What Is an Interested Trustee: HEMS, Estate Tax, and Creditors

An interested trustee is a person who manages a trust while also holding a personal financial stake in it, either as a beneficiary or as a close relative, employee, or associate of the person who created the trust. That dual role sets up a conflict of interest the IRS watches carefully. If the trust document gives the interested trustee too much discretion over distributions, the entire trust can be pulled into that trustee’s taxable estate, generating federal estate tax at a 40% rate on assets above the $15,000,000 exemption for 2026.¹ The fix is straightforward in theory but easy to get wrong in practice: restrict the interested trustee’s authority to a precise legal formula, or hand certain decisions to an independent trustee.

Who Counts as an Interested Trustee

The label “interested trustee” doesn’t come from a single statute. Estate planners use it for anyone who serves as trustee while falling into one of two overlapping categories: they benefit from the trust, or they have a relationship with the grantor that makes true independence unlikely. The tax code pins down the second category through Section 672(c), which defines a “related or subordinate party” as any nonadverse party who is a member of the grantor’s family or professional circle.²

Under that definition, the following people are automatically treated as related or subordinate to the grantor: a parent, a sibling, any descendant (children, grandchildren), a personal employee of the grantor, and any employee of a corporation where the grantor holds enough stock to influence voting control.² The logic is simple. These people may have trouble saying no to the grantor or acting purely in the beneficiaries’ interest. A son managing his mother’s trust for his own benefit faces a built-in conflict that a bank trust department does not.

The flip side is an “adverse party.” Under Section 672(a), an adverse party is someone whose own beneficial interest in the trust would be hurt if a particular power were exercised. If a trust requires the consent of an adverse party before the interested trustee can act, that consent requirement can neutralize the tax problems that would otherwise attach.² Two siblings named as co-trustees whose shares each shrink when the other takes a distribution function as adverse parties to each other. The distinction matters because it determines whether a trustee’s power triggers tax consequences or stays safely within the trust’s design.

The HEMS Safe Harbor

Estate planners solve the interested trustee problem most often by restricting the trustee’s distribution authority to an “ascertainable standard.” Under Section 2041(b)(1)(A), a power to use trust property for the benefit of the person holding that power is not treated as a general power of appointment if it is limited to the holder’s health, education, support, or maintenance.³ These four words, abbreviated HEMS, are the safe harbor that keeps an interested trustee’s powers from blowing up the trust’s tax treatment.

Treasury regulations spell out what qualifies. Powers exercisable for “support,” “support in reasonable comfort,” “maintenance in health and reasonable comfort,” “education, including college and professional education,” and “medical, dental, hospital and nursing expenses” all meet the standard.⁴ Those categories cover insurance premiums, long-term care costs, tuition from vocational training through graduate school, housing that fits the beneficiary’s established lifestyle, and similar necessities.

The trap lies in words that sound similar but fall outside the safe harbor. A power to distribute trust property for the holder’s “comfort,” “welfare,” or “happiness” does not qualify.⁴ This is where drafting errors cause the most damage. A grantor who writes “my trustee may distribute funds for my son’s comfort and well-being” has just created a general power of appointment, even though the intent was probably the same as HEMS. The IRS doesn’t care about intent here; it cares about the words in the document. Luxury travel, entertainment expenses, and charitable gifts generally fall outside HEMS as well, because they aren’t required for health, education, or basic support.

One useful subtlety: “support in his accustomed manner of living” does qualify under the regulations. An interested trustee can maintain a beneficiary’s pre-existing standard of living without triggering tax problems, even if that standard is expensive. What matters is that distributions tie back to an objective, measurable baseline rather than open-ended discretion.

Estate Tax Consequences Under Section 2041

When an interested trustee holds distribution powers that exceed HEMS, the IRS treats those powers as a general power of appointment. Under Section 2041, the value of any property over which the decedent held a general power of appointment at death gets included in the gross estate.³ It does not matter whether the trustee ever actually exercised the power. Merely holding the ability to direct trust assets to yourself, your estate, or your creditors is enough.

For 2026, the federal estate tax basic exclusion amount is $15,000,000 per person, following the increase enacted by the One, Big, Beautiful Bill signed in July 2025.¹ Assets above that threshold are taxed at a flat 40% rate. A $20 million trust pulled into an interested trustee’s estate because the document used “comfort” instead of “support” could generate a tax bill exceeding $2 million on assets the trustee may never have taken for personal use.

The statute also reaches powers the trustee released or let lapse during life. If the trustee once held a general power and gave it up, that release can be treated as a taxable transfer, pulling assets into the gross estate under the same rules that apply to lifetime gifts.³ If trust assets can also be used to satisfy the trustee’s legal obligations, such as child support, the IRS may view that as a power exercisable in favor of the trustee’s creditors, which likewise creates a general power of appointment.

The Five-and-Five Power Exception

Not every lapsed power triggers full estate tax inclusion. Section 2041(b)(2) contains a safe harbor for withdrawal rights that lapse each year: a lapse is treated as a release only to the extent the property the holder could have withdrawn exceeds the greater of $5,000 or 5% of the total trust assets at the time of the lapse.³ Estate planners call this the “five-and-five” power.

Here’s how it works. A trust holds $1 million, and the beneficiary-trustee has a right to withdraw up to $50,000 each year. Five percent of $1 million is $50,000, so the entire withdrawal right sits inside the safe harbor. When the beneficiary doesn’t exercise it, the lapse causes no estate tax inclusion at all. But if the trust allowed a $200,000 annual withdrawal from that same $1 million trust, only $50,000 of the lapse would be protected. The remaining $150,000 would be treated as a release with potential estate tax consequences. The five-and-five power is one of the most common tools for giving an interested trustee limited access to trust funds without creating a general power of appointment.

Gift Tax Consequences Under Section 2514

The estate tax problem has a companion on the gift tax side. Section 2514 mirrors the structure of Section 2041 but applies during the power holder’s lifetime rather than at death. If an interested trustee exercises or releases a general power of appointment while alive, the IRS treats that action as a taxable gift by the trustee.⁵

The same ascertainable standard exception applies. A power limited to health, education, support, or maintenance is not a general power of appointment for gift tax purposes either.⁵ The same five-and-five safe harbor also covers annual lapses. Gift tax risk is one that planners sometimes overlook, because the focus tends to sit on what happens at death. An interested trustee who renounces broad powers mid-life or directs trust distributions to other beneficiaries could be making a taxable gift without realizing it. The gift tax shares the same 40% top rate and $15,000,000 lifetime exemption as the estate tax, so the financial exposure is just as significant.

Income Tax Under Section 678

Beyond estate and gift taxes, Section 678 creates a separate income tax issue. A person other than the grantor is treated as the owner of any portion of a trust over which they hold a power, exercisable solely by themselves, to take the principal or income for their own benefit.⁶ When this applies, all income earned by that portion of the trust, whether interest, dividends, or capital gains, flows through to the trustee’s personal tax return, regardless of whether the trustee actually took any distributions that year.

Section 678(c) carves out a narrow exception for support obligations. If the interested trustee’s power is limited to applying trust income toward the support of someone they are legally obligated to support, such as a minor child, that power alone doesn’t trigger ownership treatment, unless the income is actually used for that purpose, at which point it becomes taxable to the trustee.⁶ The distinction is between having the power and using it.

Independent Trustees and Structural Fixes

An independent trustee is someone with no beneficial interest in the trust and no relationship to the grantor that would compromise judgment. Section 674(c) exempts certain distribution powers from grantor trust treatment when those powers are held exclusively by trustees who are not the grantor, and no more than half of whom are related or subordinate parties.⁷ An independent trustee can hold broad discretionary distribution powers that would be disastrous in the hands of an interested trustee.

To qualify as independent, a person must fall outside the related-or-subordinate categories in Section 672(c) and cannot be a beneficiary.² The most common independent trustees are bank trust departments, professional trust companies, attorneys who aren’t named as beneficiaries, and CPAs with no family or business connection to the grantor. For families that want to keep a relative involved without creating tax exposure, the better solution is often a co-trustee structure rather than handing everything to a corporate trustee.

Co-Trustee Arrangements

The most straightforward approach appoints both an interested trustee and an independent co-trustee, then divides their powers. The interested trustee handles day-to-day management, investment oversight, and distributions that fall within HEMS. The independent co-trustee holds exclusive authority over discretionary distributions that go beyond HEMS, such as lump-sum payments for business investments or home purchases. Because the broader power rests with the independent trustee, it isn’t attributed to the interested trustee for estate or gift tax purposes. Section 674(c) explicitly blesses this structure, as long as the independent trustees aren’t outnumbered by related or subordinate parties among the trustee group.⁷

Directed Trusts

A growing number of states authorize directed trusts, which formally split trust functions among different roles. A directed trust might assign investment authority to an investment advisor, distribution authority to a distribution advisor, and administrative duties to the named trustee. A family member can then serve as distribution advisor with HEMS-limited authority while an independent trustee handles the administrative fiduciary role. Each person is evaluated only on the powers they actually hold. The key is to define each advisor’s role explicitly in the trust instrument, since common-law fiduciary rules that govern traditional trustees may not automatically extend to advisors.

Trust Protectors

A trust protector is a third party named in the trust document with oversight powers that typically include the ability to remove and replace the trustee. If an interested trustee develops a conflict of interest, begins self-dealing, or becomes unable to serve, the protector can step in without a court petition. Most states that recognize trust protectors treat them as something other than a fiduciary, meaning they aren’t personally liable for the trustee’s investment decisions. A trust protector provision is particularly valuable in trusts designed to last across multiple generations, where the grantor can’t predict which family dynamics will emerge decades later.

Creditor Exposure When the Trustee Is Also a Beneficiary

Tax consequences get most of the attention, but there’s a creditor exposure issue that matters just as much for asset protection. The general rule in trust law is that a person cannot shield their own assets from creditors by placing them in a trust for their own benefit. Under the Uniform Trust Code, if a settlor creates an irrevocable trust and retains a beneficial interest, creditors can reach the maximum amount that the trustee could distribute to or for the settlor’s benefit. A self-settled trust, where you create and fund a trust, name yourself as beneficiary, and serve as interested trustee, offers essentially no creditor protection in the vast majority of states.

Third-party trusts tell a different story. When someone else creates and funds a trust for your benefit, and the trust limits your distribution authority to HEMS, courts have generally held that creditors cannot reach the trust assets simply because you serve as trustee. The ascertainable standard that protects against estate tax inclusion also acts as a creditor shield: because the trustee-beneficiary can only access funds for health, education, support, and maintenance, there is no unrestricted interest for a creditor to attach. Some courts have found that a trust with HEMS-limited powers qualifies as an implied spendthrift trust, blocking creditor claims entirely. The distinction between self-settled and third-party trusts is one that people consistently get wrong, and getting it wrong means the trust provides no protection at all.

Removing an Interested Trustee

When an interested trustee begins acting in their own interest rather than the beneficiaries’, the trust document and state law provide mechanisms for removal. The cleanest path is a trust protector provision that authorizes removal without court involvement. Short of that, most states allow a settlor, co-trustee, or beneficiary to petition the court for removal. Typical grounds include self-dealing, breach of fiduciary duty, failure to account for trust assets, and a serious breakdown in the trustee-beneficiary relationship that interferes with administration.

Court-ordered removal takes time and money. Beneficiaries must file a petition, present evidence of misconduct or unfitness, and convince the court that removal serves the trust’s purposes. Trustees who fight removal can drag the process out for months. The most effective protection is structural: build removal mechanisms into the trust document before problems arise. A well-drafted trust specifies who can remove the trustee, what grounds are required, and who selects the replacement. That foresight eliminates the need for litigation in most cases and gives the interested trustee a clear understanding of the boundaries from day one.

1
Internal Revenue Service. What’s New – Estate and Gift Tax
2
Office of the Law Revision Counsel. 26 USC 672 – Definitions and Rules
3
Office of the Law Revision Counsel. 26 USC 2041 – Powers of Appointment
4
eCFR. 26 CFR 20.2041-1 – Powers of Appointment; In General
5
Office of the Law Revision Counsel. 26 USC 2514 – Powers of Appointment
6
Office of the Law Revision Counsel. 26 USC 678 – Person Other Than Grantor Treated as Substantial Owner
7
eCFR. 26 CFR 1.674(c)-1 – Excepted Powers Exercisable Only by Independent Trustees