A Practical Guide to Trustee Selection: A Review of the Most Common Tax (and Nontax) Traps
When it comes to modern-day estate planning, trusts invariably are an integral part of the structure. In the authors’ daily reviews of trusts, they have found that thoughtful planning can at times be rendered problematic due to trustee selection. The consequences can range from inefficient income taxation to gift and estate tax inclusion. Some overt; others lurk in the shadows. There are three perspectives embedded in designing an effective trust strategy: the settlor, the beneficiary, and the trustee. This article touches on the beneficiary and trustee perspectives, but focuses on six key issues from the settlor’s perspective when advising clients on trustee selection.
Before assessing these issues, it is important for advisors to be familiar with four fundamental Internal Revenue Code (I.R.C.) sections.1
What You Must Know About I.R.C. §§672, 2036, 2038, and 2041
I.R.C. §672 provides a frequently used and effective safe harbor. It indicates who will be deemed independent if appointed as trustee, cleansing certain potential inclusion concerns (e.g., absolute discretion and trustee removal). To fit within this safe harbor, one first must determine if the individual is adverse, and if not, then if they are related or subordinate. An “adverse party” is someone who has a substantial beneficial interest in the trust that would be adversely affected by his or her exercise or nonexercise of the power impacting the trust and has a general power of appointment over trust property.2 A “related or subordinate party” is a nonadverse party who is 1) the grantor’s spouse, if living with the grantor; 2) the grantor’s father, mother, issue, brother, or sister; 3) an employee of the grantor; 4) a corporation or any employee of a corporation in which the stock holdings of the grantor and the trust are significant from the viewpoint of voting control; or 5) a subordinate employee of a corporation in which the grantor is an executive.3
I.R.C. §§2036 and 2038 cause inclusion in the gross estate under certain circumstances. I.R.C. §2036 causes inclusion in the gross estate the value of all property to the extent the decedent has made a transfer outright or in trust and “retained” the possession or enjoyment of, or the right to the income from, the property, or the right (either alone or in conjunction with any person) to designate the persons who shall possess or enjoy the property or the income from the property. I.R.C. §2038 requires inclusion in the gross estate of the value of all property to the extent the decedent made a transfer outright or in trust and either retained power, either alone or in conjunction with any person to alter, amend, revoke, or terminate enjoyment of the property, or relinquished such a power within three years of his or her death. For both I.R.C. §§2036 and 2038 there is a key exception for a bona fide sale for a full and adequate consideration.4
I.R.C. §2041 provides that the gross estate includes the value of all property to which the decedent at death had a general power of appointment or at any time exercised or released such a power by a disposition, which if it were a transfer of property owned by the decedent, would be includible in the decedent’s estate under I.R.C. §§2035-2038, inclusive.
A general power is one that can be exercised in favor of the decedent, the estate, creditors, or the creditors of the estate. Exceptions include 1) a power limited by an ascertainable standard relating to the health, education, support, or maintenance;5 and 2) a power only exercisable in conjunction with the grantor of the power or someone with an adverse interest.6
A beneficiary/trustee’s power to distribute to self should be limited by an ascertainable standard and prohibit satisfying self’s support obligations of another. Additionally, a beneficiary/trustee’s power to distribute to others should also be limited by an ascertainable standard. With respect to removal and replacement of a trustee, a beneficiary’s power, whether or not the beneficiary is a trustee, should either be under a trust with distributions limited by an ascertainable standard or limited to the successor being independent per I.R.C. §672(c).
The trustee must have legal capacity — age of majority for an individual and trust powers if an entity. Being organized as a bank does not automatically provide trust powers, and being state chartered restricts the powers to such state. A trustee should also have all the proper attributes, including sound judgment, impartiality, financial ability, loyalty, and trustworthiness and be excused from self-dealing, when appropriate. The optimal trustee would be located in a state with laws in furtherance of the purpose of the trust, such as income tax, creditor rights, and rule against perpetuities. This suggests that “situs” shopping when picking a trustee can be important.
The settlor must relinquish control to ensure funding is a completed gift. The transfer to a trust may or may not be a completed gift, based on the trust terms and the identity of the trustee.7 If there is a completed gift initially, immediate gift tax could be due, based on the size of the gift. However, if the gift is not complete initially, the assets — including subsequent appreciation — will be included in the settlor’s estate upon completion of the gift.8
The gift tax is applied to “direct or indirect” gifts of property whether in trust or otherwise.9 The Treasury Regulations add that a gift may be complete even if, at the time it is made, “the identity of the donee may not…be known or ascertainable.”10 However, the Treasury Regulations provide that a gift will not be complete for gift tax purposes if certain powers are retained by the settlor as a trustee, or in some situations as a co-trustee, until the retained interest or power is relinquished.
The settlor must not retain possession, enjoyment, or income, regardless of who is trustee.A transfer is a completed gift only to the extent that the settlor “has so parted with dominion and control as to leave in him no power to change its disposition, whether for his own benefit or for the benefit of another”11 and is incomplete to the extent that the settlor reserves the power to re-vest the property in himself.12 This power can be indirect, such as through the power to force a trustee to make distributions to the settlor under a trustee’s power to make distributions that is limited by a fixed or ascertainable standard, which is enforceable by or on behalf of the settlor.
A gift is also complete when a trustee, who is not the settlor has absolute discretion over distributions to the settlor, and the settlor’s creditors cannot reach the transferred property.13 The IRS has ruled privately that a gift to an “Alaska trust” (which could not be reached by the settlor’s creditors) was a completed gift even though the trustee could in its discretion make distributions to the settlor.14 In another case apparently involving an Alaska trust, the IRS recognized that transfers to the trust were completed gifts, even though the settlor was a discretionary beneficiary, because he could not re-vest beneficial title or change the beneficiaries.15 A gift, however, is generally incomplete to the extent that the settlor retains the power to change the interests of the beneficiaries among themselves.16 The Treasury Regulations clarify that a power to change beneficial interests will not cause a gift to be incomplete for gift tax purposes if the power is held in a fiduciary capacity and is subject to a “fixed and ascertainable standard.”17
Five Retained Powers Causing a Gift To Be Incomplete
The following are five examples of retained powers, which if held by the settlor alone or in conjunction with another trustee who does not have a substantial adverse interest, will cause a transfer to be incomplete unless subject to a fixed and ascertainable standard. Safe harbor: If there is a fixed and ascertainable standard, the beneficiaries would have legal rights to force distributions according to the standard, thus, divesting the settlor of dominion and control over the transferred property.
• Right to Use of Property or Income — A direction that the settlor has the right to actual use of trust property or trust income clearly comes within the meaning of the statute, regardless of who is serving as trustee. If there is a retained right to receive only a portion of the income, only that corresponding part of the trust is included in the settlor’s estate.18
• Continued Use of Residence by Settlor — Inclusion in the settlor’s estate has been argued when the settlor continues use of a residence he transferred. To find that an agreement existed at the time of the transfer, a showing of more than just continued possession of the residence is needed.19 In fact, the IRS concedes that continued co-occupancy for interspousal transfers will not of itself support an inference as to retained possession or enjoyment by the settlor.20 However, the IRS is not as lenient when the residence is given to family members other than the spouse.21
• Payment of Rent by Settlor — If the settlor retains use of the transferred property under a lease agreement that provides for fair rent, it is unclear whether I.R.C. §2036 applies. However, the trend is that I.R.C. §2036 will not apply when adequate rental is paid for the use of the property.22 The IRS has ruled privately that the donor of a qualified personal residence trust may retain the right in the initial transfer to lease the property for fair rental value at the end of the qualified personal residence trust term without causing estate inclusion.23 The IRS, however, does not concede that renting property for a fair rental value always avoids estate inclusion. Most of the cases that have ruled in favor of the IRS have involved situations in which the rental that was paid was not adequate.24
• Payment of Settlor’s Debts — The settlor is treated as having retained the “use, possession, right to income, or other enjoyment” of property to the extent that such interest is directed to be applied toward the discharge of legal obligations of the decedent/settlor, regardless of who is the trustee.25
• Support of Settlor’s Dependents — If the trust directs the trustee to make payments in support of the settlor’s dependents estate tax inclusion would occur.26 However, inclusion does not occur if the trust merely directs the payment of income to a person whom the settlor is obligated to support, if the settlor’s support obligation would continue, because the income distribution in that situation would not benefit the settlor.27
Two Retained Powers Not Causing the Gift To Be Incomplete
The following are examples of retained powers, which if held by the settlor alone or in conjunction with another trustee who does not have a substantial adverse interest, will not cause a transfer to be incomplete unless subject to a fixed and ascertainable standard.
• Settlor as Totally Discretionary Beneficiary — Discretionary trusts for the settlor are not generally included under I.R.C. §2036(a)(1).28 Some exceptions to this “general rule” are when 1) there was an agreement or understanding that the transferor would receive the income; 2) under the law of creditor’s rights, the settlor’s creditors can reach the trust income to pay the transferor’s debt; 3) the settlor is herself trustee of such a discretionary trust; and 4) the trustee’s discretion is limited by a standard that can be enforced by the settlor-beneficiary.
• Transfer to Spouse with a Potential of Having Spouse Appoint the Assets Back to Settlor — Giving the donee-spouse a power to appoint the assets back to the settlor or to a trust for settlor’s benefit should not create inclusion problems for the settlor as long as there is no express or implied agreement that the spouse would exercise the power for the settlor. Ensure that the spouses understand that there really is no preconceived plan of whether the power of appointment will be exercised because it is just included to provide helpful flexibility — and do not sign a new will exercising the power under “old and cold.”
The settlor must not have a broad distribution power if he or she is trustee. There are at least three dispositive powers that trigger inclusion, if held by the settlor.
1) Sprinkling Power. The power to shift income or trust property among beneficiaries causes inclusion under either I.R.C. §§2036 or 2038.29
2) Power to Accumulate. The power to affect only the timing of distributions clearly triggers inclusion under I.R.C. §2038 even though beneficiaries who receive the distribution may not be impacted.30 The Treasury Regulations under I.R.C. §2038 state explicitly that “§2038 is applicable to any power affecting the time or manner of enjoyment of property or its income, even though the identity of the beneficiary is not affected.”31
3) Power to Invade Principal. A power to invade principal is a power to alter enjoyment under I.R.C. §2038.32 Similarly, an unlimited power to invade principal for a beneficiary is subject to I.R.C. §2036(a)(2).33
Distribution Power Safe Harbor
The ascertainable standard limitation is a recognized distribution power safe harbor. Planners often rely on it, and apparently rightly so; however, the history of it is important. Recall that if the distribution powers held by the settlor are limited by a determinable external standard, enforceable in a court of equity, the settlor arguably does not have any power to alter the distributions because the standard sufficiently limits the settlor’s discretion. Yet, practitioners are often shocked to learn that there is no explicit ascertainable standard exception in the statutory provisions or regulations to I.R.C. §§2036 and 2038.34
In the seminal case establishing the ascertainable standard exception for a settlor controlled power over disposition, the settlor retained the power as trustee to make distributions to enable the beneficiary to keep himself and his family in comfort “in accordance with the station in life to which he belongs.” The court held that power would not cause inclusion under the predecessor to I.R.C. §2038.35 Since that time, many courts have ruled on whether particular standards are sufficient to avoid inclusion under I.R.C. §§2036 and 2038.36 Standards relating to “health education, support and maintenance” are invariably held to avoid estate inclusion, by analogy to the standards exception in I.R.C. §2041.37
A settlor must not have power to remove and replace with himself or herself — the successor trustee should be independent. The settlor will be treated as holding the powers of the trustee (dispositive or management) if the settlor can appoint himself or herself as the trustee, including as co-trustee or as a successor, at any time.38 If the settlor merely has the power to add co-trustees, the settlor generally should not be treated as holding the powers of the trustees, as long as he or she cannot appoint himself.39 Safe harbor: The IRS has battled the issue for replacing successors, eventually leading to the current safe harbor that I.R.C. §§2036 and 2038 will not apply to a settlor who can remove a trustee, but can only appoint as a successor trustee someone who was “not related or subordinate to the decedent” within the meaning of I.R.C. §672(c).40
A settlor must not be trustee of an I.R.C. §2503(c) Minor’s Trust — nor should the settlor’s spouse serve. If the settlor serves as trustee of a minor’s trust created under I.R.C. §2503(c) (to qualify for the gift tax annual exclusion), the trust assets will be included in the settlor’s estate if he or she dies while serving before the termination of the trust.41 Under I.R.C. §2503(c), there can be no “substantial restrictions” on the trustee’s exercise of the discretionary power to make distributions for the minor beneficiary.42 A discretionary power to make distributions for “support, education, care, comfort and welfare” will qualify under I.R.C. §2503(c).43 Even that standard, however, is probably too expansive to satisfy the ascertainable standard exception. In addition, estate inclusion would result if the settlor resigns as trustee within three years of his death.44 Accordingly, the settlor should not serve as trustee or co-trustee (or have the power to appoint himself or herself as trustee or co-trustee) of an I.R.C. §2503(c) trust.
Further, the settlor’s spouse generally should not be the trustee either. If the spouse dies before the trust terminates, the assets may be included in the spouse’s estate because she would have the power to make distributions in satisfaction of his or her legal obligation of support.45 Furthermore, when the child becomes of majority age, so that the spouse no longer owes a legal obligation of support, the IRS may argue that a lapse of the spouse’s general power of appointment occurs, thus, resulting in a gift from the spouse to the trust.46
Administrative powers can be problematic to the settlor if the trust eliminates court oversight. Certain administrative decisions may have the effect of shifting benefits from one beneficiary to another. For example, the power to allocate receipts and disbursements between income and principal can affect the amounts distributed to income beneficiaries and remaindermen. Similarly, a trustee’s investment powers to invest in high-growth, non-income-producing assets may shift benefits from the income beneficiary to the remaindermen. Courts have long recognized that “standard” administrative powers would not invoke the predecessors of I.R.C. §§2036 and 2038.47 However, the IRS has argued (with some success in early cases) that various broad administrative powers would cause estate inclusion under I.R.C. §§2036 and 2038.48
As the courts have sifted through these types of cases, the emerging principle is that a settlor’s broad management powers will not invoke I.R.C. §§2036 or 2038 as long as the settlor’s actions are subject to review by a court of equity (for example, if the exercise of the power is subject to fiduciary standards).49 This is particularly true if the settlor’s actions are subject to a standard that, as a practical matter, can be enforced by a court as opposed to actions taken under a “sole discretion” standard.50 However, some courts have applied this principal regarding management powers even if the settlor has very broad discretion.51
As has been shown, there are very complex rules that have evolved concerning trustee selection, and they continue to evolve. One observation is simple — for many of these areas, there are safe harbors. Practitioners would be well advised to stray from them only when necessary and only after careful consideration. Of course, including savings clauses in your documents is also very helpful in avoiding trustee selection pitfalls.52
1 All references made to the Internal Revenue Code (I.R.C.) are to the Internal Revenue Code of 1986, as amended.
2 I.R.C. §672(a).
3 I.R.C. §672(c).
4 I.R.C. §2036(a); I.R.C. §2038(a)-(b).
5 I.R.C. §2041(b)(1)(A).
6 I.R.C. §2041(b)(1)(C).
7 Before considering the trust terms and trustee selection, ensure that the settlor wishes to make a complete gift for gift tax purposes.
8 I.R.C. §§2036-2038.
9 I.R.C. §2511.
10 Treas. Reg. §25.2511-2(a).
11 Treas. Reg. §25.2511-2(b).
12 Treas. Reg. §25.2511-2(c).
13 Estate of Holtz v. Comm’r, 38 T.C. 37, 42 (1962), acq. 1962-2 C.B. 4; Rev. Rul. 76-103, 1976-1 C.B. 293 (gift not complete where trust permitted discretionary distributions to settlor and, under the controlling state law, the settlor’s creditors could reach the entire trust property; gift would become complete if trustee moved situs of the trust to a state where the settlor’s creditors cannot reach the trust assets); Outwin v. Comm’r, 76 T.C. 153 (1981); Hambleton v. Comm’r, 60 T.C. 558 (1973); Paolozzi v. Comm’r, 23 T.C. 182 (1954), acq. 1962-1 C.B. 4; but see Herzog v. Comm’r, 116 F.2d 591 (2d Cir. 1941) (several cases have specifically addressed that an incomplete gift results if creditors of the settlor/beneficiary can reach the trust assets).
14 P.L.R. 9837007.
15 P.L.R. 200944002.
16 Treas. Reg. §25.2511-2(c); Estate of Sanford v. Comm’r, 308 U.S. 39 (1939).
17 Treas. Reg. §§25.2511-2(c) and 25.2511-2(g).
18 Treas. Reg. §2036-1(a), Implied Understanding (last paragraph). The statute also applies if there is an express or implied understanding that the settlor will be allowed to use or receive income from the transferred property.
19 See Stephens, Maxfield, Lind & Calfree, Federal Estate And Gift Taxation ¶4.08[c] (2001).
20 Rev. Rul. 78-409, 1978-2 C.B. 234; P.L.R. 200240020.
21 E.g., Estate of Trotter v. Comm’r, T.C. Memo. 2001-250.
22 E.g., Estate of Barlow v. Comm’r, 55 T.C. 666 (1971) (no inclusion under §2036 even though decedent stopped paying rent after two years because of medical problems); Estate of Giselman v. Comm’r, T.C. Memo 1988-391.
23 P.L.R. 199931028.
24 Estate of Du Pont v. Comm’r, 63 T.C. 746 (1975).
25 Treas. Reg. §2036-1(b)(2); Hooper v. Comm’r, 41 B.T.A. 114 (1940).
26 I.R.C. §2036(a)(1); Treas. Reg. §2036-1(b)(2).
27 P.L.R. 8504011 (for example, the IRS has ruled that a trust requirement for the trustee to consider the beneficiary’s other resources would avoid I.R.C. §2036(a)(1) if the other resources included the support obligation of the settlor); Wishard v. U.S., 143 F.2d 704 (7th Cir. 1944) (similarly, if a trust requires that all income be distributed to a settlor’s dependent, but states that the beneficiary “should” use the income for his maintenance and support, I.R.C. §2036(a)(1) is not triggered unless local law provides that receipt of the income by the beneficiary discharges the settlor’s legal support obligation).
28 I.R.C. §2036(a)(1) (Two different phrases/words in the statute suggest that naming the settlor as a beneficiary in the trustee’s discretion might not trigger I.R.C. §2036. First, the statute refers to the settlor keeping a “right to” income. Second, the statute requires that the settlor “retain” the
income interest. As to the first argument, the legislative history indicates that the substitution of the phrase “right to the income” in 1932 was meant to broaden, not restrict, the reach of I.R.C. §2036(a)(1) and to extend it to cases where the settlor had the right to income but did not actually receive it. The second argument does lend a credible argument that a totally discretionary interest might not be subject to I.R.C. §2036(a)(1).).
29 Estate of MacManus v. Comm’r, 172 F.2d 697 (6th Cir. 1949) (predecessor to I.R.C. §2036(a)(2)); Estate of Craft v. Comm’r, 608 F.2d 240 (5th Cir. 1979) (I.R.C. §2038 inclusion where decedent had power to change beneficiaries and change their respective shares).
30 Lober v. U.S., 346 U.S. 335 (1953); Estate of Alexander v. Comm’r, 81 T.C. 757 (1983) (retained power to accumulate income for distribution every five years caused inclusion, even though all income eventually had to be distributed to the income beneficiary).
31 Treas. Reg. §2038-1(a).
32 Estate of Yawkey v. Comm’r, 12 T.C. 1164 (1949).
33 See Commissioner v. Estate of Holmes, 326 U.S. 480 (1946).
34 Treasury Regulations under various other IRC sections give guidance on what standards would constitute an ascertainable standard or a definite external standard. Treas. Reg. §§20.2041-1(c)(2), 25.2511-1(g)(2), and 1.674(b)-1(b)(5)(i).
35 Jennings v. Smith, 161 F.2d 74 (2d Cir. 1947).
36 Rev. Rul. 73-143, 1973-1 C.B. 407. Further, the IRS has recognized that assets will not be included in a settlor’s estate under I.R.C. §2038 if the settlor was empowered to invade principal only for the beneficiary’s support and education.
37 E.g., Estate of Wier v. Comm’r, 17 T.C. 409 (1951), acq. 1952-1 C.B. 4.
38 I.R.C. §2036; I.R.C. §2038; Treas. Reg. §20.2036-1(b)(3).
39 Durst v. U.S., 559 F.2d 910 (3d Cir. 1977).
40 Rev. Rul. 95-58, 1995-2 C.B. 1.
41 I.R.C. §§2036 and 2038; see Estate of Alexander v. Comm’r, 81 T.C. 757 (1983); Estate of O’Connor v. Comm’r, 54 T.C. 969 (1970).
42 Treas. Reg. §25.2503-4(b)(1).
43 Rev. Rul. 67-70, 1967-2 C.B. 349.
44 I.R.C. §2035(a).
45 Treas. Reg. §20.2041-1(c)(1).
46 See generally Zaritsky, Tax Planning for Family Wealth Transactions ¶4.05[a].
47 E.g., Reinecke v. Northern Trust Co., 278 U.S. 339 (1929).
48 E.g., State Street Trust Co. v. U.S., 263 F.2d 635 (1st Cir. 1959).
49 See Dodge, 50-5th T.M., Transfers With Retained Interests and Powers 101 (2002); Estate of Bowgren v. Comm’r, 105 F.3d 1156 (7th Cir. 1997) (the absence of a fiduciary duty was the determining factor in finding that a settlor who retained controls over Illinois land trusts was subject to I.R.C. §§2036(a)(2) and 2038).
50 See Gans & Blattmachr, Strangi: A Critical Analysis and Planning Suggestions, Tax Notes 1153, 1157 (Sept. 1, 2003).
51 Old Colony Trust Co. v. U.S., 423 F.2d 601, 603 (1st Cir. 1970) (the court that ruled in favor of the IRS in the State Street case changed its position in 1970, specifically overruling the result in State Street, and adopting a position under Massachusetts law that no amount of administrative discretion prevents judicial supervision of the trustee); Estate of King v. Comm’r, 37 T.C. 973 (1962), nonacq. 1963-1 C.B. 5 (some courts have even held that a settlor’s nontrustee powers were reserved in a fiduciary capacity, thus, invoking the general rule that administrative powers subject to court review do not trigger application of I.R.C. §§2036 or 2038).
52 Given how facile technology has made drafting, it may verge on malpractice not to include thoughtful, comprehensive savings clauses particularly as to distribution powers and trustee succession, reflecting the settlor’s intent as to estate tax inclusion as to the settlor, estate tax inclusion as to the beneficiary, marital deduction qualification, and exposure to a beneficiary’s creditors.
Mark R. Parthemer is managing director and senior fiduciary counsel of Bessemer Trust, a wealth management firm for high-net worth individuals. He oversees the firm’s estate planning and fiduciary services from Miami to Washington, D.C., leads Bessemer’s Advanced Implication Modeling team, and is a member of Bessemer’s estate planning “think tank” committee.
Sasha A. Klein is a senior vice president and director of trusts and wealth services for Sabadell Bank and Trust, an exclusive wealth management division of the bank for high net worth families. She oversees the firm’s estate planning and fiduciary services for Southeast Florida.
This article is submitted on behalf of the Tax Law Section, James Herbert Barrett, chair, and Michael D. Miller and Benjamin Jablow, editors.