What Documentation is Needed to Show HEMS Standard in Trust was Followed?
My husband and I both set up Spousal Lifetime Access Trusts. The trusts state that the trustee may distribute to the beneficiary as much of the income and principal as such trustee may determine to be beneficial for their health, education, maintenance or support. It goes on to say that trustee should be liberal in making such distributions with the needs of the spouse coming first. My question is: if a spouse makes a request for a distribution for any of the categories of health, education, support or maintenance, does it need to be in writing and, if so, what documentation supporting the request is required? For instance, for health care premiums and expenses, does the spouse requesting need to itemize these? For maintenance. for things like dining out, travel and gifts to friends, does there need to be a listing of these? For trips taken to see family and friends out of state, does the requesting spouse need to itemize these and total them? For utility, insurance, home repairs and maintenance, do these need to be itemized and totaled? At what point does the IRS audit these trusts? Upon death of first spouse? Or second spouse?
There are actually two issues here, the tax treatment and creditor protection. Spousal Lifetime Access Trusts, or “SLATs,” are designed to avoid estate tax savings and to protect property from creditors. They are irrevocable trusts that each spouse creates for the other. Under traditional trust law, if you create a trust for yourself its assets will be available to pay your debts and claims of creditors to the extent they are available to you. This is not true for trusts you create for someone else, often referred to as “third-party” trusts. For those, the funds are only subject to claim to the extent they must be paid out to the beneficiary. If distributions are discretionary, they are protected. SLATs created for one’s spouse are treated as third-party trusts and receive the same creditor protection as long as they are not reciprocal, each spouse creating the trust in exchange for the other spouse creating the other trust. It’s easiest to avoid the trusts being reciprocal if only one spouses creates one or if they are created and funded at different times.
The so-called “HEMS” standard, the restriction only permitting distributions for health, education, support and maintenance, really has more to do with tax law than creditor-protection law. If spouse A creates a trust for spouse B and spouse B is trustee of their own trust, the trust assets will not be included in spouse B’s estate when they pass away as long as spouse B is restricted in making distributions for their own benefit by the HEMS standard. This restriction is often found in credit shelter trusts that one spouse leaves for the other at death. It’s not a significant restriction, since spouse B can use trust funds to pay for their needs, but it is important that it’s followed and documented.
For both tax and creditor protection you will need to follow the terms of the trusts. So, the first question is what do the trusts say? Do they require that requests for distribution be made in any particular way? If not, simply being able to show that distributions were made for health, education, support or maintenance should be sufficient. So direct payments for health insurance premiums, home repairs and maintenance, and utility bills should be fine. In contrast, it’s hard to see how gifts to friends could fall under this standard. Dining out and travel are in more of a gray area, but are probably acceptable if they are consistent with the spouses’ lifestyle prior to the creation of the trusts. Just keep good records of how the funds are spent just in case anyone ever questions the distributions, whether the IRS or a creditor.
Frankly, if you are using the trusts to pay all your everyday expenses, I’m more concerned about them standing up to claims by creditors than issues with the IRS. But how they would be treated if either spouse were sued is a question of state law. The lawyer who drew up the trusts should be able to advise you on this.