We live in strange and unprecedented times, both from an estate planning perspective and globally. The combination of COVID-19 and a particularly tumultuous election year have led to a spike in time-sensitive estate planning. Thus, trustee selection considerations have become more critical than ever, yet fiduciaries may often be selected more for ease of naming than ability of execution. This article provides specific scenarios of planning and drafting strategies to address real examples where named trustees were unable to serve as intended. Special consideration should always, and especially now, be given to these considerations upfront during the drafting phase. Clients (or their attorneys) must have early and open communication with fiduciaries in order to combat any exigencies caused by personal or increasing societal pressures.
Election Year Tax Planning Trends
With the end of the year fast approaching, estate-planning attorneys are working to implement tax-planning strategies before any potential changes are made to the combined federal gift and estate tax exemption.
Currently, each person in the United States has a combined federal gift and estate tax exemption amount of $11,580,000 that each may use to give away assets during life or at death, or some combination thereto. At death, any assets in an individual's estate in excess of that amount are taxed at a 40% federal tax rate (similarly, any assets gifted during life in excess of that amount are also taxed at a 40% federal tax rate). As the law is currently written, if no changes are made to the exemption amount, the combined federal gift and estate tax exemption amount will automatically decrease to $5,500,000 (indexed for inflation) on January 1, 2026.
But, it could decrease even earlier and to an even lower combined federal gift and estate tax exemption amount. If there are changes in Washington, D.C. come November, these changes could become effective as of January 1, 2021 (even if retroactively). Given the combined potential for the exemption to decrease, the historically low interest rates (for October 2020, the October mid-term AFR is 0.38%) and the depressed value of some assets, clients are busy making gifts and loans to beneficiaries.
Some of the current popular trends for tax planning include the following:
- Grantor Retained Annuity Trusts: These irrevocable grantor trusts allow a client to transfer assets into the trust by making a "zero gift" (a gift that does not count against their lifetime estate and gift tax exemption) by retaining a right to receive an annuity equal to the transferred amount. The assets in the trust that increase beyond the annuity amount the client receives can then pass estate tax free to the client's beneficiaries (often times, to an irrevocable trust for children to be managed by a trustee).
- Intra-Family Loans. With low interest rates, parents are using this as an opportunity to loan money to children (again, the October mid-term AFR is 0.38%) either outright or to a trust for their benefit (if the latter, then the below trustee considerations apply). Parents can then forgive interest (and principal payments) equal to the annual exclusion amount each year, i.e., each person may give anyone $15,000 each year without applying the gift to an individual's remaining federal gift and estate tax exemption amount, thus combined one married couple can give another married couple up to $60,000 ($15,000 x 4 people) each year with no transfer tax implications.
- Defective Grantor Trusts. A widely popular planning technique is using defective grantor trusts ("DGT") for tax planning. What makes it "defective" is the fact that the assets transferred to a DGT are excluded from the trustor's estate for estate tax purposes; however, the trustor will still be required to pay income tax on all income earned by the DGT during the trustor's lifetime. One benefit is that these additional payments of income tax are not treated as additional gifts to the beneficiaries of the DGT. Many clients are creating these DGTs for their children for the purpose of receiving interests in entities or real property. At the time the assets are transferred to the DGTs (either by a gift or sale), the value of the assets is frozen. Thus, all future appreciation on those assets is essentially removed from the client's estate. The DGTs in turn will become the owners of the entities or real property (or other assets) to be managed by the trustee of the DGT. An additional discussion of the advantages and disadvantages of using a sale versus gift approach is outside the boundaries of this article.
Exigent Trustee Selection Issues
Due to the current pandemic and geopolitical situation, trustee selection has become more important than ever. Avoidable trusts and estates litigation examples abound where alternative fiduciary provisions could have yielded a more preferable result. Irrevocable trust planning in hurried scenarios in particular, such as in the current planning trends above, can often be given the least diligence in terms of trustee selection, and accordingly can actually lead to some of the most damaging long-term situations with regards to achieving trustors' objectives.
As always, even during a pandemic, non-professionals (typically family members or close friends) are the most commonly selected fiduciary. This is often simply because they are a known person to the trustor, can sometimes be someone whom the trustor feels they can still exert some level of control over, and (often falsely) that this will be a more cost-effective option. Often times, the savings in fees associated with appointing an individual trustee are more likely than not to be offset by extra legal and accounting fees due to the inexperience of the individual. Balancing control in estate planning is always a key element, but here can often backfire if the chosen trustee is willing to basically do whatever the trustor says, sometimes in (unknowing/uncaring) contradiction to the actual trust document, and the trust purpose can be (sometimes inadvertently) invalidated entirely due to this.
Especially for large and complex trusts and estates, naming a non-professional who is "learning on the job" can yield drastically negative results, and—while there is often an initial pressure to serve without charging a fee—layperson fiduciaries often retroactively end up charging a flat percentage fee (typically without having kept detailed records of the work they have done) that may be significantly higher than a tiered fee often charged by a professional or corporate fiduciary.
In addition, the trustor must be willing to accept the potential consequences that this change in relationship with a personal friend or family member (or close professional contact) may cause, if a conflict should arise. Would you still be able to invite this person to Thanksgiving if, for example, they missed a critical tax deadline costing you hundreds of thousands of dollars unnecessarily due to their lack of experience (unfortunately, a real example)? Does the proposed trustee have any personal problems, have they had substance abuse issues, or any financial challenges that might cause them to be conflicted in their duties or overly incentivized to make sure their trustee compensation continues (i.e., their only or primary source of income is from this trust)? Do they have significant debts or have they made bad investments in the past?
In addition to the above considerations, family members or close contacts in particular will often agree to serve if put on the spot simply out of a sense of helpfulness or obligation, without fully understanding the time, responsibility, and personal liability they're being asked to undertake as a fiduciary. One (surprisingly not-so-obvious) good threshold question to ask them is to explain what the terms fiduciary and trustee mean. Make time for them to at least speak with your attorney, and encourage them to retain and speak with their own attorney beforehand, since they will likely need one when they are serving anyway. If the parties are unwilling to invest in this upfront, time-wise or money-wise, this may be a red flag that the individual may not be the best choice for trustee.
Similarly, does the individual have fiduciary insurance? If not, the trust will likely have to pay for this. Even though a professional sometimes may seem more expensive upfront, they will have their own insurance (make sure they do and that it is large enough to cover a potential claim). Is the non-professional trustee even insurable? Having an attorney and the insurance company do the due diligence may be simpler than asking some of these potentially uncomfortable questions directly. If there is an unwillingness to pay for extra insurance for a layperson fiduciary, consideration should strongly be given to naming a professional trustee to ensure the trust is adequately protected.
Due to the above concerns, clients often think to instead name one of their trusted non-fiduciary professionals as their trustee. This seems like a logical choice, but can often backfire, as while the named trustee may have one or more of the skill sets of a good trustee, they may lack critical experience in actually administering trusts. They may not have business procedures in place, may not be adequately staffed to comply with applicable fiduciary duties, and may prioritize their other functions as busy professionals, especially if adequate compensation is not pre-established. Trustors should ask themselves whether their selection has investment management, accounting, legal, real estate, business management, and (critically) organizational skills, as well as the ability to handle everyday administration tasks such as bill pay and managing other service providers, if applicable.
Additional considerations should include—regardless of a professional advisor's competence in their typical role—whether they are able to make difficult, independent decisions, and whether they will act with the highest ethical considerations when in full control over an account.
Availability is also key, and is often overlooked and more complicated than initially perceived. What happens if your trustee goes on vacation (outside of COVID times)? Are they able to answer emails and sign documents remotely? Are they technologically savvy? Do they have a lifestyle that does not lend itself well to being available—such as having a busy unrelated business of their own, family commitments, constant travel or "off the grid" tendencies? Do they have partners or staff that are trained in estate administration that can cover for them when they are unavailable? Do they have someone who answers the phone and sorts the mail for them? A good proxy test is to ask how many trusts they have administered before, and see how quickly and consistently they typically respond to your emails prior to becoming the trustee. Do not expect this to change in a fiduciary relationship, and keep in mind that some correspondence is critical and simply cannot be missed or delayed without significant consequences (e.g., from the IRS, FTB or the County Assessor's Office).
Furthermore, conflicts abound in the trusts and estates world, and can often be anticipated with additional questioning during the planning process. Is a sibling being asked to be trustee of another sibling's interest? Is a step-parent? Is a non-family member being asked to oversee a family member's trust? Is the trustee also a beneficiary? Even a perceived conflict of interest can cause the best laid estate plans to come crashing down in spectacular fashion—let alone if there is an actual conflict—either due to the actions/inactions of the fiduciary or their past relationship dynamic with other parties.
Additionally, your trustee is your succession plan, but what is your trustee's succession plan? There are far too many instances where a single named trustee is unwilling, unable, or dies prior to their appointment as trustee. People thus often think that by naming multiple trustees, this solves the problem. However, we have seen many scenarios where all named successors end up being unable to serve. For example, are all the named successor trustees in the same age group? How does this compare to the length of time the trust is expected to be in existence? Are they all related to the trustor in the same way, such as all siblings, all aunts and uncles, or all business associates? The problem may arise that all named successors could be unavailable at the same time due to similar reasons (e.g., all the family decide they cannot serve without conflict; all business associates cannot serve because the business is no longer in existence, etc.)
A common solution to this issue is then to name a corporate trustee, such as a bank or trust company, as the primary or backup successor trustee. Problem solved, right? Not necessarily. Has the corporate trustee been consulted to ensure that they are willing and able to serve under the proposed scenario (at least as it is currently known)? Clients, and even attorneys, are often surprised to learn (often the hard way) that there are numerous hurdles to a corporate trustee being able to accept a matter, such as high minimum asset amounts, liquidity thresholds, ability to quickly further diversity assets, and restrictions on certain entire asset classes. Commonly, cases are turned down due to complicated operating businesses, high real estate concentrations (especially if numerous code violations are present), and matters with ongoing litigation or risk thereof. Do not assume that a corporate trustee will actually be able to serve when the time comes. Especially when they are the ultimate backup in a list of named successors, they are often not consulted at all in the planning process and so this step may be missed, causing a complete run of declinations to serve by all trustees, leaving an otherwise avoidable vacancy.
But that's easily fixed, right? First, give a trustee the power to name their own successor. However, these provisions often come in the form of allowing the last serving trustee to name their successor, but if everyone is declining, this often doesn't or can't happen, and many corporate trustees will decline to do so as a matter of policy. Okay, then secondly give the beneficiaries the power to appoint a successor? What if they disagree (i.e. is there a provision for majority rules or what if there is an even number leading to a tie)? Standard trust provisions for tiebreakers that can apply to trustees often do not apply here, since this is a vote amongst beneficiaries. Even more commonly, what if the beneficiaries seek to select a trustee who will simply give them whatever they want, thereby effectively negating the purpose of the trust?
Limiting language can also be inherently problematic in these scenarios. For example, what if a corporate trustee is strictly required by the trust (or even more restrictively, a corporate trustee with a certain high minimum asset threshold), and all such corporate trustees are forced to decline to serve due to the above enumerated issues? This is a more common situation than is often understood, and drafting into an unnecessary corner inherently forces a trust to go to court in a scenario when a private professional fiduciary or layperson is in fact needed.
Similarly, what if the trust has unexpectedly become too small or simple for any professional to serve, but a layperson is strictly disallowed? One of the most harmful situations during a trust administration can be a gap in trusteeship, so intense scrutiny should be given to whether the succession plan allows for a swift transition between trustees. For example, do the successors even know that they are named, and how will they find out? Does the currently serving trustee keep organized records in a location where the next trustee could find them (or would the successor trustee need to wait until the prior trustee's own estate is settled), or are they in a secret location or password protected on a computer, where no one else knows the password? Without a plan, this can often create a 6-12 month gap in effective trusteeship, even if someone is willing to serve.
An additional consideration that is increasingly overlooked during a time-sensitive estate planning process is whether the proposed trustee is given a draft of the trust to review ahead of time to make sure they can comply with its terms. Are they even willing and able to review and respond with constructive feedback in a timely manner? Does your proposed successor trustee have experience reviewing trust documents and/or do they have some policy that precludes them from doing so?
Solutions do not come easy in these situations, although some are suggested above, as the primary solution is a function of time that may not be available. That being said, the first aspect to consider is perhaps whether a rushed plan is wise. If a client does not understand the permanence or disadvantages of the plan being enacted, and/or a suitable trustee succession plan cannot be determined and vetted in the allotted time, simply halting the plan may be prudent until these items are finalized. If it can be accomplished, balancing flexibility and control is important. Thus, some additional suggested drafting considerations based on the above challenges include:
- Do not be overly prescriptive of the type of trustee that must always serve long-term, even if a certain type of trustee is presently advisable. Allowing corporate trustees of various sizes, private professional fiduciaries, and laypersons to serve under scenarios that may not be contemplated at the time of drafting can be essential in avoiding court intervention down the line.
- Powers to remove and replace trustees should be given the same level of scrutiny as trustee succession itself. Is the person or persons with this power qualified, available, and independent enough to make this decision? Avoid naming only a single person with no succession language, and make sure that there are applicable tiebreaking provisions. Ideally, this power holder, whether they are termed a "trust protector" or not, should (at least somewhere in the succession) be a position and not an actual named individual, so that there is a likelihood for longevity. For example, granting the power to the then-serving president of a fiduciary practice or managing partner of a law firm is more likely to ensure succession than referring to the current managing partner of a law firm by name, as they may later be unable to make the decision. Allowing each trustee the flexibility to name a successor to "jump the line" ahead of other named successors may also help them to adapt to a wider array of scenarios (although this may have the effect of changing the trustor's intent, so careful attention must be paid to this language).
- Liquidity is often one of the biggest problems in trust planning and trustee service, especially in irrevocable trusts. Requiring a certain percentage of liquidity contribution upfront (for example, 10%) can aid in allowing the trustee to execute their fiduciary duties, pay costs and fees, and react quickly when needed without having to seek additional contributions from the trustor. This is also a good check as to whether there is liquid capital being contributed at the outset in order to judge the client's understanding and commitment to the irrevocable strategy. In addition, many professional and corporate trustees will not serve as trustee where the trust does not have sufficient liquidity to pay their fees and other fees.
- If someone other than the trustee will be depended on to appraise various trust assets on an appropriate schedule, require that they do so in the trust or separate document, and have an appraiser (for example) sign that he or she can comply with the terms of the trust/document (and don't forget to name their successor).
- Weigh the pros and cons of permitting a beneficiary to act as co-trustee or sole trustee upon attaining a certain age. If a beneficiary will be acting as co-trustee, consider including language to allow the other acting trustee to determine if the beneficiary is mature enough to actually assume the position of co-trustee so as to not cause undue harm to the management of the trust. Conversely, permitting a beneficiary, where appropriate, to serve in these roles may provide the necessary flexibility that the trustors desire when creating an irrevocable trust.
Tax planning in a time of low-interest rates, depressed values and the potential for significantly lower federal gift and estate-tax exemptions has many clients sprinting to do tax planning to use up their exemptions and request discount valuations of gifted assets (which may also disappear in the future). Hasty planning can cause clients and drafting attorneys alike to forget to include language that allows for later flexibility, whether it be a testamentary limited power of appointment for a beneficiary or a broad ability (other than IRC Section 672 limitations) to remove, replace, and appoint trustees. It can also cause clients to name trustees who might not be suitable for the position. Drafting attorneys must have difficult conversations with clients, collaborate with chosen fiduciaries to ensure that the correct person is named as trustee and to ensure that flexible provisions are included so that the best-situated trustee can serve at any given time without undue expense or delay.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.