We are on the threshold of the greatest transfer of wealth in human history. It is estimated that during the next 30 years more than $30 trillion will be transferred from one generation to the next. For a variety of reasons, most of this wealth will be transferred in trusts.
Some years ago, one of us (Dennis) was a founder and served as a principal for an independent trust company. Robert, a longtime CPA friend, said: “When asked, I always refer my trust clients to you because I really don’t know how to be a trustee and my firm doesn’t approve of me getting involved as a fiduciary. This time, I have a different question — how can you make me into a trustee?”
Robert had been asked to serve as trustee on a $50 million trust, and he had referred the client to a traditional local trust department to administer the trust. The client asked: “Really? Why can’t you be my trustee? We have worked together for years. You know my businesses, my family, and I like and trust you!”
That conversation led to the realization that many people who use trusts in their estate and tax planning would rather work with someone they know and have confidence in. But many advisors — financial and legal — as well as family members, friends or business associates, are not prepared to take on the task. They may be flattered to be asked, but they don’t have the knowledge and resources required to administer trusts.
Additional Problems for RIAs
At the same time, RIAs often face two other problems. First, they can lose client accounts when trust departments and trust companies become trustees. The SEC also puts difficult and often costly requirements on RIAs who serve as trustees, making it problematic for them to serve in the role.
For example, RIAs can be deemed to have “custody” and are subject to surprise audits — to be conducted annually at the advisory firm’s expense — that will involve independent accountants reviewing financial records, verifying the existence of client funds and affirming that client assets and trades are as the adviser reported them.
However, if an “individual trustee’” is appointed, the RIA can usually be engaged by the trustee to continue to manage the portfolio and other client assets.
A Dramatic Transformation
The last two decades have also seen a dramatic transformation in the “trust world,” creating an opportunity for professionals and others who would like to offer their services as trustees.
In the late 1990s, we experienced the beginning of merger mania, with the consolidation of the banking industry. Larger banks began to acquire smaller banks across the country to increase market share and to create economies of scale. With the evolution of technology, banking institutions could leverage those innovations that allow them to increase efficiency in management capability as well as increase brand exposure in the marketplace.
However, the pursuit of profitability in a “technology world” led to the depersonalization of services from the teller line right up to the trust department. The “800” number replaced the personal relationship and expert counsel that is key to the value of the experienced and skilled trustee. Trust clients became frustrated when they lost touch with the human advisor who was replaced by cookie-cutter investment and administrative services.
Clients started looking for alternatives. They often asked the attorney who developed their estate plan, their CPA or the financial advisor who helped manage their business affairs, to be their trustee. After all, those are the people who helped get them become successful and who know their values and family dynamics. Other clients turned to family members or friends, and many accepted, not realizing the level of work and responsibility that come with the job.
Multiple Risks and Challenges
First, it’s important to understand how the trust is designed and works and where any risks and problems might be. The following factors may create risk or challenges for the trustee:
This is getting to be more and more common, and it almost always leads to problems. Remember, “blood is thicker than water.” How does a trustee handle this situation when he or she is from a different branch of the family? In carrying out his or her duties, the trustee must avoid personal judgments and ignore those parts of the family history that may have led to conflicts in the past. Sometimes this can be very difficult, and if the trustee cannot do this, he or she may need to withdraw or establish special procedures to avoid these problems.
Trustee Has a Potential Conflict of Interest
Trustee conflicts are more common that you might think. Obviously, there is a potential conflict if the trustee is also a beneficiary. There is also a less obvious conflict when the trustee is a testamentary beneficiary with other individuals. This may create a situation where the trustee is tempted to shortchange a current income beneficiary in order to increase the amount that will ultimately be distributed to the testamentary trustees. Even if the trustee does not do that, it is important for the trustee to maintain open communications and procedures to avoid being wrongly accused of that. There can also be serious potential conflicts when the trustee retains himself or his firm to provide services to the trust.
Proper Accounting and Reporting
Many individual trustees do not have the knowledge or resources to keep track of the principal and income accounts while at the same time calculating taxable income, which is usually different. We have worked with several individual trustees who did not realize the accounting was different. At the same time, we’ve seen many individual trustees fail to provide timely reports in the proper format to the beneficiaries.
It is common for a trust to hold a family business as one of its assets, especially when there is a farm or ranch in the family. This creates a host of potentially big problems. In most cases some of the beneficiaries are involved in management of the business while others are not. It may have been important to the settlor to keep the business while some of the beneficiaries would prefer to liquidate the business in order to free up funds for a more profitable or different investment. Liquidating the business may also eliminate an important source of income for the beneficiaries involved in management that cannot be easily replaced. These are only a few of the problems that can arise in this situation.
A minority of trusts provide for specific distributions; some provide limited instructions regarding distributions and many give the trustee absolute discretion to make distributions. All of these situations require the trustee to keep detailed records and to keep open communications with the beneficiaries. Sometimes, it is a good idea to obtain releases or court approval for some trustees.
Management/Investment of Assets
Assets must be managed/invested in a way that is beneficial to the interests of the beneficiaries. What happens when these interests are not in alignment? What happens if the trustee does not have the experience or background necessary to manage the investments? Even if the trustee retains experts to take on these tasks, the trustee still has the fiduciary duty to make sure the investments are properly managed. Regardless, it is always a good idea for the trustee to maintain a written investment policy statement and for the trustee to keep in mind his or her duty to properly diversify the investments. The trustee should also avoid “wasting” our unproductive assets and should properly balance the interests of the income and principal beneficiaries.
Taxation of Trusts
The taxation of trusts can be a very tricky proposition. It is important to have expert guidance when the trustee is contemplating any major transactions and/or distributions and when the trust is preparing its tax returns. What happens if in hindsight the trustee determines that he or she did something that leads to additional taxes or requires action to get a ruling by the IRS or a court? Who pays these costs? These are real life situations that can often have bad consequences for the trustee.
Long Term or “Dynasty Trusts
Historically, trusts could only exist for a limited period of time – e.g., the “Rule Against Perpetuities”. However, in recent years these rules have been modified in almost all jurisdictions to increase these periods to 100 or more years. That means the trustee must consider the interests of people who are not even born yet.
Being a trustee is hard enough, but having to deal with “difficult people” can make the job that much harder. Unfortunately, difficult people are everywhere, and they can be beneficiaries, spouses, other family members, advisors, well-meaning but uninformed relatives and almost anyone else who talks to or has a relationship with someone involved with the trust.
Also unfortunately, it may be hard to identify these difficult people in advance of becoming a trustee.
Most trusts are “irrevocable,” but the reason we put this term in quotes is because most irrevocable trusts are not really irrevocable, and the trustee may run into problems if he or she fails to eliminate a big problem by failing to take action to amend a trust.
Malpractice Insurance and More
Many of these risks can be mitigated or eliminated with the implementation of proper practices and procedures, but what happens to those that cannot be eliminated? Is the trustee properly insured from exposure to risks?
Malpractice insurance purchased by these professionals rarely covers claims made against the professional who is serving in a fiduciary role, and if they do, the coverage can be limited. For example, many malpractice policies will provide this coverage but only as long as the professional does not “hold himself or herself out as providing these fiduciary services on a regular basis.”
Indemnification clauses contained in most trusts are often inadequate and ineffective. Unlike insurance, indemnification clauses simply transfer the risk from the trustee to the trust. Under these clauses, the trustee can seek reimbursement from the trust for any damages he or she must pay, as well as for any costs and attorney fees the trustee incurs to defend against any claims. This not only puts the assets in the trust at risk, it also creates a direct conflict with the beneficiaries, especially when the beneficiaries are the ones making the claim against the trustee. To make matters worse, several states have made it more difficult for trustees to rely on these provisions.
However, if there is a fiduciary liability insurance policy in place, the insurance company is responsible for all of these costs. That is why it is paid a premium. Thus, both the trustee and the trust are protected.
There is a remarkable opportunity for legal, accounting and financial advisory professionals to leverage their existing relationships with their clients as they enter a new life phase. Their practice can evolve to meet their client’s changing needs. We plan to share more information about managing trusts in future columns.
Dennis Channer, CPA, CFP, AEP, a managing principal at Denver-based Cornerstone Investment Advisors, has over 40 years of experience in financial planning and trust management. William C. Waller Jr., Esq., practiced law for more than 40 years in the Denver area and retired as a partner in the Denver office of Ryley, Carlock & Applewhite. He tried countless cases involving contested wills, trust and estate administration, and income and estate taxes. In 2020, Dennis and Bill co-founded The Private Trust Consortium, a membership organization dedicated exclusively to providing trustees with education and tools to successfully manage trusts. The consortium offers its members fiduciary liability insurance policies underwritten by Chubb Insurance Company that protects both the trustee and the assets in the trust.