As part of your overall estate plan, you and your advisor may explore the possibility of using a Trust to accomplish your goals and objectives.  Because of the complexity of these financial instruments, it is critical to have a well versed team of professionals in place to guide you through the process.

Investing for Trusts is similar to investing for people, in that people or charities are the beneficiaries of trusts and thus the objectives, risks, and taxation issues are similar, but NOT the same.  The Primary reason is that trusts are entity-like and potentially have multiple taxpayers, multiple, and sometimes conflicting interests complicating the objective, and are held to fiduciary standards of conduct far higher than an individual for her own account.

This article relates to irrevocable trusts, since a Revocable Living Trust during the competent lifetime of the Grantor, who has the power to revoke it do not carry the weight of investing or accounting for multiple beneficiaries with conflicting interests.

Principal and Income Accounting

One issue to consider is not just the needs of the beneficiaries and the rights of the beneficiaries to access funds from the trust, but the state law and document provisions defining Trust Accounting “Income” and Trust Accounting “Principal”.  These definitions in accounting apply only to trusts and thus are often unfamiliar to non-professional fiduciaries. The reason Income and Principal are important is that many trusts differentiate between the rights to Income and Principal and as such the investments must be made in a manner that understands and reflects those needs.

Beneficiaries who are mandated distributions such as “Distribute all income, at least annually, to …” versus beneficiaries who receive at the trustee’s discretion should cause an attention by the investment advisor to consider the actual production of income by investments purchased, not just total return. Unitrust definitions under state law help with this issue, but are a matter of state law and thus do not apply to all irrevocable trusts. A unitrust defines Income as a specified percentage of Principal annually. The trustee’s knowledge of this language is important to properly support the types of investment which will support the objectives of the trust and the needs of the beneficiaries.

These rights to distributions, or possibility of distributions, leads us to another investment implication for irrevocable trusts, which is income taxation.

Income Taxation of Irrevocable Trusts

All revocable trusts are treated as “Grantor Trusts” for income tax purposes, meaning that the income tax treatment is passed back to the grantor and reported on their own return each year. Some Irrevocable trusts also operate this way due to powers in the trust to obtain this treatment. But most Irrevocable trusts are like entities who are independent taxpayers.

The rights to income and principal, discussed above, thus act as a conduit to shifting the taxation of the trust to the beneficiaries when distributions are made. The trustee should be aware of the automatic rights to income as it, generally, makes the beneficiary, not the trust, the taxpayer for the year. In discretionary distribution trusts the trustee should discuss and anticipate possible distributions for the trust in the coming year because it enables the trustee to have a better idea of who the taxpayer will be for the year, thus the state of residence of the taxpayer and their likely marginal tax rate as well as the character of income that may be most appropriate.  Character of income, such as tax-exempt or qualified dividend income, flows through with distributions. Also, irrevocable trusts reach the maximum income tax bracket at a far lower threshold than do individuals, who may have earned income as well.

These accounting and tax factors create the need for some guidance for trustees which is provided by the Uniform Prudent Investor Act.

Uniform Prudent Investor Act (UPIA)

The UPIA was developed and adopted in 1992 by the American Law Institute‘s Third Restatement of the Law of Trusts (“Restatement of Trust 3d“), reflecting a “modern portfolio theory” and “total return” approach to the exercise of fiduciary investment discretion. It has been adopted by the vast majority of states but, again, the trustee must have knowledge of the specific law of the state in which they operate the trust.

The UPIA gives specific factors to consider when making trust investments including tax considerations, the production of income, and economic conditions. It also allows the trustee to give special consideration to inception assets and assets which may have special meaning to the beneficiaries or to the purposes of the trust.  This raises the issue that, when investing for a trust, every asset is an investment, not just the marketable securities portfolio. It may include personal items, a family business, or a vacation property. All of these assets must be viewed as investments under the ownership of the trust and this often raises personal and emotional issues, not merely financial ones.

This raises one final issue when there are disputes or disagreements between the beneficiaries and the trustee, and that is the level of power conferred by the trust.

Sole & Absolute discretion

Language in the trust document often describes the investment powers of the trustee.  An often misunderstood phrase is that the “trustee has sole and absolute discretion” which, to the layperson, may appear to mean that the trustee’s actions are above scrutiny in accordance with the issues discussed in this article. I can assure you this is not the case. If the trustee had no duty to comply with the terms of the trust, the intention of the grantor, and the needs of the beneficiary, there would be no trust. The prudent trustee, therefore, communicates and documents her discretionary decisions in accordance with the standards discussed above.

Summary

It is important that you work with your advisor and his external partners closely to determine the best course of action to reach your estate planning goals.  Acting as trustee is a complex and responsible capacity, in which many factors influence the decision-making process. Working with knowledgeable and experienced partners is important to avoiding liability and achieving the objectives set forth in the trust.