California Estate Planning: Fiduciary Duties and Administration of Trusts

July 24, 2018

Fiduciary Duties and Administration of Trusts

• Discretionary distributions: “I want more.” No matter how much money there is, there is never enough. (Never. Ever. Beneficiaries’ spending skills will always outstrip the investing skills of the trustee.)
• First question: Should you provide for discretionary distributions? The standard answer is yes but sometimes the answer should be no. When no? A very large trust with predictably generous income. Editorial comment: If the money is going to this generation then it’s not going to the next generation etc., relevant to trusts for multiple generations. Mom and dad may eat all the worms (i.e., the corpus of the trust) rather than distributing any to the chicks.
  • The standard or default: “HEMS” or health, education, maintenance and support. Under IRC Section 2041(b)(1)(A) this standard does not create a general power of appointment.
  • Helpful language: Although arguably precatory, language conveying the intent of the trustor is useful, such as language indicating the intent is to favor the surviving spouse or income beneficiary over the remainder person(s), even to the extent of exhausting the principal of the trust to support the surviving spouse or income beneficiary.
  • Must a trustee consider other resources? First, what does the document say? The general answer is, yes, unless the trustee can establish that is contrary to the trustor’s intent. One practice is to obtain a copy of the most recent income tax return and a budget from the beseeching beneficiary. Considering other resources does not mean exhausting other resources.
  • Another variation is an “incentive” trust. A trust might provide for distribution of a specific sum (e.g., $25,000) on graduation from college or matching 50% of the AGI of a beneficiary. A negative is that this might penalize a beneficiary entering a profession such as the clergy or who becomes an artist.
  • Note: Can also provide access to principal by conferring a “5 & 5” power on a beneficiary(ies). This allows a beneficiary to simply request a distribution of the greater of $5,000 or 5% of the value of the trust; the trustee has no discretion in the distribution of the funds, just has to calculate the amount (typically the 5% of the value of the trust), raise the money and send out the check.
  • Under Internal Revenue Code Section 2514 and 2041, the exercise or lapse of a 5 & 5 power will have no gift or estate tax consequences.
  • Consider instead the unitrust alternative.
    
    
    • How does this work? Instead of providing net income to the income beneficiaries, a unitrust will provide for, say, 5% of the fair market value to go to the income beneficiaries. Each year the unitrust is valued and the unitrust payout is adjusted for the next year of distributions. In the case of “split interest” trusts which include individual beneficiaries and charitable remainder beneficiaries, the projected remainder that is going to charity does not qualify for a charitable deduction unless the trust is structured as a unitrust (or, related to this, an annuity trust).
    • A unitrust eliminates the inherent conflict between the interests of the income beneficiary(ies) and the remainder beneficiary(ies). If the trust increases in value both the unitrust beneficiary(ies) and the remainder beneficiary(ies) benefit. The trustee can therefore select the investments that promise the greatest risk adjusted return without a concern for how much current income those investments generate; otherwise the trustee has to be concerned about investments that may provide little or no current income.
    • Under §16336.4 can usually convert to a unitrust (subject to certain requirements set forth in the statute); the unitrust percentage will be 4%. Under §16336.5 if the beneficiaries consent in writing can convert to a unitrust with a payout percentage between 3 and 5 percent.
    • The Uniform Principal and Income Act also provides for the power to adjust between income and principal, the result of which may be to increase the income available to a beneficiary.
    • Investment management concerns
      • Diversification imperative and asset concentrations
      • Why the diversification imperative? Under modern portfolio theory (that is the theoretical underpinning of the prudent investor rule), diversification reduces overall risk. An example may help: An “oil shock” will negatively impact airline stocks but obviously benefit energy stocks, to only have airline stocks would render the portfolio vulnerable to an oil shock. It is generally desirable to have a portfolio with “negatively correlated” assets or asset classes as a decline in one asset or asset class will be offset by a corresponding rise in another asset or asset class.
        
        
        • Drives the sale of large blocs of stock and real estate holdings
        • Why not diversify? (1) Low tax cost, although the availability of a step up in basis will eliminate this rationale. (2) The trust property bears a special relationship to the settlor’s objectives. An example would be a strip shopping center or multi-tenant commercial building that was the most significant asset and source of income of the settlor.
        • Typical direction to retain is insufficient protection for the trustee(s). Consider more protective language such as the following: Trustee may retain, without liability for depreciation or loss resulting from retention, any property constituting the trust at the time of its creation or at the time of the death of a Trustor or as the result of the exercise of a stock option. Our Trustee may retain property, notwithstanding the fact that the property may not be of the character prescribed by law for the investment of assets held by a fiduciary, and notwithstanding the fact that retention may result in inadequate diversification under any applicable Prudent Investor Act or other applicable law.
          
          
        • Alternative is to have a special trustee or trust advisor in whom there is power to sell. The practical problem is finding somebody willing to serve in that capacity. A long time partner or co-investor with the settler (Although concerns about longevity will likely be present—how long will he or she be available to serve?) may be an appropriate choice.
        • Standard of care of the trustee: In general, a corporate trustee will be held to a higher standard than an individual. This is the position of the Restatement of Trusts (Section 227, Comment d) as well as reflected in case law. Basically, if you say you know more then we’re going to expect you to know more. (Unavoidable Madoff comment: How does a professional trustee, who placed funds with Madoff, defend leaving funds with an investment manager who purported to be generating returns unprecedented in terms of magnitude and consistency? Well…the band was playing really well till the ship capsized.)
        • A trustee may have a duty to seek deviation (release from) a direction to retain a concentrated position if circumstances change. Of course, whether circumstances have sufficiently changed is a judgment call. Consider a trustee operating under a direction to retain a large bloc of Enron stock. The reality is that, if the auditors did not foresee the imminent capsizing, how likely is it that the trustee would anticipate it?
        • Notice of proposed action: If controversy continues to exist regarding diversification issues, a trustee should consider the preparation of a notice of proposed action (California Probate Code Section 16500 et seq.) or a court petition for instructions (California Probate Code Section 17200 et seq.) seeking confirmation or guidance regarding the question as to whether the proposed investment policy is correct and does not violate the trustee’s duty to diversify. Under the right circumstances, it may even be prudent to seek the modification of the investment clause based upon changed circumstances (California Probate Code Section 15400 et seq.). Question: How long can a trustee rely on such a notice to retain a concentration?

• The trustee may communicate with the beneficiaries and obtain approval to retain but, as with the notice of proposed action, how long can this be relied upon? And, of course, the trustee may not obtain the approval of all beneficiaries.

• Balancing needs of income and remainder beneficiaries
  
  
  • Intent of the prudent investor rule is to provide current income while protecting against inflation for the remainder beneficiaries.
• Delegation of investments

• Prudent investor rule provides for delegation, but trustee is responsible for monitoring, hiring and firing if appropriate. Assuming the delegation is proper and the delegation is properly monitored, the trustee will not be liable for the performance of the investment manager. (Of course, if the performance is adequate, whether the trustee had properly monitored the investment manager will not likely be examined.)
• A trustee may have a duty to delegate in some instances. For example, if the trustee determines the trust should have an allocation to venture capital and the trustee doesn’t have the expertise (or time) to manage such a program, the trustee should delegate the management of the program.

• Trust advisor: The settlor, rather than simply allowing delegation by the trustee, may designate an individual or entity to manage a specific asset or manage all the investments (In which case the primary responsibility of the trustee will be to administer the trust, including making discretionary distributions.).

• Where there is a trust advisor (or special trustee) denominated delegation is a given, subject to changes in circumstances such as the demise of the trust advisor, individual or entity; Lehman Brothers’ recent fate illustrates the demise of an entity. The document needs to provide for a dismissal and replacement mechanism for the trust advisor just as is typically done for the trustee.

• Unfortunately, the trustee may be liable for allowing a deficient trust advisor to continue to serve as, absent language within the document, the trustee must verify that the exercise does not violate a fiduciary duty that the trust advisor has to the beneficiaries of the trust. The fiduciary duty will normally include the duty to diversify.

• As is usually the case, the document is determinative and the liability standard for the trustee should be lowered if the trustee must take direction from a trust advisor.

• Note: Delaware provides greater protection for a directed trustee (that is, one who takes direction from a trust advisor or special trustee). Under Delaware law the trustee can follow directions (of the trust advisor) and not be liable for any loss “except in cases of wilful misconduct on the part of the trustee.” Delaware Code Chapter 12, Section 3313. Needless to say, corporate fiduciaries like to have the bar lowered.

• Few corporate trustees will delegate investments, arguably many (if not most) individual trustees should. Delegation, properly done, will provide protection to the trustee but normally with an associated reduction in the compensation to the trustee (although not likely a “dollar for dollar” reduction).

• Adjustments between principal and income

• California adopted the Uniform Principal and Income Act (“UPIA”) effective as of January 1, 2000. The UPIA provides the rules for the allocation of receipts and expenses between income and principal. However, the UPIA also provides the trustee in some instances with discretion to make certain adjustments between income and principal. The UPIA can be found in California Probate Code Sections 16320-16375.
• Since most trusts provide for a current income beneficiary(ies) and for future remainder beneficiaries, these allocations can have a meaningful impact on the various beneficiaries.
• Areas where the trustee has discretion to make adjustments include the following:
  • Converting a trust to a unitrust
  • Per Section 16336(a) a fiduciary may make an adjustment between principal and income if the following conditions are met: (1) the trustee manages trust assets in accordance with the prudent investor rule; (2) the trust describes the amount that shall or may be distributed to a beneficiary by referring to the trust’s income; (3) without an adjustment the trustee cannot administer the trust impartially with respect to the beneficiaries.
  • Insubstantial allocations (Section 16360): An allocation is presumed to be insubstantial in either of the following cases: (1) where the amount of the allocation would increase net income in an accounting period, as determined before the allocation, by less than 10 percent; (2) where the value of the asset producing the receipt for which the allocation would be made is less than 10 percent of the total value of the trust’s assets at the beginning of the accounting period.
  • Depreciation: Per Section 16372(a), depreciation means a reduction in value due to wear, tear, decay, corrosion or gradual obsolescence of a fixed asset having a useful life of more than one year. A trustee may transfer from income to principal a reasonable amount of the net cash receipts from a principal asset that is subject to depreciation, under generally accepted accounting principles.

• Amortization of bond premiums: Per Section 16357(a), an amount received as interest shall be allocated to income without any amortization of premium. Example: Bond purchased at $105, matures at $100, at time of maturity remainder beneficiaries only get back $100 of $105 invested.

• Section 16375(a) provides that a trustee may make adjustments between principal and income to offset the impact of tax elections, income taxes imposed due to a distribution from a trust or estate, or the inclusion of distributed or undistributed taxable income of an entity (e.g., an IRA) in the trust’s taxable income.

• Reserve is not just for Englishmen, particularly important where have real estate. A trustee may seek protection here, as elsewhere, through the use of a notice of proposed action.

• Accounting to beneficiaries: Per Section 16062, a trustee shall account at least annually, at the termination of the trust, and upon a change of trustee, to each beneficiary to whom principal or income is required or authorized to in the trustee’s discretion to be currently distributed.

• The required elements of the account are set forth in Section 16063, and include: (1) statement of receipts and disbursements of principal and income; (2) a statement of the assets and liabilities of the trust; (3) trustee’s compensation; (4) the agents hired by the trustee, their relationship to the trustee, if any, and their compensation; (4) a statement that the recipient of the account may petition the court under Section 17200 to obtain a court review of the account and the acts of the trustee; (5) a statement that claims against the trustee for breach of trust may not be made after the expiration of three years from the date the beneficiary receives an account or report disclosing facts giving rise to the claim.
• The trustee may wish to provide statements to beneficiaries to whom the trustee is not obligated to provide statements and thereby bar those beneficiaries from asserting claims for actions taken more than three years previously.
• The trustee may simply provide property management statements for rental property or a separate detailing of entity transactions rather than reproducing that detail within the account for the trust.
• Section 16464 provides that a beneficiary may waive any objections to an account and thereby expedite the distribution.
• Giraldin (55 Cal. 4th 1058) (2012):
  
  
  • Trustee (other than a settlor) of a revocable trust needs to only currently account to the individual(s) who have power to revoke (basically, the settlor(s) of the trust)
  • However, the trustee will later have to account to beneficiaries after the death of the individual(s) who have power to revoke
  • Normally the settlor(s) of the trust will not want accountings to go to the (not yet certain) remainder beneficiaries of the trust
  • In practical terms the trustee should document his/her actions as trustee to avoid future objections from the remainder beneficiaries of a revocable trust