- Trust Planning
Brief Primer on Trusts
To Whom is a Trustee Answerable? The question of a Trustee’s duties and to whom the Trustee is answerable depends largely on the specific wording of the Trust in question. However, it is instructive to understand trust relationships in general before launching into an analysis of the Trust’s specific terms. The Trustee has “legal title” to the trust assets, meaning the unilateral power to conduct transactions with the same. Transactions include buying and selling assets and distributing income and principal from the Trust to its beneficiaries. The beneficiaries are divided into two categories, separated in time. The first beneficiary (or beneficiaries) are the ones entitled to get distributions currently. We will assume the Trust provides for distributions to one beneficiary for that person’s lifetime. We will call that person the “life beneficiary.” The second set of beneficiaries are the ones (or one) to whom the Trust passes when the life beneficiary dies. We call them the “remaindermen.” Now we have enough vocabulary to answer the initial question. The Trustee has duties to and is answerable to both the life beneficiary and the remaindermen. The specific Trust’s terms determine which of those sets of beneficiaries have greater rights. If the Trust states that the Trustee is to distribute any amounts in his discretion to the life beneficiary, then the remaindermen have very limited rights; they should expect they may not receive anything necessarily. Whereas, if the Trust provides that the life beneficiary is entitled to distributions for “health, support and maintenance,” then the Trustee is answerable to the remaindermen if the Trustee over-distributes to the life beneficiary. Another (optional) element in a Trust may limit the recourse of the remaindermen to hold the Trustee accountable: That is, if the Trust specifies that life beneficiary has a “power to appoint” the Trust, this is essentially the power to redirect the Trust away from a given remainderman. In such a case, any remainderman who challenges the Trustee in “over-distributing” to the life beneficiary may be left out of the Trust as a practical matter. Why is this so? When the life beneficiary realizes the remainderman is poised to challenge distributions the life beneficiary has received, that life beneficiary may well redirect the Trust away from the challenging remainderman. Bottom line: The parties to a Trust are the Trustee, the life beneficiary and the remaindermen. Their relative powers and rights depend on the terms of the Trust in question. In addition, if the Trust grants a power to appoint, the remaindermen may be well-advised to be circumspect before challenging the Trustee’s distributions to the life beneficiary.
The Role and Responsibilities of a Trustee
Before one can understand the role and responsibilities of a trustee, one must first understand some basics about a trust. At its core, a trust is divided ownership in the assets held by the trust: divided between a trustee, who holds legal title to the trust assets, and the beneficiary, who enjoys the beneficial ownership of the trust assets. In other words, the trustee manages and invests the trust assets, for the benefit of the trust beneficiary, who receives funds from the trust as directed in the governing trust document. Since the trustee has legal ownership of the assets held in a trust, but is managing the trust for the beneficiary, the trustee is a fiduciary and owes fiduciary duties to the beneficiary. In order to fulfill these duties, the trustee needs to understand the intention of the grantor (who established the trust), the power granted to the trustee, how and when distributions are to be made to the beneficiary, and what administrative functions need to be performed. It is important to note that there may be limitations on the trustee’s powers and additional duties imposed by state law, even though they were not listed in the trust documents. There are three main aspects to the responsibilities of a trustee:
- Act in the beneficiary’s best interests.
- Be familiar with the beneficiary’s needs and circumstances. To act in the beneficiary’s best interests, the trustee needs to know what those interests are.
- Avoid conflicts of interests. The Trustee owes the beneficiary a duty of loyalty and to avoid conflicts of interests. For example, the trustee should not take compensation for acting as a trustee unless the trust document or the state law allows it and the compensation is reasonable. Similarly, self-dealing such as purchasing trust assets or transacting trust business with family members can create an appearance of a conflict of interests.
- Exercise due care in the management of trust assets
- Collect the trust assets. The trustee needs to inventory what the trust owns and owes, and ensure all the trust assets are properly titled into the name of the trust.
- Protect the trust assets. The trustee needs to maintain adequate fire and other hazard insurance on the trust property. The trustee is also responsible for defending the trust against any legal claims against the trust assets. Valuables may need to be in a safe deposit box while real property has to be maintained in good condition.
- Invest the trust assets. The trustee has a duty to make the trust assets productive. The Prudent Investor Rule requires that the trustee must deal with the trust property as he would deal with his own assets in acting on his own behalf. The trust document and applicable law may limit what investments the trust can hold. Within these limits, the trustee shall invest the trust assets prudently and with the beneficiary’s best interests in mind.
- Distribute the trust assets. The trustee has a duty to distribute the trust assets in accordance with the governing trust document and applicable state law, and with the best interests of the beneficiary in mind. For example, the trust document may require that all the trust income be distributed annually, while the trust principal may be distributed only for health, education, maintenance, and support needs of the beneficiary. If the trust document specifically forbids certain distributions, e.g., an expensive car, the trustee is required to decline a request for such distribution.
- Perform administrative responsibilities.
- Maintain accurate and complete records of all income, expenses, purchases, sales and other transactions of the trust.
- File periodic and final accountings as required by applicable laws. Generally, a trustee is required to furnish the beneficiary with an annual report of the trust assets. The trustee is also responsible for filing an annual trust income tax return (Form 1041) with the IRS, should the trust’s income exceeds certain thresholds. If the trust holds business interests, there might be additional reporting requirements or tax returns required for these businesses as well.
- Coordinate with other fiduciaries. If there are multiple trustees, each co-trustee will have to coordinate and share information about decisions with others, and follow whatever voting procedures are in place for decision-making.
- Hire and manage third-party professionals. The trustee does not have to go it alone. The trustee can hire third-party professionals to assist with the management of the trust. However, the trustee has a duty to manage and review the performance of these professionals. Ultimately, the trustee is still responsible for any decisions made and action taken.
- Resign as a trustee. Depending on the trust document, the trust may only last for a specific timeframe, and/or allow for the trustee’s resignation and succession. Resignation is always an option for a trustee who can no longer serve.
Trust Planning, Who Do You Trust?
Non-Tax Considerations Depending on the size and nature of your estate, you may want to consider a more simplified Will while the estate tax exemption remains high, and you may be wondering whether you can dispense with the use of trusts in your plan. Aside from tax considerations (discussed below), the use of trusts is a highly individual matter. Estate planning is not only about taxes, but is also about inability, disability, creditors and predators, in-laws and outlaws. It is sometimes about protecting your heir from himself or herself, and sometimes more about protecting him or her from other people. It is about your legacy, about what you worked for and whom you wish to benefit from that hard work, and to what extent. A trust can provide added protection in all these circumstances: shielding assets from creditor and divorce claimants, providing asset management, and securing how assets are used in perpetuating your legacy. For all these reasons, even if we lived in a tax free world, most of our clients would still opt to include a trust in their Will for at least one of their heirs. A classic example is the “blended family,” where the wife wants to leave her estate to her husband, but have the remaining balance at his death secured for her own children. This requires a trust. Another popular approach is to leave an adult child his or her inheritance in a lifetime trust (of which the child is named as trustee), thereby protecting the inheritance from the child’s possible divorce or creditor problems and securing the amount remaining at the child’s death for grandchildren. Although these are vitally important considerations, we should remind ourselves of the responsibilities a trust imposes. Once activated (in this case, by death), a separate set of accounts and an annual trust income tax return are required. In addition, the trustee could be subject to challenge (even litigation) by the “remaindermen” (the parties who are entitled to the trust after the primary beneficiary is gone), either for improper investment choices or distribution decisions. Consider this scenario: wife is trustee of the family trust created in her deceased husband’s Will. She would like to “shut down” the trust, since she believes it serves no further tax purpose, given the estate tax law and the size of her estate at the time. It would behoove wife to get the children’s written agreement to such a course of action before proceeding. For the very reason that trusts provide various levels of protection, they cannot be disregarded unilaterally or arbitrarily. Testamentary Trusts That Save Taxes In addition, for our clients who are planning to mitigate the ultimate estate tax burden that falls on their family, the use of trusts in their estate planning is integral. Trusts can be structured so that the assets held in trust are not taxed as a part of the beneficiary’s estate when the beneficiary dies. These trusts can take a variety of forms and are called by a myriad of names (uniform nomenclature being long overdue in the estate planning community), but some of the most common types of tax-motivated trusts are discussed below. When one spouse dies, oftentimes his or her estate (up to the estate tax exemption amount) will pass into trust for the surviving spouse, and many times the children will also be included as beneficiaries of this trust. While the surviving spouse can be (and usually is) both the trustee and primary beneficiary of this trust, this trust is considered a separate entity for both income tax and estate tax reporting. As such, when the surviving spouse later dies, this trust will bypass estate taxes at the survivor’s death, having been shielded from estate tax by application of the first spouse’s exemption when he or she died. For this reason, this trust is most commonly called the “bypass trust,” but is also known by the name “family trust” and “credit shelter trust,” among others. However, now that “portability” has become a permanent aspect of our estate tax laws, a surviving spouse can potentially ‘share’ his or her deceased spouse’s unused estate tax exemption, limiting the necessity of a bypass trust from a tax point of view. When property is left to children after both spouses have died, the children’s assets can also pass into trust rather than to the children outright. Typically, each child will have a separate trust, so that investments and distributions can accommodate that child’s investment objectives and distribution needs, independent of the other children’s needs. Once a child reaches a specified age, the child usually becomes his or her own trustee, and is then able to manage the trust assets. Oftentimes called a “descendant’s trust” or “generation-skipping trust,” this type of trust allows for a child to be both a beneficiary and trustee of his or her trust, and yet maintain the trust as a separate entity for tax purposes. As such, this trust will not be estate taxed when the child dies, allowing the trust assets to pass to the next generation with no estate taxes at the child’s death. The availability of this tax advantage is limited to the amount of the parent=s generation-skipping tax exemption as of the parent’s death. Lifetime Trust Planning The trusts mentioned above are most commonly used by our clients as a part of their Will plan and do not become effective until one or both spouses die. Whereas, sometimes our clients decide to utilize their tax exemptions during their lifetimes and create gift trusts into which they transfer assets while they are living. Gift trusts can hold all manner of assets, though assets that are most likely to appreciate during a client’s lifetime are the most attractive targets for lifetime gifting. This allows the assets to grow outside the client’s estate, so that the appreciation will not be estate taxed. Since gift trusts are irrevocable once created, it is important that the client have a very high comfort level with the terms of the trust, and the permanent nature of the gift of the transferred asset. Life insurance trusts (into which clients transfer their life insurance policies) are popular gifting vehicles, because few people expect to utilize their life insurance policies themselves, and therefore are comfortable giving them away. Life insurance trusts (as all gift trusts) can be structured to be generation-skipping, and thereby afford a very effective leverage of a client’s generation-skipping tax exemption. The value of each gift to the trust is the annual premium payment on the life insurance policies, and this is the amount of generation-skipping tax exemption that is applied to shelter the entire trust from the second generation’s estate tax. This is so even though the ultimate face amount of the proceeds payable to the trust may be in excess of the generation-skipping tax exemption. Another popular lifetime estate planning trust is the Grantor Retained Annuity Trust (or “GRAT”). A GRAT is a trust where the creator of the trust (the grantor) retains an annuity payment back from the trust for a term of years (thus, the name). The value of the gift to the ultimate trust beneficiaries (typically the client’s children) is reduced by the value of the grantor’s retained annuity payments. To minimize the taxable gift, the annuity payments are typically structured to equal the initial value of the gifted property. This structure is referred to as a “zeroed-out GRAT” (i.e., the value of the taxable gift is virtually zero). While this may not sound attractive, this technique can transfer significant wealth to a client’s children if the assets transferred to the GRAT out-perform the IRS-dictated interest rate to be paid to the grantor with each annuity payment. The optimum assets to use for this trust are ones that are expected to increase rapidly in value, during the GRAT term. This is because a GRAT essentially transfers the ‘upside’ potential to the children. Assume for example that Mom transfers $1 million in assets to a 2-year GRAT when the applicable Federal interest rate is 3%. In order to “zero out” this GRAT, Mom must receive annual annuity payments totaling $1,045,000. Once Mom is paid back the $1,045,000, if excess value is left in the GRAT at the end of the 2 years, then all such excess value (the ‘upside’ potential) goes to the children completely gift tax free. Worst case, if the assets do not increase in value as expected, the assets are all paid back to Mom as part of the annuity, but there is virtually no downside risk. Importantly however, the grantor needs to survive the term of the GRAT in order for the transaction to be effective. Thus, mortality risk is an issue with these types of trusts, though they are usually designed as only 2 or 3 year trusts. One of the most powerful lifetime trusts to employ is the intentionally defective grantor trust (often called an “IDGT”). This type of gift trust causes the grantor to be the income taxpayer for the trust. The result is the grantor reports all income and loss earned in the trust on his or her individual income tax return, and any transactions between the trust and the grantor are invisible for income tax purposes. Not appealing at first glance, upon closer look this trust has distinct advantages. First and foremost, it allows the gift trust to grow in value for children and grandchildren, without being depleted by the usual income tax burdens. In effect, this type of trust allows the grantor to make future additional indirect gifts to the trust (the payment of its income tax), without these payments counting as gifts for gift tax purposes. Indeed, the Internal Revenue Service has explicitly approved this result in a 2007 Revenue Ruling. The point is that substantial wealth transfer can be achieved by this feature, given enough time. Secondly, as noted above, the income tax status of the trust allows the grantor to enter into transactions with the trust on an income-tax neutral basis. As a result, sales and leases between the grantor and the trust (which would otherwise be income taxable) are not tax recognition events. This feature allows the tax-free installment sale of an asset by the grantor to the trust at its current value, which if it appreciates significantly in future years has the effect of shifting all the growth to the gift trust/IDGT, with no diminution for income or capital gains taxes. The above summary is by necessity a generic overview of some of the most popular estate planning opportunities available with trusts. It is by no means an exhaustive treatment of trust planning, and is necessarily oversimplified to some degree. Also, many of these strategies are often applied in tandem to layer their advantages. Please visit with us further so that we may review your individual situation and discuss which options work best for your family.