Journal of Financial Planning: April 2012
Jon J. Gallo, J.D., chairs the Family Wealth Practice Group of Greenberg Glusker Fields Claman & Machtinger LLP in Los Angeles, California. Together with his wife, Eileen Gallo, Ph.D., he is a founder of the Gallo Institute and the author of two books on children and money. Their website is www.galloconsulting.com.
If you Google the term “trust and estate litigation,” not only will you find more than 1.2 million hits but many of them are coupled with phrases such as “fast-growing field,” “ever-growing opportunities,” and “hot field.” Beneficiaries’ failure to understand the terms of the trust has been cited by many commentators as a major cause of such litigation. In Family Wealth: Keeping It in the Family, Jay Hughes argues that most failed trustee/beneficiary relationships are attributable to the beneficiary’s lack of education on her or his role and responsibility as a beneficiary. He suggests that the starting question for any unhappy beneficiary is, “Are you an excellent beneficiary?” Hughes uses that question as the springboard to educate the beneficiary and defuse many situations that would otherwise wind up in the court system.
In my experience, the nonprofessional trustee’s lack of education on his or her role and responsibility is equally to blame for failed trustee/beneficiary relationships. It is the rare nonprofessional trustee who has read and actually understands the distributive and administrative provisions of the trust, let alone the relevant common law and statutory provisions of the state law that applies to the administration of the trust.
At the risk of being accused of taking food out of the mouths of my colleagues specializing in trust litigation, those of us who advise trustees could substantially reduce the rate of growth of trust litigation if we assisted our clients to become “excellent trustees.” This is essentially an educational process involving three areas:
- Understanding common law and statutory requirements applicable generally to trustees, such as the prohibition against self-dealing, the requirement that the trustee possess a minimum level of investment skills (often referred to as the “prudent person” standard), and the requirement that the trustee take into consideration the rights of income and remainder beneficiaries when making investment and distribution decisions.
- Understanding specific provisions of state law and the trust instrument relating to the rights of beneficiaries, the standards the trustee is to employ in making distributions, the rights of beneficiaries to receive reports and accountings of the trustee’s administration of the trust, and such highly technical but vital topics as the proper categorization of receipts and disbursements under the income and principal law applicable to the trust
- Helping the trustee educate the beneficiaries in many of these same issues
What follows is a suggested outline of topics that would provide trustees with a basic introduction to the principles that apply to their administration of the trust.
Basic Principles of Trust Law
Several common-law and statutory provisions are generally applicable to all trustees. For example, a trustee must avoid self-dealing. Self-dealing occurs whenever the trustee uses trust property for his own benefit, even if the trust receives adequate compensation. For example, in the absence of an express authorization in the trust instrument, a trustee who borrows money from the trust is engaged in self-dealing even though the trustee pays adequate interest and the loan is fully secured. As a general rule, the trustee is individually liable for any loss suffered by the trust by reason of self-dealing, and any profit the trustee makes individually belongs to the trust!
Similarly, a trustee is required to bring to the office the level of knowledge and skill a “prudent person” would bring to the investment of another’s money. If the individual trustee lacks that level of knowledge, he or she must retain an investment adviser and must exercise the knowledge and skill of a prudent person in selecting and supervising the adviser. Simply hiring an adviser and turning everything over with no further participation or interest is not prudent; it is a breach of fiduciary duty. Working effectively with advisers demands a set of abilities in and of themselves. Component activities include attendance at scheduled meetings, timely responses to requests for signature or answers to accounting questions, collaboration in developing necessary documents such as investment policy statements, and participation at personal or family meetings in which legal or financial information is discussed.
Equally important, the trustee must understand the need to invest in a manner that balances the rights of the income and remainder beneficiaries. Income beneficiaries typically want trust assets invested to produce more income. Remainder beneficiaries typically want trust assets invested to grow in value to equal or exceed inflation. Unfortunately, these goals are often mutually incompatible. A trustee who invests to maximize current income by investing in bonds held to maturity does so at the expense of the remainder beneficiaries. Stock investments designed as a hedge against inflation decrease income available for distribution to income beneficiaries. This problem becomes excruciatingly difficult when the corpus of the trust consists largely of an interest in a family business in which large dividends are likely to harm the business and some but not all income beneficiaries are receiving salaries or other compensation from the business.
Specific Provisions of the Trust and State Law
Once the trustee has been educated in the principles and challenges posed by general concepts of trust law, attention must be turned to the specific provisions of the trust. Among the most important and difficult challenges facing the trustee is to know what factors to take into account in exercising discretion over distributions. The trustee must understand the standards, if any, provided by the trust agreement. For example, trusts frequently employ what is known as a HEMS (health, education, maintenance, and support) standard. Treasury regulations refer to the HEMS standard as an “ascertainable standard” and generally provide that a trustee granted a HEMS standard will not be deemed to possess a taxable power over the trust that might cause adverse gift- or estate-tax consequences. Use of the term “ascertainable standard” suggests that the trustee should have little difficulty making decisions when asked for a distribution by a beneficiary. After all, the IRS says the standard is “ascertainable.” Unfortunately, the term “ascertainable” simply means that a court of equity has the power to resolve a case involving a challenge of the trustee’s determination of whether and how much to distribute.
Does the term “education” authorize the trustee to pay $500 for archery practice after school or $50,000 for postdoctoral training in France? If you are involved before the trust is signed, suggest that the trust creator and his or her attorney include in the trust an explanatory statement of the trust creator’s intent in various areas, such as the meaning of such terms as health, education, maintenance, and support. In the above example, the trustee would have received at least a modicum of guidance had the drafting attorney and the trust creator defined education as either including or excluding postgraduate study.
The trustee must similarly understand limitations and restrictions imposed by state law that are not set forth in the trust instrument. State law might impose obligations on the trustee that are not explicit in the trust. For example, in California, a trustee granted “absolute, sole, or uncontrolled” discretion is required to act in accordance with fiduciary principles and in good faith, which essentially means the trustee must understand the general concepts of trust law discussed above. Similarly, California does not permit a trustee to increase his or her fees for routine services without first providing beneficiaries 60 days’ written notice. And let us not forget the often hyper-technical state rules relating to the categorization of receipts and disbursements as income or principal. For example, if the trustee sells a non-income-producing principal asset such as raw land, state law might provide that a portion of the proceeds, which would normally be principal, may or must be allocated to income and distributed to the income beneficiaries.
Educating the Beneficiaries
Excellent trustees educate excellent beneficiaries. Although it is important for the trustee to understand the topics described in the first two sections, it does little to avoid trustee/beneficiary misunderstandings if the beneficiaries do not share in this education. I prefer to have at least one meeting with both the trustee and the adult beneficiaries in which we jointly discuss the provisions of the trust and the fiduciary principles that apply to trust administration. In my experience, the likelihood of trust litigation decreases when the beneficiaries and trustees understand their respective rights and responsibilities.