We often speak with clients who are seeking to ensure that their hard-earned assets stay within their families and remain available for the benefit of their children and grandchildren. For many of these clients, trusts can be a valuable tool, helping them to preserve their wealth across multiple generations, while potentially minimizing transfer taxes when passing assets to the next generation and protecting the assets from a beneficiary's creditors, including a divorcing spouse.
However, the ability to take advantage of the benefits of a trust depends significantly on how distributions from the trust are managed and what standard the trustee uses when making them. If distributions are made too frequently or too freely, there is a risk that trust assets may be exhausted by one generation, eliminating any benefit to further generations. Frequent and unrestricted distributions may also cause the trust assets to become exposed to tax or legal liabilities.
Grantors who want to provide for their beneficiaries and maintain the trust's unique protection benefits can provide their trustees with a clear standard for determining whether a distribution is truly in the best interest of the beneficiaries. It should be flexible enough to support the beneficiary's needs while restrictive enough to convey that they cannot tap into it as if it were another bank account.
A standard of support
The "HEMS" standard—health, education, maintenance, and support—is an approach that balances the flexibility to support the beneficiary's needs with restrictions that can help to preserve the trust for multiple generations and avoid unintended tax consequences. The HEMS standard also provides clearer guidance for a trustee and precludes the use of trust assets for nonessential spending.
That said, the HEMS standard is not overly restrictive. What specific expenditures fall under health, education, maintenance, and support is open to interpretation, within reason, and will also depend on the laws of the state in which the trust is located. While there is no definitive or exhaustive list of what constitutes a HEMS distribution, there are some general guidelines:
- Health. Generally, this might include the beneficiary's medical, dental, hospital, and nursing expenses. Less clear is whether this would also include medical expenses incurred for elective procedures, alternative forms of medical treatment, or expenses related to a healthy lifestyle, such as gym memberships.
- Education. This generally includes expenses, fees, and other costs related to attending an institute of higher education, like a college or university. It may encompass other levels of education, or other forms of training, though a grantor should consult with their attorney about documenting such things in the trust document.
- Maintenance and support. This includes expenses meant to help maintain the beneficiary's accustomed standard of living. This could include living expenses, such as mortgage payments, property taxes, and utilities. It might also include things like vacations and gifts, provided the expenses are in line with the beneficiary's typical lifestyle.
Overall, the HEMS standard is meant to address beneficiary needs at a reasonable level and help protect the assets within the trust from the IRS, creditors, and the beneficiary themselves. For example, a beneficiary may request a distribution to replace a car that has broken down. However, if the beneficiary has typically driven a practical vehicle, this is not an opportunity to upgrade to an extravagant sports car. Similarly, a beneficiary may be able to receive a distribution to take a week or two of vacation, in line with their typical expenditures. A distribution to cover a 12-month world tour, however, would likely not be appropriate. For grantors concerned about the judgment or financial discipline of their beneficiary, this can be a major benefit.
Sometimes parents can be reluctant to establish a trust because they are confident in their children's financial savvy and want them to be able to control how their inheritance is invested and spent. This is another area in which the HEMS standard can be advantageous.
Including a HEMS standard in trust documents allows a beneficiary to serve as their own trustee. Provided the beneficiary-trustee observes the HEMS standard in their administration of the trust, they may be able to avoid endangering the trust's protection benefits. In this way, the beneficiary can receive the protection benefits of the trust, while also having control over how the trust's assets are invested and distributed. That said, there are other factors to be mindful of to avoid exposure to unintended tax consequences. Grantors considering this route should first consult with their attorney before making anything official.
Consult a trust attorney
With proper administration of distributions in accordance with an ascertainable standard, it's possible to strike the delicate balance between supporting current beneficiaries and protecting trust assets for the long term. The HEMS standard is one approach, but grantors could specify more restrictive standards if they wished, perhaps limiting distributions further to just emergency situations or for a particular type of maintenance or support (say, mortgage payments exclusively). In any case, it's important to consult with a trust attorney when drafting the trust documents to ensure that whatever standard you settle on won't open you up to the risk of an unexpected outcome.
David is responsible for Fidelity's estate and wealth planning activities, including creation of new thought leadership in these areas. He heads a team of professionals that develops and delivers the depth and breadth of Fidelity's wealth planning offering.
Prior to joining Fidelity, David was managing director and head of Insured Solutions for UBS Wealth Management Americas. He served as chief operating officer of UBS Wealth Planning. David first joined UBS as a senior member of UBS Private Wealth Management, and was involved in the creation of that business for the firm. During his tenure with UBS, he also served as the chairman and president of UBS Life Insurance Company USA, Inc.; the chairman and president of UBS Financial Services Insurance Agency, Inc.; and a board member of UBS Trust Company, N.A.
Prior to joining UBS, David was a director in Merrill Lynch's Private Banking & Investment Group. He joined the firm's International Private Banking business in London and was a key member of the firm's Corporate Strategy unit.