If you create a trust or are serving as trustee, you probably won’t run into any problems if you follow the terms of the trust instrument. However, there can still be misunderstandings about how trusts work or the role of trustee that can trip up both grantors and trustees. Here are the biggest seven to avoid:
Failure to fund
One of the purposes of revocable trusts, often called “living” trusts due to a very successful promotional campaign, is to avoid probate. But this only happens if assets are transferred into the trust by retitling them. Failure to take this step can result in assets passing to people that the trust grantor never intended as well as extra legal costs. This happened in two cases we had in our office.
In the first, the decedent had signed a revocable trust form he had found in a book (this was before the internet) that directed that his estate pass to one of his nieces. But he never funded the trust. In addition, he didn’t have a will. When lawyers prepare revocable trusts, they also create so-called “pour-over” wills for their clients which direct that any assets not transferred into the trust during life be transferred into it at death. This doesn’t necessarily avoid probate, but it means that the client’s wishes are carried out. In our case, however, since the uncle didn’t have a will his estate was divided among the niece he favored as well as her brother and their cousin, a woman living on the other side of the country who had no connection at all with the man who died.
In the other case, a retired college professor drafted an excellent trust that provided for the distribution of his properties among his children and that his partner could live in their shared house for the rest of her life. However, he also did not fund the trust or sign a will. Technically, the partner had no legal rights since they were not married. However, in this case, the man’s children at some cost to themselves chose to carry out their father’s clear wishes and gave the woman a life interest in their father’s home.
Failure to file tax returns
Revocable trusts do not have to file their own tax returns. They can use the Social Security number of the grantor. Irrevocable trusts, on the other hand, must obtain their own tax identification number (also sometimes referred to as an “04” number or “EIN”) and file annual tax returns on form 1041. (This is unnecessary for trusts that don’t produce income, such as an irrevocable trust holding the family home or a vacation home that is not rented out.) As is explained in a prior article in this series, trusts rarely actually pay income taxes because the tax liability follows the income. If the income is distributed to beneficiaries, the trust issues them K-1 tax forms similar to a 1099 from a bank, and the beneficiary must report the income and pay any taxes due. So, there may be no tax liability for failure to file returns, but trying to catch up on returns not filed for several years can be an awful burden on the trustee and accounting expense to the trust.
One transition that often trips up trustees has to do with revocable trusts after the grantor’s death. At that point, they become irrevocable even though they still may be called the “John Doe Revocable Trust” or “Janet Moe Living Trust.” If the trust assets are distributed quickly, then the trustee can usually avoid obtaining a tax identification number for the trust. But if the trust continues, it must obtain its own tax identification number and may have to move funds into new accounts under the new number.
Failure to diversify investments
As trustee, you cannot put all the trust assets in one basket. Neither leaving all the trust funds in a money-market account or putting everything into the stock market is considered a prudent investment approach. Betting everything on Apple
or any other stock also is not appropriate for trust investments. Money-market accounts and Treasury bills produce very little interest and historically have been outperformed by the stock market. The stock market can be volatile with large swings, either up or down. Individual stocks are risky. A trustee must invest in a balanced portfolio that includes both stocks for growth and bonds to cushion the stock market swings.
The proportion of each should depend on the likely longevity of the trust and the likely needs of the beneficiaries. A trust for a 20-year-old who has no immediate need for the funds should be invested primarily in the stock market. A trust for an 80-year-old who requires substantial annual distributions should be invested primarily in bonds. An investment professional can guide the trustee on the most appropriate distribution and investment vehicles. Hiring an investment professional also insulates the trustee from any rearview mirror questions about investment decisions.
There are a few exceptions to these rules. A trust that will be distributed quickly can be left in cash. In fact, if a revocable trust terminates upon the grantor’s death, it’s often a good idea for the trustee to liquidate the trust holdings to facilitate distribution and avoid the risk that the investments drop in value during the estate administration time. Another exception has to do with special assets that the trustee keeps either at the direction of the grantor or for the benefit of the beneficiaries. This may include holdings in a family-owned business or real estate in which a beneficiary lives or various beneficiaries use as a vacation home. They might not be the wisest investments, but their retention serves other purposes of the trust.
Self-dealing can be either benign or malignant. Benign self-dealing occurs when the trustee jumps in to carry out tasks that might have been better carried out by others, for instance, fixing up a house to rent out and earn money for the trust. This becomes self-dealing when the trustee then seeks compensation for all the work she carried out. Often this occurs unintentionally. The trustee does the best she can not realizing ahead of time how much work is involved and then seeks payment once the burden becomes evident. That’s problematic, because the obvious question is whether the trust would have been better off if the trustee had hired an outside individual or company to do the work. And the trustee and the beneficiaries may not agree on the answer to that question. It’s best to look before you jump, and then to compromise on your fees to make sure that you have acted in the best interest of the trust.
More malign self-dealing is when the trustee hires his own property management firm or his brother-in-law’s firm to manage the property, especially if they charge more than the going rate. Or if he uses the vacation house and makes it difficult for other family members to do so. Or uses trust funds to invest in his or his child’s new startup company. In these cases, the trustee is clearly violating his fiduciary duty and can be subject to damages for doing so.
Failure to take fees
While one would think that trustees not charging fees is a good thing for the trust, it isn’t if the trustees want to get paid after the fact. We’ve often had this question from family member trustees. They’ve served for many years as trustee for a parent and now the parent has died or moved to a nursing home and the trustee wants to be compensated. This doesn’t work.
While all trustees are entitled to “reasonable” fees, what’s “reasonable” can be determined by an agreement between the grantor and the trustee. Where the family member trustee has not been taking fees, absent a written agreement to the contrary, it would appear that the trustee was serving without compensation. Further, the failure to take fees created an expectation among family members about the size of the trust and their inheritance that was not diminished by the fees withdrawn annually. Both the lack of an agreement about fees and the expectations created by the practice of not taking fees make it difficult to take out fees at a later date. In the case of the parent moving to a nursing home, the state Medicaid agency may argue that the large payment was a transfer of assets making the parent ineligible for benefits for a period. Where the parent has died, other family members may argue that the large fee payment is not reasonable and thus not permitted under the trust or state trust law.
If a trustee wants to postpone payment of fees in order to make sure that the beneficiary does not run out of money — in other words, only taking fees if money remains upon the beneficiary’s death or move to a nursing home — then this should be written out in the trust itself or in a side fee agreement. Unfortunately, most people don’t think about this ahead of time.
Difficulty saying ‘no’
It can be hard to say “no” when a beneficiary is asking for a distribution. This can cause friction when a family member is serving as trustee. But it’s important both to create the right expectations and because the trustee must think about the long-term both for the benefit of the current trustee and future remainder beneficiaries. This can be especially difficult when it looks like the trust is holding significant funds, but it must last for the beneficiary’s lifetime. If the principal is spent down, the earning power of the trust fund will diminish, starting a downward spiral that can ultimately completely deplete the trust fund.
Keeping this long-term perspective in mind, trustees often must say “no.” This occurred recently in two cases in our office. In one, the beneficiary turned 18 and wanted an iPhone 11 for his birthday. The trustees, being very frugal, owned the cheapest smartphones they could buy themselves. They turned down the request, both to set the stage for future distributions and while the trust could well afford a single iPhone 11, it could not afford to purchase every new iPhone Apple releases.
In the other case, the trust beneficiary lives on a boat. He wanted to upgrade the power supply to the newest solar power batteries at great expense. Family members questioned the beneficiary’s ability to install the new system himself and the trustee was not in a position to supervise the work himself. As a result, the trustee approved replacing the existing batteries, but not the whole new system.
It often helps to have an independent trustee just for the purpose of being able to blame a nonfamily member for refusing distribution requests. Otherwise, considerable family strife can result.
Lack of transparency
While usually not doing so for malicious purposes, some trustees fail to disclose all their distributions and investments to beneficiaries. Often this is because the trustees are busy and preparing and sending out reports seems like an unnecessary added burden, as would be the follow-up questions.
This is a mistake on a number of levels. First, beneficiaries have a right to this information. Second, failure to be transparent often raises suspicions that even if unfounded can make relationships between trustees and beneficiaries difficult. Again, where a family-member trustee does not have the time, energy or accounting ability to prepare proper financial reports, it can help to have a professional trustee that prepares these as a matter of course.
Next time: The 5 most-asked questions about trusts
Harry S. Margolis is a Massachusetts estate and elder law planning attorney. He answers consumer questions about estate planning at AskHarry.info and most recently published The Baby Boomers Guide to Trusts: Your All-Purpose Estate Planning Tools.