This article was originally published on December 2, 2015.
Imagine this scenario: you are a successful business owner with two young children. Your business is becoming increasingly profitable, and the value is growing rapidly. You would like to set aside some assets in trust both for estate planning purposes and to provide your children and future grandchildren with rainy day funds. You have a good relationship with your brother, and he knows your family well; you plan to ask him to be the trustee of a trust for your children. You would gladly return the favor someday, sharing your financial knowledge and business acumen with members of his family, but you wonder whether his career in medieval French literary research will be any help in his role as trustee. In some states, notably Delaware, it is possible to be a trustee with limited responsibility. Your brother could select an “investment trustee” to work with him and make investment-related decisions or a “management trustee” to work with him and make decisions relating to the business interests, but here let us assume you particularly want him, your trusted sibling, to take care of your family affairs now and after you are gone.
This is a dilemma we see often. Each of the Brown Brothers Harriman (BBH) Trust Companies is a professional trustee, staffed with experienced attorneys, trust officers, administrators and tax accountants. Many of our clients have asked whether it is possible for an individual – even one with little or no specialized knowledge – to be a good trustee. Our answer is yes – if the trustee keeps the following fundamentals in mind.
Dear Brother: Please Read the Trust Instrument. The trust instrument is your instruction manual. It names you as trustee and explains what you are authorized to do with the trust property. Your knowledge of Latin may help you understand legal terms, such as “to my issue per stirpes,” but you may balk at the innocuous sounding “to my issue by representation.” Here, you would need professional guidance. My attorney, who drafted the trust instrument, will give you an outline of the meaning and purpose of significant provisions of the trust. The original trust agreement will be kept in a vault at my attorney’s firm, and even after I am gone, regardless of whether my attorney still works at the firm, someone there will be able to help you review that outline of the significant trust provisions. You should also be aware that underlying the trust instrument is state trust law. Where a trust instrument is silent – by failing to mention whether you can sell trust property, for example – state laws provide lists of trust powers that round out those granted to you under the instrument.
Dear Brother: Please Understand Who Owns the Trust Property. I have placed valuable shares of my business in the trust. That is a generous gift. Whose shares are they now? I want them to be managed wisely, and I have the knowledge to make sure that they are; however, I am no longer the owner of those shares and therefore have no say as to how they are managed. My children are too young to be aware of the trust, but they will likely be very interested in it when they are older and may come to you asking for distributions. My grandchildren don’t exist yet, but they are mentioned in the trust instrument as the recipients of any remaining trust property on the death of my children.
In actual fact, you are the legal owner of the trust property. I, the owner and operator of this successful business, can no longer direct the management or distribution of the property. I transferred nonvoting shares of the business to the trust, so you do not have to worry about business decisions at this time, but you still have very important duties with respect to the trust property (described more fully further on). I have done my best to advise you through a “side letter” and “precatory” language in the trust agreement, and my intent in creating the trust governs your decisions.1 My children, even when they are in their 40s and running Fortune 500 companies, cannot direct the management or distribution of the trust property; you alone are responsible for these in accordance with the terms of the trust.
You may not be a despot, however. My children – and, when they are born, their children – also have an ownership role: they are the “beneficial owners.” Being a beneficial owner is a bit like being a shareholder in a company or a citizen of a civilized country. Someone else is in charge of running things for your benefit, but you still have some rights. In the trust context, a beneficiary has rights that are protected by state law and the courts. The greatest protection is the high standard to which a trustee is held in carrying out his or her duties, which reminds me. …
Dear Brother: Please Understand Your Duties. Under every state’s laws, trustees are expected to fulfill certain duties, and failing to do so is to be subject to lawsuit and personal liability. I have given you some guidance in the side letter and the trust as to the extent of your duties, but be wary of any general release from responsibility, as courts resist dilution of the trustee role. The following are considered a trustee’s fundamental duties, which should underlie all your actions. This is intended as a guide – not an exhaustive list. For example, it does not include any special duties of notice or other specific duties that your particular trust instrument or local state law may impose.
- You Have a Duty to Administer the Trust by Its Terms. Your purpose in understanding the trust instrument is to avoid inadvertently deviating from its terms. There is a difference between “shall” and “may.” If the trust instrument says that “the trustee shall pay all the net income to my child annually,” then you need to arrange for remittances to be made. You also need to know what “net income” means. The trust instrument may use the terms “income” and “principal” without any definition. State law provides default rules for allocating trust earnings and expenses between principal and income, so you would be wise to turn to the attorney who drafted the trust or another experienced trusts and estates attorney for guidance. It follows that you cannot deliberately ignore my clear instructions in the instrument. If, when my daughter reaches age 21, she is seriously involved with an older man who you think is out to take advantage of her, you cannot ignore the trust’s direction to “distribute all the net income to my child at age 21.” You may consult with counsel as to whether there is a way to protect this income, but you cannot simply withhold it. For this reason, I am considering drafting a “fully discretionary trust,” which will allow you to make distributions to my children (and, fingers crossed, grandchildren) in your discretion. This means that rather than tying your hands by providing in the trust agreement, you must make mandatory distributions of income or principal when the kids reach certain ages; I am truly relying on your good judgment and discretion in deciding when (and if) to make distributions to the beneficiaries.
- You Have a Duty of Loyalty to the Beneficiaries. Your job as trustee is to act in the best interests of the beneficiaries, which means that in relation to the trust, you must not put your own interests or the interests of any other person first. The courts have interpreted this standard strictly, and the slippery slope argument is given full credit. No borrowing from the trust to “tide you over”; no holding trust securities in your own brokerage account to achieve economies of scale. Perhaps I have provided that in addition to the business interests, my vacation home in Hilton Head, South Carolina, passes to the trust for my children. Suppose that by the time I pass away, the children are grown, have no interest in golf and have their own summer places. You, meanwhile, are ready to retire, and Hilton Head beckons; you would gladly buy the vacation home from the trust at its appraised value. Should you? Not under the strict standard of the duty of loyalty. You should not invite your friends to stay there either.
- You Have a Duty of Impartiality Among the Beneficiaries. Loyalty to beneficiaries begs the question: what if my beneficiaries have conflicting interests? What if, when my daughter is older, she demands that the trust support only her, leaving her children to fend for themselves? Should your payments to her be allowed to risk exhausting the trust before the remainder is paid to her children? Not unless I have expressly instructed you to favor my daughter over her children. One of the most difficult duties of the trustee is the duty to be impartial to all beneficiaries, current and future. It underlies decisions as to both investment (growth vs. income) and distribution (equal or unequal, now or later). Here, the courts do not expect the trustee to “play God.” While the standard of impartiality is strict, if the trustee has made a good faith effort to balance the interests of all beneficiaries and has good reasons for investment or distribution decisions, he or she will have fulfilled that duty.
- You Have a Duty of Skill, Care and Prudence. Ignorance is no defense, but prudence is. You should understand that the role of trustee requires a certain amount of knowledge and common sense. While an individual trustee is not expected to be a combination of attorney, accountant, business mogul and investment professional, he or she is expected to know what is needed to care for the trust and to hire such professionals as appropriate. A complicated trust agreement or an unexpected situation will require the advice of an attorney. This trust will, at least for a period, own interests in an operating business. You are a brilliant man, but you do not know much about owning a business, especially partial interests in one owned by a trust. You will therefore need to hire an accountant experienced with fiduciary income tax returns. A trust is a tax-paying entity, and the income tax treatment of a trust is different from that of an individual or a corporation; the trust will have to file its own income tax return. The important thing is to be aware what skills are required and to hire appropriately. Cutting corners, or trying to get by without professional help to save the trust money, is not acting in the beneficiaries’ best interests. Care includes keeping trust assets safe and maintaining clear and complete records that include the reasons for your decisions regarding investment, management and distributions. Prudence is the hallmark of the trustee. If the business is sold and the trust owns cash that must be invested, as long as you carefully explain the purpose and terms of the trust to a seasoned investment professional that you have selected to advise you as trustee, and as long as you have reviewed his or her investment strategy and continually monitor the professional’s performance and compliance with the agreed strategy, then you will have fulfilled your duty.
- You Have a Duty to Give Personal Attention to the Trust Fund. You were named as trustee for a reason, and your role is not to hand over management to your attorney, accountant or investment advisor and then get on with your own life. Even if I named BBH Trust Company as co-trustee with you, and you feel that you were included only because I wanted a family member in the picture, you should not hand over all the decision-making responsibility. In the past, trust law imposed a strict duty not to delegate any matters involving decision-making – investments and distributions being the most obvious. Now, most state statutes expressly allow trustees to delegate investment management. Delegation does not mean abdication, however, and you are expected to monitor your investment advisor’s performance. Generally speaking, in states that allow you to delegate, you are still personally liable for your investment advisor’s actions or omissions if you did not act prudently in selecting the advisor, setting the scope of his or her responsibility and monitoring the professional’s actions.
- You Have a Duty to Disclose the Trust to Beneficiaries. My children are babies now, but soon they will be old enough to be responsible for their own finances and care. There may be a temptation to keep the trust a secret “for their own benefit” or, worse, from a desire not to be second-guessed in decisions regarding investment and distribution. Sadly, there are situations when knowledge of the trust can be harmful: for example, when a beneficiary has a substance abuse problem and gets himself deeper into trouble knowing that his trustee will be there to bail him out. Still, the law and the courts have not allowed these situations to justify weakening the overall standard of full disclosure to beneficiaries. It is more often in both the trustee’s and beneficiaries’ best interests to disclose, as disclosure allows a better understanding of the trustee’s activity as well as an opportunity to address any problems before they can fester. The extent of the disclosure can depend on the nature of a beneficiary’s interest, but state laws can vary, and you should consult with counsel to determine how much you should disclose and how little you may disclose. Generally speaking, at a minimum, expect to send account statements to adult beneficiaries who are currently receiving distributions, and be ready to provide additional information as requested and within reason.
- You Have a Duty to Communicate with Beneficiaries. Complementing your disclosure to the beneficiary is your willingness to communicate with him or her. I have directed you, through language added to the trust agreement, to distribute trust property as needed to provide for my children’s health, education, maintenance and support. While they are young, you may be lulled into passivity by the knowledge that my husband and I are providing for our children’s well-being. In the future – which always comes sooner than expected – you will need to know what is going on in your niece’s and nephew’s lives. This is not an invitation to be nosy, but more of a duty to keep in regular touch – to actively “keep the lines of communication open” – so that my children, or their children in later years, give you enough information about themselves to guide you in investing and distributing the trust for their best interests.
- You Have a Duty of Confidentiality. The converse of disclosure and communication with respect to beneficiaries is to maintain confidentiality on their behalf, both with respect to information they have provided you about themselves and information about the trust.
- You Have a Duty to Consider the Specialized Assets. While you have no responsibility over the business’s underlying management, there are some things unique to a trust with business interests that you’ll need to keep in mind. Part of a trustee’s duty is to value the trust assets at a regular interval. For marketable securities, this job is easy, but for a privately held business like mine, how will you obtain and update the value? You may be able to work with my office, but as trustee, your timeline for valuation may be different from mine, or you may need more detailed information than is held on our books. One of the professionals you need to hire may be an appraiser with expertise in valuing closely held businesses. Another administrative factor to consider is the process of making distributions. If, after careful deliberation, you’ve determined it is in my children’s best interests to make a distribution, what do you give them? Hopefully I’ve funded the trust with cash in addition to shares of my company, but if I haven’t, or if the cash isn’t enough, what do you do? Transferring shares may not be practical, especially without a market for my kids to turn their shares into cash. You may sell some shares back to the company, but in some cases, that could lead to unintended tax results. My side letter and the professionals you’ve hired will be your guides through these nuanced issues.
Dear Brother: Please Work with Your Co-Trustee. I have considered naming a co-trustee to act with you. If I do, I will likely name a corporate trustee, or my attorney, with the idea that professional knowledge would be an added benefit. If I do, does this mean that you can relax and let your co-trustee do all the work, especially since the professional knowledge comes with a price? Yes and no. You can certainly expect your corporate co-trustee to perform the administrative duties for the trust, custody the trust assets and manage the trust investments, and bring to your attention any legal or other technical issues that may arise. However, the fundamentals discussed still apply to you individually, and you must continue to understand the terms and purposes of the trust, participate in decision-making and oversee your co-trustee’s actions.
A co-trusteeship is a team effort and requires communication. Suppose you have my daughter’s ear; she may let you know that she has the opportunity to take a semester abroad. Let your co-trustee know, as this may justify a distribution of some of the income that had previously been accumulating in the trust. Likewise, if your co-trustee needs your approval on a matter, respond promptly after careful consideration.
Finally, expect your co-trustee, whether professional or not, to do a good job. If you are unfortunate enough to have a co-trustee who behaves badly, it is your duty to do something about it. You may need only to point out an error for it to be corrected, or you may need to go to court to have your co-trustee removed.
In Conclusion. Thank you for accepting this important role. Serving as trustee for family members can be both valuable to them and rewarding to you, but understanding the full scope and legal responsibilities (and liabilities) of your role and all that it entails is important in avoiding unnecessary difficulties.
If you (or your dear siblings or other family members) would like to explore the possibility of having a BBH Trust Company serve as trustee or co-trustee, please ask your Relationship Manager, Wealth Planner or Trust Officer.
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1A side letter is a letter from the person who funded the trust (the donor) to the trustee, or the beneficiaries, describing his or her rationale for creating the trust and the intent behind the transfer; precatory language is a paragraph or two in the trust agreement describing the donor’s intent/rationale. Neither side letters nor precatory language is binding on the trustee, but both aim to give guidance as to when a trustee may make distributions.