First, a quick review of estate planning. By using a Trust, people that own assets, called "Trustors", arrange to leave their assets to other people, called "Beneficiaries". To be sure that their wishes are carried out, the Trustors designate people they trust, called "Trustees", whose sole job is to step in and carry out the Trustors' wishes when they can no longer manage their Trust, generally due to incapacity or death.
Unlike the Trustors, Trustees have no authority to change the Trust in any way. All they can do is carry out the Trustors' wishes as expressed in the written Trust. But what if circumstances would warrant a change in how those wishes are carried out? Are there any options for flexibility or oversight? The answer may just be providing for the appointment of a Trust Protector.
For a clear explanation, the following is drawn from an excellent Article by California Attorney Gregory Wilcox written for the National Association of Elder Law Attorneys (NAELA). You can obtain a copy of Mr. Wilcox's Article at:
https://www.naela.org/Public/Library/Publications/Publications_Main/NAELA_News_Archive/NAELA_News_2014/AprMay/TrustProtectors.aspx
What Is a Trust Protector?
A Trust Protector is a person named by the settlor of a trust to oversee the trustee's administration of the trust. More specifically, a Trust Protector is usually thought of as a person whose duty is to protect the beneficiaries, the trust estate, and the implementation of the settlor's purposes from an errant trustee. Some jurisdictions have statutes that address the concept, but many do not.
Trust law generally assumes that it will be the trust beneficiaries who will enforce the terms of a trust written for their benefit. Accordingly, there are provisions in many states' law requiring trustees to account for their actions to the trust's beneficiaries.
However, what if there are circumstances where it is not really reasonable to expect the beneficiaries to provide adequate supervision of the trustee's administration? What if the trustee is far away and communication is difficult (as with offshore asset protection trusts where the idea started)? Or, more relevant here, what if the trust is a special needs trust and the beneficiary is a person with a mental illness or developmental disability? Who then checks on the trustee? A Trust Protector can fill this role and thereby avoid the possible consequences of unsupervised power reflected in the famous quotation at the beginning of this article.
What Are the Powers of a Trust Protector?
When the law is silent on Trust Protectors, it is solely the settlor's language in the trust that defines the extent of the Trust Protector's powers. Virtually all Trust Protectors are given the authority to remove the Trustee, and usually also the power to appoint a replacement. Beyond this, powers vary substantially from trust to trust. The Trust Protector's power to terminate the trustee may be unlimited or require some showing of grounds. The trust can authorize the Trust Protector to appoint a successor Trust Protector if he or she is no longer able or willing to serve. Frequently the Trust Protector is authorized to reform the trust for certain purposes described in the trust. For example, the trust may need to be modified in light of changes in public benefits law or changes in the beneficiary's circumstances.
Less commonly, the trust can authorize the Trust Protector to name members of an advisory committee created in the trust, to intervene in disputes between the trustee and the beneficiary, and to control the costs of administration. Even more unusual, the Trust Protector's powers might include removal or addition of beneficiaries, approval of trust distributions, approval of investment advisors, approval of investments, and termination of the trust.
Since there are no governing statues to decide the issue, a trust providing for a Trust Protector should address the question of whether the Trust Protector can take actions that contradict express provisions in the trust. For example, can the Trust Protector appoint a successor trustee different from the one the settlor names in the trust?
What Are the Duties and Liabilities of a Trust Protector?
In order to fulfill their roles, Trust Protectors must keep themselves apprised of the administration of the trust. Accordingly, the major duty of a Trust Protector is to review the accounts and reports of the trustee. Less clear is whether the trust should require the Trust Protector to "consult" with the trustee. If the trust requires consultation, is the Trust Protector liable for failure to adequately consult?
One concern has surfaced as settlors have loaded their Trust Protectors with more and more duties. Does the Trust Protector thereby become a "fiduciary" subject to the high statutory duties of a fiduciary? Indeed, there may even be some risk that a court will find that the Trust Protector has become a cotrustee as a matter of law. Not only are there no statutory rules to help resolve such questions, there is little case law because Trust Protectors are such a new concept, only gaining significant traction since 2000.
If the Trust Protector does not understand that he or she is going to be held to fiduciary standards, it could come as an unpleasant surprise later on. If the Trust Protector does understand that he or she will be held to fiduciary standards, the proposed Trust Protector might decide that the job involves more responsibility and liability than the Trust Protector really wanted to take on. He or she might either resign or refuse to participate. Drafters can help to avoid ambiguity by expressly stating whether or not the Trust Protector has or does not have fiduciary duties to the beneficiaries of the trust.
What Are the Rights of a Trust Protector?
Clearly the trust must give the trustee the duty to keep the Trust Protector informed about the administration of the trust. Accordingly, the Trust Protector will normally have the right to receive all accounts, reports, and notices that a beneficiary receives. In addition, the trust should make clear that the Trust Protector has the same right as the beneficiary to request additional information.
A particularly sticky issue is compensation. Settlors should be advised not to expect that their chosen Trust Protectors will agree to serve for free. However, without any statutory or other standards, there is little guidance on how to set the fees of a Trust Protector. Also, it will certainly be the trustee who pays the Trust Protector's fee claims. This structure immediately reveals a conflict of interest, as the trustee hopes to keep his or her job by paying the Trust Protector whatever is requested. Some of these problems can be ameliorated, if not completely avoided, with trust language that provides little discretion with regard to the Trust Protector's compensation, such as a fixed dollar amount per year.
Tax Issues
There is a fair amount of concern in the commentary on Trust Protectors that the extensive powers given to a Trust Protector might result in adverse tax consequences. However, if a trust is set up as a revocable trust, there should not be much concern about the impact of the grantor trust rules (IRC §§671-697). All the income, deductions, and credits in the trust will be reportable by the settlor in any case. After the settlor's death, the trust itself becomes irrevocable and also becomes the taxpayer.
Instead, the tax concern for the kinds of trusts that Elder Law attorneys normally see is that the extensive powers given to a Trust Protector will amount to an inadvertent and unwanted General Power of Appointment. Roughly speaking, such a power is one that the holder can use to benefit him or herself (IRC §2041). If that happens, and the Trust Protector dies before termination of the trust, the Internal Revenue Service might argue that all the trust assets are part of the Trust Protector's estate subject to federal estate tax.
Now, in these days of huge $5 million exclusions (relative to the usual size of the trusts Elder law attorneys typically handle), one might think that the unintended creation of a General Power of Appointment is no big deal. That may indeed be true in most cases. However, Trust Protectors may not always be family members of average means, but private professional fiduciaries. Such fiduciaries would be hard to enlist if upon their death their heirs might be burdened by an unexpected estate tax on assets that are going to someone else. Although theoretically possible, such an outcome seems pretty farfetched. If Trust Protectors really are fiduciaries with resulting prohibitions against self-dealing, and especially if they are private professional fiduciaries, the IRS would find it very hard to argue that they hold any kind of General Power of Appointment. Interestingly, such potential protection from adverse tax treatment might be a reason why Trust Protector might want to be defined as a fiduciary in spite of the additional liability.
Nevertheless, to avoid such tax risks, common Trust Protector provisions are at pains to exclude any authority that might be interpreted as creating a General Power of Appointment. They do this by prohibiting Trust Protectors from having any beneficial interest in the trust estate, from appointing themselves as trustee, and from appointing any related or subordinate party as trustee (as defined byIRC §672(c)). They prohibit Trust Protectors from using any of their powers in favor of themselves, their creditors, their estate, or the creditors of their estate, and prohibit the Trust Protector from using any trust assets to discharge an obligation of support. The desire to avoid creation of a General Power of Appointment may also be a reason not to give Trust Protectors any control over their own compensation.
Who Should Serve as Trust Protector?
There are contradictions in the commentaries on the matter of who should serve as a Trust Protector. Some assume that a family member of the settlor will serve as Trust Protector, and others recommend prohibiting it. This conflict appears to have arisen from the peculiar provenance of the concept. Trust Protectors first emerged in the context of offshore irrevocable asset protection trusts. Settlors of such trusts were understandably concerned about entrusting a major portion of their wealth to an unknown trust company in a small distant country serving as a tax and/or debtor haven, such the Bahamas or the Cook Islands. The availability of a Trust Protector gave the settlors some measure of comfort that they could immediately pull the plug on a trustee who was running amok.
In such situations, there were serious concerns about the estate and income tax consequences if the Trust Protector could appoint a new trustee who was a related or subordinate to the settlor, and such appointments were therefore expressly prohibited. However, while the settlor is alive and the trust is revocable, the trust estate will all be subject to the settlor's estate and income taxes. Accordingly, concerns that apply to the power of the Trust Protector to benefit the settlor in the context of offshore trusts appear to have little bearing on the kinds of trust that Elder Law attorneys are likely to draft.
This is a fortunate result because the most natural and convenient Trust Protector for most settlors is a family member particularly where there is a private professional fiduciary or corporate/bank trustee. However, a family member is certainly a related or subordinate party under the Internal Revenue Code. Is that a problem? No, because if the trust is a typical one (a revocable trust until the death of the settlor, with the settlor serving as initial trustee), both income and estate taxes will apply to the settlor in any case. What will matter in such a case is that, after the settlor's death, any new trustee not be subordinate or related to the Trust Protector. If the new trustee were related or subordinate to the Trust Protector, the IRS might equate that to a power of the Trust Protector to appoint himself as trustee - and that might create the dreaded General Power of Appointment. In other words, there doesn't appear to be much reason to include provisions in our revocable trusts that prohibit appointment of family members of the settlor as Trust Protectors.
What Will Be the Reaction of Public Benefit Agencies?
Seldom mentioned in the commentary on Trust Protectors is the effect on the public benefits of the trust beneficiaries. All public benefits agencies review trusts that have some bearing on the support of their beneficiaries, including but not limited to the Social Security Administration (for SSI), the state agencies that administer the Medicaid program, the Department of Veterans Affairs (for VA Pensions), and Public Housing Authorities (for "Section 8" housing assistance).
It is not clear what these agencies will make of what will almost certainly be seen as unfamiliar, indeed exotic, language about Trust Protectors. The fact that there is no supporting statutory authority legitimizing such language does not help. First party trusts that contain assets of the beneficiaries are particularly likely to cause problems because they are so strictly regulated. If Trust Protectors are used at all, drafters should be careful to delete provisions that might be interpreted as allowing a violation of agency trust requirements such as reimbursement of Medicaid benefits and "sole benefit" restrictions (applicable to distributions from first party special needs trusts). The Trust Protector's right to reform the trust should be limited to actions that maintain the trust beneficiary's eligibility, and exclude any reformation that might prejudice it.
What Will Be the Reaction of Professional Trustees?
Finally, there is another issue that receives scant attention: the reaction of professional fiduciaries. There are banks that serve as trust companies and private professional fiduciaries. Both are often asked to serve as trustees of special needs trusts and other trusts that Elder Law attorneys draft. They will certainly pay special attention to the provisions for Trust Protectors because they will owe the continuation of their job as trustee to the good will and approval of the Trust Protector.
Their responses can be expected to vary. Some will welcome the opportunity to consult with a third party, but others may not be comfortable with having another party "looking over their shoulder" and second-guessing''' their performance. One way of avoiding the resistance of future potential trustees is invite the proposed trustee to participate in the drafting of the trust and its provisions for a Trust Protector.
Conclusion
Drafters of trusts, especially special needs trusts, should add Trust Protectors to their checklists of issues to discuss with their clients. Trust Protectors seem particularly appropriate where the beneficiary cannot be expected to adequately supervise the administration of the trust.
Gregory Wilcox, CELA, is an attorney in private practice in Berkeley, Calif. He is a NAELA Fellow. This article was originally published in Legal Network News, Vol. 24, No. 4, Winter 2013.
For over 20 years, the attorneys of BPE Law Group, P.C. have been advising and representing property owners and real estate licensees in dealing with their legal concerns and maximizing their opportunities. If you would like a consultation with us, please call our office at (916) 966-2260 or e-mail me at sjbeede@bpelaw.com. Our flat fee consult for new clients may get you the answers you need for the questions you have. Consultation appointments may be held at our Main office in Fair Oaks or at our Satellite office in Sun City Lincoln.
