Trust Administration Introduction Memo to Trustees
SAMPLE MEMORANDUM REGARDING TRUST ADMINISTRATION— NOT FOR COMMERCIAL USE
The average person has little experience dealing with trusts and often has many questions upon becoming a trustee for the first time. The purpose of this memo is to give a general overview about trusts and your duties and responsibilities as trustee.
Through our experience in helping people administer trusts, we have found that some have unreasonable expectations concerning the way living trusts operate following the settlor’s (person who created the trust) death. Although it is true that a living trust may reduce some costs and delays involved in transferring assets upon death by avoiding probate, many administrative chores have to be completed. Legal documents must be prepared, tax returns filed, as well as other matters that take time and money.
TRUSTS IN GENERAL
A. What is a Trust?
A trust is a legal relationship, usually evidenced by a written document called a “Declaration of Trust” or “Trust Agreement,” whereby one person, called the “Settlor,” transfers property to another person, called the “Trustee,” who holds the property for the benefit of another person, called the “Beneficiary.” The same person may occupy more than one position at a time. For example, in the typical living trust, as long as the Settlor is alive, he or she is also the Trustee and Beneficiary. On the death of the Settlor, a “Successor Trustee” (e.g., child, friend, bank) takes over as Trustee and follows the Settlor’s instructions, which are set forth in the Trust, concerning the distribution of property and the payment of taxes and expenses.
B. Living Trusts and Probate Avoidance
Although living trusts have been around for centuries, only recently have they achieved a high degree of popularity among the general public. The reason for this surge in popularity is that living trusts help to avoid probate. You might be wondering, “What is probate, and why is everyone trying so hard to avoid it?” The short answer is that probate is a court-supervised procedure for collecting a deceased person’s assets, paying debts and taxes, and distributing the property to the person’s beneficiaries (either according to the instructions the person set forth in his or her will or as determined by state law if the person died without a will). The probate process usually takes 6 to 12 months to complete, although it may take longer in complicated cases.
Probate is not a tax. When people refer to the high costs of probate, they are usually referring to the fees paid to attorneys and the personal representative. In California, these fees are calculated as a percentage of the gross (not net) value of the assets in the estate. These rates are set out in Probate Code §§10800 and 10810 (4 percent on the first $100,000, 3 percent on the next $100,000, 2 percent on the next $800,000, and so on).<
For example, let’s say that D, who is not married, dies owning one asset, a house worth $200,000 with a mortgage of $120,000. D has a will that leaves the house to D’s two children, A and B. A is named as executor. The probate fees for this case would be as follows: $7,000 to A’s attorney (plus any “extraordinary fees,” which are billed hourly but subject to court approval) and $7,000 to A (if A decides to take a fee), for a minimum total fee of $14,000. These fees are calculated without regard to the $120,000 mortgage, because the fees are charged on the gross (not net) value of the estate.
One of the reasons living trusts have become so popular in the last 20 years is that real estate prices in California have skyrocketed, leading to much larger estates and, hence, higher probate fees. In states where real estate prices are lower or where attorney fees for probate work are based on an hourly fee schedule rather than a percentage scale, living trusts are less popular than in California.
Living trusts avoid probate with respect to those assets that are transferred into the living trust before death. In other words, living trusts avoid the court procedure otherwise required to transfer assets to a person’s beneficiaries at death. However, as we explain below, even though the probate court doesn’t get involved, there is still work to do.
The living trust makes administration easier, but it does not do away with administration altogether. For example, assets still have to be collected and managed pending distribution to the beneficiaries, appraisals of assets have to be made, sub-trusts have to be funded correctly, debts and taxes have to be paid, tax returns may be required (living trusts do not avoid estate taxes, as some people have been led to believe), and legal documents must be prepared in connection with the distribution of the trust property to the beneficiaries. These activities are very similar to a probate. The major difference is that, with a living trust, everything is handled privately, without court supervision, which makes for (in most cases) a faster, less expensive administration process.
Although it may come as a surprise to you, you should realize that the post-death administration of a living trust will take time and cost money, such as legal fees, accounting fees, asset transfer fees, and your own trustee fees if you decide to accept any. The other beneficiaries of the trust, if any, will also need to understand that the process may take longer than they anticipated. However, in comparison to probate, these delays and costs are substantially reduced, often resulting in time savings of months and costs savings of up to 50 percent.
C. Court Involvement
There is also a popular misconception that the existence of a living trust avoids all possibility of court involvement. This is true (in part) only if all of the Settlor’s assets were properly funded into the living trust and there are no problems along the way. For example, if assets held outside the trust exceed $100,000 in gross value, a probate will be required for those assets in order for you, as Trustee, to collect and add them to the trust.
Furthermore, if at any time a beneficiary of the Trust believes that the Trustee has acted improperly or without regard for the beneficiary’s interests, the beneficiary may file a petition with the court to force the trustee to make a full report and accounting or to redress an alleged breach of trust, including removal of the trustee or surcharge against the Trustee.
Finally, circumstances may arise in which there are questions about whether the trustee should or should not take certain actions (e.g., selling a business interest or real property, commencing litigation). In such cases, it may be advisable for the trustee to petition the court for instructions whether to proceed in a certain way. The beneficiaries will be given notice of the hearing and will be given a copy of the petition that describes the proposed action. The matter will then be addressed in open court, and the beneficiaries will have an opportunity to appear and be heard in court. By obtaining an order from the court in this manner, the trustee may be able to cut off the beneficiary’s right to complain about the particular action if he or she fails to appear in court. Such a petition protects the trustee if there is a fear that the trustee’s decision will be second-guessed by a beneficiary. Also, if relations between the trustee and the beneficiaries are hostile, it may be advisable for the trustee to seek court approval of the trustee’s accountings to minimize potential arguments with the beneficiaries.
ADMINISTRATION OF THE FAMILY TRUST
After the Settlor’s death, the Trust continues as a management and distribution vehicle that will exist only as long as is necessary to identify and collect trust assets, pay debts and taxes, and distribute the trust assets to the beneficiaries (or in further trust, depending on the terms of the Trust). You might visualize this trust as a funnel through which all of the trust assets will pass to the beneficiaries (with the exceptions of tangible personal property, life insurance proceeds, and other nontrust assets that may pass directly to the beneficiaries outside the Trust). As successor Trustee, it is your job to collect and manage the trust’s assets, appraise trust property, pay all taxes and expenses relating to the administration of the Trust, and distribute the trust property according to the Settlor’s instructions.
In addition to the Trust, the Settlor signed what we call a “pourover” will. The purpose of the pourover will is to provide for the distribution of assets that were omitted from the Trust, either intentionally or inadvertently. One of your first tasks will be to determine what assets, if any, were omitted from the Trust. If any such assets exceed $100,000 in gross value, a probate may be required to transfer these assets to the Trust. If these assets do not exceed $100,000 in value, you can collect such assets under a declaration procedure authorized by the Probate Code. At least 40 days must elapse after the date of death before you can use this declaration procedure. Whether or not a probate is required, the original will must be deposited for safe keeping with the County Clerk within 30 days of the date of death.
DISTRIBUTIONS OF PROPERTY
A. Tangible Personal Property
Provided the beneficiaries are in agreement, the distribution of tangible personal property may be handled informally and we need not get involved. If any disagreement develops, however, the division of personal property should be handled in a more formal manner. We recommend that you carefully document and inventory the items of property available for distribution and the disposition of each. One way to document the property on hand is to videotape or photograph the household property before distribution.
Before allowing the distribution of any items of personal property, however, please note that you are responsible for reporting such items on a federal estate tax return, if required (see below). Furthermore, if any items of property (or group of items that constitutes a single collection) have a fair market value of $3,000 or more, these items must be separately appraised for federal estate tax purposes. You should therefore keep careful records of what assets are distributed and to whom, and you should obtain any required appraisals before distributing particularly valuable items.
B. Other Distributions From the Trust
One of the first questions the Trustee and other beneficiaries usually ask us is, “When will the trust property be distributed?” Many people, having heard that living trusts avoid probate, assume that all estate administration procedures are avoided and that the property in the living trust somehow passes to them automatically. Having read this far, you now understand that this simply is not true. As a result of this misunderstanding, many beneficiaries are disappointed to learn that the trust administration process is often measured in weeks or months (and in some cases longer), rather than in hours or days.
In answer to the question of when distribution will take place, we anticipate that distribution will take place in several stages. Depending on how quickly assets and liability information can be assembled, you may be able to make preliminary distributions of a portion of the trust estate within a few weeks. After we have obtained all appraisals and can project the expected tax liabilities and expenses with more accuracy, you may distribute more of the trust estate, making certain to reserve sufficient funds for payment of estate taxes, income taxes, administrative expenses, attorney and trustee fees, debts and liabilities, etc. However, if any litigation arises concerning the Trust (e.g., a “contest” of the Trust), you may have to withhold distribution until such problems have been completely resolved. (Our office has had cases in which a living trust that provided for distribution “at death” was not actually distributed until more than a year after death because of disagreements among the beneficiaries and the ensuing court procedures.)
As noted above, living trusts do not avoid estate taxes. If it is determined that estate taxes or fiduciary income taxes are due in this case, we will recommend that you retain an additional reserve in the trust after payment of such taxes until all audits are completed or until the period for assessment of a tax deficiency passes (3 years). This reserve is for your own protection. Any legal fees, accounting fees, and your own trustee fees incurred in connection with the audit process, and any tax deficiencies that might be assessed by the IRS, are chargeable to the trust. If you have already distributed all of the trust assets, you, as trustee, may have to bear these expenses and taxes yourself if the beneficiaries are unwilling or unable to contribute their fair share. If this situation applies in your case, we will assist you in determining an appropriate amount to hold as a reserve.
TRUSTEE DUTIES, POWERS, AND COMPENSATION
A. Standard of Trust Management
As Trustee, you will act in a fiduciary capacity. As such, you owe certain legal duties to the beneficiaries, as explained in more detail below. In managing the trust property, you must use at least ordinary business ability. However, if you have special skills, under California law you will be held to a higher standard of care. In any event, your management will be judged in light of the circumstances existing at the time transactions occur, rather than with the benefit of hindsight. If you exceed your trustee powers, you may be held liable for loss or damage to the trust estate.
B. Source of Trustee Powers
It is important that you understand the rules under which you must operate. These rules are derived from three sources: (1) the Trust itself, (2) statutory law (the “Trust Law” found in the California Probate Code), and (3) decisional law created by the courts.
The principal source of your Trustee powers is the Trust itself. You should therefore read the Trust carefully. In doing so, you will see that the Trust contains two types of provisions: (1) “dispositive provisions” that govern the distribution of property and (2) “administrative provisions” that govern the powers of the Trustee, payment of taxes and expenses, rules for interpreting the trust instrument, and other procedural issues. The bulk of the Trust is made up of these administrative provisions.
In creating a trust, the Settlor may include any lawful provisions that he or she wishes to govern the trust relationship. Because tax considerations are often important in creating a trust, the Trustee’s rights and duties are often limited by the tax results desired by the Settlor. The provisions of a trust may override general provisions of the Trust Law, except when the law expresses a paramount public policy. Whenever the trust instrument does not provide for a given situation, the Trust Law applies.
C. General Duties of Trustee
Your basic duties involve the collection, management, and investment of trust assets, the accumulation and distribution of income and principal under the Trust, and evaluating options regarding tax matters–which are explained in detail elsewhere in this memo.
It is a fundamental principle of trust law that you must be faithful to the interests of the Trust and its beneficiaries. You occupy a position of trust and confidence and owe a duty of care to the beneficiaries. You have a duty to administer the Trust solely in the interest of the beneficiaries and to deal impartially with them. You cannot use trust property for your own profit or for any nontrust purpose. You must not engage in any transaction that will result in a conflict of interest between you and the Trust or a beneficiary.
You have a duty to take reasonable steps to take and keep control of trust property and to preserve the trust property and make it productive. You must not commingle trust property with your own property under any circumstances. You also have a duty to take reasonable steps to enforce claims of the Trust and to defend lawsuits brought against the Trust.
You must carry out all Trustee activities personally. In other words, you may not delegate your responsibilities to others. However, you may hire attorneys, accountants, investment advisors, and others to consult with you concerning your administration of the Trust. Nevertheless, you will ultimately be held responsible for your acts or omissions.
D. Uniform Principal and Income Act
The Uniform Principal and Income Act (Probate Code sections 16320-16375) went into effect January 1, 2000, and significantly changed the way in which a trustee should think about principal and income.
In the past, “income” beneficiaries and “principal” beneficiaries were treated differently. The right to income has most often been thought to include the right to payment of dividends, rents, royalties, and similar items received as a current return on an investment. The notion of “current return on an investment” often coincides with that of “ordinary income” for income tax purposes. Capital appreciation was thought to accrue for the benefit of the principal beneficiaries, who most often were entitled to distributions following the termination of the income beneficiaries’ interests. (Many trusts provide for invasion of principal for various purposes prior to the termination of the income beneficiaries’ interests.) Those who are entitled to receive the trust assets at the termination of the trust are often referred to as “remainder beneficiaries,” the ultimate class of principal beneficiaries.
As a result of these traditional notions of “principal” and “income,” an inherent conflict was created that affected the way in which trust assets could be invested. Income beneficiaries would clamor for investments in income-producing assets (high-yield bonds, for example) while the principal beneficiaries demanded that the trustee take positions that produce capital appreciation. The trustee was required to do both or face the consternation of one class of beneficiaries.
The Uniform Prudent Investor Act became law in 1996 (see discussion below in paragraph E), and the trustee was instructed to make investment decisions “not in isolation, but in the context of the trust portfolio as a whole and as a part of an overall investment strategy having risk and return objectives reasonably suited to the trust.” (Probate Code section 16047(b).) The trustee was given a duty to diversify the investments of the trust. (Probate Code section 16048.)
Since you will be acting as the trustee of ongoing trusts after the termination of the administration period, it will be necessary to track principal and income. Therefore, every time your CPA prepares the fiduciary tax return, he should also give you a breakdown of trust income and principal for trust accounting purposes.
E. Trust Investments
The Uniform Prudent Investor Act (the “Act”) (Probate Code sections 16002(a), 16003, 16045-16054) was added to the California Probate Code in 1996. Under the Act, a trustee, who invests and manages trust assets, must comply with the “prudent investor rule.” The Act sets forth a framework which describes the prudent investor rule with regard to standard of care, portfolio strategy, risk, diversification, delegation, costs, and compliance standards. The law is of considerable advantage to trustees because it provides common sense investment guidelines. Furthermore, it provides a favorable procedure for reviewing the trustee’s actions that examines the investments made by the trustee in the context of the entire trust portfolio instead of viewing each asset in isolation. The basic reasons for establishing the Act were:
(1) Portfolio rather than individual investments;
(2) Trade off in investing between risk and return;
(3) No categoric restrictions on types of investments;
(4) Requirement to diversify investments; and
(5) Delegation of investment and management functions by trustee permitted.
The Act sets forth a laundry list of circumstances that are appropriate for a trustee to consider with regard to investments decisions: (1) general economic conditions; (2) inflation and deflation; (3) tax consequences; (4) the role each investment or course of action plays within the overall trust portfolio; (5) the expected return from income and the appreciation of capital; (6) information provided to the trustee from the beneficiaries; (7) needs for liquidity, regular income and preservation of capital; and (8) an asset’s special relationship to the trust or to a beneficiary. (Probate Code section 16047(c).)
Under the Act, as trustee, you are now provided with statutory protection when treating one asset differently from the norm if that particular asset has a special relationship to the trust or a beneficiary. More significantly, your course of action is now evaluated in the context of the “trust portfolio as a whole and as part of an overall investment strategy having risk and return objectives reasonably suited to the trust.” (Probate Code section 16047(b).)
No longer are the trustee’s individual asset investment decisions viewed in isolation. For example, if a trustee’s investment of a specific asset were to generate a loss, this loss would be viewed in light of the entire trust portfolio. The trustee could have accepted the loss in order to offset other income of the trust or to allocate trust resources to less risky assets. The Act does not, however, shield you from liability in making unsound investments or failing to exercise your power of investment in the best interests
to the trust.
Under the Act, a trustee is charged with the duty to diversify the investments when making and implementing the investment decisions. (Probate Code section 16048.) In addition, the Act sanctions the trustee’s ability to delegate investment and management functions. (Probate Code section 16052.) However, the trustee is required to exercise prudence in the selection of an agent, to establish the terms/scope of the agent’s duties and to periodically review the agent’s overall performance and compliance with the terms of the delegation. This delegation does not permit you to avoid all responsibility. You must continue to take an active role in evaluating the agent. If you have any questions about the propriety of any investment, you should seek legal advice before making or continuing the investment.
F. Providing Information to Beneficiaries
Under the Trust Law, you owe a duty to the beneficiaries to make them aware of the existence of the Trust and to keep them reasonably informed of the Trust and its administration. We will discuss with you what specific actions you and we will take to fulfill this duty.
State law also requires that you provide the beneficiaries with certain information on reasonable request and that you give a full accounting and report of all trust transactions not less often than annually or at the termination of the Trust or on a change of trustee (see Probate Code section 16062), unless the Trust instrument or a beneficiary waives this requirement in writing. (While these provisions of law technically apply only to trusts created on or after July 1, 1987, it is good practice to follow these laws no matter when the trust was executed.) The subject Trust does not waive this requirement.
Even if a formal accounting was not required, we would strongly recommend that such accountings be prepared and presented to the beneficiaries. In any event, internal accountings will be needed to provide a permanent record of trust transactions, to distinguish between principal and income transactions, and to provide a single source of data for preparation of income tax returns. Because this information must be recorded and assembled anyway, it makes sense to give this information to the beneficiaries for a number of reasons. First, it will give the beneficiaries a better understanding and appreciation for the complexity of your job as Trustee and the amount of work involved. Second, it will help to avoid misunderstandings by disclosing all relevant transactions. Third, it will start the running of a 3-year statute of limitations for all matters you disclose in the accounting. If no accounting is made, there is no statute of limitations and your liability exposure continues indefinitely.
Please note that a trust accounting is a legal document that should be prepared by a lawyer to make certain that it meets the format required by the Trust Law. Only in this way can you be assured that the 3-year statute of limitations begins to run. CPAs are not always experienced in fiduciary accounting standards and you should not rely on financial statements prepared by an accountant to satisfy the fiduciary accounting requirements of the Probate Code.
Although making formal accountings will add to the expense of administration, bear in mind that the cost is payable from the Trust (not from your own pocket, except to the extent of your prorata share if you are also a beneficiary) and is tax deductible. Because the cost is payable from the Trust, it is spread among all the beneficiaries. In other words, all of the beneficiaries will share the cost of protecting you from subsequent liability. You should give serious consideration to taking advantage of this benefit even if the Trust does not require accountings or the beneficiaries are willing to waive this requirement. Although we recommend that formal trust accountings be prepared, if you would prefer to request that the beneficiaries waive the requirement of a formal trust accounting, please let us know and we will prepare the appropriate waiver forms.