such a trust and discuss the choices to be made
by the drafter in consultation with the client.
- The Distribution Amount in the
We must first define the unitrust amount to be paid to the
beneficiary each year. Consider the following language:
The Distribution Amount shall be an amount equal to ___
percent (___%) of the fair market value of the trust as of
the close of the last business day of the preceding tax year
of the trust.
Perhaps the most difficult question is, what percentage should
the payout be? Selection of the payout percentage should start
with consideration of factors including the beneficiary's
needs, the period the trust is to continue, and the grantor's
desire for the remainder beneficiaries (e.g., should they
receive anything, receive the same principal as the trust
started with, receive the same principal adjusted for inflation,
or receive an increased principal after adjustment for inflation).
Many studies indicate that, over an extended period, a percentage
of 3 to 5% is appropriate to protect the current beneficiary
while passing to the remainder beneficiaries an inflation-adjusted
principal equal to the starting amount. Clients who have seen
the unprecedented performance of the stock market in the last
decade may at first believe these suggested rates to be absurdly
low. The rates are, however, realistic when the time line
is longer, and the life of most trusts is longer.
When considering the percentage to be used, remember that
what goes up may also come down. In years when the market
value of the trust declines, the distribution amount will
also decline. Rarely, however, do the expectations of beneficiaries
decline in concert with the financial markets. Accordingly,
using an average value of the trust over a period of years
may be used to smooth out changes in market value. Such a
variation might be as follows:
The Distribution Amount shall be an amount equal to ___
percent (____%) of the average of the fair market values of
the trust as of the close of the last business day of the
three (3) preceding tax years of the trust.
This provision will reduce the amount of variation in the
distribution amount and aid the budgeting of the beneficiary
and the cash flow projections of the trustee.
Also remember that there is no requirement in the private
unitrust that the Distribution Amount remain fixed throughout
the term of the trust. It can be changed to accommodate different
stages of the life of the beneficiary. For example, consider
the following clause:
The Distribution Amount shall be an amount equal to a
percentage of the fair market value of the trust as of the
close of the last business day of the preceding year of the
trust, the percentage being determined as follows: (i) until
_____ attains the age of forty (40) years, three per cent
(3%); (ii) Between the ages of forty (40) and fifty five (55)
years, four per cent (4%); and (iii) after attaining age fifty
five (55) years, five per cent (5%).
Such a distribution formula might be intended to minimize
distributions during the prime working years of the beneficiary,
then to increase the payout to assist with college expenses,
finally to increase again to supplement retirement.
The unitrust payout could also be introduced into the trust
after the happening of a stated event. For example, a credit
shelter trust might provide for income and principal to be
made available to the surviving spouse during his or her lifetime
in the trustee's discretion. After the death of the spouse,
however, the trust could provide for the payment of a unitrust
interest to the new beneficiary.
- A Variation - the Percentage Unitrust.
The definition of the Distribution Amount as a dollar amount
is simple and straightforward. There are, however, at least two
variations which have been suggested by Jerold Horn to be considered.
- The Mandatory Percentage Unitrust
One alternative is illustrated in the following definition
of the Distribution Amount, here called the Annual Distribution
and expressed as a percentage of the trust:
The Annual Distribution shall be ____ percent (____%)
of the trust estate as of the close of the last business
day of the preceding tax year of the trust.
This definition converts the dollar amount of the ordinary
unitrust into a percentage share of the trust. There should
be two advantages to this model. The trustee can make
the distribution in kind, and, unless the election under
§643(e) is made, there should not be a deemed sale. Of
course, the recipient takes a carry-over basis in the
property if the election is not made. Thus, by making
or not making the election, the trustee can accelerate
or defer the recognition of gain and determine who, the
trust or the beneficiary, will pay the tax.
The second advantage is that the ability to distribute
in kind permits the trustee to remain fully invested,
without maintaining a store of cash to pay the distribution
amount or without selling an investment. However, the
distribution in kind will carry out DNI to the distributee
under §§661 and 662, and increase his or her taxable income,
possibly requiring some cash to pay the resulting income
To make this concept fulfill its potential as a planning
tool, the trust document should grant to the trustee the
power to make non-prorata distributions in kind, either
explicitly in the instrument or by the incorporation by
reference of an appropriate statutory power, or both.
- The Withdrawal Percentage Unitrust
Another variation of the percentage unitrust discussed by Horn
eliminates the element of mandatory distribution and permits the
beneficiary the discretion to take some, all or none of the Distribution
Amount. This definition might read as follows:
If the beneficiary is living immediately before the end
of a calendar year, the trustee shall pay to the beneficiary
so much, if any, of the trust estate as the beneficiary shall
direct in writing before the end of the year, but the portion
withdrawn shall not exceed ___ percent (___%) of the trust
Such a unitrust might be desirable if there is a question of
whether the beneficiary will need the Distribution Amount, or
if he or she would prefer to compound those amounts. Of course,
the power of withdrawal granted here is a general power of appointment,
but its lapse would be shielded from estate and gift tax consequences
by the 5 x 5 exception of §2041(b) and §2514(e) if the percentage
withdrawal is set at 5% or lower. However, all income attributable
to the property subject to the power will be included in the income
of the beneficiary under §678(a)(2).
It must be remembered that the 5x5 exceptions are only applicable
for transfer tax purposes. The IRS has taken the position that
the lapse of such a power results in the power holder being considered
the grantor of the trust for income tax purposes to the extent
of the property not withdrawn. Thereafter, depending upon the
terms of the trust, the holder of the power may be subject to
the grantor trust rules as to an ever-increasing portion of the
- Qualification for the Marital
The Internal Revenue Code still talks of principal and income
in many places, but particularly in §2056 dealing with the
martial deduction. In §§2056(b)(5) and 2056(b)(7), dealing
with the power of appointment trust and the QTIP trust respectively,
the Code requires that the surviving spouse receive all of
the net accounting income of the trust each year. Therefore,
if the trust being drafted as a private unitrust is intended
to qualify for the marital deduction, the language set forth
below should be added:
If, in any year, the net income of the trust exceeds the
Distribution Amount, such excess shall be paid to A at least
Of course, this provision could terminate with the death
of the spouse if the trust is to continue for other beneficiaries.
- Additional Discretionary Distributions
Just as in any First/Second Paradigm trust, it may be desirable
to vest in the trustee discretion to pay additional amounts
to the beneficiary to meet circumstances not covered by the
mandated distributions. This power of distribution can be
defined as broad or as narrowly as the drafter and the client
may choose. Consider the following provision:
In addition to the Distribution Amount, my Trustee may,
in his sole discretion, distribute to or for the benefit of
A such amounts from the income or principal of this trust
as the trustee deems advisable for her health, education,
maintenance and support in reasonable comfort.
This might be considered the best of both worlds. The proponents
of the "give it to the trustee with total discretion"
school could here have whatever their favorite discretion
language is, deriving all of the admittedly real benefits
for so doing. The trustee would be permitted to meet financial
emergencies of the beneficiaries or to deny additional distributions
if circumstances dictated that course. At the same time, much
of the pressure on the trustee in terms of investment strategy
and dealing with the beneficiaries is eliminated by the mandatory
floor for distributions set by the unitrust formula.
- Source of Distributions
The drafter should also give guidance as to the income tax ramifications
of the amounts distributed. Consider this language taken from
charitable remainder unitrust forms:
The amounts distributed from the trust shall betreated
under the rules set forth in Regulations §1.664-1(d)(1) as
that Regulation exists upon the date hereof. Any capital gains
actually distributed as part of the Distribution Amount or
as a discretionary distribution shall be credited to the recipient
of the distribution on the books of the trust.
This paragraph makes clear the source of the payments made in
satisfaction of the Distribution Amount. While there is no law
explicitly making them applicable to private unitrusts, the IRS
has made it clear that the trust instrument may set forth ordering
- The Other Challenge - Providing
Every trust must have a trustee. That trustee must act as defined
in applicable trust law, but must also deal with the factors unique
to each trust. A corporate trustee is best suited to be trustee
of the Third Paradigm trust. But we have already spoken of the
growing reluctance (even outright refusal) of clients to use them.
The Third Paradigm trust must therefore be designed to bridge
the gap between these two poles - the expertise and impartiality
of the professional trustee and the reluctance of the client to
A. What Is the Problem
Why are clients sometimes reluctant to use a corporate fiduciary?
This reluctance does not arise primarily from a concern about
fees. Fees of the corporate fiduciary are usually no more that
those of other investment advisers, and frequently less. In a
very real sense, when you use a corporate trustee, you pay the
same fee for investment services that you would pay without such
a trustee, and you get the fiduciary services thrown in for good
But the reluctance does arise from anecdotal evidence of dissatisfaction
with other trusts and from a perception of the qualities of the
modern bank trustee. They are perceived as big, governed by committee,
slow to act, with frequent change in the contact person leading
to the "trust officer of the month" syndrome, and an
overriding aversion to risk. I fear that some of these perceptions
may be well-founded!
The answer to bridging the gap may be to consider carefully the
powers that can be retained by the grantor, or at least given
to a third party trusted by the grantor. These powers make the
grantor feel less "powerless" after the trust is established
and less "at the mercy of" a big institution. Thus he
or she may be more inclined to use a corporate trustee to take
advantage of the areas like investment management, tax compliance,
and record keeping where the bank has acknowledged expertise.
- A Statement of Purpose for the Trust.
The Third Paradigm trust should start with a statement of the
purpose of the trust, a plain language explanation of why the
grantor is creating the trust. While this may be challenging to
the drafter of the document, it would accomplish three things:
It would serve as a basis for the expectations of the beneficiaries
with regard to distributions from the trust. We have previously
mentioned the role of these expectations in determining the satisfaction
of the beneficiaries.
It would give guidance to the trustee for the exercise of any
discretionary powers contained in the instrument. The primary
role of the trustee is to serve as a surrogate for the absent
grantor, and a statement of purpose with enhance the trustee's
ability to fill this role.
It would hopefully protect the trust and/or the trustee from
modification of the trust in the future. It has long been the
law that the grantor and all beneficiaries could ban together
to modify an otherwise irrevocable trust. However some states
have gone beyond this to provide for less stringent requirements
for such modification. A statement of purpose in the document
should carry great weight in any proceeding seeking to change
the purpose of the trust.
C. The Power to Remove and To Replace the Trustee
There is one broad power which can,
and should, be retained by the trust grantor without adverse tax
consequences under the estate tax, gift tax, or income tax statutes.
That is the power to remove and replace the trustee. Since the
trustee carries out the terms of the trust, how it operates and
the attitude it employs in its operations are the most important
things in determining the trust's success. The grantor should
have all permitted power to control the identity of the trustee
who in turn controls the trust which he or she has established.
If the grantor has an unrestricted right to remove a trustee
and to appoint himself trustee in that place, the powers of the
trustee will be attributed to the grantor. Therefore if the trust
gives the trustee any power that would, if retained by the grantor,
trigger inclusion of the assets in his or her estate under §§2036
or 2038, the trust corpus will be included in the grantor's estate.
The present state of the law in set forth in Rev. Rul. 95-58,
1995-2 C.B. 191. That ruling provides that trust assets will not
be included in the grantor's estate under §§2036 or 2038 if the
power permits removal of the trustee and replacement only with
an individual or corporate trustee who is "not related or
subordinate to the [grantor] (within the meaning of Section 672(c))."
Under §672(c), a related or subordinate party includes the grantor's
spouse, mother and father, lineal descendants and employees. Also
included are any corporation (or employee of that corporation)
in which the grantor is an executive or significant voting shareholder.
Given the breadth of this ruling, a trustee removal power should
be included in virtually every trust. This power may be retained
by the grantor during his or her lifetime, and upon death, it
can pass to one or more persons of the grantor's choosing. In
drafting the power, the following questions should be considered:
- Who among the possible beneficiaries has the power to remove
and replace? Perhaps one has the power to remove and another
- If more than one have the power, how is the decision made?
By majority vote? Or does one individual have a tie-breaking
- Should the exercise of the power be limited to a finite number
- How is the class of permissible replacement trustees defined?
Is it limited to corporate trustees or could individuals be
- As to corporate candidates, are there are qualifying conditions
such as assets under management or jurisdiction of governing
- As to individual candidates, are there any qualifying conditions
other than that they not be related or subordinate under the
meaning of §672(c)?
There is no power more important than this one in the drafting
of the Third Paradigm trust!
- The Trust Protector (or Special Trustee or Trust
There are numerous other powers that the typical grantor would
like to have - powers such as the right to add or delete beneficiaries
or the right to alter the dispositive terms of the trust. These
powers, however, create severe estate and income tax problems
for the grantor. They should be given to someone else who could
then exercise them in accordance with the perceived intentions
of the grantor.
For many years, legal practitioners in English common law jurisdictions
have made regular use of a special trustee, often called the trust
protector, to add flexibility to trusts. The role of the trust
protector is to modify the terms of the trust when necessary to
carry out the grantor's intent.
The powers of the trust protector must be defined in the trust
document. The power can be simple, such as a right to remove and
replace trustees, or it can be more complex, such as a power to
alter the beneficial enjoyment of the trust among a class of people.
There is no limit to the varieties of these powers; each trust
drafter can fashion them in many ways to serve the needs of the
clients and of the trust beneficiaries.
Powers that may be granted to a trust protector and that might
be desired by the grantor would include:
- The power to amend the dispositive terms of the trust, such
as adding or removing beneficiaries or changing ages of distribution.
- The power to amend the administrative terms of the trust,
such as removing and replacing the trustee.
- The power to appoint his or her own successor as trust protector.
- The power to exercise discretion as to the recipient, time,
nature and amount of distributions from the trust itself.
- The power to change the legal situs of the trust.
- Who can be a Trust Protector
The powers given to the trust protector can be broad and sweeping,
so we must be concerned with the tax impact of them. The first
question would be, who can serve as trust protector? Clearly,
the grantor should not. Many of the powers given to a trust protector,
other than the power to change trustees, would surely cause the
trust corpus to be included in the grantor's estate under §§2036(a)(2)
Moreover, the grantor should not have a power to remove and replace
the trust protector. Under the rationale of Rev. Rul. 95-58, the
Service can attribute the powers of a trustee to the grantor who
holds a power of removal and replacement, if the successor can
be a related or subordinate party. Given the broad powers of the
trust protector, it is probably best to avoid any temptation to
the Service to extend the rationale of that ruling to these facts.
For transfer tax purposes, almost anyone other than the Grantor,
and specifically including a spouse or child, can be named as
trust protector. Indeed, a good argument could be made that the
ideal trust protector is the spouse of the grantor. Who else would
have such an intimate knowledge of the grantor's desires and wishes
in establishing the trust? And who else who know the beneficiaries,
their strengths and their weaknesses so well? Regulations. §20.2036-1(b)(3)
provides that its provisions do not apply to powers held by a
person other than the transferor. So do the Regulations under
§2038. Case law also supports the statement that the spousal powers
will not cause estate tax questions. In Kneeland v. Com'r,
the decedent had established an irrevocable trust for children
and grandchildren. The grantor's spouse was given a power to revoke
the trust and return the trust corpus to the grantor. The court
held that the trust was not included in the grantor's estate because
the spouse's power did not require that result. Of course, in
none of these cases or Regulations was there any agreement or
understanding between the grantor and the spouse as to the exercise
of the power, and there should be none!
It is important to recognize that some of the powers given to
the trust protector may be sufficient to constitute a general
power of appointment in the holder. Thus if the power given to
the spouse permitted him to vest title to the property in himself,
his creditors, his estate or the creditors of his estate, that
would be a general power and the trust corpus would be included
in his estate. However, if that power is limited by an ascertainable
standard, it will not be a general power, and no inclusion will
If there is no spouse available, or if the grantor desires the
trust protector to have powers that could cause estate tax inclusion,
the trust protector should be unrelated individual who is not
subordinate within the meaning of §672(c). Lineal descendants
of the grantor are not a good choice since they are normally beneficiaries
of the trust itself. As beneficiaries, their exercise of powers
may be challenged as biased toward themselves and the powers may
constitute general powers of appointment with estate and gift
tax consequences. All in all, not a good choice. This points us
to an unrelated individual or perhaps a corporate entity.
For income tax purposes, the rules are different from those we
have discussed above.. Section 672(e) provides that the grantor
of a trust will be treated as holding any power held by his or
her spouse. Moreover, any power held by a "related or subordinate
party" will be deemed held by the grantor. See §672(c). Most
of the powers granted to a trust protector, other than purely
administrative powers, would or could be sufficient to make the
grantor owner of the income of the trust under §§673 to 677 of
Accordingly, unless the trust protector is not the spouse or
a "related or subordinate party," the trust likely will
be a grantor trust, causing all items of income and gain to be
taxed to the grantor. But consider (i) the trust protector can
have the power to make money available to the grantor with which
to pay the tax, and (ii) the payment of the tax liability would
further reduce the grantor's estate without the making of a gift.
All things being said, a general rule is that the trust protector
should not be the grantor or a beneficiary under the trust document.
Otherwise, the field is wide open!
F. A Word of Caution
In many instances, the Internal Revenue Code - the ruler of the
Paradigm Two trust - provides exact and detailed requirements
which must be met if a trust is to perform its intended purpose.
If you desire to use a trust protector in such a trust, you must
be sure that the powers granted to the protector do not include
the power to change any of the statutory requirements for the
trust. Some examples may be helpful:
- In trusts intended to qualify for the marital deduction under
§2056 (except for an estate trust), the Internal Revenue Code
requires that all income be paid to the spouse each year and
that no other person be a permissible beneficiary of the trust
during the lifetime of the spouse. Any trust protector should,
therefore, have no power to violate either of these requirements.
- Similar requirements are imposed on a trust which intends
to be a Qualified Subchapter S Trust (QSST) under §1361(d).
Again the protector's powers should be limited to prevent any
possible violation of the Code requirements.
Other types of trusts that have specific tax requirements would
include, be not be limited to, the following:
- A §2503(c) trust for minors;
- A direct skip trust qualifying for the annual exclusion under
- A charitable remainder trust under §664;
- A grantor retained income trust under §2702;
- An Electing Small Business Trust (ESBT) under §1361(e); or
- Any trust with Crummey withdrawal powers, at least
with respect to any existing power.
In structuring a trust protector provision in such an environment,
a two-pronged approach is probably desirable. First, the specific
powers granted to the trust protector should be carefully examined
to see which should be eliminated and which modified. Then a savings
clause could be added to the provisions similar to that set forth
in Paragraph E of Exhibit B.
For too long we lawyers have created trusts without devoting
sufficient time and energy to the question of how they will operate
in the future. Today, however, external forces in the nature of
wealth, the nature of investment management, the nature of the
taxation of wealth, and the nature of the trust manager force
us to take another look at our tried-and-true drafting habits.
The conclusion reached from this review is that we should change
what we do. We should consider alternative forms of trust distribution
formula, especially the private unitrust. We must also consider
the changing nature of the institutional trustee, and draft trusts
better adapted to the needs of the grantor in this environment.
Provisions such as the trust protector provisions permit us to
blend the best skills of the institutional trustee with those
of an individual familiar with the grantor's wishes to achieve
the optimum result for our clients.
LAW IN NORTH CAROLINA:
PRUDENT INVESTMENTS AND TOTAL RETURN INVESTING
In 1999, North Carolina joined the majority of states in this
country which have adopted the Uniform Prudent Investor Act. This
Act, codified as Article 15 of chapter 36A of the North Carolina
General Statutes, basically provides that the trustee should invest
the trust assets "as a prudent investor would, by considering
the purposes, terms, distribution requirements, and other circumstances
of the trust." N.C.G.S. §36A-162(a). From this rule and the
others stated in this Article, we see the following principles
which govern trustee behavior:
- The trustee should focus on total return; the distinction
between income and principal is lessened in importance. (§36A-162(c)5.)
- The trustee should focus on the entire portfolio, not individual
assets within it. (§36A-162(b).)
- The trustee may invest in any kind of property so long as
it is prudent to do so. (§36A-162(e).)
- The trustee must review the assets of the trust upon assuming
office, and decide to retain or dispose of them to bring the
portfolio into compliance with this rule. (§36A-164.)
- The trustee may delegate authority for investment decisions
if it is prudent to do so and if the agent is selected with
reasonable care. (§36A-169(a).)
- The trustee has a duty to diversify the portfolio unless,
under the prevailing circumstances, it is prudent not to do
This statute is effective January 1, 2000, and applies to express
trusts existing on and created after the effective date, unless
the terms of the trust are to the contrary. (§36A-171.)
LAW IN NORTH CAROLINA
MODIFICATION OR TERMINATION OF IRREVOCABLE
In 1999, North Carolina adopted a new statute offering an opportunity
to modify or terminate irrevocable trusts in certain circumstances.
The statute, codified as Article 11A of Chapter 36A of the General
Statutes, provides as follows:
- If the grantor of the trust is the sole beneficiary, he can
compel modification or termination of the trust at any time.
- If the grantor and all beneficiaries agree, they can compel
the modification or termination of the trust without approval
of a court. (§36A-125.3)
- If one of the beneficiaries of the trust does not consent,
the others may seek modification or partial termination from
the court. The court can approve the relief requested if it
finds no harm or impairment to the beneficiaries who do not
- If all beneficiaries of the trust consent, they may seek modification
or termination of the trust in a court proceeding, presumably
even if the grantor is alive and does not consent. (§36A-125.4(a))
- If the actions desired by the beneficiaries would effect a
material purpose of the trust, the trust cannot be modified
or terminated unless the court determines "that the reason
for modifying or terminating the trust under the circumstances
substantially outweighs the interest in accomplishing a material
purpose of the trust." (§36A-125.4(b))
- In its considerations, the court may modify or terminate the
trust if (i) the purpose of the trust has been fulfilled, or
become illegal, or become impossible of fulfillment; or (ii)
owing to circumstances unanticipated by or unknown to the grantor,
the continuation of the trust would defeat or impair the accomplishment
of the purposes of the trust. (§36A-125.7(a))
PROVISION FOR A TRUST PROTECTOR
[Adapted from a form by Hodgman in his article
cited in the Bibliography]
- I appoint _________________ as Trust Protector hereunder.
If ____________ fails or ceases to act as Trust Protector, he
may, but is not required to, appoint any one or more successor
Trust Protector as provided in the following paragraph. No trust
created under this instrument is required to have a Trust Protector
acting with respect to that trust.
- The Trust Protector acting from time to time, if any, may
appoint any one or more individuals (other than me, my spouse,
or a descendant of mine) as successor Trust Protector. Any appointment
of a successor Trust Protector shall be in writing, may be made
to become effective at any time or upon any event, and may be
single or successive, all as specified in the instrument of
appointment. The Trust Protector may revoke any such appointment
before it is accepted by the appointee, and may specify in the
instrument of appointment whether it may be revoked by a subsequent
Trust Protector. In the event that two or more instruments of
appointment or revocation by the same Trust Protector exist
and are inconsistent, the latest by date shall control.
- Any Trust Protector may resign by giving prior written notice
to the trustee. All trusts created under this instrument need
not have or continue to have the same Trust Protector. The provisions
of this instrument that relate to the Trust Protector shall
be separately applicable to each trust held hereunder.
- The Trust Protector may, with respect to any trust as to which
the Trust Protector is acting, modify or amend:
- The trust administrative provisions of Article ___ relating
to the identity, qualification, succession, removal and appointment
of the trustee;
- The financial powers of the trustee set forth in Article
- The provisions of Article _____ relating to the identity
of the contingent beneficiary of the trust property;
- The withdrawal rights granted under Article ____ of this
instrument (except a withdrawal right already in existence
at the time the Trust Protector seeks to exercise the power
conferred under this paragraph); and
- The terms of any trust created hereunder with respect to
(i) the purposes for which the trustee may distribute trust
income and principal, and the circumstances and factors the
trustee may take into account in making such distributions,
(ii) the time for the distribution or withdrawal of any portion
of the principal or income of the trust, (iii) the termination
date of the trust, either by extending or shortening the termination
date (but not beyond any applicable perpetuities period),
and (iv) the identity of the permissible appointees under
the testamentary power of appointment granted to the beneficiary
for whom the trust is named.
- The provisions of this Article shall not apply to any trust
created hereunder which is intended to qualify for the marital
deduction under the provisions of §2056 of the Internal Revenue
Code or which is intended to qualify for the charitable deduction
under any provision of the Code.
- The rights and powers conferred on the Trust Protector under
this instrument, including, without limitation, the power to
remove trustees, and all rights and powers granted the Trust
Protector under Paragraph D of this Article, shall be exercisable
only in a fiduciary capacity.
- Notwithstanding any other provision of this instrument, the
Trust Protector shall not participate in the exercise of a power
or discretion conferred under this instrument that would cause
the Trust Protector to possess a general power of appointment
within the meaning of Sections 2041 and 2514 of the Code.
- The Trust Protector acting from time to time, if any, on his
or her own behalf and on behalf of all successor Trust Protectors,
may at any time irrevocable release, renounce, suspend, cut
down or modify to a lesser extent any or all powers and discretions
conferred under this instrument by a written instrument delivered
to the trustee.
The following Bibliography lists the articles most important
to an understanding of the thoughts presented here. I suggest
that these articles be read to give you a flavor of the excellent
research which has been done in this area, for all of them have
contributed to my understanding of these issues. (Errors, however,
are all mine.) From time to time, specific reference is made in
the notes to articles cited here when some particular fact or
language is extracted. That citation is to the name in brackets
following each article.
Darin N. Digby, "What Powers Can a Donor Retain Over
Transferred Property?", 24 ESTATE PLANNING 318 (Aug./Sept.
Joel C. Dobris, "New Forms of Private Trusts for the
Twenty-First Century - Income and Principal," 31 REAL
PROP. PROB. & TRUST LAW J. 2 (1996). [Dobris I]
Joel C. Dobris, "Changes in the Role and the Form of
the Trust at the New Millennium, or, We Don't Have to Think
of England Anymore," 62 Albany L. Rev. 543 (1998). [Dobris
Mark B. Edwards, "Trusts for the Third Century: The
Third Paradigm," 18 THE WILL AND THE WAY, No. 1 (November
James P. Garland, "The Problem with Unitrusts,"
THE JOURNAL OF PRIVATE PORTFOLIO MANAGEMENT, No. 4 (Spring
David R. Hodgman, "Drafting Flexible Irrevocable Trusts
- Whom Can You Trust?", 23 ESTATE PLANNING 221 (June
Graham D. Holding, Jr. and Christy Eve Reid, "The Private
Unitrust vs. The Discretionary Trust as a Paradigm for the
New Century," 18 THE WILL AND THE WAY, No. 2 (Feb. 1999).
William L. Hoisington, "Modern Trust Design: New Paradigms
for the 21st Century," 1997 U. MIAMI INST.
ON ESTATE PLANNING 6-1 (1997). [Hoisington]
Jerold I. Horn, "Prudent Investor Rule, Modern Portfolio
Theory, and Private Trusts: Drafting and Administration Including
the "Give-Me-Five" Unitrust," 33 REAL PROP.
PROB. & TRUST LAW J. 1 (Spring 1998). [Horn]
David W. Keister & William J. McCarthy, Jr., "1997
Principal and Income Act Reflects Modern Trust Investing,"
26 ESTATE PLANNING 99 (March/April 1999). [Keister/McCarthy]
Jonathan R. Macey, AN INTRODUCTION TO MODERN FINANCIAL THEORY
(2nd ed. 1998). [Macey]
Robert J. Rosepink, "The Total Return Trust - Where
and How to Tax Capital Gain, 137 TRUSTS & ESTATES 12 (Oct.
Robert B. Wolf, "Defeating the Duty to Disappoint Equally
- The Total Return Trust," 32 REAL PROP. PROB. &
TRUST LAW J. 45 (Spring 1997). [Wolf I]
Robert B. Wolf, "Total Return Trusts - Can Your Clients
Afford Anything Less?" 33 REAL PROP. PROB. & TRUST
LAW J. 133 (Spring 1998). [Wolf II]
Robert B. Wolf & Stephen R. Leimberg, "Total Return
Unitrusts: The (TRU) Shape of Things to Come," 10 RIA EST.
PLANNER'S ALERT 15 (Dec. 1998). [Wolf/Leimburg]