Trust Administration: Challenges and Best...

Trust Administration:

Challenges and Best Practices Managing Fiduciary Powers and Duties; Controlling, Protecting and Distributing Trust Assets; Disbursing Fees and Expenses

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TUESDAY, FEBRUARY 7, 2012

Presenting a live 90-minute webinar with interactive Q&A

Dawn Hallman, Atty, Hallman & Associates, Norman, Okla.

J. Brian Thomas, Atty, Law Office of J. Brian Thomas, Dallas

Mary A. Akkerman, Atty, Woods Fuller Shultz & Smith, Sioux Falls, S.D.

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Trust Administration:

Challenges and Best Practices

Dawn D. Hallman, J.D. Hallman & Associates, P.C.

Leaders in Estate and Business Planning

2230 McKown Drive

Norman, Oklahoma 73072

(405) 447-9455

www.hallmanlawoffice.com

February 7, 2012

Strafford Publications

http://www.hallmanlawoffice.com/

Trustee’s Duties and

Powers

The Trust is the Operating Manual

6

Sources of Authority

Trust Instrument

Main Source of Trustee’s Power

Guideline for Trustee’s conduct

Trustee Must Understand Content

7

Sources of Authority

Statutes

Uniform Trust Code

Attempt to unify law regarding trusts

24 States have adopted

Still differences in fiduciary law

Variation of Uniform Trust Code

Individual State Trust Act

8

Standards of Fiduciary Conduct -

Overview

Duty to Obey Terms of Trust

Duty of Prudent Administration

Duty of Loyalty

Duty of Impartiality

Duty to Keep Records and Report

Disclosure

9

Duty to Obey Terms of Trust

10

Duty of Prudent Administration

Trustee “runs” the trust

Act in “good faith”

Terms and Purpose of the Trust

Best interest of ALL beneficiaries

Prudent Investor Act

Consider purpose, terms, and distribution requirements

Other circumstances

Looked at as a whole, not each individual investment

11

Duty of Loyalty

Avoid Conflicts of Interest

Direct conflicts

Appearances of impropriety

Trustee Should Not Profit

Common law rule, “no further inquiry” rule

Trustee’s acts on own account considered

voidable upon action by the beneficiaries

12

Duty of Loyalty

Trustee can be exonerated from the “self-dealing” rules if: Transaction authorized under Trust

Transaction approved by the Court

Beneficiary did not commence judicial proceedings within statute of limitations

Beneficiary consented to Trustee’s conduct, ratified transaction or released Trustee

Transaction entered into before person became Trustee

13

Duty of Impartiality

Trustee must act impartially with respect to

Trust beneficiaries

Investing

Managing

Distributing trust property

Beneficiaries’ respective interests

14


Trustee required to keep beneficiaries reasonably

informed:

Administration of the Trust

Material facts necessary for beneficiaries to protect their

interest

Trustee must provide beneficiaries with:

Copy of Trust (entire trust v. applicable provisions)

Reasonably requested information

Change of Trustees and contact information

15


MUST keep Trust property separate from

personal property

Can have nominee registration

Keep adequate records

16

To Whom Does Trustee Report?

Old Common Law – only current (income) beneficiaries entitled to accounting and reports

UTC – qualified beneficiaries (current and remainder beneficiaries) are entitled to reporting

Some states – modified the two – concern overburdensome and undue interference by remainder beneficiaries

17

Prudent Investor Rule

Requires a fiduciary to invest trust assets as if

they were his own. Trustee must consider

needs of Trust beneficiaries, provisions of

regular income, preservation of trust assets,

etc. Trustee should avoid investments that are

excessively risky.

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Prudent Investor Rule - Applied

A prudent investment does not always turn

out to be a good investment

Rule only applies to the decision making

process

Was it a good investment idea based on the

knowledge the Trustee had at the time

19

Delegating Authority

Trust may Allow Trustee to:

Delegate authority

Appoint co-trustee

Give limited Power of Attorney under Trust

REVIEW THE TRUST DOCUMENT

20

Working with a Co-Trustee

Joint and Several Liability

Usually point person for contact with the

beneficiaries

Individual serving as Co-Trustee with a

Corporate Trustee

Individuals serving as Co-Trustees (majority

rules or unanimous vote)

21

Control & Protection of Assets

CHANGE THE LOCKS on the house

Keep jewelry, securities, personal items of great

value in a safe place, to which only trustees have

access

Use “Location List” provided by Trustmaker

Draw up new affidavit if needed

Notify everyone of death

22

Protecting the Assets:

Maintain adequate insurance coverage

for homeowners, fire, flood, liability

Don’t sell assets without consulting an

attorney (especially partnerships, etc.)

23

Gather the Advisors

Estate Planning Attorney

CPA familiar with estate tax returns

Financial Planner/Counselor

Use the advisors the Trustmaker used,

when possible. 24

Good vs. Bad Administration

Depends upon the trust document

itself

Plan for administration when

drafting

Not all trusts are created equal

Know accounting/tax issues

Maintain Trust and client contact 25

Trust Administration

Challenges and Best Practices

J. Brian Thomas

972.808.6977

[email protected]

The Law Office of J. Brian Thomas

www.jbrianthomas.com

Trust Administration: Inventorying and Controlling Trust

Assets Account for All Trust Property

Be Able to “Touch” Everything

Safeguard and Insure Adequately

Diversify Where Needed (Pay Close

Attention to the Trust Instrument and the

Prudent Investor Rules)

27




Assets Know What You’re Working With

Real Estate Personal

Property Cash

Stocks and

Bonds

Mineral

Interests

Business

Interests

Notes and

Receivables Liabilities

Overall

Portfolio

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Assets Dealing With What You’re Working With

Secure the Property

Evaluate the Property’s Worth (Good, Bad and Ugly)

Insure Property Against Loss

Review All Agreements Pertaining to the Property’s Use (Determine if this Use Should Continue)

Keep Property Growing (Interest vs. Non-Interest Accounts)

Identify Special Attachments or Limitations to Particular Assets (e.g. “Never Sell the Exxon Stock”)

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Trust Administration: Dealing with Beneficiaries and the

Exercise of Discretion The Big Three Rules:

Communicate – Often and Effectively

Be Consistent

Document Everything

30




Exercise of Discretion Communication Types:

Initial Notices

Mandatory and/or Discretionary Actions of the

Trustee

Notices of Right of Withdrawal or Right to

Distribution

Responding to Demands for Information and

Accountings

31




Exercise of Discretion Trustee ≠ Legal Advisor

Trustees have their own rights and legal

obligations worthy of effective counsel.

Beneficiaries often have an entirely separate

set of rights and/or obligations. DO NOT

perpetuate the misconception that the Trustee

can serve some advisory role to the

beneficiary.

32




Exercise of Discretion Be Consistent in the Exercise of Discretion

Is there a standard that the Trust instrument

holds the Trustee to? (HEMS or similar

discernable standard)

If not, does the Trustee have an appropriate

level of information upon which to base a

consistent standard of discretion?

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Exercise of Discretion Typical Information Needed to Effectively

Exercise Discretion: Beneficiary’s employment status (or efforts at gaining

employment)

Documentation of enrollment in educational institutions

Financial statements and tax returns

Documentation of alternative sources of income

Beneficiary’s housing and healthcare circumstances and potential future needs

34




Exercise of Discretion Document EVERYTHING

Beneficiary Distribution Request Form

Trustee Distribution Checklist

Assume that the Trustee’s decisions and

activities will be questioned and

scrutinized. Paper the file at every turn.

35

Trust Administration: Challenges and Best Practices

Mary A. Akkerman Woods, Fuller, Shultz & Smith P.C. 300 S. Phillips Avenue, Suite 300

Sioux Falls, SD 57104 (605) 336-3890

[email protected]

mailto:[email protected]

Terminating Trusts

• Why Termination? – The trust corpus has become too small for

administration to be cost effective.

– The purpose of the trust may no longer be necessary.

– The trust may have ambiguous or unworkable dispositive provisions.

• If so, it might make sense to modify or reform the trust or to decant into another trust rather than terminating the trust.

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Why Termination? (cont’d)

• The trust expires by its terms.

• The purpose of the trust is impossible to achieve.

• The purpose of the trust has become unlawful or contrary to public policy.

• The trust has been revoked.

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Which Law Applies?

• Look to the governing instrument first – The trust instrument itself may provide a

mechanism for termination. Unless the terms of the trust violate public policy, they should be valid and enforceable so long as the trust itself is valid.

– If the trust does not provide a method to terminate the trust or the method provided does not fit your client’s needs, you may need to look to the governing jurisdiction’s statutes.

39

Applicable Law

• The trust will often contain a choice of law clause in favor of a particular state’s laws. – The governing law might not apply to procedural

matters (i.e., terminating the trust) if the trust is being administered in or is court supervised in another state.

• If the trust is court supervised in a particular jurisdiction, that state’s laws will apply to procedural matters even if another state’s laws govern the substantive terms of the trust.

• Even if the trust is not court supervised, if it is being administered in a jurisdiction other than the state in the choice of law clause, the state of administration will typically be considered the trust situs, and that state’s procedural law will apply.

40

Applicable Law (cont’d)

• If the trust is silent as to termination or if the trust’s mechanism for termination does not suit your needs, look to the law of the trust’s situs.

– Is trust situs in a Uniform Trust Code state?

41

Uniform Trust Code

– According to the National Conference of Commissioners on Uniform State Laws (NCCUSL) The Uniform Trust Code (UTC) was promulgated:

• To provide a comprehensive model for codifying the law on trusts. While there are numerous Uniform Acts related to trusts, such as the Uniform Prudent Investor Act, the Uniform Principal and Income Act, the Uniform Trustee’s Powers Act, the Uniform Custodial Trust Act, and parts of the Uniform Probate Code, none is comprehensive.

42

Uniform Trust Code

• Enables states which enact it to specify their rules on trusts with precision.

• Will provide individuals with a readily available source for determining their state’s law on trusts.

Origin: Completed by the Uniform Law

Commissioners in 2000, and amended in 2001, 2003,

2004 and 2005.

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Uniform Trust Code

• Has been approved by

– American Bar Association

– ABA Real Property, Probate and Trust Law Section

– AARP

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States that have enacted the UTC with some modifications

Alabama Maine North Carolina Tennessee

Arizona Missouri North Dakota Utah

Arkansas Michigan Ohio Vermont

District of Columbia

Nebraska Oregon Virginia

Florida New Hampshire

Pennsylvania West Virginia

Kansas New Mexico South Carolina Wyoming

In 2010, the UTC was introduced in New Jersey but has not been passed. In 2012, the UTC was introduced in Massachusetts. See www.nccusl.org

45

http://www.nccusl.org/

Non-UTC states

• Have individual laws regarding trust termination. – Many states considered “trust havens” have not

adopted the UTC. • Alaska

• Delaware

• Nevada

• South Dakota – See http://thetrustadvisor.com/news/states for a chart

ranking the states into tiers designed to show the most favorable trust jurisdictions.

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http://thetrustadvisor.com/news/states

Termination of trusts at common law

• This outline will discuss termination of trusts at common law. However, most trust procedure is governed by state statute, so certain state statutes will also be discussed.

• Because almost half of jurisdictions have adopted the UTC, this outline will discuss termination procedure under the UTC.

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Comparisons

• This outline will also discuss South Dakota’s trust laws to compare and contrast with the UTC.

– UTC Article 4 governs modification or termination of trusts.

– SDCL Ch. 21-22 governs administration of trust estates. Pursuant to SDCL § 21-22-2, SDCL §§ 55-3-24 to 55-3-44, inclusive, apply to all court-supervised actions or proceedings.

48

Termination as Directed by the Governing Instrument

• If the trust itself gives the trustee authority to terminate the trust under certain circumstances and those circumstances have been met, the trustee will either be compelled to terminate or will have discretion to terminate, depending on the language.

49

Examples of language

• “Any trust under this agreement may be merged with any trust established by the trustor’s spouse and having terms substantially the same as those of the trust hereunder with which it is merged.”

– This language allows the trustee the discretion to merge one spouse’s mirror trust into the other spouse’s, terminating one of the trusts.

50

Examples (cont’d)

• “No trust under this agreement shall continue beyond expiration of the period of twenty-one years after the death of the survivor of the trustor, the trustor’s spouse and all issue of the trustor living on the date of the trustor’s death. On the expiration of such period, each trust then in existence shall terminate and the remaining trust property shall be distributed to the person for whom such trust is named.” – Similar language is often seen in states with the

Rule Against Perpetuities. This time, the trustee must terminate if conditions are met.

51

Examples (cont’d)

• “The trust shall terminate if the Trustee shall determine that the continued administration would be unduly burdensome or expensive to the beneficiaries. In such event the assets of the Trust shall be distributed to the person entitled to the income.”

– Here, the trustee has discretion to determine whether administration costs outweigh benefits. If so, the trustee must terminate the trust.

52

Revocation of a trust

• If the trust is revocable and the grantor is still alive, the grantor typically retains the power to revoke the trust if desired.

– Example

• “The trustor reserves the right to amend or revoke this agreement in whole or in part by written instrument filed with the trustee.”

53

UTC Sec. 410

• A “trust terminates to the extent the trust is revoked or expires pursuant to its terms, no purpose of the trust remains to be achieved, or the purposes of the trust have become unlawful, contrary to public policy, or impossible to achieve.”

54

SDCL §§ 55-3-23 to 55-3-29

• Provides the ability to modify an irrevocable trust.

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Termination by Agreement of the Interested Parties

• If the appropriate parties agree, trusts may often be terminated even where the trust instrument does not so authorize.

– UTC Sec. 411(a) allows that “a noncharitable irrevocable trust may be modified or terminated upon consent of the settlor and all beneficiaries, even if the modification or termination is inconsistent with a material purpose of the trust.”

56

Termination by Agreement (cont’d)

SDCL § 55-3-24 allows an irrevocable trust to “be

modified or terminated upon the consent of all the

beneficiaries if continuance of the trust on its

existing terms is not necessary to carry out a

material purpose. Whether or not continuance of

the trust on its existing terms is necessary to carry

out a material purpose, an irrevocable trust may

be modified or terminated upon the consent of the

trustor and all of the beneficiaries.

57

Procedure

• The beneficiaries may consent/agree to modification and termination if continuation is not necessary to carry out a material purpose of the trust.

• A written agreement among beneficiaries or written consents to a proposed modification or termination should be obtained.

• All interested parties (i.e. the trustee and beneficiaries) may enter into an agreement setting forth the terms of the modification or termination of the trust in other situations.

58

Procedure (cont’d)

• A written agreement among all interested parties or written consents to a proposed modification or termination should be obtained –SDCL § 55-3-24.

• Judicial approval is not required if all interested parties agree/consent and if no interested party is unable to contract or is unable to consent through virtual representation as discussed below – UTC Article 3; SDCL §§ 55-3-24; 55-3-32 to 55-3-38.

• Even though court approval may not be required, it may be sought upon the petition of any interested party –SDCL § 55-3-25.

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• SDCL § 55-3-24 states that if a trust is so terminated, “the trustee shall distribute the trust property in accordance with the trustor’s probable intention or in any other manner as agreed by all the beneficiaries.”

60

Exercise of Power by an Agent

• “The trustor’s powers with respect to termination or modification may be exercised by an agent under a power of attorney only to the extent the power of attorney expressly so authorizes.” SDCL § 55-3-24

• UTC Sec. 303(3) allows that an agent with “authority to act with respect to the particular question or dispute may represent and bind the principal.”

61

Exercise of Power by a Conservator

• “A conservator may exercise the trustor’s powers under this section only if approved by the court supervising the conservatorship.” SDCL § 55-3-24

• UTC Sec. 303(a) allows a conservator to bind the conservatorship.

62

Consent by a Person Under a Disability

• “If the consent of a person under disability is required, such consent may be given by any person upon whom notice may be served pursuant to §55-3-35.

63

SDCL § 55-3-35

• SDCL § 55-3-35 is a virtual representation of the statute that allows a party “with the same interest as a person under disability” to receive process as a representative of the class of interests to which the person under disability belongs. If there is no person not under a disability with the same interest as the person under a disability, the person’s conservator, if one has been appointed, may be served. If there is no person with the same interest and no conservator, the natural parents may be served, or if there are no natural parents alive, the adoptive parents may be served.

64

SDCL § 55-3-35 (cont’d)

• If none of the above applies, the party who has assumed the person’s care and custody may be served. If the person is an adult and there is no conservator, notice may be served on an agent under a durable power of attorney, a guardian, a trustee of the person’s estate, or any person responsible for the adult’s care and custody.

65

SDCL § 55-3-27

• Allows that, “[e]xcept as otherwise provided by terms of the trust, if the value of the trust property of a noncharitable trust is less than fifty thousand dollars, the trustee may terminate the trust.”

– SDCL § 55-3-27 also allows that termination under this section pursuant to court order, as discussed on the next slide.

66

Termination by Court Order

• UTC Sec. 412 allows a court to terminate a trust if termination will further the purposes of the trust, if continued administration would be wasteful or impracticable or would impair the trust’s purpose.

– If terminated pursuant to this section, the trust’s assets are to be distributed in accordance with the terms of the trust.

67

Termination by Court Order (cont’d)

• UTC Sec. 413 allows a court to terminate a charitable trust under the principles of cy pres if the charitable purpose becomes unlawful, impracticable or impossible to obtain.

– If such termination is allowed, the court will mandate that the trust assets be distributed in manner consistent with the trustor’s charitable purpose.

68


• UTC Sec. 414 allows termination of an uneconomic trust worth less than $50,000.

• UTC Sec. 417 allows a trustee to combine trusts after notice to qualified beneficiaries.

69


• SDCL § 55-3-25 allows a trustor, trustee, or beneficiary to petition the court to affirm a proposed modification or termination of a trust if the provisions of § 55-3-25 have not been met. – If a beneficiary does not consent, the court may

approve a requested modification or termination if the rights of the non-consenting beneficiaries are “not significantly impaired or adversely affected.” Id.

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• SDCL § 55-3-26 allows a trustee or beneficiary to petition the court to “modify the administrative or dispositive terms of the trust or terminate the trust if, because of circumstances not anticipated by the trustor, modification or termination of the trust would substantially further the trustor’s purpose in creating the trust.”

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• SDCL §55-3-27 allows a trustee or beneficiary to petition the court for modification or termination of a noncharitable trust or appoint a new trustee if the court determines that the value of the trust property is insufficient to justify the cost of administration. – Under this section, the court must examine

whether appointment of a new trustee to continue the trust is feasible.

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• SDCL § 55-3-28 states that “[o]n petition by a trustee or beneficiary, the court may reform the terms of the trust to conform to the trustor’s intention if failure to conform was due to a mistake of law or fact and the trustor’s intent can be established.”

– This section may also be used to achieve favorable tax objectives so long as the trustor’s intent is not defeated.

73


• SDCL §55-3-29 allows a trustee to combine two or more trusts or divide a trust into two or more trusts “if the combination or division does not impair the rights of any of the beneficiaries or substantially affect the accomplishment of the trust purposes.”

• On petition, “the court may affirm or prevent a proposed combination or division; and, if the terms of the trust instruments creating the trusts are inconsistent, the court shall resolve such inconsistencies in its order by establishing the terms of the trust that will survive the combination or division.”

74


• SDCL § § 55-3-23 to 55-3-29 are not the exclusive methods to modify or terminate an irrevocable trust. See SDCL § 55-3-30.

• A trust automatically terminates if its term expires, its purpose is fulfilled, its purpose becomes unlawful or impossible to fulfill, or, in the case of revocable trusts, the trust is revoked—SDCL § 55-3-23.

• The virtual representation statues found at SDCL §§ 55-3-32 to 55-3-38 apply in any proceeding where their consent is necessary. SDCL § 55-3-31.

75


Charitable trusts may be modified by court order where “the purpose and object of such charity is imperfectly expressed, or the method of administration is not indicated or is incomplete or imperfect, or [when] the fulfillment of the special purpose expressed in a trust for charitable or public purpose is or becomes impracticable, impossible, inexpedient or unlawful…” Any trustee, interested party or the state attorney general may petition for an order directing the trust to be administered to “accomplish the general purposes of the instrument and the object and intention of the donor…” if the donor’s consent is obtained if the donor is still living – SDCL § 55-9-4.

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Procedure

• Any trustee or beneficiary may petition for court supervision pursuant to SDCL § 21-22-9.

• Interested parties may also petition for the requested modification or for a court order or directions regarding “any matter relevant to the administration of the trust.” SDCL § 21-22-13.

• Notice of the petition “shall be served on trustees, beneficiaries, and attorneys of record, either personally or by mail, addressed to each at his or her last known post office address as shown by the records and files in the proceeding, at least fourteen days prior to the hearing unless the court for good cause shown directs a shorter period.” SDCL § 21-22-18.

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• The court may allow service by publication (once a week for three weeks prior to the hearing in a legal newspaper in the county of the hearing) if the number or persons to be served and the expense involved would be burdensome. SDCL § 21-22-19.

• If all beneficiaries join in the petition in writing or waive notice and a hearing in writing, notice will not be required. SDCL § 21-22-21.

• Any interested party may object to the petition. If such objections are brought, the court may order them to be filed and may adjourn the hearing and continue it to a contested calendar. SDCL § 21-22-16.

• The court may require or allow witnesses or production of evidence. SDCL § 21-22-25.

78

Decanting

• Decanting involves the idea that a trustee with authority to make discretionary distributions may appoint trust property in further trust instead of making distributions outright.

• A trustee may “decant” trust funds from one trust into a different trust.

• This principle existed at common law but has now been codified in South Dakota and certain other jurisdictions.

• South Dakota’s decanting statutes are found at SDCL §§ 55-2-15 to 55-2-21, inclusive.

• Other states with decanting provisions include Alaska (Alaska Stat. § 13.36.157), Delaware (12 Del. C. § 3528), Florida (Fla. Stat. § 736.04117), New York (NY EPTL § 10-6-6(b)), and Tennessee (Tenn. Code Ann. § 35-15-816(b)(27)).

79

Decanting (cont’d)

• Decanting is appropriate where the trustee has discretionary authority and wishes to “pour” funds from one trust to another trust with terms more favorable for current needs.

• SDCL § 55-2-15 allows a trustee with “discretionary authority” to make income and/or principal distributions to a beneficiary to instead exercise that authority by appointing all or part of the assets subject to that power to the trustee of a second trust.

• Beneficiaries of the second trust must be either proper objects of the exercise of distribution power, or “one or more of those other beneficiaries of the first trust to or for whom a distribution of income or principal may have been made in the future from the first trust at a time or upon the happening of an event specified under the first trust.” Id. at (1).

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• Under this statute, the second trust may, within certain limits, have different beneficiaries.

• For example, contingent beneficiaries of the first trust may be named as primary beneficiaries in the second trust. Id.

• SDCL § 55-2-15 also requires that the trustee take “into account the purposes of the first trust, the terms and conditions of the second trust, and the consequences of the distribution.”

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• The trustee may wish to decant to a second trust to preserve or promote the trustor’s primary purpose in establishing the first trust.

• If more drastic changes are desired, it may be advisable to seek reformation by beneficiary consent or court approval, as discussed above.

• Tax consequences, as discussed below, should be considered before decanting.

82

Decanting – beneficiary consent/court approval

• As it is authorized by statute, decanting does not require beneficiary consent or court approval. – However, SDCL § 55-2-18 requires that decanting

be done by “an instrument in writing, signed and acknowledged by the trustee and filed with the records of the trust” and that all beneficiaries of the first trust be notified in writing at least 20 days prior to decanting. Information in the notice must include a copy of the proposed decanting and a copy of the second trust.

83


• SDCL § 55-2-18 further allows that, if all beneficiaries entitled to notice waive notice, the trustee may decant immediately.

– Beneficiaries include anyone entitled to notice and a copy of the first trust. Id.

• See SDCL § 55-2-13.

– South Dakota’s virtual representations apply to such notice requirements - SDCL § 55-2-18.

• See SDCL §§ 55-3-31 to 55-3-38, inclusive.

• Decanting may be applied to testamentary trusts or irrevocable inter-vivos trusts – SDCL § 55-2-15

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• Decanting may not result in the reduction of a fixed income interest for which a marital deduction has been taken or to a charitable remainder trust or to a GRAT – SDCL § 55-2-15(a)-(c).

• The power cannot be exercised to extend the IRC § 2503(c) vesting period – SDCL § 55-2-15(3).

• The power cannot be exercised over any portion of the trust to which a beneficiary has current withdrawal rights (i.e. Crummey rights or 5x5 powers) – SDCL § 55-2-15(5).

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• The terms of the trust must not prohibit exercise of the authority by a spendthrift clause or provision prohibiting amendment of the trust – SDCL § 55-2-15(6).

• SDCL § 55-2-15(2)(a) limits the power to decant unless held to an ascertainable standard if the trustee is also a beneficiary or if any beneficiary of the first trust has the right to change the trustees of the first trust. See discussion of estate inclusion issues on the following slides.

86

Exercise of a Power of Appointment

• Anyone holding a power of appointment may have the power to appoint all of the trust assets as directed by the scope of the power, essentially terminating the trust.

– UTC Sec. 302 allows the holder of a general testamentary power of appointment to bind those whose interests are subject to the power.

87

Exercise of a Power of Appointment

• SDCL § 55-1-24(5) defines a “power of appointment” as “an inter-vivos or testamentary power to direct the disposition of trust property, other than a distribution decision by a trustee to a beneficiary. Powers of appointment are held by a person to whom a power has been given, not the [trustor].”

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Exercise of Power of Appointment

• See Also SDCL § 29A-1-201 (36) • “’Power of appointment’ means a power to vest absolute ownership

in the property subject to the power, whether or not the powerholder then had capacity to exercise the power. ‘General power of appointment’ means a power exercisable in favor of the powerholder, the powerholder’s estate, the powerholder’s creditors, or the creditors of the powerholder’s estate, whether or not the power is also exercisable in favor of others. “Presently exercisable general power of appointment” includes a power to revoke or invade the principal of a trust or other property arrangement, but excludes a power exercisable only by the powerholder’s will.”

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Exercise of Power of Appointment

• SDCL § 29A-1-108 • “For the purpose of granting consent or approval

with regard to the acts or accounts of a personal representative or trustee, and for purposes of consenting to modification or termination of a trust or to deviation from its terms, the sole holder or all co-holders of a presently exercisable general power of appointment are deemed to act for beneficiaries to the extent their interests (as objects, takers in default, or otherwise) are subject to the power.”

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Watch Out for Unanticipated Consequences

• Consider whether the changes will be given effect by the IRS and whether there will be unintended or adverse tax effects.

– Income taxes

– Where the property is being sold or exchanged for another asset.

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Unintended consequences – Income taxes

• Decanting: Is the new trust the same as the old trust for income tax purposes? – The new trust’s distributable net income (DNI)

would be shifted to the new trust, including capital gain – see Reg. 1.643(a)-3(e).

– Decanting may eliminate or create state or local taxation if the trust situs is changed.

– If less than the entire trust corpus is decanted, this may be the equivalent of a discretionary distribution by the trustee.

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Unintended consequences (cont’d)

– Such distribution may carry out DNI to the beneficiary.

– The new trust should obtain its own taxpayer identification number unless it is a grantor trust.

– Negative basis assets decanted to a new trust may result in recognition of gain pursuant to Crane, 35 AFTR 773, 331 U.S. 1, 91 L.Ed. 1301, 1947-1 C.B. 97 (1947).

– However, IRC 643(e) provides that the fiduciary’s basis carries over to the beneficiary, and this may override Crane.

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Unintended consequences (cont’d)

– Trustees may wish to seek a private letter ruling before decanting negative basis assets or may wish to leave such assets in the old trust.

– Decanting may result in beneficiaries recognizing gain.

– Normally beneficiaries only experience income to the extent the distribution carries out DNI – see IRC 662(a).

– However, the IRS may contend that a change in the beneficiary’s interest may trigger income, pursuant to Cottage Savings Ass’n, 67 AFTR 2d 91-809, 499 U.S. 544, 113 L.Ed. 2d 593, 1991-2 C.B. 34 (1991).

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Other Tax Consequences

• Conversion of a domestic trust to a foreign trust (or decanting from a domestic trust to a foreign trust) may result in gain recognition under IRC 684; however, there is an exception if the grantor is still living - see IRC 684(b).

• The power to add to the class of beneficiaries may cause a non-grantor trust to be treated as a grantor trust.

• When drafting a non-grantor trust, consider adding a provision to bar decanting in a manner that would add to the class of beneficiaries within the meaning of IRC 674.

• Consider also whether giving a beneficiary a lifetime power of appointment constitutes a power to add to the class of beneficiaries pursuant to IRC 674.

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Gift Taxes

• Recognized where property is transferred or deemed transferred during lifetime for less than adequate consideration.

• If a beneficiary agrees to or does not object to decanting or a change in the trust that dilutes or forfeits a beneficial interest in the trust, a taxable gift may result.

• The power to decant, if held by a beneficiary (acting as trustee), may result in a taxable gift.

• Consider giving the beneficiary a limited power of appointment to avoid this result.

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Estate Tax

• Recognized where property is transferred at death. • If decanting results in the beneficiary making a gift, that beneficiary’s estate

will likely include the decanted trust property if the transfer falls under IRC 2035, 2036, 2037, 2038, 2039, or 2042.Even if the beneficiary doing the decanting was given a limited power of appointment to prevent a completed gift, the property might still be included in the beneficiary’s estate pursuant to IRC 2036(a)(2) and/or 2038.

• SDCL § 55-2-15(2)(a) limits the power to decant unless held to an ascertainable standard if the trustee is also a beneficiary or if any beneficiary of the first trust has the right to change the trustees of the first trust. This would avoid estate inclusion.

• Self-settled trusts are generally included in the grantor’s estate if the assets can be reached by creditors.

• SDCL Ch. 55-16 allows self-settled spendthrift trusts, so decanting of a self-settled trust in South Dakota should not result in estate inclusion unless the trust is moved to a state which does not allow self-settled trusts.

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GST Tax

• Recognized where property is transferred to a skip person.

• Special considerations for grandfathered GST trusts.

• Irrevocable trusts established on or before September 25, 1985, are exempt from GST trusts and are thus called “grandfathered GST trusts” – see Tax Reform Act of 1986 §1433(b)(2)(C), as modified by the Revenue Reconciliation Act of 1990 §11703(c) and the Technical and Miscellaneous Revenue Act of 1988 §1014(h)(5).

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GST Tax (cont’d)

• The IRS has held in numerous private letter rulings that if a modification does not result in any change in the quality, value, or timing of any beneficial interest under the trust, a grandfathered GST trust will not lose its exempt status.

• Grandfathered status may be lost if the trustee decants other than by state law in effect when the trust became irrevocable or by authority granted in the governing instrument.

• No decanting statutes were in effect before September 25, 1985, so any state law in effect at the time a grandfathered GST trust became irrevocable would have been a common law power to decant.

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GST Tax (cont’d)

• A distribution from a GST exempt trust to a new trust should not jeopardize exempt status if the terms of the governing trust or applicable state law at the time the trust became irrevocable authorize the distribution without beneficiary consent and if the new trust will not extend the time for vesting beyond any life in being at the date the original trust became irrevocable plus 21 years – see Reg. 23-2601-1(b)(4)(i)(A).

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Other Taxes

• State, local and property taxes.

• When moving trusts from one jurisdiction to another, or when changing applicable state law, these taxes may be avoided, decreased, or increased, depending upon the facts of the situation.

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Alternatives

• Disclaimers.

• Interpretation of the trust.

• Consent to and indemnification of the trustee’s actions.

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Other Pitfalls

• Changing the trust may trigger a no-contest clause. – No-contest clauses are unenforceable in South

Dakota if probable cause exists for the challenge pursuant to SDCL § 29A-2-517.

– No-contest clauses governed by another state’s law may be enforceable.

• Cost – Attorneys fees, court costs, etc. – Uncooperative beneficiary or co-trustee – Objections to proposed changes may tie things up

in court.

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Pitfalls (cont’d)

• Adverse tax consequences, as discussed above. • State law

– Procedural or substantive law in the original jurisdiction may prevent or hamper adjustments to trust.

– Possible trigger of no-contest clauses, as discussed above.

– It may be advisable to seek the opinion of or assistance from local counsel if moving a trust to or from another jurisdiction.

– Some jurisdictions will not allow trusts to move if there is a resident trustee or trust property located in that state.

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Pitfalls – Privacy concerns

• Privacy concerns

– Trust files in South Dakota courts are permanently sealed upon any interested party’s request pursuant to SDCL § 21-22-28.

– Delaware and Alaska offer some limited privacy.

– Trust proceedings in other states are a generally matter of public record.

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Final Accounting

• Check to see if the trust instrument waives the requirement of accountings.

• If the trust is terminated by consent of interested parties, consider asking for a waiver of final accounting as part of the agreement.

• Even if the trust is terminated by its own terms of by court order, it may be worthwhile to ask all interested parties to waive a final accounting. – It is usually helpful to point out that preparation of

a final accounting can be a time-consuming and costly process and waiver will save time and fees.

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Final Accounting (cont’d)

• If any party asks for a final accounting, it generally must be prepared even if not required by the trust document.

• If prepared, the final accounting must show all assets of the trust at the beginning and end of the accounting period as well as all expenses, income, and distributions. – It can either be sent to the interested parties for their

approval without court approval, or court approval may be sought.

– If court approval is obtained, the trustees are generally protected from liability as to all information disclosed in the final accounting, absent fraud, intentional misrepresentation or material omission.

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Final Accounting (cont’d)

– If court approval is not obtained, state law will dictate how long beneficiaries have to object to a final accounting.

– If they do not object within the statutory time frame, they will be deemed to have consented to the final accounting. • In South Dakota, beneficiaries have 180 days

from the mailing of the accounting to object. SDCL§ 55-3-45.

– Notice of the applicable statute of limitations to object should be included on the accounting.

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Final Tax Return

• The trustee must file a fiduciary income tax return (Form 1041) for the trust each year (this return is separate from the trustee's own personal tax return).

• Trusts may be on either a calendar year or a fiscal year. When obtaining an EIN from the IRS, the trustee may make this selection.

• The final tax return may be for a stub period which is less than a 12-month period.

• In the 1041 return the trustee shows: – all income derived by the trust; – the tax credits relating to that income; – the allocation of income between beneficiary and trustee

income; and – any taxable distributions made.

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Final Tax Return (cont’d)

• The trustee then calculates the tax payable on the beneficiary income, trustee income and taxable distributions. Ttrust beneficiary details needs to be filled out for each beneficiary. This is then included in the 1041. – The beneficiaries can then claim a credit for tax paid on their

beneficiary income and taxable distributions (and their share of tax credits) in their own personal income tax returns.

– Note: A trust cannot choose to allocate credits to beneficiaries who may be better able to use them than other beneficiaries. The imputation credits and FDP (foreign dividend payment), formerly dividend withholding payment, credits attached to dividends distributed as beneficiary income must be allocated in proportion to the total distributions received from the trust.

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Final Tax Return

• Some trustees may ask their legal counsel to secure preparation of any necessary tax returns, and some may prefer to work directly with an accountant. – Some attorneys prepare 1041s or have their

paralegals prepare these returns.

– Some attorneys refer clients directly to a knowledgeable accountant and rely on the accountant to prepare the necessary tax returns.

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Final Distribution

• If the trust is being distributed as the result of court-ordered termination, ask the court for permission to make a final distribution in accordance with a proposed distribution schedule. Or, if distributions have already been made, ask the court to approve distributions.

• Obtain receipts from beneficiaries whenever possible. • If the final distributions are being made pursuant to an

agreement among interested parties, get receipts and consents to the final distribution from all interested parties.

• Be mindful of any time limits set by the trust instrument, state law, or court order.

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Preventing Follow-Up Disputes and Litigation

• Obtain consents from all necessary parties whenever possible.

– Encourage unrepresented interested parties to seek independent legal counsel if desired.

• Obtain a court order approving the trustee’s actions if consents from all interested parties cannot be obtained.

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Trust Administration: Challenges and Best...

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