Now that you are
trustee of your own revocable living trust, you will want to manage it to
maximum advantage. While this is not difficult to do, you should remember that
a trustee cannot always do everything that an individual can do, particularly
after the death of a settlor when a trust has become irrevocable.
This article is
intended to give you some general information and guidelines concerning the
management of the trust during a trust's three phases: (1) when both settlors
are living; (2) when only one of the settlors is living; and, finally, (3) when
no settlor is living. This article also covers such diverse areas as record
keeping, tax returns, proper investment and management procedures, the duties
and liabilities of trustees, and allocation of assets (upon division into
separate trusts).
Because each trust
document is different and each case has its own special facts, the general
rules set forth in this article will not always be applicable and this memo
cannot substitute for specific advice on specific legal questions as they
arise. Nor can this memo substitute for common sense and caution.
Each trustee must read
and be familiar with the terms of his trust, and must carefully comply with
those terms. If questions arise respecting the interpretation of the trust,
record keeping, forms of title, whether or not a particular investment or sale
can be made, etc., your attorney, accountant, or other advisor should be
consulted. While the revocable living trust is a useful and flexible estate
planning tool which, in many instances, can save substantial estate and income
taxes, it demands careful administration if its tax and other benefits are to
be achieved.
MANAGEMENT DURING
LIFE OF SETTLORS
A revocable living
trust commences the moment the trust has been executed (signed) and funded.
Complete funding of
the trust is not necessary to establish it, but transfer of at least one asset
to it is necessary. Different types of assets require different procedures to
effectuate the transfer of title from the names of the settlors into the name
of the trustee, and the length of time necessary to transfer title to the name
of the trustee will vary depending upon the particular asset involved.
Some assets not
initially transferred into the trust may later be transferred into the trust
even at or after the death of a settlor. For example, the ownership rights in
insurance on the life of a settlor (or another person) is usually not
transferred to the trust, instead the proceeds are made payable (by beneficiary
designation) to the trust at the insured's death. No matter when an asset is
transferred into the trust, the trustee must take care to properly collect the
asset, have title registered in the name of the trust (i.e., the name of the
trustee), allocate the asset to the proper account and thereafter keep proper
records of the transactions concerning that asset.
The benefits of a
revocable living trust, such as avoidance of probate proceedings, accrue only
to those assets held in the name of the trustee. Therefore, it is important, as
assets are sold and new assets purchased, that the trustee handle all
transactions as trustee and that he be certain that new assets are registered
in trustee's name.
Protecting Trust
Assets. Once assets have been
transferred to the trust, the trust agreement is fully operative as to those
assets. So long as both settlors are alive and competent, they may control the
manner in which assets are invested and the manner in which the income and
principal of the trust is distributed. The settlors will have this control even
if they are not trustees. Thus, it is conceivable that the trustee may have no
significant responsibilities during the first phase of the trust, i.e., when
both settlors are living.
Nevertheless, any
assets which have been transferred to the trust and which should be covered by
insurance should also be protected by insurance while they are within the
trust. If insurance is already in force, the insurance policy should be amended
to add the trustee as an insured party. This can usually be done at no cost.
Assets such as stocks
and bonds should be placed in safekeeping, such as a separate safe deposit box.
This safe deposit box should be used only for trust assets and should be held
in the name of the trustee. In this manner, bearer securities (such as
municipal bonds) can always be identified as trust assets. The successor
trustee, upon presentation of a true copy of the trust, will be able to obtain
access to the safe deposit box.
Actions of the
Trustee. The trustee is the
legal owner of the trust assets. If there is more than one trustee, the
trustees own the assets with survivorship rights similar to those of joint
tenants. Property held in the name of multiple trustees will pass to the surviving
trustees upon the death of a trustee. If more than one trustee is acting, the
trustees must act together unless the trust instrument expressly provides to
the contrary.
The trustee is not the
agent of the beneficiaries; the trustee is an independent party who is
responsible for his own actions. However, when both settlors are living and
directing the actions of another person acting as trustee, this responsibility
is not to persons who might take an interest in the trust in the future so long
as both settlors are living and the trust is revocable. As indicated below,
once a trust becomes irrevocable, future beneficiaries may obtain enforceable
rights and the trustee then may act only after considering these rights.
When both settlors are
living, the trustee should segregate the trust assets and keep trust records
sufficient to allow the settlors to prepare normal personal income tax returns.
Identifying the Trust
for Tax Purposes. The IRS exempts your
trust from filing all income tax returns, so long as you report all income,
gains and losses on your personal return. The trust is not treated as a
separate taxable entity, and you will not lose any income tax advantages by
holding assets in the name of the trust.
For example, the
transfer is non-taxable, your basis in the property is not affected, and the
one lifetime exemption of the first $500,000.00 (if married and filing jointly)
of gain on the sale of your home is still available.
Upon the death of a
settlor, the trust will become a separate taxable entity and will be required
to file fiduciary income tax returns.
Investments. During the first
phase of the trust, investment of trust assets is handled in the same manner as
it would have been handled by the settlors were there no trust in existence,
except that trust transactions should be undertaken in the name of the trustee
and not in the names of the settlors as individuals.
PROCEDURES ON DEATH
OF A SETTLOR
When a settlor dies, a
portion of the living trust (usually consisting of all or part of the deceased
settlor's separate property and his share of the community property) will
usually become irrevocable. The duties of the trustee then become more
important and his responsibilities become substantially greater.
At the death of a
settlor, trust assets must be valued, death tax returns must be filed, assets
must be allocated to the proper accounts or subtrusts, appropriate books
(records) must be established so that the income and principal receipts of each
trust which has become irrevocable can be recorded accurately and investments
must be more carefully made because the trustee is now responsible to all of
the trust's beneficiaries, even if they are not yet born and identified.
Normally, the
trustee's attorneys or accountants will prepare the federal estate tax returns
necessitated by the death of a settlor. They will also assist the trustee in
collecting assets, valuing them and allocating them between trusts. The
attorneys will, upon request, assist with any questions of trust administration
or interpretation. Most of these items relating to the continuing management of
the trust are discussed in greater detail below.
MANAGEMENT
DURING LIFETIME OF SURVIVING SETTLOR
Upon the death of one
of the spouse settlors, the living trust is usually divided into two separate
subtrusts, the Survivor's Trust and the Decedent's Trust. To the Survivor's
Trust is allocated one-half of the settlors' community property, all of the
surviving settlor's separate property, and, in some instances, a marital
deduction share. The balance of the trust property will be allocated to the
Decedent's Trust. Furthermore, your trust may provide for the creation of a
third trust called the Qualified Election Trust which will usually have all of
deceased settlors' separate property and his or her share of the community
property not allocated to the Decedent's Trust.
Because federal law
allows the trustee to minimize taxes by valuing the decedent's share of trust
assets both at date of death and six months thereafter (unless they have been distributed
or sold) allocation of assets may need to occur between the Decedent's Trust,
the Survivor's Trust and the Qualified Election Trust (if applicable). Once the
trustee has determined the extent and value of the assets which are held by the
trust, the trustee will allocate those assets between the Survivor's and
Decedent's trusts and the Qualified Trust (if applicable) in the manner
required by the trust document itself.
Most trust documents,
however, now allow the trustee to allocate various whole assets (rather than
undivided interests) to each trust -- to achieve better management, to
encourage future estate planning, and to meet the varying needs of the
different beneficiaries. For example, if the home and its contents are held by
the trust it is quite common to allocate them to the Survivor's Trust (rather
than a one-half interest to the Survivor's Trust and a one-half interest to the
Decedent's Trust) so that the surviving spouse has not only their continued
use, but the complete freedom to dispose of them as his or her needs dictate.
It should be remembered that the Survivor's Trust usually remains subject to
revocation by the surviving spouse after the death of the first settlor to die,
or, if it is not revocable, it is almost always subject to a general power of
appointment (the power in the surviving spouse to designate how the assets of
the trust are to be distributed), thus property allocated to the Survivor's
Trust almost always remains subject to the control and disposition by the
surviving settlor.
The actual allocation
of the trust assets is usually accomplished by book entry in the accounting
records of the trust rather than by actually registering title to the assets in
the name of the specific subtrust (i.e., Survivor's or Decedent's Trusts). This
allows the assets of the trust to be managed as a unit for purposes of economy.
For example, if 60 shares of certain stock are allocable to the Decedent's
trust and 40 shares of the same stock are allocable to the Survivor's Trust,
the actual certificate will probably be for l00 shares held in the name of John
Doe, trustee, etc. If it becomes appropriate to sell the shares held by one
trust an retain the shares held by the other trust, this can always be done so
long as accurate accounting records are kept.
The mathematical
computations governing allocation of trust assets, while not difficult, are
complex because of many factors which may be present. For example, while the
property may be equally allocated to each of the Survivor's and Decedent's
Trusts, death taxes, funeral expenses and expenses of last illness are usually
chargeable only against the Decedent's Trust; debts (i.e., unpaid bills
outstanding at time of the deceased settlor's death) may be chargeable equally
to both trusts or in varying proportions to the trusts depending upon the
nature of the debt and the amount of separate or community property available
to satisfy the debt. Thus, it is most important when allocating trust assets
for the trustee to consult with attorneys or accountants skilled in fiduciary
accounting (as opposed to business accounting) so that the all-important
"starting figures" for each trust may be determined. The importance
of proper asset allocation and generally getting off to a good start cannot be
overemphasized.
Record Keeping. After the death of one of the spouse
settlors the accounting records for the Survivor's trust are kept in the same
fashion as the revocable living trust records are kept prior to the death of
the spouse. However, the accounting records for the Decedent's Trust and the
Qualified Election Trust, if applicable, must, of necessity, be kept in greater
detail and with greater accuracy. Because the Decedent's Trust and the
Qualified Election Trust, if applicable, are separate taxpaying entities and
because the trustee has responsibilities to both the income beneficiaries
[usually the surviving spouse and sometimes other members of the family, and
the remaindermen (those who will receive the property on termination of the
trust)], careful records must be kept of the transactions of the Decedent's
Trust and the Qualified Election Trust, if applicable, which has become
irrevocable.
These records must
distinguish between income and principal, receipts and disbursements. For
example, if the trust holds a note received on the sale of an asset and the
note is being paid on an installment basis, each payment most likely will
include both a repayment of the principal portion of the note and interest.
These items must be allocable to the income account while the note repayment
portion is allocable to the principal account. (This treatment may or may not
be the same for income tax purposes since fiduciary accounting and fiduciary
income taxation are not always parallel.)
Similar careful
treatment must be accorded expenses allocable to principal and expenses
allocable to income. In some instances, the trustee has the discretion to
determine the manner of allocation as between principal and income or, in less
frequent instances, to make the determination when the allocation is not clear.
When any question of allocation arises, the accountants or attorneys should be
consulted.
Please note that
fiduciary record keeping differs substantially from normal bookkeeping or even
from corporate or personal income tax record keeping. A fiduciary is
responsible for every penny which passes through his fingers and must therefore
account to the penny. Thus, the trustee is required to keep a precise record of
every receipt and disbursement, every gain and loss, every distribution to a
beneficiary, and every change in the nature of an asset of the trust. This is
not difficult if good records are kept from the inception of the Decedent's (or
other irrevocable) Trust. However, failure to keep good records will require
time consuming and costly reconstruction of trust records for both tax and
accounting purposes, and will raise adverse inferences against the trustee
should a dispute arise at a later date.
Tax Returns. As indicated above, the Decedent's
trust and the Qualified Election Trust are separate taxable entities. As such,
they may select a fiscal year, are required to obtain their own taxpayer
identification number, and are required to file their own tax return. Even if
all of the income of the Decedent's Trust and the Qualified Election Trust is
distributable to the surviving spouse, some "income" may still be
taxable to the Decedent's Trust and the Qualified Election Trust, and capital
gains generated by sales or exchanges of assets held by the Decedent's Trust
and the Qualified Election Trust are almost always taxable to the Decedent's
Trust and the Qualified Election trust, respectively.
Fiduciary income
taxation is a highly specialized field and most accountants are not familiar
with its intricacies. Therefore, it is extremely important that an accountant
familiar with fiduciary income taxation be employed to prepare the Family Trust
income tax returns, or that an attorney supervise the accountant in the
preparation of the return. The Survivor's Trust fiduciary income tax return is
prepared in the same manner as the fiduciary income tax return for the
revocable living trust was prepared when both settlors were alive.
Powers of the Trustee. The powers of the trustee are generally set forth in
detail in the trust document. Depending upon the terms of the trust, the powers
given the trustee may be very restricted or almost unlimited. However, even
where he is specifically granted absolute or sole discretion the trustee must
always act in good faith, considering the interests of the income beneficiaries
and the remaindermen. Unless specifically authorized otherwise by the trust,
joint trustees must act unanimously. Sometimes a trustee may delegate powers to
another trustee or to an agent. However, a trustee should be very cautious
about the types of functions which he delegates to a person who is not a
trustee. For example, "ministerial" functions may be delegated, such
as the trust accounting work or management of a farm property or a business.
Nevertheless, notwithstanding the delegation of the authority, the trustee is
responsible to oversee the delegated work and is responsible for the actions of
the ministerial agent. Discretionary powers (for example, determining whether
or not to distribute income or principal) may not be delegated. All decisions
concerning trust distributions should be made by the trustee. Decisions
concerning trust investments should usually be made by the trustee unless the
trust expressly provides for the retention of separate investment counsel or
vests the investment decisions in one particular trustee. However, even then
the delegating trustee probably has the responsibility to see that the
delegated power is used prudently.
Generally, the trustee
has broad powers to sell, lease, borrow, pledge, and otherwise manage the
assets of the trust in a businesslike fashion. If a question arises as to the
existence or exercise of a power that is not clear from the terms of the trust,
the attorneys should be contacted. In these cases where no ready answer is available
(whether it concerns trustee's powers or other terms of the trust) a petition
may be filed with the Probate section of the Superior Court and the matter
usually can be resolved within a short time.
Duties of the Trustee. The trustee has an
absolute duty of loyalty to the beneficiaries of the trust. This means that
although the trustee is the legal owner of the trust assets, all actions taken
in connection with the administration of the trust must be with the sole
interest of the beneficiaries in mind. Any self-dealing by the trustee is a
breach of trust. The trustee cannot deal in any way with the trust's assets
which would personally benefit him (as for example buying assets for himself or
selling assets to the trust) even if such action would be advantageous to the
beneficiaries, unless authorized by the trust instrument.
Investments. The trustee has the
responsibility for administering the trust in a manner most beneficial to the
beneficiaries in accordance with the terms of the trust agreement. Normally,
the trustee will be given power to invest as would a "prudent man",
namely, to manage the trust funds with regard to their permanent disposition
and considering both the probable income to be earned as well as the probable
safety of the principal. Such a standard recognizes the trustee's duty not only
to the income beneficiaries but also to the remaindermen.
Thus, for example, if
the trustee invests in a wasting asset, such as an oil royalty interest subject
to depletion, a portion of the income received must usually be set aside as a
reserve to replace the depleting principal; otherwise, the interests of the
remaindermen would be prejudiced. Conversely, the trustee may be required by
the terms of the trust to establish no reserves or even to retain certain
assets although they produce no income. Thus, you can see that paying close
attention to the terms of the trust is of great importance. If there are
questions, the trustee's attorneys should be contacted without fail.
Record Keeping and
Accounting. The trustee is usually
required to furnish the beneficiaries of a trust an annual accounting of his
actions. This accounting shows the starting balance of the trust assets, adds
the receipts and gains and deducts the distributions, losses and disbursements and
then shows the remaining balance on hand at the end of the accounting period.
The starting and closing balances will generally be at the "carrying
value" for the trust which is most often their income tax basis. A good
account will also show market values for the assets so that the investment
decisions of the trustee can be more accurately measured.
A trustee must act
with the highest good faith towards the beneficiaries and use ordinary care and
diligence whether he is paid for his services or not. The trustee may not deal
with the trust property for his own profit, or for any purpose not connected
with the trust. The trustee may not obtain any advantage over a beneficiary or
take part in any transaction with a beneficiary unless the beneficiary, with full
knowledge of the transaction and having the legal capacity to enter into the
transaction, specifically consents to this and permits the trustee to do so.
Similarly, the trustee may not commingle his own property with the trust
property; thus, separate accounts and accurate record keeping are an absolute
necessity. A trustee always has the duty of care.
Trustee Liabilities. In many ways, the trustee is an insurer. If the trustee is
negligent, he may be surcharged (i.e., fined) for his negligence. Thus, penalties
and interest for failure to file tax returns will normally be borne personally
by the trustee. Moreover, the tax laws make a trustee personally liable for
unpaid death taxes to the extent of the assets held by him. Thus, most trusts
allow the trustee to withhold distribution of trust property until all death
taxes are determined and paid so that the trustee will not be later required to
pay the taxes from his own personal funds. Failure to invest the trust property
will subject the trustee to liability for simple interest on the uninvested
funds. If a court were to find that the trustee willfully failed to invest the
trust property, he would be liable for compound interest and perhaps additional
surcharge.
Fees. trustees are
entitled to reasonable compensation for the services performed to the trust.
Often the trust document will specify an amount or a limitation. If it does
not, a trustee is entitled to compensation in the same manner as would anyone
else performing similar management or investment services. This usually depends
upon the time involved, the responsibilities undertaken, the results achieved,
and the magnitude of the problems encountered.
Management
of Trust after Death of Both Settlors
The discussion of the
activities, duties and liabilities set forth in Section IV above also applies
to the management and distribution of assets after the death of both settlors.
Often the terms of the trust will then require specific allocation of certain
assets to specified beneficiaries or trusts, as, for example, all of the stock
in a family business to those children involved in the business; or will charge
a beneficiary's share with loans previously made to him or with prior gifts,
etc. Obviously, the terms of the trust must be examined carefully to see that
all of the settlors' directions are carried out.
If there are
continuing trusts for children or grandchildren, these trusts may be separate
trusts (i.e., separate tax entities each requiring its own tax return) or
separate shares (i.e., one trust with varying interests requiring only one tax
return). Normally, the trust document will specify that separate trusts are to
be used as they are usually most advantageous from an income tax standpoint.
If at any time trust
income has been accumulated (i.e., not distributed but rather added to
principal), the federal and Arizona income tax laws only require special
computations resulting in additional taxes or refunds when the accumulated
income is distributed. These "throwback" rules are quite complex and accountants
or attorneys should be consulted if there are any questions regarding them. The
need to be familiar with and understand the terms of each trust cannot be
overemphasized.
SUMMARY
AND CONCLUSION
The revocable living
trust is a flexible and useful device for managing property and, in many
instances, saving death and income taxes. However, like a partnership or
corporation, it must have adequate management and record-keeping procedures.
Once these procedures
are properly established their continued maintenance is relatively easy. Most
trusts can be managed by individual trustees, after they are successfully under
way, with minimal assistance from accountants and attorneys, thus achieving
numerous benefits for the settlors, their children, and other beneficiaries, at
minimal cost.
Nevertheless, being a
trustee is a substantial responsibility and a trustee should not hesitate to
seek professional investment, accounting or legal assistance whenever questions
arise. An ounce of prevention is worth a pound of cure.
