Scott Roberts, CPA, CLU
Not all wills and revocable trusts are created equal, as we know. We have previously discussed the tax ramifications of various distribution provisions of trusts. But those same distribution provisions can also have asset protection implications.
A very common estate planning technique is to create a marital trust with a Qualified Terminable Interest Property (QTIP) election and a credit shelter trust upon the death of the first spouse. The provisions governing these two trusts are very important. For example, a marital trust with a QTIP election is required to distribute all the income. Failing that, the trust can lose its tax preferred status. Unfortunately, very often, those same distribution requirements are written into the credit shelter trust sections also. That is, the credit shelter trust’s income is required to be distributed each year. But since a mandatory income distribution is not a requirement for a credit shelter trust, the question is: should we make the income distributions from a credit shelter trust a requirement. From an asset protection standpoint, the answer is simple – the income distributions should be at the discretion of the trustee instead of mandatory. If the income distributions are mandatory then a creditor could just stand by and wait for the distributions each year, effectively hampering the asset protection aspects of the trust. However, with discretionary distributions the trustee can simply retain the assets, including the income, until the creditor issue has been resolved.
This same issue presents itself when savvy clients have used lifetime trusts for children or more remote beneficiaries in order to avail themselves of generation-skipping tax savings and asset protection. While these descendants’ trusts often contain discretionary income (and principal) distribution provisions, if they require mandatory income distributions then we have the same creditor problems. As such, it almost always makes sense to have discretionary income distributions whenever possible.
This particular issue, mandatory versus discretionary income distributions, is an important drafting point that comes up when even the most sophisticated estate planning documents are reviewed. Clients who appreciate the merits of continued asset protection for the wealth they have built should always consider the implications.
All that said, every client situation is unique and there may be circumstances where mandatory income distributions, and the certainty they provide, outweigh the asset protection aspects. As always, you should consult with your tax and estate planning advisor.