Most professionals who work with trusts have plenty of “nightmare
stories” about trustees chosen by clients for their irrevocable trusts.
No doubt this is because trustees are often chosen without careful
consideration of the qualifications required.
In this issue of The Wealth Counselor, we will examine who can,
who should, and who should not serve as trustee; non-tax and tax
factors that should be considered when selecting a trustee; who can, and
should, be given the right to remove and replace a trustee; and using a
team approach to segregate duties among lay and professional trustees.
Background
Irrevocable trusts are created in two ways:
1) A revocable trust becomes irrevocable after the grantor has died.
2) An irrevocable trust is established while the grantor is living to
save estate taxes (by removing assets from the grantor’s estate) and/or
for asset protection or Medicaid (Medi-Cal in California) planning.
While a grantor may technically be allowed to serve as the trustee of an
irrevocable trust he creates, it is not a good idea at best. That is
because if the grantor has any discretion with trust asset
distributions, it could lead to inclusion of the trust assets in his
estate for tax, Medicaid and other purposes, which could frustrate the
trust’s objectives.
Often there is someone the grantor knows who the grantor suggests to be
the trustee. Typical choices are the grantor’s spouse, sibling, child,
or friend. Any of these may be an acceptable choice from a legal
perspective, but may be a poor choice for other reasons. For example,
some families would be torn apart if one sibling had to ask another for a
distribution.
Left to their own devices, clients trustee appointments will frequently
be made (out of ignorance) with little consideration of the
qualifications the trustee should have. Likewise, those who agree to be
trustees typically have no idea what they are getting into.
Non-professional trustees often are overworked, underpaid,
unappreciated, find they are dealing with unhappy and unappreciative
beneficiaries, and may even wind up being sued by the beneficiaries.
With this in mind, let’s look at some factors (non-tax and tax) that should be considered when selecting a trustee.
Non-Tax Considerations for Selecting a Trustee
Here are some of the characteristics that the client should consider in choosing an individual trustee:
Judgment: Clients typically want their trustee to make the same
decisions they would. Someone who shares the grantor’s values, virtues,
spending habits and faith is more likely to do this. Also, consider
whether the trustee candidate will be aware of his own capabilities and
weaknesses. If the trustee candidate does not have accounting or
investment experience, would she have the judgment to admit this and
engage an appropriate qualified professional?
Availability/Location: Does this trustee candidate have the
time required to be a trustee? Will he be available when needed or will
work and/or family demands leave too little time for trust
responsibilities? Where does the candidate live? If the trustee lives in
a place different than the trust situs, different laws may apply. Is
living near the beneficiary important?
Longevity: How long will the trustee be needed? Many grantors
are most comfortable with friends who share their values and have gained
wisdom from life experiences, but someone near the grantor’s age may
not live long enough to fulfill the job. A trust established for the
grantor’s child will likely need a trustee for many years to come. Thus,
for trusts that may last a long time, a corporate trustee is often the
preferred choice.
Impartiality: The trustee must be capable of being impartial
among the beneficiaries. This is especially difficult to do if the
trustee is one of several beneficiaries. Corporate trustees, because
they can be impartial, are often chosen to prevent a sibling or relative
from being placed in an uncomfortable (and often unfair) position.
Interpersonal Skills: The trustee needs to be able to
communicate well and effectively to the beneficiaries and to
professionals who may be involved with the trust. Some people may be
good record keepers or investors, but lousy at diplomacy or feel
intimidated or even be offended if a beneficiary gets an attorney. A
good trustee will need to be able to work calmly and well with all
involved.
Attention to Detail: Does the trustee understand the serious
duties that come with the job and is she willing to be accountable for
her actions? Fiduciaries are often thought by the beneficiaries to be
guilty until proven innocent. While it may not happen, the trustee
should assume he will be sued at some point and keep meticulous records
as a ready defense. A trustee who expects to be sued will be much better
prepared than one who doesn’t think it will happen and, as a result,
does not take the record keeping requirement seriously.
Investment Experience: While it is helpful to have investment
experience, the trustee can certainly get by without it, as long as
he/she recognizes this is an area for which to secure professional help.
Also, if the trustee lives in a place different than the trust situs,
different investment laws may apply, making it especially prudent or
even essential to seek professional assistance.
Planning Tip: CPAs can
make good trustees, but often are unwilling or unable (because of
insurance considerations) to serve. Sometimes, the best choice would be a
corporate trustee. Seldom will the unguided grantor even think of using
a team, which can include both various professionals and friends and
family members.
Fees: The non-professional trustee rarely discusses fees with
the beneficiaries. Often, family members and friends will not charge a
fee for their services out of a sense of family duty or respect for the
grantor. But trustees should be paid and, more often than not, an unpaid
trustee will eventually come to that conclusion or fail to diligently
carry out his duties. From the outset, a trustee should keep close track
of time and expenses so that a reasonable fee can be substantiated.
Generally, a reasonable fee is what a corporate trustee would charge, so
thinking that a non-corporate trustee will do the same necessary work
for less is false economy.
Planning Tip: Become
knowledgeable about the fees charged by corporate trustees in your area
as a guideline. Talk about trustee fees when establishing the trust to
avoid problems and misunderstandings later.
Insurance: Anyone serving as a trustee needs to have plenty of
insurance (errors and omissions or liability). Some of the laws that
govern trustees are absolute standards, so a trustee needs to have
adequate insurance for protection in the event of a mistake or an
innocent error. The amount of insurance needed can depend on the degree
to which a trustee is indemnified. However, legal defense costs in
trustee litigation can be very large and are typically borne by the
insurer.
Indemnification: This often comes up when family members or
friends are serving as trustee. Grantors want to indemnify family
members and their friends; they do not want them to be sued. It is
possible to reduce or eliminate the prudent investor rule for such
trustees. However, indemnification is a two-edged sword because it may
result in the non-professional trustee not taking the job seriously.
Planning Tip: A good alternative is to have a family member or
friend serve with a corporate fiduciary that is assigned the
administrative and investment responsibility. The family member or
friend trustee could make or veto discretionary distributions, but
having no oversight, administration, or investment obligations would be
less likely to be sued if something goes wrong.
Planning Tip:
Indemnification might be appropriate in a situation with obvious bad
family dynamics, where the siblings are already fighting each other yet
the grantor insists on naming one sibling as trustee. In such a
situation, your recommendation to name a corporate fiduciary instead
should be well documented.
Planning Tip: Waiving
the prudent investor rule can also be helpful in other situations,
depending on the use of the trust. For example, with the sale of an
appreciated asset(s) to a grantor trust, the trustee is usually buying
hard-to-value assets (real estate, wholesale business interest) from the
client in order to shift future appreciation to the trust and away from
the grantor. Rather than starting initially with a corporate fiduciary
who is not familiar with the asset or situation, it may be more
effective (saving both time and money) to have the initial trustee be
someone close to the family who better understands the issues, and then
change later to a corporate fiduciary. Waiving the prudent investor rule
and providing indemnification for the initial trustee in this situation
could make sense.
Planning Tip: Being
able to waive all or part of the prudent investor rule when using an
irrevocable life insurance trust (ILIT) gives greater latitude and peace
of mind to make some of the transactions meet the unique needs of the
client. Beware, however, of the risk that the trustee, shielded from
liability, may fail to do the appropriate work to make sure that the
insurance held in the ILIT is appropriate as markets change.
Note: Florida is considering a statute that would relieve
trustees of the duty to review the propriety of investments in life
insurance policies, which would, in effect, waive the prudent investor
rule for life insurance policies owned by ILITs. This would help to
solve the problem of corporate trustees not wanting to serve as the
trustee of ILITs due to the obligation to review policies that have not
performed very well.
Tax Considerations
Estate Tax
If a purpose of the trust is to remove assets from the grantor’s estate,
the grantor cannot have any role in determining who gets distributions
or when they occur. However, the grantor can have the power to remove
and replace the trustee or to control the investments of the trust.
Neither of those will cause estate tax inclusion providing the grantor
cannot appoint a trustee who is related or subordinate to the grantor
(as would be a brother, employee or someone else who will capitulate to
the grantor’s wishes). Interestingly, there is no problem appointing, at
the inception of the trust, an initial or successor trustee who is
related or subordinate to the grantor.
Planning Tip: It is
unclear if a grantor can have the right only to remove a trustee and
allow the next named successor trustee to take over. While also unclear,
it seems that a grantor can reserve the right to remove and replace
someone who is not a fiduciary (for example, a trust protector).
Income Tax
A non-adverse trustee having certain powers may trigger grantor trust
rules and cause the grantor to be taxed on the trust’s income. In some
instances the client may not want the tax to come back to the grantor
and instead want a trust that is a separate tax-paying entity for which
the income that is distributed to the beneficiaries is be taxed to the
beneficiaries.
Planning Tip: Because
the trustee’s identity may affect state income tax as well, you may be
able to shift the trust situs to a state with a lower income tax rate.
Depending on the trust assets, this could be important as some
investments (such as oil and gas) may be taxed significantly higher in
some states than in others.
Beneficiary Removal and Replacement of Trustee
This is an area that is customizable for each trust and can help
maintain some downstream flexibility. Some grantors may not want the
beneficiaries to be able to remove the trustee, especially if the
grantor is aware of family quarreling. But if the corporate or
individual trustee knows it cannot be replaced there is little need for
responsiveness or careful attention to investments. Because there does
need to be a way to have the trustee removed if things should
deteriorate, the document can include that the trustee can only be
removed for cause as determined by the court. On the other end,
spendthrifts may want to “trustee shop” until they find one that will do
whatever they want, so there will need to be some restraints on when a
trustee can be replaced.
Team Approach
There are times when a team can do a better job than a single trustee.
Having more than one trustee, even with different duties and
responsibilities, can work well for many situations. The trust can
benefit from assigning the trustees specific duties based on their
strengths and experience. Of course, the fewer people who are involved,
the less complicated the administration. Also, disagreements will have
to be worked out. If there are two trustees or any even number,
deadlocks are possible. With an odd number, a simple majority would be
needed. If an agreement cannot be reached, the court can be allowed to
intervene as a last resort.
Also, as mentioned earlier, family member trustees can work with
professionals as paid advisors instead of as trustees. This would allow
the advisors to provide valuable input and insight into both the
grantor’s desires and the personalities of the beneficiaries, without
being so exposed to possible lawsuits.
Planning Tip: Ethical
issues can arise if the attorney represents more than one trustee, so
she should be sure to have a waiver of conflict or other plan in place.
Planning Tip: Naming
someone as trustee is a nomination. The person named is under no
obligation to accept the responsibility when the time comes, and it is
not unusual for someone to refuse to serve or to step aside once he
understands the duties and responsibilities involved. For this reason,
it is important for the trust maker to name several successor trustees
and to clearly communicate with each before finalizing the choices. Most
drafting attorneys will also recommend naming a corporate trustee as
trustee of last resort, especially if no procedure for appointing
successors is provided to the beneficiaries, short of going to court.
The Trustee’s Duties and Responsibilities
A trustee has many duties and responsibilities. A partial list is:
* administer the trust * collect trust property
*be loyal * inform and report to beneficiaries
*be impartial * diversify investments
*be prudent * keep records and no commingling
* control and protect trust property * enforce and defend claims
Conclusion
A competent trustee is as important to the success of a trust as its
being well-drafted. Naming a favorite family member as trustee may not
be the smartest (or kindest) thing the grantor can do. As experienced
professionals who have seen the consequences of unwise choices for
trustee, we are in a unique position to counsel our clients with their
and their beneficiaries’ best interests in mind.
To comply with the U.S. Treasury
regulations, we must inform you that (i) any U.S. federal tax advice
contained in this newsletter was not intended or written to be used, and
cannot be used, by any person for the purpose of avoiding U.S. federal
tax penalties that may be imposed on such person and (ii) each taxpayer
should seek advice from their tax adviser based on the taxpayer's
particular circumstances
For professionals' use only. Not for use with the general public.