Duties of a Trustee

Trustees if there are more than one. The duties are the responsibility of each Trustee individually and together as a group. In fact, if one Trustee appears to be harming the Trust in any way, the other Trustees are obligated to take all necessary steps to stop the harm and correct any damage.

Distribution of Funds

Probably the most important duty to the beneficiaries is the Trustee's obligations to distribute funds from the Trust. This is also the task that may cause the most disagreement and potential for challenge. The Trustee generally is given power to distribute income and principal, although the standard for each may be different. The Trust document sets out the Trustee's powers and instructions for distributions. A Letter of Wishes (not legally binding but helpful in determining the intent of the creator when making discretionary decisions) may provide additional guidance to the Trustee. Distributions may either be mandatory (e.g. "the Trustee shall pay…") or discretionary (e.g. "The Trustee may in their discretion pay principal to …"); and may be allowed to draw from income or principal or both.

Advisory Language

Unless the Trust instructs the Trustee to make mandatory distributions, the Trustee must look to, and be guided by the advisory language in the Articles of the Trust concerning distributions. A good attorney will draft a Trust with

discretionary language that achieves all the necessary tax planning goals of the Trust. (e.g. "The Trustee may distribute principal in the Trustee's discretion for the health, support, maintenance and education of the beneficiaries" is a common example.) However, often the advisory language, while sufficient from a legal and tax perspective, is unhelpful to the Trustee in determining the true intent of the Grantor of the Trust. Does education include basket weaving classes in Hawaii? Would support include an exotic sports car to commute to work? If you are lucky you will have the opportunity to speak with the Grantor to understand her true intent and make notes for the Trust records. If you cannot make notes, and the attorney has not drafted expanded advisory language into the Trust which includes broad guidance to the Trustee, then you will hopefully have a Letter of Wishes to guide you. Once used only in the off shore Trust world, Letter of Wishes is now more common in U.S. Trusts and simply is a side letter to the Trustee from the Grantor explaining their intent for use of the Trust and its funds. This is not binding on the Trustee but can certainly be considered in the use of discretion.

Mandatory distributions are common with Trust income. A Martial Trust for example must pay all the income annually to the surviving spouse to qualify for the marital deduction (deferral of estate tax until the death of the surviving spouse). Trusts also reach the maximum tax rate quickly (less than $15,000 of income) and so it is often tax advantageous to pay out the income to beneficiaries who will be in lower tax brackets than the Trust. While not all Trusts direct the payment of all net (after taxes and expenses) income, if they do the instruction to the Trustee is simply "The Trustee shall pay net income…." or "The beneficiary is entitled to receive…." Income is then generally paid out monthly or quarterly to the beneficiaries.

"Sprinkling" income and principal

If the Trust does not require mandatory payments of income, then the distribution of income (and usually principal as well) is left to the discretion of the Trustee to decide how much income is paid out, if any, and to which beneficiaries. The ability to pay funds among a class of beneficiaries is generally referred to as a "sprinkling" power, as if the Trustee was watering the beneficiary garden. The Trustee is also usually instructed to add any undistributed income to principal annually. Here the Trustee has all the usual obligations: to know the needs and circumstances of the beneficiaries; to ask for documentation to support a request for funds if required by the Trust; to decide how much to give (one time or ongoing); to justify any unequal distributions among the beneficiaries; and it is a best practice to document the decision. It is also a best practice to revisit the decision on at least an annual basis or as the circumstances of the beneficiaries change. It is also a best practice for the Trustee to perform a general annual review of the Trust and this would be an appropriate time to review the distribution plan as well. A Trustee should not forget to consider the tax implications of any distribution plan. What is the beneficiaries tax bracket? Will a distribution to a grandchild trigger Generation Skipping Tax. It would be worthwhile to have the attorney for the Trust or the Trust tax advisor review any distribution plan first. Their advice should of course become part of the Trust record.

Income typically consists of dividends from stocks and interest payments from bonds. If your portfolio has basic investments like stocks, bonds and mutual funds, income is fairly straight forward.

The Trustee's obligations to identify income and principal become more difficult with many of the complex investments used today. How do you generate income from structured products, private equity funds or options? If your Trust portfolio contains complex investments (e.g. structured notes, options, hedge funds, etc.) you may not be able to effectively administer the Trust with the basic definition of income and principal. You may need to use the Power to Adjust or a Unitrust approach if it is available to you. Unique assets (limited partnership interests, limited liability company shares, real estate, oil and gas, etc.) may also make it difficult to administer the Trust using a pure income distribution approach. In situations like these it may make sense to use the Power to Adjust or Unitrust approach.

The Power to Adjust

The Power to Adjust (PTA) is part of the Uniform Trust Code and has been adopted by many states as part of their Trust law. The PTA was created to give Trustees investment flexibility by allowing them to, as a discretionary action, adjust funds between income and principal as a way of being fair and equitable to both classes of beneficiaries, current and future. A Trustee typically will make a decision to adjust funds from principal to income or vise versa if one class of beneficiaries has received a windfall from some investment, or if the investment portfolio generates a lot of asset growth but insufficient income. The adjustment may take the form of (1) a one-time adjustment to equalize a windfall benefit or (2) an ongoing adjustment where a percentage of the portfolio is "deemed" to be income so the income beneficiary will receive an appropriate share of the investment portfolio's total return. For example, if the Trust holds some undeveloped land for many years which produces little or no income but appreciates substantially, when the land is finally sold the remainder beneficiaries will have received the benefit of a large increase in the principal funds. The income beneficiary however will have received less income over the

years than if the value of the land was invested in stocks and bonds. Here the Trustee may make a one-time discretionary adjustment using the PTA to pay a portion of the sales proceeds from the land to the income beneficiary as their share of the return on the investment. Another example of the use of the PTA would be where a Trustee determined an aggressive investment portfolio would be in the best interest of both classes of beneficiaries by maximizing the potential total return. However, an aggressive portfolio would not generate sufficient income to meet the needs of the current beneficiaries. Here the Trustee can exercise discretion under the PTA to pay the current beneficiary a percentage of the market value of the Trust as "deemed income", meaning a reasonable share of the total return of the Trust which is deemed to be an appropriate income amount. Note: as with any discretionary action by the Trustee, the decision should be documented with a rationale and any supporting information used in reaching the decision.

Unitrusts

The Unitrust approach is similar to the exercise of the PTA. While Unitrusts have been used for Charitable Remainder Trusts and Charitable Lead Trusts for some time, it is a relatively new approach for personal Trusts. Like the PTA the income beneficiary's interest is expressed in terms of a percentage of the overall portfolio, revalued annually, instead of the net income earned by the assets. While the creator of the Trust may establish the percentage in the Trust document, it is more common for the Trustee to elect to "opt in" to a unitrust approach using the power granted all Trustees under the state law. Many states have adopted a unitrust option either alone or together with a PTA option for the Trustee. If the unitrust approach seems to be the best solution for the goals of the Trust and in the best interests of current and future beneficiaries, then the Trustee must make a series of discretionary decisions. First, the unitrust approach generally implies investing the portfolio for total return, so the investment objective should be aggressive. Hopefully this will maximize the growth of the assets benefiting both current (percentage payout on a larger base of assets) and future beneficiaries (preserving and growing their eventual remainder interest). Second, the Trustee must elect to use a percentage payout as the "deemed income" of the Trust. Depending on the state law, the unitrust percentage may be fixed in the statute (e.g. 4%) or provide the Trustee with a range (e.g. 3% to 5%). If a range is allowed the Trustee must also select the appropriate percentage within the range. [Trustee tip: When a percentage range is allowed by law the language of the statute will often give the Trustee complete discretion to select the number and provide that it will be presumed reasonable. It is recommended as a best practice to ensure the percentage number you have selected is reasonable under the circumstances and supported by the needs of the beneficiaries. Don't forget to document this part of the discretionary decision along with any supporting documentation and keep with the permanent records of the Trust.] Thirdly, if not provided by state statue, the Trustee should decide if the unitrust number will be net or gross of its proportional share of realized gains and losses. In many cases the Trustee will be required to provide notice to all adult interested parties to complete the process. The intent is to allow anyone potentially impacted by the conversion to a unitrust to object. Don't forget to document the entire process and keep a permanent record for your files.

Records and Reporting

Among the most fundamental duties of a Trustee are the duty to keep records of the Trust and the duty to keep interested parties informed. It is the Trustee's responsibility to maintain records of all the investments, mandatory and discretionary distributions, tax payments, correspondence, and any other relevant information. The primary record tool is often the regularly issues statements (or collection of statements if multiple custodians are used) from the financial institution where the Trust assets are held. The statement should reflect all assets held, their market value, sales and purchases of assets, fees paid, and distributions made from the account. If many institutions are used it may be more cumbersome and confusing to rely on the many statements. The Trustee may then consider having an accountant prepare a consolidated annual accounting from the statements summarizing all the activity. Statements are typically prepared and delivered to the Trustee and interested parties monthly or quarterly depending on the preferences of the beneficiaries. Typically a Trustee is required to deliver a statement (also referred to as an "account") to the beneficiaries at least annually. Check with the attorney for the Trust to

determine who is considered a beneficiary or "qualified beneficiary" under the applicable Trust law. Some states require a Trustee to provide statements only to beneficiaries currently entitled to receive distributions from the Trust. Other states will require the Trustee to provide statements to "qualified beneficiaries" which include not only the beneficiaries currently entitled to receive distributions, but also include "presumptive remainders" who are usually the individuals (or charities) who would receive the remaining balance of the Trust outright if the Trust terminated today.

While statements will typically be a satisfactory record the financial activity of the Trust, the Trustee will also need to maintain copies of all the other documentation that is part of the record of the Trust. Any original legal documents should be maintained by the Trust's attorney who has the means for safekeeping legal documents. If the attorney won't keep the originals, or if an attorney is not regularly engaged with the family planning, then the Trustee should ensure original documents are kept in a safe deposit box, vault or lockbox. Other documents may be kept electronically, or in hard copy, but should be safe and easily accessible when needed. Any correspondence to or from the beneficiaries should be maintained. Where decisions were agreed to at meetings or conference calls, the Trustee should create a memo or detailed letter of the discussion and ultimate decision which should be kept as well. Where the Trustee made a discretionary decision to pay funds from the Trust, a memo should be created discussing the request, authority in the Trust to make the payment, and any supporting information. This memo should be available in the Trust records to explain any distribution shown in the statement from the financial custodian. Any mandatory payments showing on the statements can be justified by the terms of the Trust Agreement instructing the Trustee to pay out the net income, percentage of assets, etc.. Tax returns must be kept. Also, any advice received from accountants, lawyers, valuation experts or investment advisors should be kept. An annual review should be created by the Trustee and maintained as well, and should include an analysis of the investments and distribution needs, with a conclusion either maintain the current course or make changes because of changing circumstances.

Remember: keeping records is not only a Trustee's duty to the beneficiaries, it is also the only way a Trustee can prove he acted prudently and fairly while administering the Trust. Complete records are an essential part of a defense against possible legal action. Because it is a Trustee's duty to maintain all records of the Trust, if the Trustee loses records then in a legal action the presumption may be against the Trustee and for the party claiming the Trustee acted imprudently, lost funds, etc.

As noted above, reporting must be done to the "interested parties", so the Trustee must first confirm who is included in that group. It is almost always the beneficiaries receiving funds now, but could include "sprinkle" beneficiaries who are permitted to receive funds now but, in the discretion of the Trustee, are not currently allocated any funds. In a growing number of states it could also include the "presumptive remainders" who are first in line to receive the balance of the Trust when it terminates. It could include charitable entities and possible the Attorney General's office of the appropriate state who oversees charitable bequests. A "silent Trust" may only require reporting to the Grantor of the Trust. Guardianships, and other court supervised Trusts may require an annual or more frequent accounting to be filed in court. The Trustee must know who they are required to report to and should check with counsel if they are uncertain as to the required recipients or the frequency. Most reporting can be satisfied by statements, but some annual filing (e.g. for Guardianships) may require the Trustee to hire an accountant to prepare a summary of activity for the review period. The cost should be properly paid by the Trust.

In addition to the regular reporting a Trustee is required to provide, any interested party can "compel" an accounting by the Trustee. Interested parties would include Co-Trustees, current beneficiaries and remote beneficiaries, or anyone having a present or contingent interest in the Trust. If an interested party suspects the Trustee is not fulfilling their obligations or is just not providing information on the administration of the accounting, that party can ask the court having jurisdiction to require ("compel") the Trustee to provide information on the investment performance and distributions. A Trustee is always under an obligation to provide information until they are released from their obligations when they resign, are removed or when the Trust terminates.

Taxes

The operation of a Trust has many tax implications. The very act of funding a Trust usually has gift tax implications if the Trust is irrevocable. The creator of the Trust will be responsible for paying the gift tax or using their available exemptions. The attorney drafting the Trust or the creator's accountant should provide advice about any federal or state the tax liability incurred by funding a Trust. There may be exceptions to this rule (e.g. Revocable Trust or Grantor Trust), and funding certain charitable trusts may minimize gift tax by providing an income tax deduction for the creator. These taxes should not be the responsibility of the Trustee. However, once the Trust is funded, the Trustee will be responsible for other taxes.

The Trustee must ensure a tax return is filed for the Trust every year (1041). Like a corporation, a Trust is a separate tax paying entity. Unless the Trustee has a tax preparation background it is recommended a professional (accountant or attorney) prepare the returns as an expense of the Trust. While certain Trusts may be exempt from paying taxes (e.g. Revocable Trusts, Grantor Trusts,

Charitable Trusts), often an informational return is required to be filed anyway. Remember, as a taxpayer, the Trust will be responsible for state taxes as well as federal taxes. Each state has laws addressing the tax liability of Trusts. As Trusts can often have multi state contacts (e.g. Grantor in one state; Trustees in multiple states; beneficiaries in multiple locations) it is especially important for the Trustee to get professional tax advice to sort out the appropriate tax filings for the Trust.

A typical irrevocable Trust will report and pay taxes on realized gains from the principal portfolio. In some instances where the Power to Adjust is being applied and some principal has been paid out as deemed income the Trustee may elect to pass out a proportional share of the realized gains to the income beneficiary. Whether the Trust pays income taxes will depend on who is the recipient of the income at the end of the taxable year. If all income is paid out during the year to the income beneficiary, then the income tax liability should flow out to the beneficiary as well. If some or all of the income is retained in the Trust, then the Trust will pay the appropriate (federal and state) income tax.

The Trustee is also responsible for sending out the Trust's K-1 advice or "tax letter" to the beneficiary of the Trust. Each beneficiary receiving funds from the Trust during a calendar year must report any tax liability on their tax returns. Depending on the nature of the distribution from the Trust, the beneficiary may have income tax liability, capital gain tax liability, or possibly receive a tax free distribution of principal. The Trustee must tell the beneficiary how much was distributed to them and the tax character of the distribution. A Trust does not produce a 1099 like an investment account, and is not held to the same reporting time frame as 1099 reporting. A Trust produces a tax letter for each beneficiary receiving income or principal distributions in the tax year as soon as the information is available. If the Trust owns certain investments that do not produce tax information by April 15th of the following calendar year, then the Trustee will have to put the Trust return on extension and advise the beneficiaries they will need to put their own returns on extension.