The HEMS standard, specifically the Health, Education, Maintenance and Support standard, is a “needs-based” discretionary distribution standard that limits the absolute discretion of a trustee to distributions that are consistent with the HEMS standard, providing for the needs of the beneficiary whilst not unnecessarily diminishing the value of the trust fund. The standard is said to be “ascertainable” because it is defined in jurisprudence and it is capable of judicial interpretation.
Introducing the HEMS standard may offer important US Federal estate and income tax protections, as well as asset protection benefits. This research note reviews the HEMS standard under the South Dakota Codified Laws (SDCL), and the principle US Federal estate and income tax issues.
Understanding Support Interests under the HEMS standard
Support interests are those which contain mandatory language, such as “shall,” coupled with a standard capable of judicial interpretation, such as the HEMS standard, for example “the trustee shall make distributions for health, education, maintenance, and support.” SDCL 55-1-38(2). Support Interests are different from Mandatory Interests, where trustees have no discretion in determining whether a distribution should be made or the amount of the distribution. SDCL 55-1-38(1). The beneficiary of such a Support Interest has a legally enforceable right to a distribution, and the exercise of the trustee’s discretion is subject to judicial review for unreasonableness, dishonesty, improper motivation, or failure, if under a duty to do so, to act. 55-1-42.
Discretionary Interests
A discretionary interest is one with respect to which a trustee has discretion to make or withhold distributions. A discretionary interest may be evidenced by permissive language followed by the HEMS standard, such as “the trustee may make distributions for health, education, maintenance, and support.” SDCL 55-1-38(3). A discretionary interest is neither a property interest nor an enforceable right. It is a mere expectancy, and no creditor may force a distribution with regard to a discretionary interest. The reasonableness standard does not apply, and a court may review a trustee’s distribution discretion only if the trustee acts dishonestly, acts with an improper motive, or fails to act if under a duty to act. SDCL 55-1-43.
Tax Benefits of the HEMS standard
Introducing the HEMS distribution standard can shield beneficiaries from US Federal estate and income tax exposure. In respect of US Federal estate tax, where the beneficiary is also the trustee, the HEMS standard may prevent the beneficiary of a Support Interest from being treated as the holder of a general power of appointment under USC Section 2041, and avoid US estate tax inclusion.Â
Similarly, in respect of US Federal income tax, the HEMS standard may protect the beneficiary of a Support Interest from being treated as the “owner” of the trust for US income tax purposes under USC Section 678, and avoid income tax attribution. However, the mere inclusion of the HEMS standard, if not actually followed by the trustee, would not protect the beneficiary from US estate tax inclusion or US income tax imputation.
Asset Protection
If the trust contains a spendthrift provision, notwithstanding the beneficiary’s right to force a Support Interest distribution, no creditor may force such a distribution. No creditor may reach a Support Interest distribution, and no trustee is liable to any creditor for paying the expenses of a beneficiary of a Support Interest. SDCL 55-1-42.
For more information on how the HEMS standard can benefit your estate planning and asset protection, feel free to contact our team or explore our services to see how we can assist you.
