Section 7B: Trustee Selection

7B.3 TRUSTEE LIABILITIES

Trustee liability is another factor to be considered by the grantor when selecting a trustee. For example, an individual trustee may be exposed to personal liability for a breach of his or her duty that is owed to the trust beneficiaries. An individual trustee may, however, be judgment proof (or close to it). Corporate trustees, on the other hand, are accountable, regulated, and have liability and fidelity insurance, as well as sufficient assets to satisfy a judgment for a breach of duty.

7B.3(a) Typical Trustee Liabilities

Typical trustee liabilities1 include the following:

  • Environmental matters2;
  • Taxes;
  • Tort liability (in the absence of liability insurance and sufficient trust assets);
  • Contractual liability (in the absence of an individual trustee disclosing his or her trustee capacity);
  • Surcharge for breach of duty, i.e., for failure to perform any of the duties described in section 9.2, above;
  • A co-trustee’s breach of duty;
  • A predecessor trustee’s breach of duty; • An agent’s errors and omissions;
  • Violation of securities law;
  • Violation of consumer protection laws;
  • Liability as a title holder; and
  • Criminal liability.

7B.4 TRUSTEE ATTRIBUTES

In selecting an individual or corporate trustee, the following factors and characteristics concerning the proposed person should be considered by the grantor:

  • The prospective individual trustee’s honesty and integrity.
  • The prospective individual trustee’s impartiality and objectivity.
  • The prospective individual trustee’s knowledge and experience concerning

investments, the prudent investor rule, tax issues, etc., or the ability to recognize when to hire advisers with such knowledge and expertise.

  • The prospective individual trustee’s administrative capabilities and inclinations, or the ability to recognize when to hire advisers with such knowledge and expertise.
  • The prospective trustee’s availability, permanence, and continuity. Will the prospective individual trustee be able to devote sufficient time to the affairs of the trust? Will the trustee’s location be distant from the trust beneficiaries? Most beneficiaries prefer to deal with a trustee (or trust officer) who is close by. What is the prospective individual trustee’s health and age, particularly if the trust term is greater than the prospective individual trustee’s life expectancy or period of good health and mental acuity?
  • The prospective individual trustee’s reliability and ability to handle significant responsibility.
  • The prospective trustee’s knowledge of the grantor’s family, the family’s dynamics, the special needs of a disabled or incapacitated beneficiary, the family-owned business, and the ability to remain impartial when resolving family disputes.
  • The prospective trustee’s ability to not be influenced by an overly aggressive or manipulative beneficiary.
  • The prospective trustee’s compensation requirements. Corporate trustees generally charge a fee based on a percentage of the trust’s assets. In smaller trusts, that can be very expensive, especially when the trustee has a minimum fee charge. Family members often serve without fees or for a modest fee.
  • The prospective trustee’s citizenship and residence and their potential income tax consequences to the trust.

7B.5 INSURED’S SPOUSE AS BENEFICIARY-TRUSTEE OF THE CONTINGENT MARITAL DEDUCTION TRUST

7B.5(a) General Power Of Appointment Marital Deduction Trust

If the ILIT contains a marital deduction trust that is a general power of appointment trust described in IRC section 2056(b)(5), there should be no adverse transfer tax consequences to the grantor’s spouse while serving as sole trustee of that trust after the grantor’s death; all of the income is required to be distributed to the spouse and all of the property will be included in the spouse’s gross estate under IRC section 2041.

7B.5(b) QTIP Marital Deduction Trust

If the ILIT contains a marital deduction trust that is a QTIP trust, there may be adverse transfer tax consequences to the grantor’s spouse if he or she serves as the sole trustee of the QTIP trust. The potential for adverse tax consequences arises if the grantor’s executor elects to make a partial QTIP election as to part of the marital trust. The partial QTIP election may accomplish nothing if the trustee-spouse has the right to discretionary distributions of principal from the non-elected portion of the marital trust. This is because the spouse will hold a general power of appointment (under IRC section 2041) over the non-elected portion and that property will be taxed in the spouse’s estate, thus subjecting the non-elected portion of the QTIP trust to double estate taxation. If the grantor’s executor makes a reverse QTIP election under IRC section 2652(a)(3) to use the grantor’s GST tax exemption (or to preserve the ILIT’s GST inclusion ratio of zero), the trustee-spouse should not possess any powers over the QTIP trust that would be treated as a general power of appointment under IRC section 2041. If the reverse QTIP property is includable in the spouse’s gross estate under IRC section 2041 (instead of IRC section 2044(b)(1)(A)), the spouse will be treated as the “new” transferor for GST tax purposes, thus wasting the deceased grantor’s GST tax exemption.

Practice Point: A more basic issue is whether the prohibit- ed powers would cause the QTIP trust to be classified as a general power of appointment marital deduction trust under IRC section 2056(b)(5). If so, no reverse QTIP election can be made, thus losing the opportunity to allocate the grantor’s unused GST tax exemption (or to preserve the ILIT’s GST inclusion ratio of zero by allocating the ILIT property to the reverse QTIP trust). Additionally, a partial QTIP election or Clayton contingent QTIP election may not be available, thus losing post-mortem planning opportunities, such as the previously taxed property credit under IRC section 2013 or equalizing the spouses’ estates. But see, Priv. Letter Rul. 20024015, where the IRS permitted a QTIP election for a trust that gave the surviving spouse a testamentary general power of appointment. In that letter ruling, the IRS stated that “at Taxpayer’s death, the value of the qualified share will be includible in Taxpayer’s gross estate under section 2041, and Taxpayer will be the transferor of this value for generation-skipping transfer tax purposes.”

7B.5(c) Sole Trustee Of Marital Trust

If the grantor’s spouse serves as sole trustee of the marital deduction trust, and has the power to withdraw trust principal (even though limited by an ascertainable standard for federal estate tax purposes), nevertheless, the IRS may assert that the spouse holds the power (for income tax purposes only) to vest the corpus in him or herself, and as such, is taxable on any on gain recognized by the trust, under IRC section 678(a). This income tax effect, if desired, could be used to reduce the size of the spouse’s estate. The spouse could reduce the estate by using his or her own money to pay the trust’s income taxes. See, section 8.3, above.

7B.5(d) QDOT Marital Trust

The QDOT rules do not prohibit the noncitizen surviving spouse from serving as a co-trustee of the QDOT marital trust. The only mandatory role of the U.S. trustee is to withhold the QDOT tax imposed on distributions to the surviving spouse. IRC section 2056A(a)(1)(B). However, if the noncitizen surviving spouse is a co- trustee who has the authority to control all substantial decisions of the trust (i.e., control all decisions other than ministerial decisions concerning the trust), and the noncitizen surviving spouse subsequently becomes a non-U.S. resident, the QDOT may be classified as a foreign trust for U.S. income tax purposes. IRC sections 7701(a)(30)(E) and (31)(B); Treas. Reg. §301.7701-7(d).

7B.5(e) Second Marriages

Having the grantor’s spouse serve as sole trustee of the marital deduction trust may not be appropriate in second marriages when there are children from the first marriage. Particularly in a second marriage, the interests of the spouse and children may conflict. In this situation, an independent trustee may be better able to carry out the grantor’s intent as expressed in the trust.

7B.6 INSURED’S SPOUSE AS BENEFICIARY-TRUSTEE OF THE ILIT OR CREDIT SHELTER TRUST

The issues discussed in Chapter 8 (concerning tax-sensitive powers regarding the beneficiary-trustee) apply to the surviving spouse if he or she serves as a beneficiary-trustee of a non-marital deduction trust, such as the ILIT or resulting credit shelter trust.12 If the spouse is a grantor of the ILIT, an insured under the ILIT, or a donor of property to the ILIT (other than merely consenting to gift splitting under IRC section 2513), the issues discussed in Chapters 2, 3, and 4 (concerning income, gift, and estate tax) should be reviewed and the spouse should not serve as a trustee of the ILIT. Also, the issues discussed in section 9.5(d), above, concerning foreign trust status, also apply to a non-U.S. citizen surviving spouse and the credit shelter trust. See, also, section 1.3, above and section 10.15, below. Another reason for prohibiting the spouse from serving as a trustee of the ILIT is the lack of flexibility concerning contingent Crummey withdrawal right beneficiaries. An independent trustee can be given the power to make discretionary distributions of trust income and principal to the contingent beneficiaries, thereby obviating an IRS attack based on naked Crummey withdrawal rights. Depending on the relationship of the beneficiaries to the spouse, the spouse may not be able to hold discretionary distribution powers, and may be limited to holding trust distribution powers limited to an ascertainable standard, which could be more easily enforced by a disgruntled beneficiary.

Practice Point: In no event should the grantor’s spouse serve as a trustee of an ILIT that holds a second to die policy that insures the grantor and the spouse.

7B.7 THE INDEPENDENT TRUSTEE

An independent trustee is defined in IRC sections 672(c)and674(c). See, section 2.6, above.

7B.7(a) Using An Independent Trustee

Use of an independent trustee avoids the imputation of the trustee’s powers to the beneficiaries and permits greater flexibility for trust distributions. See, Paragraph 4.1(A) of Sample ILIT. Also, unlike a beneficiary-trustee (such as the grantor’s spouse), an independent trustee can possess tax sensitive powers and make discretionary income and principal distributions to a beneficiary without adverse tax consequences to the independent trustee. The IRS sanctions the unfettered removal and replacement of an incumbent trustee if the replacement trustee is an independent trustee. Thus, the grantor, a beneficiary, or a beneficiary-trustee can be given the power to remove an incumbent trustee for any reason, and replace that trustee with an independent trustee without fear that the IRS will treat the power of removal and replacement as an impermissible power held by the grantor, beneficiary, or beneficiary-trustee (as the case may be). Rev. Rul. 95-58, 1995- 2 C.B. 191. Priv. Letter Rul. 9607008. See, Paragraph 6.21 of Sample ILIT concerning the removal and replacement of a trustee.

Drafting Example:

An “Independent Trustee” means a person who is not related or sub- ordinate (within the meaning of IRC section 672 (c)) to me or to any beneficiary with respect to the trust in question.

Drafting Example:

At any time after Settlor’s death, the then surviving adult beneficiaries who are sui juris and not incapacitated, and then eligible to receive current income from the trust, acting by unanimous written consent, may remove the trust’s Trustee, for reasonable cause, and • Irrevocable Life Insurance Trusts §9.7(b)

may, in the absence of a nominated successor Trustee then willing or able to serve or continue to serve as Trustee, appoint a successor Trustee(s), who is an Independent Trustee; provided, no person, acting alone, may remove or name a Trustee of a trust that would be included in that person’s gross estate solely by reason of this right of removal or appointment.

7B.7(b) Tax-Sensitive Powers Held By Independent Trustee

As previously mentioned, an independent trustee can possess tax-sensitive powers without adverse tax consequences. See, Paragraph 7.1(C)(4) of Sample ILIT regarding the appointment of an independent trustee to exercise certain tax-sensitive powers.

7B.7(c) Second Marriages

 An independent trustee is appropriate in second-marriage situations. See, section 9.5(e), above.

7B.7(d) QDOTs

An independent trustee is appropriate for marital deduction trusts that are QDOTs (provided the independent trustee is a U.S. trustee).

Practice Point: Within the definition of an “independent trustee,” the following individuals are not related or subordinate parties under IRC section 672(c), as concerns the powerholder: the powerholder’s nieces, nephews, grand- parents, spouses of children, spouses of grandchildren, spouses of brothers and sisters, and partners of the power holder. However, the following individuals, if they are a non-adverse party, are treated as a related and subordinate to the powerholder: the powerholder’s spouse if living with the powerholder, the powerholder’s father, mother, issue, brother or sister, and certain employees of the powerholder or his or her business. Treas. Reg. §1.672(c)-1.

7B.8 INSURED’S SPOUSE AND THE INDEPENDENT TRUSTEE AS CO-TRUSTEES

Having an independent trustee serve as a co-trustee of the marital deduction and credit shelter trusts with the surviving spouse provides flexibility and permits the surviving spouse to have some control, as a co-trustee, over the affairs of the trust. A co-trustee arrangement of this type is always appropriate, if desired by the client; and especially appropriate in second-marriage situations. In such instance, all discretionary powers and all tax-sensitive powers must be exclusively vested in the independent trustee.

Drafting Example:

The power to make discretionary distributions of principal or income not limited by an ascertainable standard shall be vested exclusively in (and exercisable only by) an Independent Trustee. If the incumbent trustee is not an Independent Trustee, the incumbent trustee may appoint an Independent Trustee to serve as co Trustee with the incumbent trustee. The Independent Trustee so appointed shall serve concurrently with the appointing trustee until the appointing trustee resigns, dies, or becomes incapacitated and is succeeded by a successor trustee (as nominated under this trust agreement).

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