Making Principal Invasions under Florida Law when an Interested Party is Serving as Trustee
There will always be situations when a client will want to name an interested person to serve as trustee of a trust he or she is setting up. There used to be two reasons for concern whenever someone such as a surviving spouse was named as trustee. The first reason related to the possible estate and gift tax consequences depending on the type of powers given the spouse/trustee over the payment of either income or principal.1 Most Florida attorneys feel that this is no longer a problem in light of the enactment of F.S. §737.402(4)(a). However, there is at least one situation in which there could still be tax problems notwithstanding this statute, which will be discussed in this article.
The second reason for concern whenever someone such as a surviving spouse is named as trustee involves the conflict of interest that exists when an individual has authority to invade the principal of a trust for his or her benefit. In this respect, one of the fundamental duties that a trustee owes in connection with the administration of a trust is the duty of impartiality.2 Regarding this duty, a trustee holds the trust estate for the benefit of those entitled to the remainder just as much as he holds it for the persons entitled to immediate beneficial enjoyment.3 It is this duty of impartiality that is put to the true test whenever an interested person such as a surviving spouse is named as trustee.
Types of Principal Distributions
There are three types of principal distributions from trusts that will be relevant for purposes of this article. The first type are distributions that are clearly within the definition and boundary of the standard used. An example would be a distribution for essential food and clothing under a “support” standard. The only question here might be whether the amount to be distributed is proper.
The second type are those in whichit is uncertain whether the proposed distribution is within the boundaries of the standard used. An example would be a distribution requested for nonessential cosmetic surgery under either a “health” invasion standard or a “best interests” invasion standard. Another example would be a distribution requested for an “around the world cruise” under a “support” invasion standard (when trips of this sort were not part of the beneficiary’s lifestyle while the settlor was alive). In either case, there is no guarantee that a court would approve the requested distribution.
The third type of distributions are those in which there is no authority in the trust instrument to make such distributions. Examples include distributions for unquestionably luxury items when the invasion provision permits distributions only for the beneficiary’s “support.” Another example would be a distribution to allow a beneficiary to make gifts to descendants in which the trust merely allows principal distributions for the spouse’s health, support, and maintenance.
Significance of Type of Used Remainder Disposition
The provision of the trust instrument that identifies those individuals other than the spouse to whom the trustee owes a duty of impartiality is the remainder provision. There are two types of remainder provisions relevant for purposes of this article. The first type, “option A,” would provide something similar to the following: “Upon the death of my wife the trust estate shall be equally divided among my children who are then living.”
The above provision is in contrast to the provision that is used in many contemporary trusts (“option B”) which provides that the remainder be distributed: “In equal shares to each child of mine who is then living and the descendants, collectively, of each child of mine who is then deceased.”
With the first provision, upon the death of the husband the class of possible remaindermen closes and there is no possibility of additional members being added to the class. With the second provision, however, you are never really sure until the surviving spouse’s death of just who will be entitled to the trust remainder. The death of one or more family members prior to the spouse’s death can result in grandchildren or even younger descendants becoming entitled to part of the trust remainder.
Statutory Framework
There are two statutes that can apply whenever an interested party is serving as trustee. The first statute, F.S. §737.402(4)(a), prevents a trustee from exercising certain types of powers when the trustee is also the beneficiary of certain types of trusts. One of the purposes for enacting this statute was to provide protection to Florida attorneys from possible malpractice suits resulting from their drafting of overly broad invasion provisions in most nonmarital trusts. To provide this protection, the legislature tried to use an approach similar to one approved by the IRS in Rev. Rul. 54-153.4 That revenue ruling held that if there is a state statute that prevents a trustee from exercising a power set forth in a trust instrument, since the statute overrides the trustee’s right to exercise the power, the trustee is deemed not to possess the power in question. However, since the legislature did not follow the exact approach approved in Rev. Rul. 54-153, there might be at least one situation in which there could be tax consequences notwithstanding this statute.
Reading F.S. §737.402(4)(a) by itself leaves one with the impression that as long as the standard for invasion is limited to the spouse’s health, support, education, or maintenance, the trustee is free to exercise the power within the boundaries of the standards used. However, the legislature has also enacted F.S. §737.403(2), which states: “(2) If the duty of the trustee and the trustee’s individual interest. . . conflict in the exercise of a trust power, the power may be exercised only by court authorization, except as provided. . . . ”
Whenever a trustee has authority to pay trust principal to himself or herself, even if pursuant to an ascertainable standard, the exercise of this power will reduce the amount available for the remaindermen upon the trustee’s death. Therefore, the trustee’s individual interest clearly conflicts with the duty of impartiality in such a case and F.S. §737.402 (2) requires court authorization of any distribution to the trustee.
There are certain applications of F.S. §737.402(2) that may not be obvious at first glance and, therefore, should be clarified. The first of these is the types of trusts the statute applies. In this respect, this statute applies in any situation in which there is the possibility of a conflict of interest occurring. Consequently, unlike F.S. §737.402(4)(a), it can apply to a marital trust just as much as it applies to a family trust or an irrevocable trust.
A second observation concerns the type of standards of invasion it might encompass. In this respect, no matter whether the invasion standard involved is one for the spouse’s “best interest,” or her “happiness” or only for her “support,” since in each case the interest of the spouse conflicts with the interest of remaindermen, the statute should apply.
A third aspect concerns this statute’s application to mandatory distributions (“shall” as opposed to “may”). Even under these circumstances, there is still the question of what is the proper amount that should be distributed to the trustee/spouse and such a conflict should result in the statute being applicable.
Unborn or Minor Beneficiaries
Because in many cases a client will choose to use option B (which provides that descendants step into the shoes of their deceased ascendants), there is always the possibility that unborn or minor children might step into those shoes and thereby be entitled to part of the trust remainder upon the death of the surviving spouse. In light of this possibility, what must be considered is the generally accepted rule that a guardian of an infant or unborn child may not surrender or dispose of a ward’s property except for a reasonable quid pro quo.5 Since any distribution of principal will reduce a ward’s possible future share of the trust estate, it appears that whenever option B is used, a guardian should be appointed to represent minors and unborns and such guardian has a duty to oppose any proposed distribution to the spouse. This would appear to be the rule no matter how appropriate or necessary the distribution might be. This duty to oppose would rest on the ground that there is just about no possibility of any benefit ensuing to the ward. This duty on the part of the guardian will have further significance as will be explained in more detail.
Is it Possible to Get Around F.S. §737.403(2)?
Having to obtain court authorization of every principal distribution to the spouse and having to appoint a guardian to represent the interests of unborns or minors can become an administrative nightmare. Therefore, can you get around the hearing requirements of F.S. §737.403(2)?
F.S. §737.307 specifically recognizes the binding effect that a validly executed consent has on a beneficiary regarding claims for breaches of trust against a trustee. A beneficiary’s consent generally will be considered binding and this rule applies in most cases even if the allocation or distribution was improper or completely unauthorized under the terms of the trust agreement.6
Is it possible to get around F.S. §737.403(2) by the use of consents? In order for consents to be effective, the consents would have to be from everyone who would be entitled to the trust upon the death of the spouse. In case option B is used, this group would also include those persons who may become entitled to the trust remainder because of the death of their ascendants. In most situations it is not possible to state with certainty who these individuals will be, but some of them could be individuals who are currently either unborn or minors.
If either unborn individuals or minors could ultimately become entitled to part of the trust remainder, there is a definite problem since, as previously indicated, a guardian should take no action that would dispose of the ward’s property except in exchange for something of equal value.7 Further, this appears to be the rule even with distributions that are clearly authorized by the invasion standard in question. For example, consider a proposed distribution to take an around the world cruise under an invasion provision for the spouse’s “happiness.” Even though the standard “happiness” is sufficiently broad in scope to permit such a distribution, the guardian, by consenting, is permitting the dissipation of property that potentially might some day be the ward’s. Since there would be no benefit ensuing to the minor from this distribution (unless the minor was going on the trip), the guardian, based on his duty owed the ward, presumably should not consent to the distribution.
There obviously comes some point in which 1) the possibility of a minor or unborn individual ever becoming entitled to part of the remainder is so remote, and/or 2) the distribution is so clearly authorized under the standard in question, that there is just about no chance that a court would ever overturn the distribution. But where this point is determined to be depends to a large extent on the risk tolerance of the attorney representing the trustee. Consequently, there seems to be no current substitute to court authorization under F.S. §737.402(4) with regard to distributions to the spouse.
Proper planning could have avoided the above uncertainty. including a five and five power in the trust, in most cases the wife could use this withdrawal power as an alternative to meet her needs. However, since a five and five power is not held by the wife in her capacity as trustee, it would not be subject to the hearing requirements of F.S. §737.402(4) and, if properly drafted,8 it would not have any tax consequences.
Proposed Uniform Trust Act
The American Bar Association has finished work on a proposed Uniform Trust Act.9 Article 3 of the proposed act provides that to the extent there is no conflict of interest involved with respect to the particular question or dispute, either a parent, a guardian, or a person having a substantially identical interest may represent and bind the interests (i.e., furnish a binding consent) of minor or unborn children. At first, this seems to be a step forward. But is this new code possibly also creating a trap for the unwary? For example, consider a situation in which an independent guardian is appointed to represent unborn children and this guardian consents to a distribution that is completely unauthorized under the trust. Even though this consent bars any later objection an unborn child may have against the trustee, there still seems to be a cause of action that this child could assert against the independent guardian upon obtaining his 18th birthday for any resulting loss that occurs.
Potential Liability to Attorney
In Florida, a third party not in privity with the attorney may still recover for the attorney’s professional negligence if the third party was an intended beneficiary of the attorney’s client (i.e., the husband) or a beneficiary of a will when the client’s apparent interest in drafting the instrument in question was the benefit of the beneficiary.10 If it is shown that the actions of the attorney frustrated the intent of the settlor and the beneficiary’s share is lost or diminished as a result, the attorney could be found liable for the loss.11
Since minor or unborn individuals would be intended beneficiaries under option B, there is potential liability to any attorney who advises a spouse/trustee to make distributions to herself under such circumstances. Because of the possibility that a proposed distribution will be found to be outside the boundaries of the standard used (or if the amount distributed is excessive), by recommending any distribution other than one clearly authorized he is essentially rolling the dice in the hope that no unborn or minor beneficiaries ultimately become entitled to part of the trust. Because of this potential liability, the interests of such possible beneficiaries should not be compromised. In drafting an opinion letter regarding any proposed distributions, the attorney’s only apparent option would be to advise the spouse that a hearing under F.S. §737.403(2) is an absolute necessity when option B is used.
Taking Steps to Limit Liability
Although it is not possible to completely eliminate all of the trustee’s exposure to liability in connection with certain principal distributions, this does not mean that steps cannot be taken to reduce or possibly redirect this potential exposure. Consider, for example, the case of clearly unauthorized distributions such as a proposed distribution to enable the beneficiary to make gifts when the trust does not specifically authorize such distributions. In such a case have the recipients of the gifts specifically agree in the consent forms they execute consenting to the distribution that if a claim is ever asserted by someone who was either unborn or a minor child at the time of the distribution, that the recipients will contribute to and bear their proportionate share (possibly out of their shares of the remainder of the trust) of the claim asserted by said individual up to the amount of the gifts they received. Since the recipients are benefitting from the proposed distribution, it is only fair that they should also bear the consequences of any claims that might result from said distributions.
Possible Tax Consequences When an Interested Person Is Trustee
There will be many cases in which a husband will want to appoint his spouse as either the sole trustee or a co-trustee of his credit shelter trust or his irrevocable life insurance trust. In such a case, in addition to paying his spouse the income, he might want to provide something similar to the following: “The trustee may also pay to my wife so much or all of the principal of the trust estate as the trustee, in her uncontrolled and absolute discretion, may deem desirable, from time to time, for her health, support, education or maintenance.”
The reason for drafting the invasion provision as set forth above is an invasion provision that limits discretionary distributions to the health, support, education, or maintenance of the beneficiary/trustee is specifically permitted by F.S. §737.402(4)(a). Therefore, such powers can be exercised by the surviving spouse (although as indicated previously the spouse still might need court approval under F.S. §737.403(2)).
With the above provision the surviving spouse/trustee is granted total and absolute discretion over the amount that can be distributed for her health, support, education, or maintenance. Further, what might be even more troubling than the grant of absolute discretion is that the spouse as trustee is given the power to distribute not only what is necessary for these purposes, but also what she deems is desirable. The issue, therefore, is whether the language “in her uncontrolled and absolute discretion may deem desirable,” when the surviving spouse is serving as a trustee, broadens her power to the point in which it is no longer an ascertainable standard for measuring her needs, thereby making it a general power of appointment under §2041 and §2514.
Sections 2041 and 2514 are concerned with the breadth of the trustee’s power. In this respect, Regulation 20.2041-1(c)(2) states:
A power to consume, invade, or appropriate income or corpus, or both, for the benefit of the decedent which is limited by an ascertainable standard relating to the health, education, support or maintenance of the decedent is, by reason of section 2041(b) (1) (A), not a general power of appointment. A power is limited by such a standard if the extent of the holder’s duty to exercise and not to exercise the power is reasonably measurable in terms of his needs for health, education, or support (or any combination of them).
The above regulation seeks to achieve two objectives. The first is to limit the permissible invasion standards to only those four specifically mentioned in the regulation thereby excluding invasion standards such as welfare, best interests, benefit, happiness, etc. The second objective, which is more subtle and, therefore, rather easy to overlook, is to limit distributions to only those that are “ascertainable” in relation to whatever standard is used.
In order to be a power that is considered ascertainable, the power holder’s duty to exercise must be “reasonably measurable in terms of the power holder’s needs.” What this regulation envisions is an invasion provision that has definite and certain boundaries and limits. The spouse/trustee would then make an objective determination of her needs based on this invasion standard and distribute only the amount necessary to meet those needs considering of course her station in life (but she would be restricted by the upward boundary of the standard used). As explained by the court in Estate of Carpenter v. U.S., 80-1 USTC Par 13,339, when a distribution is governed by an ascertainable standard, enjoyment of the trust property can be said to be controlled by external events rather than by the trustee. With such an ascertainable standard, “The trustee’s role is limited to the ministerial task of discovering, as contrasted with deciding whether to distribute or accumulate.”12
Some commentators have indicated that the difference between simple and absolute discretion is one of degree, not of kind.13 Therefore, when absolute discretion is granted, they feel that courts might be less inclined to find an abuse of discretion.14 This possibility would seem to indicate that a trustee possessing absolute discretion might have some additional leeway (i.e., luxuries as opposed to necessities) regarding the amount that can be distributed from which tax consequences could flow. Also, when the phrase “may deem desirable”is considered, there should be very little doubt that what may be desirable for the spouse’s support is something entirely different than what is actually necessary, particularly when the spouse is making that determination. The phrase “may deem desirable” is broader in scope and implies a degree of contentment for the spouse. It indicates somewhat an intention to permit the spouse/trustee to create her own standard regarding the amount of the distribution rather than limit herself to the standard set forth in the invasion provision. If looked at from this standpoint, the above provision appears to permit a totally subjective decision of what amount to distribute based on the spouse’s thoughts, emotions, whims, and desires. Since the language of the above invasion provision is not certain and definite, arguably the trustee’s power is not “reasonably measurable in terms of the beneficiary/trustee needs” as required by this regulation.
The above provision appears to be just the type of language that Regulation 20.2041-1(c)(2) is intended to deal with. Therefore, such language could support an IRS argument that the surviving spouse has some additional leeway over the amount of the distributions which means that the power is not “reasonably measurable” as required by Regulation 20.2041-1(c)(2) and, therefore, taxable.
Because of the above possibility, many attorneys feel that the providing of absolute discretion to a surviving spouse, particularly when combined with phases like “as the trustee deems desirable” or “as the trustee deems advisable” is a risky approach. Such provisions could have serious tax consequences, or at least result in a long and expensive federal estate tax audit. To avoid this risk, the following might be a preferable alternate provision:
The trustee may also pay to my wife so much or all of the principal of the trust estate as is necessary, from time to time, for her health, support, and maintenance, in the manner of living to which she is accustomed to at the time of my death, taking into account my wife’s other income and other resources from all sources known to the trustee.
The above provision should provide a standard that is “reasonably measurable in terms of the beneficiaries needs.” However, since even this provision does not get around the hearing requirements of F.S. §737.403(2), the best approach might be to combine the above invasion provision with a properly drafted five and five power. The spouse could use her five and five power in the vast majority of cases and only use the above invasion power when absolutely necessary.
Conclusion
Whenever an interested person is named as trustee of a client’s trust, there are certain additional issues that must be considered. Failure to properly address these issues could result in unanticipated problems in the administration of the trust.
1 See I.R.C.§§2041 and 2514.
2 55A Fla. Jur. 2d, Trusts §164.
3 Saunders v. Richard, 35 Fla. 28, 16 So. 679 (1895).
4 1954-1 CB 185.
5 49ALR 2d, 1095, 27 Am. Jur., Infants §124 et seq.
6 29 ALR 2d 1034, §9 at 1044.
7 See supra note 5.
8 For the tax consequences if the five and five power is not properly drafted, see Estate of Dietz, TCM 1996-471; see also Tiernan, What Powers Over a Credit Shelter Trust Can the Spouse Possess? 23 Estate Planning 424 (Nov. 1996).
9 www.law.upenn.edu/bll/ulc/ulc_frame.htm.
10 Drawdy v. Sapp, 365 So. 2d 461 (Fla. App., D1).
11 Rosenstone v. Satchell, 560 So. 2d 1229, 15 Fla. L. Weekly 5, 844 (1990 Fla. App. D4).
12 Id at P 84,322.
13 See Halbach, Problems of Discretion in Discretionary Trusts, 61 1425, 1433. See Trustees’ Absolute and Uncontested Discretionary Powers, Trusts and Estates Magazine 1063 (Oct. 1965).
14 See Matter of Bisconti, 306 N.Y. 442, 119 N.E. 2d 34 (1954).
Jeffrey R. Miner is an attorney practicing in Hallandale with the firm of Crouch and Miner, P.A. in the areas of real property, probate and trust law.
Peter B. Tiernan practices in Margate and concentrates in estate planning, tax matters, and trust drafting. He has written for The Florida Bar Journal, Estate Planning Magazine and is a frequent author for the Journal of Taxation.
This column is submitted on behalf of the Tax Section, Marvin C. Gutter, chair, and Michael D. Miller and Lester B. Law, editors.
