Discretionary Trust Distributions of Principal and Income: Avoiding Beneficiary Challenges and Adverse Tax Consequences

Determining whether and when to make a discretionary distribution of trust assets presents significant challenges for trustees and estate planning counsel in drafting trusts. Trust counsel must fully understand the impact and risks to a fiduciary in exercising discretion to make distributions, particularly of the trust principal, when structuring distribution provisions in discretionary trusts.

A discretionary trust is a complex trust that allows a trustee discretion over income or assets distributed to defined beneficiaries. Generally, trust documents specify standards for discretionary distributions. The most common measure is the health, education, maintenance, and support (HEMS) standard, defined in Treas. Reg. 20.2041-1(c)(1) as an "ascertainable standard."

Trust drafters may include other "unascertainable" standards to guide fiduciaries. Absent careful drafting and thoughtful trustee selection, the use of an unascertainable standard may trigger a tax recognition event such as a general power of appointment.

While courts generally give wide latitude to a trustee's exercise of discretion to make distributions, beneficiary challenges to distributions have succeeded in cases where the court finds flaws in the discretionary provisions or the trustee's exercise of distribution powers. Counsel must be fully aware of permissible standards to deter beneficiary disputes and avoid adverse tax and accounting consequences.

Listen as our experienced panel provides a practical guide to structuring distribution provisions in discretionary trusts, outlines liability risks involved, discusses appropriate factors, considerations, and standards, and examines potential creditor or other beneficiary claims arising from a trustee's decision to grant or deny a discretionary distribution request.