Realities of the Trust Situs Marketplace
| Publication year | 2005 |
| Author | By Philip J. Hayes, Esq. Kay E. Henden, Esq. |
By Philip J. Hayes, Esq.1 * Kay E. Henden, Esq. **
Few estate planning developments have generated as much or as heated controversy as the relatively recent domestic "forum shopping" for trust situs. States that have entered the situs selection contest have enlisted trust companies, home-state attorney and even academics in the marketing effort, resulting in a proliferation of materials pertaining to situs and the benefits of selecting State X over State Y. One South Dakota law review article2went so far as to promote a new tort - "negligent trust situs" - for the hapless California attorney who makes the mistake of choosing California situs over South Dakota.
Opponents of the practice, on the other hand, contend that many of the comparative law articles are authored by persons with vested interests and should be understood in that context. They hold that this body of work contains some misleading or even inaccurate information, and subtly preys on the fears of trustors and their attorneys.
We hope this article, although necessarily limited in scope, provides a reasonably objective survey of the issues and options available to trustors, trustees and their attorneys.
A. Trust Situs is Elective
Situs of a trust is loosely equivalent to domicile for a natural person, though many exceptions apply. To take full advantage of trust-situs potential, a trust must overtly elect its situs.
The state law designated by the trustor applies for virtually all purposes except taxation, provided that the designated state has a "substantial relation" to the trust, and the application of its law does not violate the strong public policy of the state with which the trust has its most significant relationship.
Taxation of the trust is dependent upon many factors (see Section II.E. below), but can be controlled to a degree by judicial selection of trustees and location of administrative responsibilities. Since these items are controllable by terms of the instrument, the tax aspects of a trust can be modified to a degree by situs selection.
If the instrument is silent, a default situs is selected, normally either the state where primary administration of the trust takes place, or where the books and records of the trust are kept. With testamentary trusts, the law of the decedent's residence may still apply in some situations even if trust administration has moved out of the state. Likewise, if a trust owns real property the law of the situs of the land may trump the law of the state of administration.
B. Characteristics of Trust Affected by Situs
A different state law may be applied to each of four different aspects of a trust:
1. Validity/Substantive Matters
Courts generally strive to uphold the validity of a trust or its provisions if reasons can be found to do so. Scott, Law of Trusts, Fourth Edition (2001) §§ 593, 600. If the trust has even minimal ties to the state specified as controlling its validity, such as residence of a trustee, it will generally be upheld even if some terms of the trust would cause it to be invalid in the state of creation (e.g., violation of the local state's rule against perpetuities).
2. Construction/Interpretation
Issues of construction are meant to determine the trustor's intention, not the validity of the trust. The trustor can choose which state's law applies to construction, regardless of connection between the trust, the trustor, the state whose laws are being sought to be applied, or whether movables or real property are involved.
Examples of matters generally viewed as construction or interpretation include: Definitions of classes of beneficiaries, such as "issue"; whether adopted individuals are considered issue and under what circumstances (e.g. only if adopted during minority); how intestate heirs are defined; whether and how virtual representation will apply.
3. Administration
As with construction and interpretation, the trustor can choose which state's law applies to administration, regardless of connection between the trust, the trustor the state whose laws are being sought to be applied, or whether movables or real property are involved.
Examples of matters generally viewed as administrative include: Investment powers, fiduciary compensation, ability to modify or terminate trusts, duties owed to beneficiaries, trustee liability, removal of trustees, principal and income issues, etc.
4. Taxation
Unlike other aspects of a trust, taxation is determined by a variety of factors independent of the trustor's directions. These factors include domicile of trustor, trustee, or one or more beneficiaries, location of certain types of assets, place of primary trust
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administration, and many others. See Section II.E. below for a more detailed discussion of this topic.
Given that a trustor may elect to "locate" his trust in a state other than that in which he resides, what circumstances suggest that such a course is advantageous? The possibilities are limitless, depending upon the trustor's objectives, but the following are a few of the primary areas prompting interstate trust creation.
A. Trust Duration
Trustors sometimes want to create trusts that last in perpetuity, or at minimum far beyond the time period permitted by local state law. The motivation for establishing such a trust is often the desire to avoid the generation-skipping tax at intervening generations. If the estate tax is repealed, this element may become less important and the inconvenience of "foreign" administration may become a major issue. In the interim, however, the option of establishing a "foreign-state" trust is available to address this objective.
At least 23 jurisdictions have abolished the rule against perpetuities (the "Rule"), provide an opt-out, or allow a trust to last for a determined number of years (see Table One). Most trusts contain provisions regarding the term of the trust or include savings clauses that refer to the rule against perpetuities of a particular state.
The Rule is substantive - it pertains to the validity of the trust - and consequently in electing state law care must be taken to ensure that the "situs" state has sufficient contacts with the trust that this and similar provisions do not adversely affect validity.
B. Creditor Protection
Another reason to consider establishing a trust that is sited in a state other than that in which the trustor resides is the differing ability to shelter trust assets from the creditors of trust beneficiaries, including the trustor himself.
1. Spendthrift Trusts in General
Under the common law, creditor or spendthrift protection varies widely among the states. The traditional distinction in asset protection is between "discretionary" vs. "support" trusts.
With a discretionary trust, the trustee has absolute discretion over distributions. The beneficiaries have no property right in the trust because they cannot enforce a standard for distribution; therefore their interest in the trust is completely protected from creditors, regardless whether the trust contains a spendthrift clause.
Under a support trust, distributions to a beneficiary are based on a standard of beneficiary support, often health, education, maintenance, and support ("HEMS," the estate tax general power of appointment standard of I.R.C. § 2041). If HEMS or any other standard is used, especially if the standard is mandatory ("shall") versus discretionary ("may"), the beneficiary may compel the trustee to make distributions under the standard. A creditor of the beneficiary may step into the beneficiary's shoes and compel distribution - unless the trust contains a spendthrift clause. Even with a spendthrift clause, however, "exception creditors" can reach a beneficiary's interest in a support trust. Most states recognize three: 1) alimony or child support, 2) necessary services (e.g., medical expenses), and 3) claims by U.S. or state taxing authorities.3 The Uniform Trust Code ("UTC") adds an exception for services or materials that preserve the beneficiary's interest in the trust.4
a. California Probate Code
California Probate Code § 15306.5(b) provides that, notwithstanding a spendthrift clause in a support trust, a beneficiary's creditors may reach up to 25% of the payment, income or principal that otherwise would be made to or for the benefit of, a beneficiary. However, a creditor cannot compel a trustee to make a discretionary payment to or for the benefit of the beneficiary.
If the beneficiary is entitled to receive an amount in excess of the amount necessary for his or her support and education, or the trustee in its discretion has determined to pay the beneficiary more than is needed for his or her support and education, then the excess amount can be attached to satisfy a money judgment. Cal. Prob. Code § 15306.7.
b. Uniform Trust Code
The UTC has been adopted in some 15 states, and although there are variations in specific sections enacted, these states treat most situations similarly (See Section III.A. below).
The provisions of the UTC regarding spendthrift trusts (Article 5) have proven extremely controversial. Opponents argue that §§ 814a and 504, which (as in California) impose an automatic good faith standard for distributions from discretionary trusts, weaken the creditor protection of those trusts, i.e., the beneficiary's interest has been elevated to a property right. Traditionally, the strong majority view has been that the appropriate standard is bad faith or abuse.
The net result of the UTC is to blur the traditional distinction between discretionary and support trusts. Critics of the UTC recommend that clients avoid UTC states if creditor protection is intended, and cite Ohio as a prime example of what can go wrong in a jurisdiction that imputes a reasonableness standard to the trustee's exercise of discretion. See In re Estate of Winograd (Ohio 1989) 582 N.E.2d 1047.
c. Other State and Federal Statutes and Case Law
In Oklahoma...
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