A revocable trust is often the foundational document in the plan to avoid probate. Probate can be an expensive, time-consuming, and public process. Some plans include irrevocable trusts to achieve tax-driven results or for other reasons. No matter which kind of trust we consider, of the many decisions that clients make when creating an Estate Plan, naming a trustee tops the list in importance. While any competent adult may serve as trustee, many states place restrictions on which entities may serve as trustee.
Let’s start with location, which should be one of the more obvious considerations for a trustee. A trustee should be a United States (U.S.) person for tax purposes. If any of the following are true: a non-U.S. person serves as sole trustee, non-U.S. persons constitute at least half of the trustees, or if a non-U.S. person may make any “substantial decisions,” then according to Treas. Reg. 301.7701-7(d)(1)(ii), the trust will be considered a foreign trust for income tax purposes. Generally, foreign trusts have increased reporting requirements for contributions to or distributions from the trust. The U.S. grantor of the trust needs to file the Form 3520, Annual Return to Report Transactions with Foreign Trusts, and the Trustee needs to file the Form 3520-A, Annual Information Return of Foreign Trust with a U.S. Owner. If the Trustee fails to file that form, then the U.S. grantor may face penalties. In addition, Internal Revenue Code (“IRC”) Section 684 triggers gain recognition when no U.S. beneficiaries exist or when the trustor dies. Thus, if possible, name a U.S. person as trustee or find a suitable entity to serve. Note that under some circumstances, naming a trustee who lives in another state may subject the trust to state income tax if the trustee resides in a state that determines the domicile of the trust-based upon the residence of the trustee. Clearly, a Grantor(s) needs to analyze location when determining who to name as trustee.
Aside from selecting a U.S. person to serve as trustee, let’s examine some of the important characteristics that a trustee should possess. The word “trustee” contains the word “trust” which provides the first clue about who will make a good trustee: someone the Grantor(s) trusts. An individual serving as trustee will have to make numerous decisions throughout the administration of the trust and these decisions require a certain degree of judgment, experience, impartiality, investment sophistication, record-keeping ability, and the ability to avoid conflicts of interest. The trustee will need to follow the letter and spirit of both the trust agreement and the governing state statutes. These decisions become more complex when tension exists between the beneficiaries. Many clients believe that naming siblings as co-trustees will force the siblings to work together. Often, it has the opposite effect and causes resentment and a situation in which quid pro quos are the norm. Another common situation involves a trust created for the benefit of a spouse during their life with the remainder to children who are not the biological children of the surviving spouse. Giving the trustee power to make distributions of principal for the surviving spouse would reduce the amount passed to the children upon the death of the surviving spouse. The individual serving as trustee needs to understand these family dynamics and the potential for rifts to occur. Clients often believe their family to be immune to these behaviors, but a well-counseled and wise client understands that these problems occur frequently and plans for them.
Once the Grantor(s) has confidence that the proposed individual trustee possesses the power to navigate a messy situation involving beneficiaries, the Grantor then needs to understand the powers that the trust agreement gives to the trustee and the impact of those powers. This begins with deciding what distribution standard will guide the Trustee. Giving a trustee absolute, unlimited, or sole discretion puts the trustee in complete control of distributions and makes it harder for a beneficiary to compel distributions if the trustee isn’t making them. While this standard provides the highest level of asset protection, it comes at a price. One option would be instead to insert a power to distribute for health, education, maintenance and support, also knowns as the “HEMS” standard. The HEMS standard provides less asset protection because if a potential creditor falls into any of those categories, that creditor may be able to defeat the asset protection component of the trust.
The HEMS standard plays an important role in trust distributions for other reasons as well. If a beneficiary serves as trustee of their own trust, but can make distributions in their absolute, unlimited, or sole discretion, then that beneficiary has a general power of appointment over the assets in that trust. IRC Section 2041 will include assets over which a beneficiary has a general power of appointment in the estate of that beneficiary upon the death of said beneficiary. If the beneficiary does not have a taxable estate, then estate tax inclusion may not matter. Further, if a beneficiary trustee may make distributions to another beneficiary under the absolute, unlimited, or sole discretion standard, then that beneficiary-trustee may have made a gift to the other beneficiary. Clearly, using the HEMS standard for distributions provides safeguards, especially when a beneficiary serves as trustee.
Finally, the Grantor(s) needs to consider who will serve should the original choice be unable or unwilling to serve. The same considerations discussed above should guide the Grantor(s) in selecting a successor trustee. Clearly, competing interests color the appointment of an individual trustee. An individual with the right temperament may reside in an undesirable location. The Grantor(s) may lack individuals with the right temperament. Finally, even if the trustee resides in the U.S. and has the other necessary skills, the Grantor(s) needs to review and understand the distribution standards in the trust to avoid undesirable consequences.