The Trustee of Your Dreams
When setting up trusts for heirs, business owners often give too little attention to the most important issue: the selection of a trustee.
Many successful family business owners put plenty of thought into estate planning. They grapple with complex, tax-driven planning techniques. They struggle with concerns about family-member relationships. They agonize over how to divide stock and voting control between active and inactive family members.
Chances are that after all of these deliberations, your estate plans will involve trusts. Yes, trusts are a necessary evil for reducing estate taxes. More importantly, you will probably see them as critical to such nontax objectives as delaying your kids' and grandkids' receipt of your estate until they are ready for the responsibility of owning it. After thoughtfully looking in your crystal ball, you'll probably decide that somewhere between ages 25 and 60 should be about right.
Much artful crafting goes into writing a trust document. After all, the trust probably will be around for a long time after you're gone. The document must cope with ever–changing business conditions; family members' abilities and relationships; births and deaths; medical, educational, and other special needs; tax laws; government administrations; and any number of other issues that no one can predict.
Unfortunately, most business owners fail to recognize that even the best trust document is just that: a document. Pieces of paper may have lots of legal authority, but they cannot dictate savvy business decisions, happy and productive family relationships, an appropriate work ethic and moral values, and the other great gifts that you wish to leave your family.
Once the machinations of creating the trust document are complete, business owners all too often give little attention to what is probably the most important trust issue: the selection of a trustee. The right trustee can help further your dreams and hopes for the business's and family's future. In short order, the wrong trustee can undo careful tax planning, squander assets, alienate family members, and run the business into the ground. It makes little sense to struggle over structuring a trust to benefit future generations only to hand responsibility over to an inappropriate or incompetent trustee.
Selecting the right trustee involves far more than simply choosing between an individual and an institution (usually a bank). Of course, that choice is important, but many people make it based on cost alone. As a result, the “honor” of being trustee is bestowed on an unsuspecting friend or family member. I can tell you from experience that you get less than your money's worth from a free trustee. Cost can be a minor issue given the fact that individuals and institutions have differing skills, capabilities, experience, and personalities (called “cultures” in the institutional world).
So how can you pick the right trustee? As with any multi-dimensional issue, specific family and business situations dictate different answers. Only hindsight will tell whether you made the right decision. However, three actions will maximize the potential for your trust to accomplish your objectives over the long term:
- Match the trustee's abilities with responsibilities and family needs.
- Ensure that the trustee can be held accountable for his actions.
- Distinguish the trustee's roles from those of other people involved with the family and business.
Matching abilities with needs
Of course, the trustee must be competent to manage the property owned by the trust. Highly successful lawyers, dentists, and business owners can be terrible stock portfolio managers. Conversely, a competent money manager may not be the best choice to handle the responsibility of managing family business stock. Even a successful business owner can be a poor choice of trustee for your business-owning trust if he lacks either the time or interest necessary to handle the responsibility.
You also should consider expected changes in what the trustee will manage. For example, appointing a friend to handle the nominal responsibilities of a life insurance trust may become a big mistake when the trust receives and must invest the insurance payoff.
Trust documents typically specify how much judgment the trustee may use in making income and other distributions to beneficiaries. They rarely should substantially restrict this authority because flexibility is important to contend with the family, economic, business, and tax changes that inevitably occur over a trust's long duration. But as a trustee's discretion increases, the care given to the selection process must increase.
The reason is simple. As a trustee's decision-making freedom grows, so does the likelihood that those decisions will be questioned by the beneficiaries. Consider the burden you place on your son if you appoint him trustee with discretion to distribute to his siblings. Is it fair or appropriate to put him in the position of determining his siblings' (or his siblings' children's) needs? Will he be able to stand up to inappropriate demands, or will he give in to maintain family harmony? Can he be objective in making decisions affecting other family members' lifestyles?
How good of a friend are you if you put your best friend in this position?
A bank trust officer may not be inherently more qualified to make these distribution decisions, but it may be better for the family to rally together against a stingy trust officer than to take shots at an equally stingy and perhaps biased sibling, aunt, or old-timer friend of Dad's.
Be careful about letting your trustee selection (or the provisions of the trust document itself) diminish your grown children's ability to determine their children's financial upbringing. I've seen parents become nervous wrecks upon discovering that well-meaning grandparents made the grandkids millionaires at age 25. Although there are many valid tax and family reasons to create trusts for your grandchildren, be sure to:
- Talk with your adult offspring to make sure that they concur not only with your trustee selection, but also with the financial authority that you give the trustee with respect to their kids.
- Consider allowing your son or daughter to be trustee, at least with respect to determining the amount and timing of distributions to his or her children. Your grown children will have estate tax problems if they have the right to take trust property for themselves, but they can be given substantial say over their children's financial interests.
- Consider giving each adult offspring the right to alter his or her children's shares of the trust when you die. This power (called a “limited testamentary power of appointment”) can permit your son or daughter to favor a grandchild with special needs over other grandchildren. It also can allow them to delay distributions to, or even disinherit, an irresponsible grandchild.
In some ways, trustees are like Supreme Court Justices. They usually are appointed for life. Within the vague bounds of something lawyers call “fiduciary responsibility,” trustees are not particularly accountable to anyone. That's okay as long as they perform their jobs reasonably well. While trust documents provide guidelines for your wishes and intentions, documents are only as good as trustees who abide responsibly by their terms. Even if you have the utmost confidence in the trustee you appoint today, there's a good chance that the trust will outlast him, or at least his ability to do the job.
Bankers believe their institutions will last forever, so selecting a bank may eliminate the dead or incompetent trustee issue. Unfortunately, institutions don't make decisions, people do. You may have confidence in that institution's people today, but they won't be there forever.
How can you make sure that your trustee and any successor trustees continue to act responsibly over the many years and lifetimes that the trust may span? The answer is to make sure your trustee is accountable to another authority. There are a variety of authorities to whom the trustees may be made accountable for their actions:
Authority #1: You. You could retain the power to fire and replace the trustee. If the trustee you initially choose turns out to be incompetent or unresponsive, you could appoint a new one. As it turns out, however, this straightforward approach carries some risks. In 1979, the IRS ruled that a retained right to fire and replace a trustee was equivalent to retaining the trustee's powers, which could cause trust assets to be taxed in your estate. The Tax Court recently overruled the IRS on this matter, but relying on that decision can be dangerous; the IRS may pursue its view in other courts. In any case, you may not be around when the need to replace the trustee arises.
Authority #2: The beneficiaries. You could give the beneficiaries the right to replace the trustee. This approach is appealing because it makes the trustee accountable to the ultimate owners. However, if you created the trust to protect the property from the kids, giving them the power to replace an uncooperative trustee may be like asking the fox to guard the hen house. Instead, consider permitting the beneficiaries to fire the trustee only for “good cause.” Of course, there can be disagreements over the definition of good cause, but at least it's a step away from giving the kids a unilateral right to go shopping for a compliant trustee. Also, prohibiting the beneficiaries from capriciously dismissing the trustee will keep the IRS from trying to tax the property in their estates.
Authority #3: A trust protector. You could give someone else (sometimes called a “trust protector”) the power to fire and replace the trustee. A trust protector typically has no economic interest in the trust and acts solely in a trustee-oversight capacity. A trust protector avoids the issues in Authorities 1 and 2, but appointing such a person has a practical downside. Besides having to find a good trustee, you have the burden of finding the right trust protector—and you also must consider successors for that role.
Authority #4: Co-trustees. Some people name co-trustees, hoping that two people will be more accountable for their actions than one. It is possible that two trustees with complementary skills can be more effective than a single trustee. Multiple trustees also can reduce the risk of outright fraud, but they do not directly address the underlying question of accountability for their actions. What happens if you have two lazy trustees? What happens if you have two trustees that disagree on how to manage the trust or what to distribute to the beneficiaries?
Authority #5: A board of trustees. If two trustees can be better than one, why not name a whole board of trustees? Be careful. Boards of trustees can easily become viewed by the beneficiaries as self-perpetuating institutions that are concerned only marginally with their best interests. Unlike a corporation's board of directors, there are no stockholders who can fire a trust's board. Just like the co-trustee approach, adding more people to the equation does not create accountability. In fact, it can create confusion as to who is responsible for what.
There are obviously pluses and minuses to each of the five approaches to ensuring trustee accountability that I've described. No one solution is applicable to every case, and the right approach for you must be based on the specific circumstances of your family and business.
Distinguishing the trustee's role
Some professional trustees are voluntarily becoming more responsive to beneficiaries, if not more accountable. Outspoken beneficiaries, an overabundance of litigation-minded attorneys, and competition have forced institutional trustees in particular to pay more attention to relationships with beneficiaries.
Even so, of all people, wouldn't family members have the family's best interests at heart? Wouldn't they have the best understanding of family needs? Perhaps. But naming family members as trustees can create tremendous confusion and conflicts of interest. On balance, my advice is that you should avoid giving family members multiple hats to wear.
We all know about the confusion that can arise when family members have multiple roles—parent, child, owner, boss. The family business consulting profession has arisen in response to the need to untangle the resulting conflicts.
As we've seen, trusts create two new sets of roles for business owners to sort out. First, trusts create beneficiaries, otherwise known as “the kids” and other family members you love. Presumably, you created the trust to benefit them financially in some way. At the same time, the trustee also enters the picture. The trustee's role is to preserve and protect the trust's property and distribute it at the appropriate time to the beneficiaries. In many respects, the trustee becomes a financial parent for the beneficiaries. The trustee's duty is to the beneficiaries.
Suppose you choose your oldest daughter as your management successor. You give her voting stock. You put the other kids' stock in trust and appoint your daughter as trustee so that she controls the company and her siblings won't interfere with her business decisions.
That may sound like an ironclad solution to a sticky succession problem. But think about it from the other kids' perspectives. You have disenfranchised them. You have given their sister complete control over their financial destiny as it relates to their inheritance. (Would you have appreciated one of your siblings having financial control over you?) When they call up their trustee to look into whether the business is well managed and a good investment for their trust, what do you suppose the trustee says and does?
You are probably the only superhuman who can run both the family and the business. Get back to the basics for a minute. You establish the trust and choose a trustee to preserve and protect the family's economic well-being, not to run your business. You can't expect a 20-plus page document to step into your shoes. It probably is unfair to ask one of your kids or another relative to take on that burden.
Although it may dilute your daughter's absolute control, an objective, nonfamily trustee ultimately might be better able to mediate all your children's needs and interests. Having your daughter (or anyone else) act as both trustee and business manager is a recipe for disaster. The reason is simple: The trustee's primary responsibility is to act in the beneficiaries' best interests. When the business's interests are inconsistent with the best interests (real or perceived) of one or more of the beneficiaries, disagreement and conflict are virtually inevitable.
The best bet is to assign different roles to different people. The trustee's role in the business should be limited to that of an informed shareholder who votes for directors. Ideally, those directors should include non-self-interested outsiders, who have the function of overseeing management and setting business strategy for the overall benefit of the shareholders. Key managers (including family members active in management) should be accountable to this board of directors. The trustee then can be accountable to the beneficiaries, without the conflict that arises from also being a corporate manager and/or family member.
You blur these different roles at your family's risk. Given the long-term nature of trusts, you are playing with fire if you don't act to distinguish these roles from the beginning. If you can accept that the trustee need not be active in day-to-day business management, you substantially increase the number of potentially qualified candidates. You no longer need to find the superhuman to fill your shoes and can instead divide your many burdens among the people and institutions qualified to fill your different roles.
The final piece of the puzzle is to educate your children, trustees, managers, and directors. Everyone concerned must understand and accept their roles and responsibilities. For example, the trustee should fully understand and agree with the philosophies by which you want the trust managed. This person or institution should want to serve as trustee and should review and understand the trust documents before they are finalized.
It's also important not to keep the trustee's name or the trust's terms secret from your beneficiaries. You should explain your decisions and intentions so that everyone can understand your expectations and have input into your actions. Your beneficiaries must get to know and respect your trustee.
Even if you intend to create trusts only by will at death, you should consider all of the above actions and issues now. Like a good business successor, the best trustee is carefully selected and trained, and accepted by the family members, before you leave the scene.
Ross W. Nager is executive director of the Arthur Andersen Center for Family Business in Houston, TX.