Summary:  Recent Arizona case exposes weakness in many inheritance protection trusts.

If your estate plan includes inheritance protection trusts for your children or other beneficiaries, you may want to consider an amendment in response to a 2016 Arizona legal case.[1]  The case involved an inheritance trust established for a child by his Mother’s will upon her death.  The IRS filed a tax lien against the trust because the beneficiary owed substantial personal income taxes from prior years.  The beneficiary argued that the inheritance was a “purely discretionary trust” and therefore not a personal asset subject to the lien[2].  The judge ruled against the beneficiary based upon a careful review of the specific trust provision regarding distribution of income and principal.  
 
The relevant provision stated, “The Trustee shall pay to [the beneficiary] so much or all of the net income and principal of the trust as in the sole discretion of the Trustee may be required for support in the beneficiary’s accustomed manner of living, for medical, dental, hospital, and nursing expenses, or for reasonable expenses of education, including study at college and graduate levels.”

The judge interpreted the phrase “shall pay” as a mandatory fiduciary duty owed to the beneficiary by the Trustee, although he also noted that specific calculations were left to the discretion of the Trustee.  This approach is sometimes referred to as a “discretionary support” or “hybrid” trust.  The combination of the Trustee’s duty to make distributions (“Trustee shall pay to the beneficiary…”) and the inclusion of guidelines regarding how to define support (“in the beneficiary’s accustomed manner of living…”) gives the beneficiary an underlying right to distributions from the trust – at least to the extent of the support guidelines.  The judge applied this logic to permit the IRS to attach a lien to the beneficiary’s interest in the trust.[3] 

For maximum protection of inheritance you leave to others, it may be appropriate to amend your will or living trust to clarify your intent that a Trustee’s power to make distributions is purely discretionary and not mandatory.  Otherwise, a creditor could use the above-described case to establish a legal argument that diminishes, or worse, eliminates the protections you intended to create. 

If your trust was drafted by a Wealth Counsel attorney using its industry-leading WealthDocx software[4], it probably does not include the type of extraneous wording (“in the beneficiary’s accustomed standard of living”) that contributed to the adverse ruling in this case.  However, WealthDocx, by default, uses the phrase “shall pay” and that may be enough to give creditors a slight opening to argue that you actually intended to create a discretionary support trust.  Thus, in response to this recent Arizona case, I recommend an amendment that does the following:

• Uses the phrase “may pay” instead of “shall pay.”
• Includes the sentence, “The discretion to make distributions includes the discretion to distribute nothing.”
• Includes conservative guidelines of this nature, “Accordingly, I request that my Trustee always consider the other known resources available to the beneficiary before making discretionary distributions.  I desire that preservation of principal be a priority for purposes of this trust and that the beneficiary show genuine need before my Trustee makes any discretionary distribution.” 

I believe that these changes will eliminate any ambiguity about your intent and strengthen the protection an inheritance trust is capable of providing. 
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[1] Duckett v. Enomoto, U.S. District Court, D. Arizona; April 18, 2016.

[2] A purely discretionary trust does not grant a property interest to the beneficiary because the Trustee is not legally obligated to make any distributions to the beneficiary.  See A.R.S. §14-10504(E).

[3] Whether the IRS could immediately seize assets from the trust to pay the lien is a different matter and was not ruled upon in the case. 

[4] Bouman Law Firm has used WealthDocx software exclusively since October 2006.  

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Contrary to popular belief, it is rarely a good idea to name parent and child as joint owners of a bank or investment account.  Here is why:  
     

1. Exposes the parent’s assets to the child’s creditors.  If the child is sued, the child must disclose the joint account to the court and plaintiff’s attorney.  The burden falls on the child to convince a court that the child contributed nothing and that the account really belongs to the parent.  Similarly, the account would be a reportable asset if the child filed for bankruptcy.
2. Eliminates the fiduciary duty a child would otherwise have.  A child as joint owner has no fiduciary duty to manage the account in the best interest of the parent.  By naming the child as agent, the fiduciary duty is maintained so that misuse of funds by the child remains a crime punishable by law.
3. Parent loses full control of the account.  Although intended to facilitate a child helping the parent, a controlling child or the jealousy of other siblings could spoil the arrangement.  Similarly, if the child needs money, there is nothing to prevent the child from taking it without permission. 
4. Assumes the child will behave like a Saint.  The parent can only hope the child “does the right thing” and uses the joint account to pay estate bills and then shares it with other beneficiaries as directed in the parent’s estate planning documents.  The child’s attorney would be correct under the law to counsel the child otherwise.
5. Creates potential eligibility penalties upon application for ALTCS.  The parent must report gifts made within the prior 5 years when applying for nursing home benefits through the ALTCS program (Arizona Long Term Care System- a component of Medicaid).  Naming a child as joint owner may be interpreted as a gift that triggers a penalty and delays the start of benefits.
   

If there is a legitimate reason to have a child assist a parent with management of a bank or investment account, the better alternatives to joint ownership are (1) Title account in parent's individual name and add child as agent under financial power of attorney, and (2) Title account in trust name and add child as co-Trustee.   The only time when I would recommend joint ownership between parent and child is when they are operating a business together.