August 27, 2018
Author: Puneet Cham
Organization: Latimer LeVay Fyock, LLC
As we know, a trustee owes several duties to the beneficiaries of the trust, including a Duty to Report or Account, Duty to Properly Administer the Trust, Duty of Loyalty and, of course, a Duty of Impartiality toward the beneficiaries. As a rule of thumb, when a trust has more than one beneficiary, whether concurrent or successor, the trustee’s duty is to deal impartially with each of them. See Comtrade, Inc. v. First National Bank, 497 N.E.2d 527 (Ill. App. Ct. 1986). Keep in mind that the duty of impartiality extends beyond just the treatment of beneficiaries in the trustee’s exercise of discretion to distribute income and principal, but may also include decisions to:
1. repair, replace or improve trust assets (i.e. real estate);
2. remain neutral over conflicts between two beneficiaries and not become an advocate of one over the other;
3. communicate to all beneficiaries any change of investment policy or any other action;
4. diversify assets to benefit both concurrent and successor beneficiaries; or
5. replace any non-productive property for an income beneficiary.
If the trust is unclear and the trustee cannot get a consensus from the beneficiaries towards a particularly action, then he or she should strongly consider seeking direction from a court. See Bornstein v. First United, 597 N.E.2d 870 (Ill. App. 1992) under which the trustee of a land trust correctly filed an interpleader action in the face of an ambiguous trust agreement and conflicting claims by concurrent beneficiaries. The court ruled that the “trustee acted property in refusing to convey land trust property to one beneficiary individually in light of the other beneficiary’s conflicting directions and complied with its duty to treat each beneficiary impartially by interpleading parties and letting [the] trial court adjudicate [the] conflict.”
An alternate solution when dealing with multiple concurrent beneficiaries may be to split the trust in separate sub-trusts for each beneficiary. See McNeil v. McNeil, 798 A.2d 503 (Del. 2002) under which the Supreme Court of Delaware determined that the trustee’s decision to divide a pot trust for the benefit of four children was rational to address the differing needs and desires of four different families and to reduce the likelihood of dispute and litigation over claims of uneven distribution.
The exception to the duty of impartiality is, of course, if the trust agreement provides otherwise.
EXAMPLE
Family Trust
Upon the death of the grantor, all of the trust estate which shall not be allocated to a Marital Trust or used for payment of debts, taxes and expenses shall be allocated to a separate trust, designated as the “Family Trust” of which the Grantor’s spouse and all of the Grantor’s descendants living at any time shall be the beneficiaries.
The trustee is hereby authorized to distribute to or for the benefit of any one or more of the beneficiaries of the Family Trust all or as much of the net income or principal of such trust as the trustee deems to be in the best interests of said beneficiaries, provided however, that during any time in which a beneficiary of the Family Trust is a co-trustee or sole trustee then the trustee is hereby authorized to distribute only as much of the net income or principal of such trust as is necessary for the support of said beneficiary or beneficiaries so acting as cotrustee or sole trustee.
Notwithstanding the foregoing, in making any distributions of the net income or principal of the Family Trust, the trustee shall give preference to the interests and concerns of the Grantor’s spouse and need not consider the interests of any other beneficiary with respect to such distributions.
A trust agreement can always direct the trustee to favor one beneficiary over another. In the absence of abuse by the trustee, courts will not prevent the trustee from doing so.
Where the trust agreement is silent on who gets priority, the trustee should not favor one beneficiary over the other. This places the trustee in a very difficult position of trying to balance the needs of all the beneficiaries, concurrent and successor. Keep in mind however, that treating all beneficiaries impartially, is not intended to mean treat all beneficiaries equally. The Restatement (Third) of Trusts, §79 Cmt. b., provides that It would be overly simplistic, and therefore misleading, to equate impartiality with some concept of “equality” of treatment or concern – that is, to assume that the interests of all beneficiaries have the same priority and are entitled to the same weight in the trustee’s balancing of those interests.
When applying distribution standards to the same class of beneficiaries (i.e. children), it is natural to assume that the grantor intended for the trustee to treat each beneficiary differently based on their particular characteristics. However, in Illinois, absent language in the trust directing the trustee to do so, the trustee cannot favor one beneficiary over the other, despite well-grounded reasons for doing so. See Huffman v. Gould, 64 N.E.2d 773 (Ill. App. Ct. 1945).
Where there are multiple concurrent beneficiaries, and no clearly stated priority in the trust agreement, the Restatement (Third) of Trusts, §50 Cmt. f., suggests that there are certain inferences of “Favored Statute” that can be made, albeit taken on case by case basis, such as:
1. The relationship of the settlor to the beneficiary whereby the beneficiary at the top of the line of descendants is favored over his or her own issue and the grantor’s spouse is favored over the grantor’s descendants (irrespective whether or not the spouse is an ancestor to said descendants);
2. Per Stirpes – Among multiple lines of descent (i.e. all of the settlor’s issue), there is an inference of priorities per stirpes whereby (i) the various lines are entitled to similar, impartial treatment and that (iii) favored status within a line begins with the person(s) at the top (e.g. the settlor’s child or the children of a deceased child)
The Restatement provides an excellent illustration of Favored Status which is: As trustee of a trust created by H, T is directed to pay all of the income to W (H’s widow) for life, with further grant of discretionary power to make principal distributions “to W and to any one or more of my issue as T may deem appropriate for her on their comfortable support, health, education and general best interests”; the remainder is to be distributed on W’s death to S’s then living issue. “Context” suggest that W is the primary beneficiary of this trust, with a favored position for T’s exercise of discretion. This is reinforced by an inference based on her “relationship to the settlor.”
The Restatement concludes that T is to give priority to W’s needs so that she may continue her lifestyle and to have appropriate care and other suitable benefits. Similarly, S’s children are to receive favored status over their own issue.
DRAFTING POINTER: If the grantor wishes to include certain considerations among a class of beneficiaries or allow for unequal distributions or prioritize current and future beneficiaries, then he or she should clearly specify that intent in the trust agreement, rather than rely on inferences of “favored status”. See Carter v. Carter, 965 N.E.2d 1146 (Ill. App. 2012) where daughter of decedent, a remainder beneficiary of a marital trust for the benefit of decedent’s spouse (daughter’s step-mother), brought an action against the trustee (also the step-mother) , in part, for breach of duty of impartiality. The marital trust provided all of the income to the spouse, but no access to principal. The trust allowed trustee to invest the assets “regardless of diversification.” As such, the step-mother choose to invest in tax-free municipal bonds, which could have had the effect of reducing the overall principal. The Illinois Court of Appeals rejected the daughter’s arguments on the grounds that the decedent intended for the spouse to generate income from any investment (i.e. regardless of diversification), that there was no express language requiring the trustee to consider the results of any investment on the principal and the trust instrument expanded the prudent investor rule thereby allowing for such investments. How about the trustee who focuses on the present interest beneficiaries simply because they are there? This is not an unusual problem for the trustee. These beneficiaries can exert a significant amount of influence and pressure on the trustee, especially because the trustee has to deal with them on a day to day basis. Compare that with a residuary beneficiary who might not see his or her interest for the lifetime of the present interest beneficiary. The Restatement (Third) of Trusts, §79 Cmt. b., provides that Impartiality does mean that a trustee's treatment of beneficiaries or conduct in administering a trust is not to be influenced by the trustee's personal favoritism or animosity toward individual beneficiaries, even if the latter results from antagonism that sometimes arises in the course of administration. Nor is it permissible for a trustee to ignore the interests of some beneficiaries merely as a result of oversight or neglect, or because a particular beneficiary has more access to the trustee or is more aggressive, or simply because the trustee is unaware of the duty stated in this Section.
It is clear that the rule of thumb in Illinois is that absent specific language in the trust agreement, present interest beneficiaries and successors beneficiaries are to be treated impartially. However, does the inclusion of a discretionary distribution standard allow, for example, the trustee to exhaust the principal in favor of the current beneficiaries and to the detriment of the successor beneficiaries? Or is that in violation of the duty of impartiality without express language in the trust? In Illinois, the answer appears to be yes, the assets can be exhausted and no, it is not a violation of the duty of impartiality for doing so. See Dial v. Dial, 38 N.E.2d 43 (Ill. 1941) under which the grantor left real estate in the care of his son as trustee for the benefit of his disabled daughter for her “proper care and attention as long as she lives. Upon the death of my said daughter, the title in fee to the share so bequeathed to my son as trustee, shall go to my said son… in fee simple absolute.” The Illinois Supreme Court held that, based on the distribution standard, the grantor intended for his daughter to access as much income and principal from the property during her lifetime as was necessary for her care, even if it exhausted the trust estate to the detriment of the son.
TOTAL RETURN TRUSTS
In the typical scenario, the grantor creates a trust under which the trustee is required to pay a particular beneficiary income only (the “income beneficiary”). Upon the income-beneficiary’s death, the trustee is authorized to distribute the principal to a different beneficiary or beneficiaries (the “residuary beneficiary”). This arrangement can be the cause of significant conflict among the income beneficiary who is seeking high income generation, the residuary beneficiary who is seeking growth in principal and the trustee who is caught in the middle. If trust assets are invested to produce income, it is likely that the trust will see less growth of the principal. Conversely, if trust assets are invested to grow principal, then the trust assets will not likely generate significant income.
What’s the solution? Illinois’ Total Return Trusts, 760 ILCS 5/5.3, (the “TRT Act”)
I. What is a Total Return Trust?
A. Modern Portfolio Theory (or don’t put all your eggs in one basket). The concept of total return stems from the modern portfolio theory of investing which states, in a nutshell, that by diversifying assets among a variety of investments, you can reduce overall risk while still maximizing gain. It is a commonly used technique for asset allocation among financial advisors.
B. A Total Return Trust attempts to remove the inherent conflict and animosity between the income beneficiary and the residuary beneficiary by allowing the trustee to convert the trust into a “unitrust”. This allows the trustee to distribute a fixed percentage amount each year to the income beneficiary without regard to whether the source of the distribution is from income or principal. By converting the trust in this manner, the interests of the income beneficiary and the residuary beneficiary are aligned. Risk and reward are shared equally by the income beneficiary and the residuary beneficiary. The trustee is then freed up to focus on the long term growth of the principal. If the principal grows, then presumably the percentage amount that the income beneficiary receives annually also increases.
C. Under the TRT Act, the annual distributions to the income beneficiary is 4%, unless otherwise agreed to by the parties to be 3% - 5%. At an initial glance, it would appear that the income beneficiary would like distributions to be set at 5% annually, while the residuary beneficiary would like to set the rate at 3%, once again potentially putting the beneficiaries at odds. However, a lower percentage also has a much greater probability of increasing over time as growth is reinvested into the principal rather than being distributed outright. It is not uncommon for trustees to choose a middle ground at 4%.
1. From an estate tax perspective, the income beneficiary may want to have a high payout of 5% in the marital trust to reduce the overall task burden on the second spouses death and a low 3% payout on the bypass trust to preserve the assets.
2. The IRS has determined that these trusts still qualify for the marital deduction after conversion
II. How Does it Work? A Trust can convert into a Total Return Trust in one of three ways:
A. Conversion by Trustee. Under this method, the trustee declares unilaterally his or her intention of converting the trust to a Total Return Trust. The trustee is required to:
1. Confirm that there this at least one or more legally competent income and residuary beneficiaries;
2. Provide written notice to all of the income and residuary beneficiaries;
3. No beneficiary objects in writing within 60 days of receiving the notice;
4. The beneficiaries each sign an acknowledgement confirming they received the notice
B. Conversion by Agreement. Under this method, the trustee and the beneficiaries all agree to convert the trust to a Total Return Trust. The trustee is required to:
1. Written agreement signed by all primary beneficiary or all beneficiaries currently eligible to receive income or principal
C. Conversion by Court. Under this method, in the event that a beneficiary objects within the 60 day period discussed above or there are no legally competent beneficiaries, then
1. The trustee can petition a court to allow the conversion;
2. The beneficiary can also petition the court to reconvert from a Total Return Trust or change the annual percentages, if the trustee does not respond to such requests within 6 months;
3. The court may order any of the following actions:
a. Select a distribution percentage other than 4%;
b. Average the valuation of the trust’s net assets over a period other than 3 years;
c. Reconvert from a Total Return Trust; and
d. Direct the distribution of the net income (determined as if the trust was not a
Total Return Trust)
III. Post Conversion. Once the trust is converted to a Total Return Trust, the trustee has the following additional obligations:
1. The trustee shall make income distributions to the income beneficiary in accordance with the trust agreement;
2. The annual distribution amount shall be calculated as a percentage of the net fair market value of the trust assets averaged over the lesser of (i) the three (3) preceding years, or (ii) the period during which the trust has been in existence;
3. The distribution percentage shall be 4% if the conversion was decided unilaterally by the trustee or 3% - 5% if the conversion was agreed upon by the trustees and the beneficiaries
GETTING ALONG WITH THE BENEFICIARIES
The idea of how the trustee and the beneficiaries, both concurrent and successors, can get along during trust administration should begin at the drafting stage. Trust administration, at its core, is all about the grantor’s intent. In that regard, below is a list of items to consider to make clear the grantor’s intent:
A. The Trust Agreement. Ideally, the trust agreement should be the first and only place that a trustee needs to determine the grantor’s intent. A properly drafted trust agreement will make clear:
B. Distribution Standards: The distribution standard should be clear and concise. Consider defining terms such as HEMS or best interests and providing guidelines in terms of what are appropriate requests.. Determine whether the trustee should consider:
1. Standard of living – have the grantor fill out a check list:
• At death;
• When trust is created;
• At the time of distribution.
2. Other sources of income;
3. Incentive provisions;
• Maintain a job;
• Reach a certain level of education;
• Stay-at-home parent or in the military;
• Drug free;
• Free of undue influences.
4. Beneficiaries. The grantor should be make clear who the beneficiaries are and what priority, if any, they would receive income and principal. In determining priority, consideration should be given to individual beneficiaries, classes or groups of beneficiaries, present interest beneficiaries, residuary beneficiary and income only beneficiaries.
5. Trustees. Where beneficiaries have conflicting interests (i.e. mixed families), the grantor should consider appointing an independent trustee or co-trustee, rather than a sole trustee-beneficiary;
• An independent trustee removes the emotion associated with treating various beneficiaries differently (i.e. saying no to one beneficiary and yes to another) and the risk of family blow-out;
• Lessen the success of pressure or “good beneficiary/bad beneficiary” tactics;
• An independent co-trustee or sole trustee also has the added benefit of avoiding estate tax inclusion and creditor protection.
a. Purpose Clause. Consider adding a general purpose clause for additional guidance to the trustee.
b. Savings Clause. Be sure to include the proper savings clauses to avoid unintended tax consequences, particularly for a beneficiary-trustee;
c. No Contest Provision. Although questionable in its legality, it can be useful as a deterrent from an overly exuberant beneficiary;
d. Trust Protector. Name a trust protector to place an additional check on the trustee.
6. Letter of Wishes
a. Consider having the grantor prepare a non-binding letter of wishes for the beneficiaries
7. During Trust Administration
a. Process. In almost every instance, a documented and consistent process for any decision by the trustee will save him or her even if the result is a negative one, particularly if the trustee is later called upon to defend his or her decision in court. Remember - How the trustee comes to a decision is greater than the results of that decision
i. Keep a detailed file
ii. All distribution requests should be in writing and should include:
1. Amount requested;
2. Reason for request;
3. Consider a timeframe to submit the request prior to the need for distribution, unless an emergency;
4. Keep detailed records of any “emergency” distributions
5. If the trustee has to look at other resources, then consider:
a. What information you will need (i.e. income tax returns, bank account statements, pay stubs, etc.)
iii. Multiple concurrent beneficiaries. Consider having each beneficiary submit certain information annually so that the trustee can properly determine the beneficiaries needs, especially under a support distribution standard.
1. Neutral – do not take sides in disputes between beneficiaries
2. Preference – do not give preference beyond the terms of the trust
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iv. Unusual distribution request.
1. Disclose it to all relevant beneficiaries;
2. Obtain releases for the request, if possible;
3. Seek court construction (i.e. interpleader).
b. Communication. Keep open lines of communication with the beneficiaries.
i. Annual or bi-annual beneficiary meetings;
ii. Accountings – should be regular. Illinois law requires at least annual accountings to the beneficiaries;
1. Three year statute of limitations upon receipt of an accounting;
2. Keep detailed time sheets if you intend to charge fees. Illinois allows for reasonable fees. What is reasonable is based on a number of factors, including:
a. Skill and experience;
b. Amount of time spent administering the trust each year;
c. Complexity of the trust assets;
d. Amount handled by the trustee vs. delegated to others; and
e. Risk assumed by the trustee.
iii. Trust Agreement – consider giving a copy of the trust agreement to the beneficiaries, particularly the income/residuary beneficiaries