Today, more of our clients are becoming receptive to planning that uses irrevocable trusts intended to manage significant wealth for future generations of the settlor’s family. Consequently, the idiom “you get what you pay for” may be more relevant than ever when selecting a trustee who may be responsible for managing extensive wealth for infinitely longer periods of time.
At its core, a trust instrument creates a contractual relationship that imposes fiduciary responsibilities on the trustee to administer trust assets for the benefit of beneficiaries, in accordance with the terms of the agreement. Trust agreements are often lengthy and complex documents governed by ever-evolving and complex tax laws. Whether or not the trustee is able to parse through trust provisions, a trustee may be held personally liable to the beneficiaries in the event of a breach of the trustee’s obligations and duties of care, loyalty and impartiality.
Hiring a professional trustee is a value proposition that the trust creator should seriously consider to ensure that the trust is administered in accordance with the trustee’s duties.
Pros and Cons
Practitioners working with clients planning to set up trusts might wish to discuss the pros and cons of having a professional trustee. Ultimately, it’s the settlor’s decision whether to appoint a professional trustee when the trust is initially settled. The practitioner’s role is to be available to help identify the pros and cons of using a professional trustee. A practitioner must be well-versed in the risks of a non-professional trustee and understand the advantages of a professional trustee when the size and complexity of the trust warrant it or when the factual circumstances necessitate it.
The biggest drawback and likely the client’s most pressing concern will be the cost. Professional trustees charge commissions of 50 to 150 basis points annually and may charge fees for other services to the trust. There may also be legal fees on top of the commission and ancillary costs.
Not all trusts need professional trustees. Trusts that terminate on the happening of a particular event expected to occur in the near term wouldn’t necessarily need a professional trustee. It may be cost-prohibitive for trusts that hold corpus under $1 million worth of assets to have a professional trustee because the expense will just continue to dwindle the trust corpus over time. Alternatively, the trust may not be able to afford a professional trustee, even if one would be beneficial, if the trust holds illiquid assets such as non-voting interests in closely held businesses or undeveloped land and therefore doesn’t have the liquidity needed to pay a professional.
When a professional trustee isn’t warranted or practical, the trust agreement should nonetheless provide for a mechanism to appoint a professional trustee to make it easier to appoint one if and when the current serving trustee or a majority of all adult beneficiaries decide that it’s in the trust’s best interests.
Some trusts are particularly difficult to administer and might be drafted to require that a professional trustee serve at all times unless it becomes uneconomical for the trust to continue.
For example, split-interest trusts, such as charitable remainder and charitable lead trusts, have very specific regulatory requirements.1 Failure to meet the regulatory requirements can taint the charitable benefits and opportunities of establishing those trusts in the first place.
When family relationships are already strained and beneficiaries are particularly difficult or unsophisticated, a professional trustee may be uniquely qualified to serve as an impartial arbiter to protect the family’s wealth. A professional trustee can be expected to have knowledge and resources to engage with experts who can help navigate issues affecting trust administration.
Generally speaking, the use of a professional trustee should be the norm rather than the exception. Although the size and complexity of the trust are relevant considerations, in most cases, a settlor will choose a professional once all the factors are accurately presented and fairly discussed.
Selection Tips
Once you’ve determined that a professional trustee is warranted, the next task is to select the right professional trustee. A professional trustee should neither be related nor subordinate to the settlor or beneficiaries and should otherwise qualify as independent pursuant to Internal Revenue Code Section 672. A trust instrument should explicitly define who qualifies as an independent trustee to ensure that the trustee meets the statutory criteria on acceptance and for the duration of their service.
In addition to qualifying as an independent trustee, the professional trustee should be well-versed in the rules governing fiduciary relationships so that they might meet their fiduciary obligations as set forth in the trust instrument. The professional trustee should have adequate professional liability coverage and a staff available to assist the trustee in administering the trust. Professional trustees should have the expertise to understand the tax implications of decisions required to be made in administering the trust, as well as the appropriate professional demeanor and impartiality necessary to deal with the beneficiaries. If the trustee is a corporation, the corporation should appoint a qualified trust officer within a dedicated trust services team. The corporation should also have significant assets under management on its trust platform. A truly qualified professional trustee will have a detailed intake process and will vet the trust relationship prior to committing to serve.
Risks of Using Layperson
When insisting that a professional trustee isn’t necessary, clients often protest that their family member or friend has the very best intentions and would never commit an act of fraud, negligence or malfeasance. In reality, the number of ways in which a layperson can increase risk to the trust and beneficiaries is almost limitless. A properly selected professional trustee can significantly mitigate risks by avoiding the areas that could cause trouble for a lay trustee, such as:
- Failing to create and maintain a separate account to receive income from the investments of the trust.
- Making investments that aren’t permitted under the trust agreement.
- Making distributions to beneficiaries who aren’t then eligible to receive distributions from the trust.
- Improperly reimbursing the original settlor for tax liability arising out of the income earned by the trust.
- Making distributions to a beneficiary without first evaluating the income tax or generation-skipping transfer (GST) tax implications of such distribution.
- Exercising or failing to exercise trustee powers in a way that changes the taxability of the trust from a nongrantor trust to a grantor trust, thereby shifting the tax liability back to the settlor.
The risk of each of these errors or omissions can range from an additional income tax, possible claims from beneficiaries, loss of investment opportunities or, in more egregious cases, inclusion of the assets funding the trust back into the original settlor’s estate for estate tax purposes.
Many practitioners believe that distributions by a trustee who’s related to the original settlor should be limited to an ascertainable standard. The thinking goes that imposing such a limitation might help to overcome an attempt by the Internal Revenue Service to cause inclusion of the trust assets in the settlor’s estate on the grounds that the settlor retained control over disposition of the assets by allowing a related or subordinate trustee too much discretion.2
On the other hand, when a professional, independent trustee has broad authority under the trust instrument to make discretionary distributions not limited by an ascertainable standard, the same concerns don’t typically apply. In exercising authority to make wholly discretionary distributions, a professional trustee can be expected to use independent judgment that won’t likely be attributable to the original settlor, thereby severely curtailing the risk of IRC Section 2036 inclusion. This is particularly true when the professional trustee is otherwise bound by a professional code of ethics, as in the case of attorneys and certified public accountants.
Professional Trustee Benefits
A professional trustee should have adequate skill and expertise to avoid the pitfalls detailed above. Specifically, a qualified professional trustee should be well positioned to:
- manage trust assets properly;
- act as an unbiased arbiter;
- ensure that distributions from the trust are only made in accordance with terms of the trust;
- certify that the trust meets its obligations under agreements to which the trust is a party; and
- properly analyze the tax consequences of trust transactions, including income, capital gains, estate, gift and GST taxes.
The professional trustee may be more likely to oversee the day-to-day management of the trust, including collecting on any installment sale notes, demanding payment from the grantor when necessary, making estimated payments for income tax purposes, managing real estate and the associated costs for same, hiring other professionals like accountants and wealth advisors for the trust, diversifying the holdings of the trust when possible or mitigating the risk of an over concentration within the trust.
A professional trustee should have the technical skill to divide trusts and maintain separate trust shares when necessary to maximize the opportunities of the GST tax exemption available to the trust. Additionally, a professional trustee should understand why and when to exercise a power to adjust between principal and income, particularly when a closely held business is the primary asset in a trust.
In each such case, the settlor and beneficiaries may expect the professional trustee to communicate decisions in a clear and effective manner, in accordance with the laws governing trustees and the obligations set forth under the trust agreement.
Giving beneficiaries creative solutions. It’s not unusual for a professional trustee to contemplate solutions that a layperson might not be aware of.
Let’s take a common example—a beneficiary requests a large cash distribution to buy a second home. A layperson trustee might simply liquidate assets of the trust to make a distribution, creating a capital gains event within the trust and pushing value out of the protective shield of the trust into the hands of the beneficiary. On the other hand, a sophisticated, professional trustee might instead initiate a call to the trust’s wealth advisor and tax preparer to determine the most tax-advantaged ways to raise the necessary liquidity to provide the requested resources to the beneficiary. The trustee might evaluate whether it’s better to lend cash to the beneficiary for the home purchase or have the trust purchase the property for the benefit of the beneficiary. To the extent that the trust instrument allows for either option, these alternatives would preserve estate tax and divorce protections, which would be otherwise wasted by an outright distribution from the trust.
A professional trustee may be more likely than a lay trustee to collaborate with advisors to identify opportunities for tax savings. Some common examples include:
- tax loss harvesting at the end of the year to mitigate income and capital gains tax incurred by the trust;
- modification of the trust’s terms to take advantage of a change in the law or Tax Code;
- GST tax planning;
- exercise of certain powers under the trust to remove beneficiaries for limited purposes (that is, when a divorce or other lawsuit is imminent); and
- other elections under either the trust terms or the Tax Code that ensure the optimal treatment of the trust for income, capital gains, estate, gift and GST tax purposes.
Additional protections in the event of a divorce. Assets in a trust may be vulnerable to a divorce claim when the trustee is also the divorcing beneficiary, and in fact, many practitioners would argue that a beneficiary has a greater level of protection on trust assets when a professional, disinterested trustee is serving. Even when the trust agreement expressly limits the beneficiary-trustee to an ascertainable standard when making distributions, it’s unclear whether a spouse could reach the assets of a trust by arguing that mistakes were made in administering the trust or making distributions from it, thus possibly tainting what would otherwise be protected trust property. For example, if the beneficiary-trustee regularly takes distributions for support and maintenance during the marriage, perhaps a non-beneficiary spouse might successfully argue that those distributions should be considered in determining equitable distribution, child support and alimony awards.
The best practice when asset protection is a primary objective of establishing the trust is to engage a professional trustee who can evaluate the situation and creditor risk before making distributions from the trust. Specifically, a professional trustee would likely avoid making regular distributions to beneficiaries and possibly withhold distributions when a beneficiary might have a creditor or divorce risk.
Implement Safeguards
Even though a professional trustee is typically held to a higher standard than a layperson3 and could be bound by additional professional standards of ethics, as in the case of attorneys or certified public accountants, it may be a good idea to enhance the trust by including the appointment of a trust protector with the power to remove and replace the professional trustees. Depending on the jurisdiction and the purposes of the trust, it may be possible for a trust protector to serve in a non-fiduciary capacity. Depending on the laws of the relevant jurisdiction, often the grantor, grantor’s spouse or one or more adult beneficiaries might be considered to serve as trust protector, so long as that wouldn’t hinder the underlying purpose of the trust planning. A practitioner may consider drafting the trust instrument to grant a trust protector unfettered discretion to remove and replace the trustee with another independent trustee. In other situations, it may be better to allow removal and replacement of a professional trustee only for specific enumerated reasons—even limited to removal for cause only.
While a client may initially think that appointing a family member or friend to serve as trustee is cost-efficient and convenient, a practitioner should discuss and highlight the potential long-term risks to such a selection. A professional trustee qualified to assume the responsibilities of administering a trust in accordance with its terms and applicable laws from Day 1 will likely achieve benefits that far exceed any cost savings from choosing a lay individual. Navigating legal complexities towards satisfying planning objectives can be a demanding task. It’s no wonder, then, that the use of professional trustees has become more common in recent years!
— Many thanks to our colleagues at Avelino Law, LLP: A. Jude Avelino, partner; Glenn J. Christofides, counsel; Thomas R. Szieber, Jr., counsel; and Molly E. Depew, associate attorney, for their collaborative feedback and assistance in drafting this article.
Endnotes
1. See Treasury Regulations Section 1.664-1, et seq. A professional trustee could be crucial to meeting the complex obligations for split-interest trusts established under Internal Revenue Code Section 664 and related regulations. The Internal Revenue Service scrutinizes charitable trust transactions much more closely than non-charitable trusts. Further, the relevant state or local jurisdiction may impose additional reporting requirements. For example, the New York attorney general requires separate reporting and usually a fiduciary accounting to prove that the charitable interest was satisfied under the terms of the trust agreement. In our experience, a professional trustee is more likely to collaborate with the trust’s other advisors in a way that will better withstand governmental scrutiny. A complete discussion of charitable trust requirements is beyond the scope of this article.
2. Such a challenge would generally be brought by the IRS under IRC Sections 2036(a) or 2038.
3. See In re Knox, 96 A.D.3d 1652 (2012), in which the court held the professional trustee to a higher standard under the prudent investor rule.