Patricia M Angus is a lawyer and consultant to high net worth families on governance and philanthropic planning. She is Counsel to Day, Berry & Howard in New York.
Family trusts, set up to take care of the welfare of family members, are often a source of confusion for beneficiaries. Education about the specific details of trusts is as important as legal structures and will ensure the long-term success of the family business
For many families in business, the family company is only one of many entities in which family members have a shared interest. It is often the case that the founder of the family business or members of later generations establish one or more trusts to take care of the long- or short-term welfare of the family.
After years of experience, it has become clear to me that there is a need for better understanding by family members creating trusts and, more importantly, by the family member trust beneficiaries, about what a trust is and how it works. Ironically, the beneficiary, who is the very person for whom a trust has been established, is often confused about fundamental trust concepts. This confusion can lead to an unhealthy sense of dependence and lack of control, as well as a missed opportunity to be fundamentally involved in a very important aspect of one's life.
The education of family members, especially beneficiaries, is as important as the creation of legal structures and the proper investment of assets to ensure the preservation and growth of family wealth and enhance the beneficiary's life. Not only can proper education help family members better understand the specific details of the arrangements they are establishing or inheriting, it can also help ensure the long-term success of the family and its business.
This article summarises some fundamental issues (based on US law) that members of families in business can and should strive to understand about the trusts they create and that are created for them. The process should begin at the inception of the trust and continue for its duration. This will help the beneficiary better understand how to play an active role in the admin- istration of the trust.
This list hardly begins to address the complex set of issues that each trust entails. However, a beneficiary who is aware that it is important to understand these issues and who undertakes to gain a better understanding of them will have made great strides toward achieving some of the powerful ways that a trust can assist them in life.
A beneficiary should receive a copy of the trust agreement, or at least relevant parts of it, from the trustee. The trust agreement provides a set of instructions for the trustee and guidelines for the beneficiary.
The trustee should also provide a summary (oral or written) of the trust and be available to answer questions about its terms. It is only by reference to the specific provisions of the beneficiary's own trust that he or she will fully understand the beneficiary's rights and responsibilities under the trust.
The trust agreement defines the key parties to the trust relationship as:
- the "grantor" or "settlor": contributes funds to the trust and generally sets its terms;
- the "trustee": the individual, bank or trust company responsible for holding the trust funds and implementing its terms;
- the "beneficiary": a person who is to receive current benefits (income and/or principal) from the trust;
- the "remainderperson": anyone who is entitled to receive trust property when it terminates.
The beneficiary should seek clarification on what the trustee can or must do with trust income and principal. Often, the agreement will state that the trustee is to pay income to a particular beneficiary, generally annually or more frequently. It may also provide that principal is to be paid at certain ages or from time to time in the trustee's discretion.
A trustee who has discretion over payment of trust income and/or principal is subject to certain standards that determine when payments can be made. Under a broad standard, the trustee may pay principal for any reason or not at all. A more restrictive standard might state that principal may be paid for the emergency needs of the beneficiary. The beneficiary and trustee should discuss openly the types of payments that can be made.
The trust agreement provides specific guidance on the trustee's powers. This part contains important information that will give the beneficiary key ideas on what the trustee can and cannot do for him or her. For example, before the beneficiary calls the trustee to request a distribution, it would be useful to find out whether a loan would be possible.
The beneficiary should also see if any specific powers are reserved for them. He or she may have a "power of appointment" that gives the ability to determine where trust property goes on the beneficiary's death. For tax or other reasons, it might be better for the beneficiary to take a loan rather than a distribution.
The identities involved
The beneficiary should know who the other parties to the trust relationship are, currently and in the future. The trustee can be one or more individuals or institutions. There may be an investment advisor available for management of trust assets.
The beneficiary may be one of several people (family members or others) to whom income and principal may be paid.
The beneficiary should also understand whether and to what extent he or she will have the ability to request or demand removal of the trustee. It would also be helpful to find out whether there is a trust "protector" or other trust advisor. Finally, if all or part of the family business is held in trust, it would be helpful for the family member to understand the exact holding structure.
Purpose of the trust
Ideally (but infrequently), the trust agreement will contain a statement of the grantor's reasons for establishing it. If the trust agreement is not clear, the beneficiary should nonetheless seek clarification of the purpose. Understanding the mission will help the beneficiary keep the arrangement in perspective. If the trust agreement is not clear, the beneficiary should ask the trustee, lawyer or other advisors for some background information.
The beneficiary will not necessarily be happy with the grantor's purpose. But it may help keep potential frustration and anger directed where it belongs, rather than at the trustee who is merely carrying out the grantor's wishes.
The trustee's duties
A trustee is a fiduciary and, as such, must act in the best interests of the beneficiaries and remaindermen. If a trustee takes advantage of its legal ownership of the property, it faces not only the ire and wrath of disgruntled beneficiaries, it can face legal action by them.
In addition, a trustee has a number of specific duties, including duties to: exercise reasonable care, skill and caution; keep and render accounts of administration; take and keep control of trust property; keep the trust property separate and make the trust property productive.
Rights and responsibilities
One unique aspect of the trust structure is that the beneficiary is an integral, indeed the most important, person in the overall structure and yet most often the beneficiary is not involved in the process of establishing the trust or in its administration.
This can lead to an unhealthy feeling of dependence. In order to maximise the benefits he/she may receive from the trust and to ensure the well-being of the overall trust arrangement, the beneficiary should be comfortable with his/her rights and responsibilities.
The beneficiary's rights include the right to:
- Review the trust agreement and related documents;
- Expect the trustee to be accountable to each beneficiary and remainderperson of the trust;
- Have a trustee who is willing to maintain open communication;
- Attend regular (at least annual) meetings with the trustee in order to discuss trust matters and the beneficiary's personal financial circumstances and goals, and to provide input on the trustee's performance in light of the trustee's duties and responsibilities;
- Seek removal of a trustee in appropriate cases.
The beneficiary's responsibilities are to:
- Participate actively in trust affairs;
- Understand the trust's mission or overriding purpose;
- Understand the general nature and composition of the trust assets;
- Understand his/her rights and responsibilities under the trust agreement and how this relates to the rights and responsibilities of other beneficiaries and remainderpersons;
- Gain a basic understanding of trust law;
- Obtain a general understanding of investment fundamentals, including modern portfolio theory and how it fits with the prudent investor rule;
- Understand the trustee's roles and responsibilities;
- Develop a general capacity to understand trust accounting;
- Know how and in what amount trustees and other professionals are compensated, and obtain a general understanding of the budgets for the trust and investment entities in which the trust will be invested.
Duration of the trust
Most trusts are governed by a local "perpetuities period", which usually states that no trust (other than a charitable trust) may last more than one lifetime (starting at the time the trust is created) plus an additional 21 years. This centuries-old restriction is now being loosened in many jurisdictions. All new trusts in Delaware, South Dakota, Alaska and many other states (and countries) may now last in perpetuity.
A beneficiary does not need to become an accountant to gain a basic understanding of trust accounting. The basic concept – that a trust is established with contributed assets, known as trust "principal", and any amount that is generated by that principal (interest or rent) is considered "income" – is quite simple. More specific definitions of income and principal are provided by the law governing the trust. Indeed, the definition of "income" can be quite complicated.
The beneficiary should be aware that trust accounting principles are not always the same as tax rules. In this way, a beneficiary may be subject to tax on income that he or she did not actually receive but which is attributed to the beneficiary.
Each trust is governed by the laws of a particular state (or country). These local laws and court interpretations provide guidance to the trustee and beneficiary about trust administration. In general, the terms of the trust agreement will apply to the extent that they are not otherwise prohibited by law. A grantor may choose the laws of a particular state or country, so long as there is a sufficient connection with that state, to obtain certain benefits. For example, an increasing number of trusts are established in Delaware because there is no state fiduciary income tax, there is enhanced asset protection and a trust can last forever.
The trustee (or, in an increasing number of cases, its delegate) will be responsible for investing trust assets. The beneficiary should, at a minimum, understand the basic available investment options, including cash, stock, bonds, mutual funds, real estate, art and "alternative" investments such as hedge funds. The trustee will be responsible for deciding whether to retain the original assets and for ensuring that the investments match the trust's goals.
The beneficiary should seek to understand the basics of "modern portfolio theory", which states that the most important factor in determining a portfolio's performance is the allocation of assets over time – not stock picking
or market timing.
The beneficiary should be able to engage in a discussion of each asset class, the historical return for each class and its function in the portfolio. The asset allocation can and should be adjusted as the needs of the beneficiary – and the financial climate – change over time.
The "prudent investor" rule
Traditional rules limited the trustee's ability to invest trust assets under a fairly restrictive standard that emphasised maintaining principal even if growth was hindered. Under the new "prudent investor rule" adopted by many states, a trustee must develop an overall strategy for the trust portfolio in light of the present and future needs of beneficiaries while taking into account risk and return.
Diversification among asset classes is considered essential. The "total return" of the trust is paramount. Each asset or class is looked at in the context of the entire portfolio. Trustees must balance income and growth. They may also delegate their investment responsibility so long as the delegation is prudent.
This law is being complemented by another new law to ensure that investments chosen for total return (including "growth" stocks) do not adversely affect income beneficiaries. New rules now allow trustees to adjust between income and principal and in some cases to choose a specific percentage ("unitrust amount") of the trust to be considered "income" for distribution.
Many of the ideas in this article, especially beneficiary roles and responsibilities, have been explored in greater detail by James E Hughes, Jr elsewhere. Hopefully, this article will add to the resources that families in business draw upon to reduce misunderstandings that can lead to conflict and to ensure that trusts are truly beneficial in the lives of trust beneficiaries.
A trust beneficiary who takes on the task of learning more about his or her trust will certainly reap the benefits, not only with respect to the trust but also in other relationships with the family and its business.