One of the main reasons you establish a trust is to distribute your assets to your chosen beneficiaries according to your wishes.
The trustee oversees carrying out your wishes according to the terms of the trust.
Often, especially when children are the beneficiaries, you want the trustee to pay certain obligations for the beneficiaries before distributing the trust's assets. Or, you may wish to make partial distributions depending on a variety of factors, like age.
HEMS is a standard that helps guide the trustee on the types of distributions they may make to a trust beneficiary.
What is HEMS?
HEMS is simply an acronym for "health, education, maintenance, or support."
But the critical thing to know is that the IRS recognizes HEMS as an "ascertainable standard" created by the Internal Revenue Code of 1954.
An ascertainable standard is one you can measure. Suppose you instruct the trustee to give your children enough money each year to make them happy. In that case, that is not an ascertainable standard because it cannot be measured.
But suppose you instruct the trustee to use the trust assets, or a portion of them, for the "health, education, maintenance, and support" of the beneficiaries.
That can be objectively measured and is an ascertainable standard.
This difference becomes important for tax reasons and asset protection.
When a trustee is limited to a HEMS ascertainable standard for distributions, they must ensure that whatever they distribute to the beneficiaries falls within one of the four categories. Failure to do so can have a variety of negative results, including tax consequences and loss of asset protection.
Why Use the HEMS Standard in Trusts?
One crucial reason trusts frequently use the HEMS standard is for tax reasons.
Suppose a trust beneficiary is also the trustee. In that case, the HEMS standard prevents the value of the accounts and property in the trust from being included in the beneficiary’s gross estate for federal estate tax purposes.
Likewise, suppose a trustmaker has created a trust to transfer accounts and property out of their taxable estate and wants to act as a trustee to make distributions to the other trust beneficiaries.
In that case, the HEMS standard, if included, prevents the trust’s property from being included in the trustmaker’s taxable estate.
The HEMS standard is an IRS safe harbor rule that can prevent the property in the trust from being subject to estate taxes at the death of the beneficiary or the trustmaker.
Another critical reason to use a HEMS distribution standard in trusts is to prevent a beneficiary’s creditors from obtaining trust property by filing a lawsuit against the beneficiary. This prevention can often be accomplished by using the HEMS standard in combination with a spendthrift provision.
By legally limiting the purposes for which the trustee can make distributions to the beneficiary, the trustmaker has built important asset protection features into the trust.
For example, suppose a beneficiary was sued, and the opposing party demanded that the trustee or beneficiary use trust property to pay the lawsuit judgment. The beneficiary and the trustee could refuse because the trust clearly does not allow distributions for that purpose.
The trustee would have a difficult time trying to include payments to a beneficiary’s creditors in the standard of allowable distributions for the beneficiary’s “health, education, maintenance, or support.”
The trustee has a fiduciary responsibility to the trust beneficiary and not to the beneficiary’s creditors. So, the HEMS standard becomes a very effective tool to prevent creditor lawsuits from reaching the trust property. This effect is generally true even if the trustee and the beneficiary are the same person.
Practical Application of HEMS
Trustees that have HEMS standards in the trust often ask, “What are the specific standards?”
Unfortunately, there is no clear bright-line definition for them.
But, such ambiguity, while frustrating, also allows enough flexibility that a trustee has some discretion to do what is in the beneficiary’s best interest.
Following are some examples of the types of expenses that the HEMS standards often include:
● eye care, glasses, contact lenses, vision correction surgery
● allergen cleaning services
● cosmetic surgeries
● alternative medical treatments (e.g., acupuncture, massage therapy, etc.)
● substance abuse rehabilitation programs
● extended vacations or retreats to improve mental health
● health-related home improvements or renovations
● home healthcare or long-term care expenses
● gym, spa, golf club memberships
● exercise equipment
● healthcare supplements
● psychiatric treatments
● handicap-related transport and mobility services and items
● regular healthcare checkups and exams
● emergency and regular medical treatment
● healthcare, dental, vision insurance premiums
● mental health counseling
● tuition for all levels of public or private schools
● graduate or professional degrees including medical school, law school, etc.
● study-abroad programs and related travel expenses
● a beneficiary’s support between semesters or during unpaid internships
● school-related expenses including room, board, books, computer, etc.
● private tutoring
● extracurricular-activity related expenses
● graduation costs, proms, class rings, announcements, robes, etc.
● career training
● daycare for dependents to allow a parent time to attend classes and study
● uniforms and school clothes
Maintenance and Support
● rent or mortgage payments
● down payment on a home
● living expenses and support for a beneficiary engaged in charitable work or low-income vocations that provide social and community benefits
● insurance premiums including life, auto, disability, or homeowner’s policies
● vehicles and related repairs and maintenance
● charitable contributions
● continuation of family gifting for birthdays, weddings, holidays, baby showers, etc.
● property taxes
● legal fees
● supporting family members
● continuation of typical and periodic vacations
● home repair and maintenance
● seed money to start a business
Again, it is important to remember that the examples above are only some of the expenses that are commonly justified under the HEMS standard.
A trustee must exercise some judiciousness when making distributions. They need to demonstrate to potential lawsuit plaintiffs, judges, and the IRS that the HEMS standard prevents the beneficiary from having complete control over the trust property.
For example, suppose the trustee distributes enough money for the beneficiary to purchase and drive a Ferrari when the beneficiary usually drives a Toyota.
Or, the trust pays for a six-month vacation to Greece instead of the beneficiary's usual one-week Disney World vacation. The trustee may be putting the trust's tax and asset protection properties at risk by disregarding its terms.
HEMS in California
HEMS is a powerful standard in California trusts as well
However, you should clearly understand using "shall distribute" versus "may distribute."
If you instruct the trustee that they "may distribute," you are giving them discretion.
In California, "a discretionary power conferred upon a trustee is not left to the trustee's arbitrary discretion but shall be exercised reasonably." (section 16080 Probate Code).
And, subject to some exceptions, "...if a trust instrument confers 'absolute,' 'sole,' or 'uncontrolled' discretion on a trustee, the trustee shall act in accordance with fiduciary principles and shall not act in bad faith or in disregard of the purposes of the trust" (section 16081 Probate Code)."
Both of these California Codes help the trustee distribute the assets according to the HEMS standard and your wishes.
The HEMS Standard is a Powerful Tool
Attorneys often use the HEMS standard for good reason when drafting trusts.
The HEMS standard can be a powerful and effective tool to reduce the risk of unnecessary taxation for each generation as wealth passes through the family.
And the standard can also protect trust property from people from attack by creditors, divorcing spouses, and predators.
If you have questions about what qualifies as an appropriate distribution under the HEMS standard, please reach out to us.
We have the experience and knowledge to guide you through these consequential decisions.
What to Do Now
A well-thought-out trust is an important part of your California estate plan.
A HEMS standard can help ensure that your beneficiaries are supported according to your wishes
San Diego Legacy Law is a qualified California law firm specializing in estate and trusts.
Our attorneys are familiar with all California estate and trust laws and how they can best help you achieve your estate planning goals.
Call today for a free consultation and learn your next best steps.