IRS Circular 230 Legend: Any advice contained herein was not intended or written to be used and cannot be used, for the purpose of avoiding U.S. Federal, State, or Local tax penalties. Unless otherwise specifically indicated herein, you should assume that any statement in this communication relating to any U.S. Federal, State, or Local tax matter was not written to support the promotion, marketing, or recommendation by any parties of the transaction(s) or material(s) addressed in this communication. Anyone to whom this communication is not expressly addressed should seek advice based on their particular circumstances from their tax advisor.
Caveat: These are ROUGH meeting notes to help you follow the audio lectures on this web site. Do not rely on these notes for any decision making. Similarly, the audio file of this seminar merely presents general planning ideas for trustees, not specific advice or guidance.
i. Gather information.
ii. Review the law.
iii. Evaluate the equities.
iv. Arrive at a clinical resolution.
i. Emotions of participants.
ii. One or both lawyers may be unprofessional or pursuing a self interest.
iii. The relationship between the lawyer and their client may be something other than the clinical and logical relationship it should be.
iv. Sibling or other rivalries.
v. A myriad of issues can hinder a reasonable resolution of the estate problems.
i. Too often the documents (wills, trusts) ignore the people component.
ii. How have the people lived? Who has what types of assets? What are the expectations of the family members?
iii. Attorneys should be obliged to be counselors, not just Scribner's. Many lawyers see their roles solely as technicians. They simply execute their clients' wishes uncritically. Other lawyers see themselves on the other end of spectrum and function almost like therapists.
iv. As a litigator, one sees documents setting up trusts which have no human component. The real life problems, the people issues and depth of emotions, all can be foreseen.
v. The will and trust should reflect the intent of the testator and grantor. But the "counseling" component should be part of the lawyer's role. Ultimately, the lawyer should draft what the client wants.
i. This is the first issue to address.
ii. Ask yourself before accepting the appointment as trustee whether you really want the role, and whether you can really carry it out.
iii. The next question, before accepting is to review the trust document. Find out about the family. What are the family dynamics? Have these issues been considered? Example: If children of first spouse are trustees for the second wife's trust, every dollar they give her will be a dollar they don't get. This is almost begging for a problem. Regarding the second wife, if later has health issues or becomes incompetent, a court may have to intervene to determine how distributions should be made. But these are the issues that the trustee to be should evaluate.
iv. **HAVE A MEETING WITH YOUR FIDUCIARIES BEFORE THE DOCUMENTS ARE ACTIVATED**
v. Have a family meeting to review issues and feelings in advance.
vi. The concept that people with different points of view should be allowed to be heard. The fear that this will split up a family is often an excuse. In many cases airing the issues will avoid worse problems later.
i. Investment arena. How does the trustee invest the trust assets to balance competing interests.
ii. Distribution field. How and when should a trustee make distributions and how can the trustee use the unitrust or power to adjust to balance competing interests.
iii. How is tax burden to be shared? How and what tax elections should be made? How do you determine which client or beneficiary bears the brunt of this.
i. Prudent Investor Act governs the investment of trust assets.
ii. Must formulate overall strategy to meet trust objectives.
iii. Not individual security selection but rather an overall allocation based on facts and circumstances, size of trust, anticipated duration, and other factors listed in the statute.
iv. Trustees must invest for total return - income plus growth.
v. Must consider income, growth potential, and risk attributes of each asset.
vi. This creates conflict between income beneficiaries who are primarily interested in growth, especially if constrained by traditional definitions of accounting income.
vii. Base line objective of a trustee is to preserve purchasing power. Trust portfolio must be designed to keep pace with inflation. Mere preservation of principal is not sufficient unless purchasing power is preserved.
viii. No investment is inherently too risky, but risk must be managed.
ix. Must diversify unless determine that it is in best interests of beneficiaries not to.
x. Delegation of investment responsibility is permitted if skill and care is exercised in delegating and it is monitored.
xi. Prudent Investor Act sets forth a standard of conduct. Must document that this has been done.
xii. Different asset classes have different return expectations. The higher the return generally the higher the volatility. The role of the trustee in constructing the portfolio is to mix investment classes to get the best return within the appropriate risk parameters.
i. Each portfolio has a yield component and a capital appreciation component, and the aggregate of the two is the total return.
ii. Must keep pace with inflation so must evaluate returns versus inflation.
iii. A trust which is 65% fixed income and 35% equities provides the minimum exposure to equities necessary to keep pace with inflation. This might imply that every trust should have some exposure to equities.
iv. Consider taxes and fees in making the asset allocation.
i. Depending on State
1. Power to adjust.
2. Unitrust election.
3. Choice between power to adjust and unitrust regimes.
ii. New Jersey - power to adjust between 3-5%. Prior to that there was a 4% safe harbor. The change was made to conform to IRS regulations that a 3-5% adjustment between income and principle is deemed reasonable.
iii. Delaware - power to adjust and flexible unitrust regime between 3-5%.
iv. Varies by state.
v. Unitrust has fixed percentage
i. New Jersey gives you a band from 3-5% to adjust.
ii. How do you determine what to do?
iii. Start the analysis.
1. If you had a balanced portfolio with a 7.6% rate of return.
2. What if could get a 10.3% rate of return in a growth portfolio.
3. But look at components of return and note that most of the return at that level is in the growth portion.
4. If yield declines because portfolio is invested for growth, might be able to give current beneficiary (income beneficiary) the same return by making an adjustment from principle to income.
i. Allocation of capital gains is a significant factor. Who bears the tax burden is a significant decision. With a unitrust regime you are locked in to whatever capital gains tax treatment the trustee elects in the first year of the trust.
ii. In contrast with a power to adjust you can adjust to deal with this.
iii. Consider how trust is invested. If the bond portfolio is tax exempt then the income is not taxable to the income beneficiary. If the bond portfolio is in taxable instruments the current beneficiary may have to bear this tax.
iv. Huge impact over duration of trust from what might be small tweaks in this.
i. Stock concentration can be a problem.
ii. Even if the trust instrument absolves her of responsibility from retaining a concentrated block of stock, case law has still held the trustee responsible (liable) even when the trust had permitted it.
iii. Must document:
1. Why the concentrated position is being held.
2. Demonstrate that you are monitoring the stock.
3. Language in the trust.
i. Carefully examine the individual facts and circumstances of the trust, beneficiaries, etc.
ii. Do not blindly rely on protection in the trust instrument.
iii. Must maintain communication with beneficiaries.
iv. Must carefully maintain records.
i. Written document.
ii. Prepared by the investment advisor or portfolio manager.
iii. Describes goals and objectives for investment.
iv. Client for a trust is the trustee.
v. Purpose is to create transparency as to how assets of trust will be managed.
i. Prepare financial plan, analyze cash flows, review insurance coverage, and create long term projections addressing client goals.
ii. End result of the process is a target rate of return necessary to accomplish goals.
iii. This is how you go from financial planning to investment management.
iv. Define the asset allocation model to achieve that target rate of return.
v. Establish management procedures to achieve this objective.
vi. Show communication of returns, and other matters pertaining to tax, performance and other management objectives.
vii. Time horizon - how long will this IPS be valid.
viii. Agreed upon components may include various matters.
ix. Which accounts will be managed. What is included and what is not.
x. Constraints and restrictions on account.
xi. Background data.
xii. Variance limits.
xiii. Signature of all parties to IPS.
i. Time horizon, plus extension.
ii. Accounts to be managed. Market value of account.
iii. Cash flow. What deposits are anticipated to come into the account. This information is used in re-balancing of portfolio. Risk is managed by re-balancing of portfolio. In rough terms, sell the winners and buy the losers in order to maintain balance.
iv. Withdrawals that are anticipated (cash out flows). Default cash position of say 1%.
v. Who is actually managing and directing investment philosophy and policy, e.g. the trust agreement.
vi. Fees. Expenses.
vii. Purchasing power rate of return.
1. Rate of risk must increase to get better rate of return. But if you can eliminate uncompensated risk you can achieve the same return with less risk and exposure. Diversification can often accomplish this.
2. Diversification use to be within an asset class, but modern portfolio theory stresses diversification across different asset classes.
3. Net return.
viii. Restrictions on portfolio design.
ix. Additional cash holdings to fund distributions.
x. Define and express range of methodologies available to come up with a target rate of return.
1. One is a risk free rate of return and layering different target rates of return on top of this based on different factors. What methodology is being used. Example, if you say bonds will get a 5% rate of return, what methodology is used to come up with this assumption.
2. Portfolio design is part of the IPS.
xi. Distinction between asset class investment (passive) and active management (ability of individual to outguess or outperform the capital market rate of return).
xii. Timing. When it will be implemented.
xiii. Re-balancing of the portfolio. This is a re-alignment of the target allocations from current back to the target allocations. Example: once per quarter? More frequently?
xiv. Understanding that a deviation from the target design could change risk and return parameters.
i. Some advisers use target portfolios, some use customized. Consider taxable versus tax free, risk tolerance, age and other factors.
ii. Quantify risk, e.g., standard deviation. This can guide and explain the different scenarios of downside risk, etc.
iii. In one of 20 years what is the worst downside you might experience with the particular investment mix.
iv. 100 year storm scenario - what is the worst case in 1, 2, 3 and 5 year scenarios.
v. All this can become part of the investment policy statement.
iii. Premium notices (some show dividends).
iv. In force illustration.
1. Should receive at the end of every policy anniversary.
2. Planned premium should be reflected. That is the amount of money the insured was getting billed.
3. Cash value.
a. Year prior.
b. Is it declining?
4. Cost of actual insurance.
a. If cost exceeds payment the differential may come out of cash value.
5. Forecast, if you pay planned premiums when the policy will expire.
i. Continue policy.
ii. Cash in policy.
iii. Sell policy with a life settlement.
i. Not a proposal to buy life insurance.
ii. Obtain an in-force ledger for the actual policy.
iii. Payment projections.
iv. Evaluate cash value.
1. What is payment on cash value?
2. If cash value goes up what happens to death benefit? Does it increase or stay the same?
3. When does death benefit expire?
4. How long is coverage guaranteed.
i. To have a policy reinstated requires new underwriting.
i. Beneficiaries have sued trustees on the basis that they did not shop insurance policies and premiums so that less coverage was obtained than could have been for the premiums paid.
i. Accounting prepared.
ii. Formal accounting approved by court versus an informal accounting.
i. Which state income tax should be paid.
ii. If filed incorrectly, what if statute of limitation has run? May only be able to file for refunds for past 3 years.
i. Don't simply rely on last year's income tax return. SALY (same as last year,) is not sufficient.
ii. You need to review the trust document to determine what you have to file for income tax purposes.
i. Name of the trust. Sometimes the manner in which a tax return is filed may differ with name on SS-4 (EIN), or how it is known. Whatever the ID number was filed under should be what is on the income tax return.
ii. Name and addresses of trustees. This is important for situs issue, see below.
1. Where was the instrument written? Must state clearly.
2. What is the tax situs. This is not a simple question. The fact that a trust was written in New Jersey doesn't make it taxed in New Jersey. It is a New Jersey resident trust if set up by someone in New Jersey.
a. Key cases: Potter and Pennoyer. If you have a New Jersey grantor and name a New York trustee and a New Jersey person is the beneficiary, this is not a New Jersey taxable trust.
b. Original cases did not make the residency of the beneficiaries a factor, but it is the domicile of the trustee that is determinative currently.
c. The above assumes no source income in New Jersey.
i. Income earned from a business or from real or tangible property located in New Jersey.
d. See instructions on NJ-1041.
3. New York Trust.
a. Section 605.
b. If no New York source income and no trustees in New York, even if set up by New York resident and a New York resident trust it is not a New York taxable trust.
4. If done wrong consider filing amended income tax returns with the state but the statute of limitations may affect the ability to get it.
Subscribe to our email list to receive information on consumer webcasts and blogs, for practical legal information in simple English, delivered to your inbox. For more professional driven information, please visit Shenkman Law to subscribe.