Trustees owe a fiduciary duty to both the income beneficiaries and the remaindermen of the trusts they administer. These duties include the general duties of care, loyalty, honesty, and good faith and fair dealing applicable to all fiduciaries, as well as particular duties specific to their position. Fulfilling these duties can be challenging when the trust contains especially large or complicated assets, especially if the trust is a charitable remainder or charitable lead trust required to abide by complex federal regulations. What should trustees of such trusts be aware of with regard to investment and management of trust assets?
First, a quick explanation of certain types of trusts. A charitable remainder trust (CRT) provides an opportunity to preserve income while avoiding taxes. Broadly speaking, a CRT’s creator (also known as the donor) irrevocably transfers assets to a trust and specifies non-charitable beneficiaries to receive income from the trust for a period of time. The donor also designates a charity to receive the remaining trust assets outright when the trust terminates. A CRT offers the donor multiple tax advantages. First, a donor may take a charitable income tax deduction for the property donated to the trust. In addition, and particularly helpful if an asset is highly appreciated, the trustee can sell the asset for its current fair market value and pay no capital gains tax. Moreover, the trust is exempt from paying income tax on certain income produced by trust assets.
A charitable lead trust (CLT) offers different tax advantages. With a CLT, the donor funds a trust that makes payments to a designated charitable beneficiary during its specified term (for instance, during the life of the grantor). When the trust terminates, the remainder of the trust property passes to a non-charitable designee. A CLT allows the donor to shelter assets from the estate tax while still passing them on to recipients of the donor’s choice.
The primary and principal source for a trustee’s duties is the document that creates the trust (the “trust instrument”). A trustee’s duties are also imposed by common law and by state statute.
Traditionally, common law precluded a trustee from delegating its duties, including investment duties. Consequently, unless the trust instrument or state law allowed it, the trustee itself was required to manage investments of trust property rather than delegating investment decisions to a broker or investment advisor. In Texas, this rule changed with the adoption of the Uniform Prudent Investor Act and the Uniform Principal and Income Act (collectively, “UPIA”), effective in 2004. Written to update trust law to accommodate significant changes in investment practice since the 1960s, versions of the UPIA have been adopted in most states in the U.S., and have both clarified and modified some of a trustee’s historical duties.
First, the UPIA confirms that a trustee who invests and manages trust assets has a duty to comply with the rule known as “the prudent investor rule.” This rule requires a trustee to act as a prudent investor would, keeping in mind the purposes, terms, distribution requirements, and other circumstances of the trust. The trustee is to exercise “reasonable care, skill and caution” in carrying out this duty. (See Texas Trust Code Chapter 117, Sec. 117.003(a), 117.004(a).)
Next, the UPIA clarifies that a trustee must manage and invest individual trust assets with a focus on the trust’s total asset portfolio, not simply to maximize income. (Sec. 117.004(b).) Note that a trustee must perform a delicate balancing act with respect to the interests of income beneficiaries versus the remaindermen. That is, the trustee owes a duty to the income beneficiaries to maximize income distribution, and at the same time must guard against unnecessary risk to preserve trust assets that ultimately pass to the remaindermen. The law lays out specific circumstances for a trustee to consider that acknowledge this tension:
Additionally relevant to a trustee’s investment decisions is the newly-imposed requirement to diversify trust assets. (Sec. 117.005.)
Also new under the UPIA, a trustee is no longer prohibited from delegating asset investment and management to an appropriate professional. (Sec. 117.011.) Indeed, in light of the obligation to invest with an eye to total return, the need to balance competing interests, and the duty to diversify, it may be a breach of the prudent investor rule not to delegate investment decisions to a qualified broker or investment advisor.
The trustee must follow the prudent investor rule when delegating authority to an agent to invest and manage trust assets. Congruent with this rule, the trustee is to exercise reasonable care, skill and caution in choosing an agent (that is, a broker or adviser) and establishing the scope and terms of the delegation consistent with the trust’s purpose. Importantly, the UPIA imposes on the trustee a continuing obligation to monitor and review the agent’s actions for compliance with the delegation. (Sec. 117.011.) If the trustee discovers malfeasance or error by the agent, it must act quickly to remove the agent and remedy the situation. Thus, a trustee who fails to properly monitor a broker or investment advisor breaches its duty to the trust’s beneficiaries and can incur liability therefor.
What can go wrong if a trustee fails to keep on top of a broker’s activity? To begin with, a broker could engage in any of the types of securities fraud discussed here, causing losses to the trust. Moreover, in the case of a CRT or CLT, a broker could inadvertently create negative tax consequences for the trust.
The federal tax code specifies that, although a CRT’s passive income is exempt from taxation, it must pay a 100% excise tax on “unrelated business income,” also known as “UBI.” (IRC Sec. 664(c)(2)(A).) So-called UBI comes in many different flavors under IRS regulations. For example, while income from an apartment rental is considered passive income not subject to tax, income from hotel rentals is UBI and thus taxable. (See, e.g., 26 CFR 1.512(b)-1.) In addition, certain debt-financed income is included in UBI. This is important because any securities purchase made on margin may be considered debt-financed and therefore any profits would be subject to the excise tax – and a well-meaning broker may recommend margin investment without being aware of the consequences. (Note that margin purchases no longer disqualify the trust from its tax exempt status altogether.)
As another example, particularly relevant here in Texas, income from a “working interest” in oil and gas investments can raise a UBI problem. (26 CFR 1.512(b)-1.) Again, a broker or investment advisor unfamiliar with the IRS regulations governing CRTs might inadvertently cause an issue for the trust.
If a trustee complies with the UPIA in selecting and delegating investment authority to a broker, it will not be held liable to the trust or the beneficiaries for that broker’s actions, except under specific circumstances. (Texas Trust Code Chapter 117, Sec. 117.011(c).) Note, however, that one of these exceptions may be broad enough to swallow the rule, at least as far as registered brokers and investment advisors are concerned. Even if the trustee has complied with the statute in delegating investment power, it can still be held liable for a broker’s actions if, under the terms of the delegation, the trustee or a trust beneficiary is required to arbitrate disputes with the broker. Now recall that most disputes involving registered brokers are subject to FINRA arbitration. This is good reason for any trustee to be particularly sensitive to any dispute-resolution provisions in its agreements with brokers and investment advisers.
If you have additional questions or concerns about the parameters of a trustee’s duties or authority to delegate asset investment and management authority, contact us at 866-597-2221, or via our contact form.