Originally published in October 2017
Copyright © 2017 Knox McLaughlin Gornall & Sennett, P.C.
A trust is an entity that separates "legal" ownership from "equitable" ownership. Legal ownership includes the name in which the entrusted assets are titled and the responsibility for managing those assets. The trustee is the legal owner and, as such, the trustee is responsible for administering those assets in accordance with the terms of the trust agreement. "Equitable Ownership" basically means the right to benefit from the assets placed in the trust. Those rights of "equitable" or beneficial ownership are given to the trust beneficiaries. The parties can in some instances "wear more than one hat," and therefore it is possible for the grantor’s children to also act as trustees of their own trusts, of which they are (during their lifetimes) the beneficiaries. So long as there are other beneficiaries – e.g., their children (the grantor’s descendants) – the grantor’s children can also act as trustees of the trust established for their benefit.
It is important to understand different types of trusts as they impact not only the trust administration, but also reporting requirements.
What is a “living trust”? Literally, a “living” trust is any trust created during the grantor’s lifetime. However, from a practical standpoint, the term “living trust” is most often used to refer to a revocable trust, i.e., a trust by a grantor during his/her lifetime, which is, by its terms, amendable or revocable by the grantor at any time while the grantor is still alive.
How a (revocable) living trust works. A revocable trust operates in much the same way as a Will, except that the trust governs only those assets that have been transferred (re-titled) into name of the trust. Because a living trust only covers trust assets, it is common practice to also have a “pour-over” Will drafted that governs the disposition of any assets not already titled in the name of the trust. This is essentially a Will that states that the testator’s residuary estate (remaining assets) is/are to be transferred at the testator’s death over to the trustee of the living trust. In this way, the living trust acts as the principal dispositive document affecting the disposition of the decedent’s assets.
Rationale for “Living Trusts”. A revocable trust arrangement ordinarily costs more (not less) to establish than living the assets under a Will. That is because (a) there are more documents to prepare and (b) additional work is also needed to re-title assets into the trust. The rationale for such arrangements is that the revocable trusts supposedly save money on the “back end” in the form of lower administration costs when the grantor dies.
Common misconceptions about living trusts:
Situations where living trusts can be helpful. While the advantages of living trusts are frequently exaggerated and/or oversold, living trusts can nevertheless still be useful in certain situations. Some examples include:
Problems/Disadvantages with Living Trusts.
The term "irrevocable," meaning that you could not simply "take back" the assets placed in the trust. In order to get the benefits of using an irrevocable trust, the trust by its terms, must be irrevocable. All irrevocable trusts can be divided into two groups: grantor trusts and non-grantor trusts.
Non‑grantor trusts are irrevocable trusts whereby grantors do not retain any powers (within Sections 671-678 of the Internal Revenue Code) which makes them grantor trusts (see below). As such, non‑grantor trusts bear the burden of income taxes (both federal and state), unless there are distribution mechanisms in place which allow to shift the income tax burden to trust beneficiaries. The most straightforward one is a distribution of income to a trust beneficiary. In very general terms, any net taxable income remaining in the trust at the end of the trust’s tax reporting period is taxed to the trust at the tax rates applicable to the trust, and any taxable income distributed to the trust beneficiaries is taxed to them at the rates applicable to the individuals.
Historically, tax rates applicable to trusts were similar to those applicable to individuals, and therefore, wealthy individuals found it beneficial to fund trusts for family members, such as children, in order to take advantage of the tax brackets applicable to trusts at lower income levels—in other words, to have the income taxed at lower tax rates. The grantor trust rules discussed below were a response to perceived abuse of trust tax rates. If the trust is a non‑grantor trust, the trustee must file fiduciary (trust) income tax returns reporting items of income, gain, loss, and deduction generated by the trusts.
GRANTOR TRUSTS GENERALLY
While the grantor trust rules were originally enacted to combat perceived abuses on the part of taxpayers, clever planners eventually found ways to utilize the rules to accomplish client’s tax and non-tax objectives. A series of rules evolved known as the “grantor trust rules” and provide, under certain circumstances (those set forth in Section 671‑678 of the Internal Revenue Code), that the trust’s existence for federal income tax purposes is disregarded altogether, and the trust tax attributes imputed to the creator (the “grantor”) of the trust or to others. The 1986 Tax Reform Act significantly compressed the income tax brackets applicable to trusts. The 1986 legislation all but eliminated the income tax benefit of shifting income from individuals to trusts. Thus, the original rationale for grantor trust rules arguably no longer exist, but the rules themselves remain part of the tax code to this day.
One common use of the “grantor trust rules” has been to “leverage” the benefits of gifting in trust to family members. Specifically, because under the grantor trust rules, the income generated on entrusted assets is generally imputed back to the grantor (trust creator), the grantor, by paying the income tax, is able to increase the amount effectively given to the beneficiaries (in the form of tax paid on their behalf) without having to recognize it as a “gift” for tax purposes.
Another way in which the grantor trust rules can be useful to taxpayers is in a commercial context. Many small businesses are organized as corporations subject to tax reporting under Subchapter S of the Internal Revenue Code (“S Corp”). S Corp status is elective and is in many cases very beneficial, but is at the same time subject to various requirements. One such requirement for electing S Corp status (the “S election”) has to do with the types of persons and/or entities that are permitted to own stock in the corporation. In order to maintain the integrity of a corporation’s S election (and continue its status as an S Corp), a corporation is generally only permitted to have individuals and certain types of entities as shareholders. As a general rule, trusts are generally not permitted to be shareholders of an S Corp; but, like most rules, there are certain exceptions to that general rule. One such exception is for a grantor trust. If a trust qualifies as a “grantor trust” for federal income tax purposes, its status as a trust is disregarded for federal tax purposes and it can therefore hold shares of stock in an S Corp without causing the corporation to lose its status as such. Accordingly, if an advisor thinks that it will be in a client’s interest (possibly for asset protection reasons) to put an S Corp business into a trust, it is important for the trust to be a “grantor trust.” Under such circumstances, if the grantor happens to be in a lower tax bracket than the trust (which, with the highly compressed tax rates applicable to trust, is now often, though not always, the case) the grantor trust rules can also have the added benefit of causing the business’s income to be taxed at the grantor’s lower tax rate(s) rather than at the higher tax rate(s) applicable to the trust.
The trustee should open separate bank accounts in the name of the trust. Such accounts can be checking accounts, savings accounts, brokerage accounts, etc., depending on the investment strategies employed by the trustee and the trust purposes. If the trust receives securities and other investments from the grantor or from any other sources, the trustee should open a separate investment account with an investment company or a bank that the trustee has previously interviewed and feels comfortable managing these assets. This account should be opened in the name of trust. Under Pennsylvania law, a trustee may delegate investment duties to an investment advisor. However, the trustee is ultimately responsible for ensuring that the trust assets are invested in accordance with the trust purposes, the intention of the grantors, and the beneficiary’s needs.
Unless it is a revocable trust, the trustee must obtain an EIN number for the trust. It is a simple process that takes about five (5) minutes by filling out a form online.The trustee will need to know, among other things, the exact name of the trust, the grantor’s name, the date the trust was funded, and the mailing address of the trust. It is important to obtain the EIN after the trust is funded rather than at the time the trust is created. If the trust has been in existence with the EIN number without holding any assets in its name, the trustee will start receiving letters from the IRS inquiring into the trust activities and return filings.
A QSST election is made by a trust beneficiary, while an ESBT election is made by a trustee. Usually, these elections are made upon consultation either with a CPA or an attorney. In any case, if any of such elections has been previously made, (or if not, should it be made), the trustee should understand the effect of such elections on the trustee’s duties related to trust distributions. For instance, under the QSST election, a beneficiary will be considered the sole trust beneficiary for the share of income earned by an S corporation which stock is held in the trust and which is attributed to the trust. Because the income beneficiary will be considered the only trust beneficiary, solely for income tax purposes, the company’s stock also will be considered to be owned by such beneficiary. This means that all income, losses, deductions, and credits of the company allocated to the stock that is owned by the trust will be reported on the personal income tax return of the income beneficiary. If the corporation makes a distribution to its shareholders, the trust must distribute all income (cash) received from the corporation to such income beneficiary. The corporate distributions should be deposited into the checking account held by the trustee in the name of the trust. Remember, that federal and state income tax regimes are not identical. For instance, for Pennsylvania income tax purposes, the trust will need to pay its own Pennsylvania income tax. Unless the trustee feels comfortable in navigating the Internal Revenue Code and tax returns, the trustee should contact the accountant for the trust to ensure that appropriate income tax returns are filed.
Management (or better to say, mismanagement) of the trust assets gives rise to a fertile ground for litigation. Unless the trustee is versatile in the market strategies or has a good understanding of the closely held company which stock is held in the trust, the trustee should retain professionals to assist him. As set forth above, the trustee may delegate certain duties to professional advisors if the trust agreement allows the trustee to do so. This entails a process of interviewing professionals such as investment advisors, accountants, and attorneys, who can assist the trustee with the trust administration. The investment advisors will ensure that the trust investments are managed in accordance with the purposes of the trust. An accountant will ensure the income which the trust’s assets produce will be reported on the appropriate tax returns. An attorney will ensure that the trust documents are kept in order, which may include trustee’s resolutions, if necessary, to document the important decisions made by the trustee with regard to the trust’s investments, distributions, and liabilities.
The retention of professionals is not obligatory. All of the above duties that can be performed by an investment advisor, accountant, and attorney can be carried out directly by the trustee. However, if no professionals are retained by the trustee, all of these tasks must be performed by the trustee on at least an annual basis and the trustee will bear the fiduciary responsibility for not complying with the trust terms and not maintaining documentation in a timely manner.
As we all know, we are all different. Trustees sometimes forget this simple truth and treat the trust beneficiaries alike without paying due attention to their needs. Also, the hopes and visions held by a grantor at the time of setting up a trust may not hold true after the grantor’s death. If the trust document provides for a Trust Protector, this is the most flexible way to address these concerns.
The concept of a "Trust Protector" provision adds flexibility to the trust design. Remember that the type of trust that we are discussing is, by its terms, irrevocable; and therefore once the trust is created, the grantor cannot "take back" the trust property or alter the terms of the trust agreement. The Trust Protector provision attempts to address this particular limitation associated with the use of irrevocable trusts. The intent behind a Trust Protector provision is to incorporate flexibility into the trust agreement in order to address changed circumstances that may not have been foreseeable at the time that the trust was initially drafted. Although, as just noted, it is not possible to allow the grantor to alter the terms of the trust agreement, it is, however, possible to give an independent third party (defined as someone who has no interest in the trust and who is also not "related or subordinate" to the grantor, or to a person having the power to remove the trustee, or to any trust beneficiary) the power to change the terms of the Trust. The Trust Protector therefore cannot be a family member nor can the Trust Protector be someone "subordinate" to the grantor (e.g., an employee). The Trust Protector is instead an independent third party who is given broad powers to reform the trust provisions in the event that it becomes necessary to do so. Although the Trust Protector must be an independent third party, some trusts provide for each of the grantor’s children to allow the child (in his or her capacity as trustee of their respective trusts) to choose who can act as the Trust Protector.
As already noted, the need for a Trust Protector is triggered by an unknown fact or an event that was not foreseen at the time the trust agreement was drafted. Such unforeseen events could occur in any number of ways. For example, if the tax laws were re-written to revise the criteria for a particular benefit of the trust, then the trust document could be reformed (in the future by the Trust Protector) to conform with such future legislative enactments. A Trust Protector provision may also be helpful in the event that a trust beneficiary becomes disabled or develops a substance abuse problem. In such a situation, if the trust beneficiary has an unalterable right to request income or principal, then the trustee may be required by the Department of Public Welfare of the state where the beneficiary resides to pay for all of the costs of the disabled beneficiary's treatment, even though many of such costs may otherwise be subsidized through public assistance. In such a situation, we would recommend the use of a "special needs" trust, i.e., a trust that is designed to exclude the trust income and principal from the disabled beneficiary's "resources" for the purpose of qualifying for medical assistance or other forms of public assistance. In such a case, the Trust Protector provision provides an additional tool to make the appropriate adjustment to accommodate such changed circumstances.
Such a provision, at a minimum, provides an opportunity for greater flexibility in administering the trust. Some states, including Alaska lawmakers, passed the statute expressly addressing the powers that may be granted to a trust protector and a trust protector's liability for its actions. Thus, while there are no absolute guarantees in life, we believe that the Trust Protector provision is potentially a very useful tool and that it makes the trust as flexible as one can make it, based on the state of the law as it exists today.
The trust document, as supplemented by the state statutes and case law, grants certain rights to the beneficiaries. For instance, it is quite common to come across so called powers of appointment held by beneficiaries over the trust assets. The trust beneficiaries can be granted limited powers of appointment over the trust assets and thus appoint the trust assets (including closely held business interests) in favor of a wide class of persons, excluding themselves, or their estates, or their creditors but including their children or other offspring. The beneficiaries’ exercise of the limited power of appointment would likely not cause any of the tax benefits associated with the trust to be lost. More specifically, assuming that the grantor’s children exercise their power of appointment after the GST Exemption has already been allocated by the grantor (a very reasonable assumption), a proportionate part of the GST Exemption would attach to the appointed assets. In addition, if the grantor’s children decide to exercise their power to appoint the trust assets to one or more of their children (or other descendants) by distributing those assets to a separate trust for that child (or other descendant), then the appointed assets would also retain the same asset protection for that child (or other descendant) that it had in the original trust. Significantly, the trust documents can be written in a way that makes this limited power of appointment (also known as a "Special Power of Appointment") exercisable by the beneficiary (i.e., the grantor’s child) during his or her lifetime or at his or her death or both. This ability to exercise the Special Power of Appointment during the beneficiary's lifetime or at his or her death adds substantial flexibility to the grantor’s estate plan and to the beneficiary's own estate plan, because it allows the beneficiary to take into account later events in deciding whether (and to what extent) he or she wishes to make lifetime and/or testamentary gifts to members of the next generation or to other beneficiaries. It is also important to remember that during such time, the beneficiary still enjoys the tax benefits and asset protection features of the trust.
Depending upon the amount involved, and the manner in which the power is exercised, exercise of the Special Power of Appointment may trigger a reporting obligation for Federal Gift Tax purposes or Federal Estate Tax purposes, and therefore the beneficiary should keep its tax advisors informed of any significant gifting by the beneficiary and the beneficiary’s own estate plan. However, we believe that the power of appointment feature makes the trust that much more flexible from a planning standpoint.
Trusts (both revocable and irrevocable) may provide for various distribution standards. The trust distributions can address both income and principal, or just one of each. The distributions can commence (or cease) at certain age or event. Distributions can be made to a group of beneficiaries or just one beneficiary. Distributions can be mandatory (“must” or “shall”) or discretionary (“may”). There can be standards inserted in the trust documents which will allow the trustee to weigh on when such distributions can be made (for instance for health, support, maintenance and education), and whether any other resources outside the trust should be considered in deciding on the amount of the distribution. Sometimes the standard can be quite ambiguous, such as comfort and happiness. (As we all know; some people cannot be happy no matter what. That is a challenge for the trustee!)
For instance, trustee may come across the following language in the trust documents: “Whenever the provisions of this Agreement provide that the Trustee take into account all other sources of income and support and the assets available to any such beneficiary, the Trustee may also consider such other circumstances and factors as the Trustee believes are relevant, including funds which might be made available by enforcement of the legal obligation of any person (including any governmental entity) to furnish support or education, and the advisability of supplementing such income or assets, the tax consequences of any such distribution, and in the case of any descendant of the Grantors, the character and habits of the beneficiary, the diligence, progress, and aptitude of the beneficiary in acquiring an education and the ability of the beneficiary to handle money usefully and prudently and to assume the responsibilities of adult life and self-support.”
The trustee always needs to remember that even if the trust document has very little so say about the standards of distribution, there is always state case law that can give more guidance. For instance, standards like “health”, “support”, and “education” can include the following:
Trustee must also remember that even though he/she may be receiving phone calls from the current income beneficiaries demanding the trust distributions, the trustee also has to consider future (i.e. remainder) beneficiaries. It is a truly balancing act maintained by the trustee in ensuring that the trust assets are invested by taking into considerations all groups of the beneficiaries.
One has always heard attorneys asking the trustees to document their decisions. Whether such decisions relate to the trust distributions or investments, it is important to have such decisions being reduced to a writing.
Irrevocable trusts typically include language (often referred to as "spendthrift" language) that provides that the assets cannot be attached by creditors or other outsiders. Because of this language, the entrusted assets are difficult for creditors and others to attach in the event that a trust beneficiary is ever sued or divorced. The assets are legally owned by the trust (rather than the beneficiary) and therefore, as such, the assets are not freely available to a party filing a lawsuit against the trust beneficiary or even to a spouse in the event of a divorce. In regard to a divorce context and depending on the laws of the state where the beneficiary resides, the trust assets are not subject to "equitable division" (among the spouses). An important caveat is that the income and in the case of a child support, the principal, which a spouse is entitled to receive from the trust assets may be considered by a court in determining a spouse's alimony or child support obligation, depending on the laws of the state where the trust beneficiary resides.
However, the trust assets' protection against equitable division (as between the former spouses) is significant, particularly because alimony and child support obligations are often conditioned on future events (such as remarriage or passage of time) and are, in any event, negotiable between the parties. Simply put, if a spouse does not need to worry about losing assets, he or she is better positioned to negotiate other issues, such as alimony and/or child support.
The trust can also protect against a beneficiary's own indiscretions. For example, if a beneficiary has a gambling, drinking or substance abuse problem, or if the beneficiary is simply not good at managing his or her own funds, then the trust's ownership of the funds has obvious benefits. While these events are presumably (and hopefully) unlikely for most clients' children, with each succeeding generation, the risk of a divorce, lawsuit or any of the other unfortunate circumstances just discussed obviously becomes greater.
The primary disadvantage to using a trust is that in the future, there will be more ongoing compliance. For example, because a trust is a separate tax reporting entity, fiduciary tax returns will have to be filed to report the trusts' ongoing revenues and expenses to the appropriate tax authorities. Also, to ensure that the trust is respected for asset protection purposes, the trustee must keep good track in writing of his/her decisions, related to the trust distributions and investments. However, we believe that it is important to keep this consideration in perspective, and to properly weigh it against the very significant benefits of using a trust.
To become a trustee, one does not need to go to college. Most individual trustees learn on the job. Is it good? Lawyers love the answer: “It depends”. If a person named as a trustee had no prior experience in handling the trusts, he or she will be held to the standard of “reasonableness”. It means that if the decisions reached by a trustee are reasonable under the circumstances (even though such decisions may be wrong), such decisions are acceptable. However, if the trustee holds off to have certain expertise and knowledge in dealing with trusts, the standard to which the trustee will be held is much higher.
Regardless of whether or not the trustee has experience in handling trusts, there are certain things with which each trustee should be familiar. One of them is the Rule Against Perpetuities. Some states have abolished the Rule Against Perpetuities. The Rule Against Perpetuities (the "Rule") is a very old law applicable in many states, which basically limited the number of years that any form of property (including cash, stock, real estate, etc.) could be kept in trust. The application of the Rule was incredibly complicated. If a trust is governed by the laws of a state that has abolished the Rule, the assets can be kept in trust for a very long period of time surpassing lives of many generations to come. This is important because it magnifies the trust's beneficial features, i.e., the tax benefits and the asset protection features. The longer the trust is in force, the longer the trust assets have to appreciate with all of that appreciated value shielded by the GST exemption.
One of the main reasons why people create trusts for their families is to protect the family from creditor claims. Divorces, bankruptcies, drug addictions and other events can devastate and impoverish families quickly. The trust provides a substantial barrier between the trust beneficiaries and their creditors. However, such a barrier is not bullet proof and may be pierced by the court under certain circumstances. Although the interest held by the trust beneficiary is not subject to equitable division under Pennsylvania law, it may be considered for the purposes of determining the amount of child support and alimony payments in a divorce or child custody proceeding. Even though the trust does not provide complete protection against all creditors of a trust beneficiary, it is an extremely efficient asset-protection tool interposing a substantial barrier against creditors.
As discussed above, one of the way to modify a trust is to engage a Trust Protector. If that is not feasible, the trust can be modified by the beneficiaries with consent of the living grantors. If, however, all grantors passed away, the trustee may petition a court for modification. Alternatively, if the trust has a very modest amount of assets, the trustee usually has a statutory discretion to terminate the trust and distribute the assets to the beneficiaries, outright and free of trust.
Peace is a great thing to have, especially if it is peace within a family. It also applies to the situations when there is more than one trustee. As a general rule, a majority rule dictates how the decisions need to be made. However, it is always important to check the trust document for specifics. It may provide (to the surprise of the trustees), that unanimous consents may be required. Or, alternatively, a consent of a third party (e.g. a close family member, an advisor, etc.) is needed to carry out a decision. The best way to approach this is to check the trust document for specifics. And, of course, do not forget to obtain an errors and omissions insurance that may be available to the trustee. States differ in their treatment of trustee’s errors and omissions. Some states are quite generous in holding trustees exonerated from liability, while others will impose harsher thresholds to meet. Insurance is one of the practical ways a trustee can protect himself/herself from disgruntled beneficiaries.
Originally published in October 2017
Copyright © 2017 Knox McLaughlin Gornall & Sennett, P.C.