Trusts enable individuals to ensure the financial health of loved ones long after they are gone, but only if they are properly set up and administered. Trustees bear a great personal responsibility in ensuring that the trust is handled properly. The authors detail the different types of trusts, their taxation, and the trustee’s responsibilities, providing both planning strategies and advice for administering trusts after they take effect.
CPAs will occasionally encounter a client who is called upon to be a trustee and or to advise someone in that position and responsibility. In a previous CPA Journal article, the authors described how to set up a trust before death and what needs to be done to administer the estate (“Preparing for a Spouse’s Death from a Financial Perspective,” October 2016, http://bit.ly/2X3jUMx). That article focused on the person or persons setting up the trust. This article will discuss the actual handling of a trust, including what happens after the estate transfers assets to the trust.
Estates and Trusts
Estates need to be administered and distributions made to the beneficiaries. This process could take a few months to a few years, depending upon the complexity of the assets, the decedent’s situation, and the ease with which the assets can be located. In addition, some trusts established in a will require ongoing asset management and distributions made separately from the estate. Trusts established in a will are called testamentary trusts; trusts established separately during life are called inter vivos trusts. Regardless of how they are established, they are administered in a similar manner.
With testamentary trusts, the executor will make a distribution of the assets necessary to fund the trust in accordance with the terms of the will. This can be done any time after death, but is generally done when all of the estate’s assets are distributed, which is usually after all the liabilities are paid. While a full discussion of the strategies of an executor and the selection of assets is beyond the scope of this article, it should be noted that when someone dies without a will, there can be no provisions for trusts (although a trust can be created by a court).
Definition and Types of Trusts
A trust is an entity established by a person, called a grantor, for the benefit of others, called beneficiaries, that is controlled or operated by a third person or entity, called a trustee. The beneficiaries can consist of one group that receives the current income (a fixed dollar amount or percentage of assets) and another group who will receive the trust principal or corpus at a later time. The principal beneficiaries can be the same people as the income beneficiaries; either type of beneficiary can also be people not yet living, such as children born after the trust is established. There is wide flexibility and great leeway in setting up the beneficiaries and the distribution terms, but once established, they cannot easily be changed, if at all.
There is wide flexibility and great leeway in setting up the beneficiaries and the distribution terms, but once established, they cannot easily be changed.
Trusts where absolute title to assets transferred to the trust passes to the trust with an independent trustee are called irrevocable trusts, meaning that the grantor cannot generally change the terms. Lifetime (inter vivos) transfers made to an irrevocable trust are subject to gift tax. All trusts established under a will are irrevocable because, obviously, the grantor/decedent cannot make any changes. Trusts where the grantor can make changes whenever they want, for whatever purpose, are called revocable trusts or living trusts.
A grantor trust is a type of irrevocable trust where the grantor is not the trustee but has certain rights as defined in Internal Revenue Code (IRC) sections 671–679. Because of these rights, the trust’s income is reported on the grantor’s individual income tax return, and the grantor pays the income tax instead of the trust or the income beneficiaries, regardless of whether he receives any income or distributions from the trust. Inter vivos transfers to grantor trusts are subject to gift taxes, as with nongrantor trusts. During the grantor’s lifetime, separate taxpayer identification numbers (TIN) are not required for a grantor trust; the grantor’s Social Security number is used. Some banks, brokers, and insurance companies might require separate TINs, causing fiduciary tax returns to be filed, but the income tax is still paid by the grantor.
In a living trust, the grantor is usually also the trustee; even when not the trustee, the grantor has the power to make any desired changes for any purpose at any time (i.e., the trust is revocable). These trusts are not recognized for income or estate tax purposes; transfers to a living trust are not subject to gift taxes and do not create a taxable situation. Living trusts become irrevocable upon death of the grantor/trustee; if the grantor is the trustee, the alternate trustee becomes the trustee and assumes complete control of the trust. Living trusts, like grantor trusts, do not need to file tax returns or use separate taxpayer identification numbers; they use the grantor’s Social Security number, and the transactions are reported on the grantor’s individual income tax return. All transactions in a living trust are disregarded for any tax purposes, income or estate. Upon the grantor’s death, a TIN needs to be obtained. Finally, living trusts are legal entities and as such may provide certain protections to the beneficiaries. The implications of this should be discussed with a knowledgeable attorney.
Trustees must be chosen to administer a trust. In a testamentary trust, a person other than the executor is occasionally chosen, conferring different rights and obligations to the executor and to the trustee. In some respects, the choice of trustee is a more important decision than choosing an executor, because once the estate is settled, the executor’s job is completed. A trustee, however, will remain until all the assets are ultimately distributed. Note that trustees do not assume their duties until the assets are distributed to the trust.
Testators or grantors should select trustees whom they believe will exercise strong, fair, compassionate, and independent judgment. Suggestions include a bank, attorney, accountant, spouse, child, close friend, cousin, nephew, or other trusted relative. Whoever is chosen must be fiscally astute, and the primary beneficiaries should have comfort in the selection. Furthermore, multiple trustees can be designated to provide for divergent interests to be represented. If an even number of trustees is selected, there should be a built-in mechanism for tie breaking. Occasionally some trustees are given extra votes to provide a limited mechanism for control.
Trustees (and executors) are entitled to statutory fees, even if no such fee is stipulated in the trust documents. If there is a desire not to pay fees, this should be specifically stated. Similarly, trustees (and executors) may or may not have to obtain a fidelity bond, depending on the will or trust; thus, any desire to forego obtaining fidelity bonds must likewise be stated in the document establishing the trust. Such bonds are obtained from insurance or bonding companies and ensure the truthfulness and performance of the executor and trustee.
Irrevocable trusts that are not grantor trusts or living trusts are taxed on undistributed income at the trust tax rate schedule. Such trusts that distribute income to beneficiaries receive a deduction for the distributions, and the beneficiaries pay the tax on their individual income tax returns. The trust files IRS Form 1041, U.S. Income Tax Return for Estates and Trusts; beneficiaries are provided with a Form K-1 to report the income distributed to them. (Note that trust tax rates and income ranges are more compressed than individual rates.)
Long-term capital gains are usually not considered income that can be distributed, so the trust is taxed on this income. The trustee can make certain elections (beyond the scope of this article) to have the beneficiaries pay the tax on that income. This should be discussed carefully before such elections are made.
A trust must use a calendar year for reporting, unless the trust is created under a will or is a living trust and an election is made using IRS Form 8855, Election to Treat a Qualified Revocable Trust as Part of an Estate. When a fiscal year is permitted, the trust can elect to use a fiscal year that ends in any month through the month before the anniversary of the month of death. For example, if a grantor dies in June, the trust can elect to use a fiscal year ending in any month up until the following May.
Filing requirements and exemptions also apply to trusts and estates. The instructions spell out the filing requirements, and trustees must be aware of this. For these purposes, two general categories of trusts apply: simple trusts and complex trusts. A simple trust is one that distributes all of its income currently; no charitable contributions are permitted, and amounts allocated to the corpus are not distributed. A complex trust is a trust that does not qualify as a simple trust. Estates, on the other hand, can make distributions as the executor determines for as long as the estate is kept open. Income retained in the trust or estate is taxed at the trust tax rates. Exemptions are as follows: decedents’ estates, $600; simple trusts, $300; and complex trusts, $100.
Trust returns using Form 1041 must be filed if there is any taxable income for the year, if there is gross income of $600 or more, or if a beneficiary is a nonresident alien.
A trustee’s responsibilities are spelled out in the document creating the trust, be it a will or a trust agreement. Any power not so given cannot be exercised, with certain narrow exceptions. A trustee has very broad powers not only to control the distributions in amount and timing, but also to invest the principal. A trustee can also have the power to invade principal to make a distribution to a particular beneficiary to the exclusion of other beneficiaries.
A trustee has very broad powers not only to control the distributions in amount and timing, but also to invest the principal.
Some trusts contain provisions where the trustee can make uneven distributions to people in the same class of beneficiaries; this is called a sprinkling power. For example, the income beneficiaries can be the grantor’s children and grandchildren. Some of the children or grandchildren may be very wealthy, while others may be less so. A trustee with a sprinkling power can arbitrarily make distributions to the poorer children while distributing nothing to the wealthier children. This can create conflict, especially since in many instances these are subjective decisions. A person nominated as a trustee should be aware of this, as well as the potential for conflict, before accepting the role and responsibilities of trustee.
It is also usual for a trust to permit an invasion of principal to benefit a beneficiary if there are “ascertainable standards of health, education, and/or support” of a beneficiary. When this occurs, the trustee should try to have the grantor prepare a letter or description of when this power may be exercised.
Other duties of a trustee are to pay the trust’s bills, maintain insurance for trust property, develop an investment strategy that balances cash flow with potential for asset growth with minimal or reasonable risk, oversee the investments, maintain detailed records, report promptly to beneficiaries, and make timely distributions to beneficiaries. A trustee can also make payments on behalf of a beneficiary rather than making such payments directly to the beneficiary (e.g., medical bills, tuition, mortgage payments). Separate trust accounts should be opened for operating expenses and distributions, and there must be no comingling of funds with the trustee’s personal funds.
Trusting Trustees and Executors
A potential trustee or executor should make sure she knows what she is getting into before accepting this responsibility. The authors have heard many stories of executors and trustees overstepping their bounds by self-dealing, paying themselves exorbitant fees, making terrible investment decisions, generally disregarding the responsibilities they have assumed, or engaging in illegal actions. Below are tips to ensure the reliability of trustees and executors and to protect the beneficiaries:
- Choose the trustee and executor with care. This is not a popularity contest; an important and serious responsibility is being conferred.
- Appoint more than one person, preferably people who are independent of each other and require joint decision making on most matters over a stated amount, such as $10,000, $50,000, or $100,000, depending upon the amount of funds involved.
- Consider appointing a bank or trust company, which may have more safeguards in place.
- Require a fidelity bond. This is an expense, but the insurance company will then ensure the proper performance of the executor or trustee. Part of their due diligence will be to assess the creditworthiness and background of the people selected.
- Ask for regular reports of financial activity and a listing of assets and liabilities at least quarterly. Note that fiduciaries have the responsibility to regularly account to the beneficiaries.
- When the reports are received, compare the changes in assets and liabilities with the last report. Make sure the beneficiaries understand what caused the changes and that the changes agree with the activity reports for the same period and the terms of the trust.
- If brokerage accounts are involved, ask either for copies to be sent directly from the broker or for online access to view the transactions. An independent recognized securities broker should be used to hold the funds rather than the trustee.
- Immediately question anything that is not understood; if the response is still not understood, assume that the transaction is improper and ask someone else to review and explain it.
- Engage a good accountant and attorney when setting up plans for and instructions about responsibilities of a trustee. Poorly drafted wills or trust instruments can cost families far more emotionally and financially in the long run than the upfront cost of engaging experienced professionals.
- Make the threat of discovery of any improper or illegal actions clear.
If a business needs to be valued for purposes of inclusion in the trust, the CPA’s firm might not be considered independent for a conclusion of value.
It is impossible to protect against every situation, but setting up a sound plan should deter most people from dishonest actions. Incompetent or inappropriate actions usually happen when the grantor picks the wrong person. Grantors should exercise thorough seriousness in decisions; the family’s well-being may depend on it.
Trustees’ Investment Responsibilities
Most trustees have inherent and serious conflicts or concerns on how to invest the trust’s assets. Besides individual investment decisions and deciding on a big-picture asset allocation plan, trustees need to balance the interests of the income and corpus beneficiaries.
Trustees must decide whether to invest the funds to maximize current income or to provide for either the safety or growth—or both—of the ultimate principal. In many cases this is a massive guessing game, with the conflicting parties wanting what appears best for them at the time. Furthermore, as with most investment decisions, success is a moving target.
How a trustee invests the funds is a very real issue that many times is not confronted until the trustee has made the investment decision and one of the beneficiaries criticizes the results. For this reason, it is suggested that an investment manager or financial professional be engaged to advise on alternative asset allocation plans and expected returns. In many cases it might be advisable for an investment policy statement to be prepared, possibly with the acquiescence of the various classes of beneficiaries (Sidney Kess and Edward Mendlowitz, “Helping Individuals Determine Their Investment Goals,” The CPA Journal, January 2016, http://bit.ly/2P1x4H7).
Investing the trust’s assets can be particularly troublesome when there is a second marriage; when some beneficiaries are well off and others not so comfortable financially; when there are large age gaps among beneficiaries; when some beneficiaries have many children and others none; when a beneficiary is not capable of handling his affairs or is overloaded with debt or a large amount of personal guarantees; when a beneficiary is a gambler, alcoholic, or drug addict; when a beneficiary is going through a divorce; when some beneficiaries are risk takers and others very risk adverse; when there is a period of great turbulence in the economy or financial markets; or when the trustee is completely trusted by the grantor but is totally inept with financial affairs. All of these issues and many more need to be considered when choosing trustees. This is why some choose a professional trustee to work alongside a trusted friend or relative.
A trust may provide for a degree of asset protection and a shield from future creditors. This is a very technical issue, and the trustee should have a serious consultation with an experienced attorney in these areas of law. Dynasty trusts can be set up to last past the lives of children and grandchildren, and even those yet to be born. Trustees need to be aware of these features and should take care to follow the rules that might come from having these trusts.
CPAs as Trustees
Often a client will ask his accountant to serve as a trustee. This kind of request indicates great trust in the accountant’s judgement; however, it carries with it serious responsibilities. Some of the following issues are specific to CPAs, but many also apply to anyone serving as a trustee.
First, consider liability risk and whether professional liability insurance covers this; there is always a risk of being sued, not necessarily because of any wrongdoing. A beneficiary may disagree with the actual distribution allotted in the trust document compared to what others received. Others may question whether the accountant is thoroughly familiar with the duties of a trustee or is prepared to deal with each set of beneficiaries as a group and individually to respond to their questions and concerns.
There might be ethical issues if a trust asset is a business with financial statements or tax returns prepared by the accountant/trustee or her firm, or independence issues if the CPA firm performs any attestation services for such a business. Questions may arise about the amount and frequency of compensation for serving as trustee, as well as whether there are multiple trustees and the payment will need to be shared. There is also the question of whether the CPA’s service as trustee includes the tax return preparation for the trust, or if a separate firm should be engaged.
If a business needs to be valued for purposes of inclusion in the trust, the CPA’s firm might not be considered independent for a conclusion of value. In addition, prior transactions of a business or of the trustee/executor might need to be reviewed for irregularities, or a claim of such by one of the beneficiaries could require an investigation. Friction with beneficiaries may arise when distributions are at the option of the trustee and are delayed or withheld, or made in an unequal manner based on requirements of need as stated in the trust document. Finally, prospective trustees should gauge their availability to meet with beneficiaries having financial difficulties.
The Right Person for the Job
Trusts are effective tools for transferring and managing wealth across generations and accomplishing family wealth management objectives. They are necessary under the right circumstances, but they are also fraught with dangers and complicated rules. Because of this, the choice of trustee, as well as the responsibilities such a trustee will have, represent very important decisions and should not be made lightly or without careful consideration.
Partial List of Trusts
Trusts that are never grantor trusts (Must file Form 1041)
- QTIP (qualified terminable interest property) trust
- Credit shelter trust or bypass trust
- Charitable remainder annuity trust (CRAT)
- Charitable remainder unitrust (CRUT)
- Charitable lead annuity trust
- Charitable lead unitrust
- Qualified Subchapter S Trust (QSST)
- Offshore trust
Trusts that can be or usually are grantor trusts (Need not file Form 1041)
- Irrevocable life insurance trust (ILIT)
- Split-dollar funding life insurance trust
- Cross-purchase life insurance trust
- Disability buyout insurance trust
- Generation skipping transfer trust
- Qualified personal residence trust
- Grantor retained annuity trust (GRAT)
- Grantor retained unitrust (GRUT)
- Intentionally defective irrevocable trust (IDIT)
- Dynasty trust
- Asset protection trust
- Delaware incomplete nongrantor trust (DING)
- Electing small business trust (ESBT)
- Spousal lifetime access trust (SLAT)
Trusts that are totally disregarded for tax purposes (Need not file Form 1041)
- Living or revocable trust
- Voting trust
- IRA trust
- Totten trust