Trustees are obligated to meet their duties, described in Part 2 of this series. To do so, the trustee must complete a number of tasks throughout his or her service as trustee.
Throughout, the trustee must consider whether he or she has the power to take a particular action. Well-drafted trusts include a lengthy section spelling out exactly what the trustee may do in administering the trust. Generally speaking, if an action benefits the beneficiaries, the trustee may do that act if authorized in one of three ways. First, the trust document might specifically authorize the action. Second, state law might authorize the action even if the trust document is vague. And, third, a court can authorize the action.
Task 1: Investment of Assets
One of the trustee’s primary jobs is to invest trust assets. Idaho has adopted the Uniform Prudent Investor Act. Under that Act, the trustee must follow the purposes of the particular trust in determining asset allocation strategy. The trustee must consider the expected duration of the trust, the needs of trust beneficiaries, and tax consequences. Investments must be well diversified, but any lawful investment vehicle is acceptable if consistent with the overall investment strategy.
Often, the trust will require the trustee to distribute all income to the current beneficiary and, when that person dies, distribute the principal to other beneficiaries. This creates a conflict for the trustee: invest for income generation for the current beneficiary or principal growth for the future beneficiary. If the trust provides guidance, the trustee should of course follow the guidance. Otherwise, the trustee will need to carefully consider the competing interests in making investment decisions.
As a practical matter, when a trustee first steps into the role, she must review the trust’s assets and decide whether the current investment strategy is appropriate. If not, she may have to take steps to make the strategy appropriate. This may require liquidation of certain assets (like real estate) to permit investment in more suitable assets.
Task 2: Distribution of Assets
The task of distributing assets is, of course, a fundamental job of a trustee – he is the gate-keeper for the trust’s assets. Trusts often require a trustee to distribute “all income” to a beneficiary. Although that instruction seems clear, it depends on the trustee selecting appropriate investments and account correctly for principal and income. Or, the trust may require the trustee to distribute a percentage of the value of the trust on particular dates. Naturally, if the trust requires a distribution, the trustee must make that distribution.
Many trusts also give the trustee discretion as to the timing and amount of certain distributions. These discretionary distribution provisions vary widely from trust to trust. Some trusts may give no guidance to the trustee on how to exercise the power. Other trusts may use a phrase called “ascertainable standards” or may say distributions may be made for healthcare, education, maintenance, and support (sometimes called HEMS). Still other trusts may spell out a number of factors for a trustee to consider in making a distribution. Regardless of the trust language, the trustee will often need to maintain a relationship with the beneficiary to fully understand whether a particular distribution is appropriate. The trustee may need to understand and consider a beneficiary’s entire financial picture in making these distributions.
Typically, a trustee has the power to choose which assets to distribute and in what form. Often, trust distributions will be in cash. However, a trustee could elect to distribute securities, real estate, or any other asset directly to a beneficiary, rather than liquidating the asset. Indeed, distributing an asset (rather than liquidating it) may be the best approach for the beneficiary, as it may result in tax savings.
Task 3: Record-keeping
The trustee must be careful to keep clear, thorough records of trust activity. Those records will form the basis for every decision the trustee makes. Without them, the trustee could get fired or even be held personally responsible for alleged losses related to the trust. Some amateur trustees skip this task, to the detriment of themselves and their beneficiaries. Establishing an effective record-keeping and accounting system is vital to the success of any trustee.
Typically, a trustee will keep records such as bank and brokerage statements, real estate documents, and copies of old tax returns. In doing so, the trustee should remember that a beneficiary can, at any time, request access to those records. If they are incomplete or in disarray, the beneficiary may come to distrust the effectiveness of the trustee and seek her removal.
In addition to the standard financial records, the trustee should document every investment decision and distribution, including the rationale for each. Having adequate notes to detail the trustee’s decision-making process is vital to keep from losing a lawsuit.
As an example, imagine the trustee gets a letter from the beneficiary requesting payment for extensive cosmetic surgery. Upon reading the trust, the trustee decides that elective cosmetic procedures are not “healthcare” and thus are not covered by the trust. The trustee should respond in writing that the request is denied and the rationale for the denial. The trustee should then keep both letters as a record of the decision process.
Task 4: Accounting
The trust document and state law require the trustee to provide routine accounting to the beneficiaries – typically on an annual basis. The accounting should show the initial value of assets, income and principal transactions through the year, and final value of assets. In order to do so, the trustee will have had to keep accurate records throughout the year. Often, it benefits the trustee to provide such an accounting. If the beneficiaries do not object, the trustee’s liability may be limited. Plus, in the event the trustee gets sued, having accurate, consistent accounting records will vastly improve the trustee’s chances of success.
Task 5: Taxes
Most trusts are separate taxpayers under U.S. law. Thus, many trusts must file tax returns, and make estimated tax payments over the course of the year.
To start, a new trustee must learn about taxation of trust income. One significant consideration is that trust income gets taxed at higher percentage rates than personal income. Thus, it benefits the beneficiaries if the trustee can make sure that any income gets taxed to the beneficiaries, rather than taxed to the trust. This requires the trustee to distribute such income to the beneficiaries when appropriate, within the taxable year of the trust.
Trustees should know that certain trusts are “grantor trusts,” which do not need to file tax returns at all. Grantor trusts are not separate tax payers and any income is taxed to the grantor personally.
One additional tax consideration: When someone dies, certain assets will receive an adjustment in tax basis for calculating future capital gains taxes. Thus, trustees must consider this consequence when thinking about distributing assets. Trustees must also assure that they have appraised trust assets near the time of death. Otherwise, the trustee won’t have evidence of the new tax basis for use by the trust or beneficiaries.
Stay tuned for Part 4, in which we will discuss trustee compensation!
