Living Trust Administration

Frequently Asked Questions

The average person has little experience dealing with trusts and often has many questions upon becoming a trustee for the first time. Through our experience in helping people administer trusts, we find people have a variety of expectations concerning the way living trusts operate following a death. Most people know that one of the greatest benefits of having a living trust is that in many cases it can drastically reduces the costs and delays involved in passing on assets at death. A living trust accomplishes this feat by avoiding probate.

What many people don’t realize is that even without a probate there are many administrative chores that have to be completed: various legal documents need to be prepared, tax returns have to be filed, and other numerous other matters that can be both costly and time consuming. This is how SRP can help navigate the complexities of trust administration.

Contents

What is a Trust?

A trust is a legal relationship, usually evidenced by a written document called a “Declaration of Trust” or “Trust Agreement,” whereby one person, called the “Trustor,” transfers property to another person, called the “Trustee,” who holds the property for the benefit of another person, called the “Beneficiary.” The same person may occupy more than one position at a time. For example, in the typical living trust, as long as the Trustor is alive, he or she is also the Trustee and Beneficiary. On the death of the Trustor, a “Successor Trustee” (e.g., child, friend, bank) takes over as Trustee and follows the Trustor’s instructions, which are set forth in the Trust, concerning the distribution of property and the payment of taxes and expenses.

Following the death of the Trustor, the Trust continues as a management and distribution vehicle that will exist only as long as is necessary to identify and collect trust assets, pay debts and taxes, and distribute the trust assets to the beneficiaries (or in further trust, depending on the terms of the Trust). A trust can be visualized as a funnel through which all of the trust assets will pass to the beneficiaries (with the exceptions of tangible personal property, life insurance proceeds, and other nontrust assets that may pass directly to the beneficiaries outside the Trust). It is the successor Trustee’s job to collect and manage the assets of the Trust, appraise trust property, pay all taxes and expenses relating to the administration of the Trust, and distribute the trust property according to the Trustor’s instructions.

Living Trusts and Probate Avoidance

Although living trusts have been around for centuries, only recently have they achieved a high degree of popularity among the general public. The reason for this surge in popularity is that living trusts help to avoid probate. Many people ask, “What is probate, and why is everyone trying so hard to avoid it?” The short answer is that probate is a court-supervised procedure for collecting a deceased person’s assets, paying debts and taxes, and distributing the property to the person’s beneficiaries (either according to the instructions the person set forth in his or her will or as determined by state law if the person died without a will). The probate process usually takes six to twelve months to complete, although it may take longer in complicated cases.

Probate is not a tax. When people refer to the high costs of probate, they are usually referring to the personal representative’s fees and the attorneys’ fees. In California, these fees are calculated as a percentage of the gross (not net) value of the assets in the estate ($3,150 on the first $100,000, 2% on the next $900,000, and so on). For example, let’s say that D, who is not divorced, dies owning one asset, a house worth $200,000 with a mortgage of $120,000. D has a will that leaves the house to D’s two children A and B. A is named as executor. The probate fees for this case would be as follows: $5,150 to A’s attorney (plus any “extraordinary fees,” which are billed hourly) and $5,150 to A (if A decides to take a fee), for a minimum total fee of $10,300. These fees are calculated without regard to the $120,000 mortgage, since the fees are charged on the gross (not net value) of the estate.

One of the reasons living trusts have become so popular in recent years is that real estate prices in California have skyrocketed, leading to much larger estates and, hence, higher probate fees. In states where real estate prices are lower or where attorneys’ fees for probate work are based on an hourly fee schedule rather than a percentage scale, living trusts are not as popular as they are in California.

Living trusts avoid probate with respect to those assets that are transferred into the living trust before death. In other words, living trusts avoid the court procedure otherwise required to transfer assets to a person’s beneficiaries at death. However, even though no court procedure is involved, that does not mean there is nothing to do as the Trustee of the estate. The living trust makes administration easier, but it does not do away with administration altogether.

Assets still have to be collected and managed pending distribution to the beneficiaries, appraisals of assets have to be made, debts and taxes have to be paid, tax returns may be required (living trusts do not avoid estate taxes, as some people have been led to believe), and legal documents must be prepared in connection with the distribution of the trust property to the beneficiaries. These activities are very similar to a probate. The major difference is that, with a living trust, everything is handled privately, without court supervision, which makes for (in most cases) a faster, less expensive administration process.

It comes as a surprise to many Trustees that post-death administration of a living trust is time consuming and costs money in terms of legal fees, accounting fees, asset transfer fees, and even the Trustee’s fees, if the Trustee decides to accept any. The other beneficiaries of the Trust, if any, often need to be educated that the process may take longer and cost more than they anticipated. However, in comparison to probate, these delays and costs are substantially reduced, often resulting in time savings of months of delays and costs savings of 50 to 90 percent.

Court Involvement

There is also a popular misconception that the existence of a living trust avoids all possibility of court involvement. This is true (in part) only if all of the Trustor’s assets were properly funded into the living trust. If there are assets held outside the trust which exceed $100,000 in gross value, a probate will be required for those assets in order for a Trustee to collect those assets and add them to the trust.

Moreover, if at any time a beneficiary of the Trust believes that the Trustee has acted improperly or without regard for the beneficiary’s interest, the beneficiary may file a petition with the court, to force the Trustee to make a full report and accounting or to redress an alleged breach of trust, including removal of the Trustee or surcharge against the Trustee.

Finally, circumstances may arise in which there are questions about whether the Trustee should or should not take certain actions (e.g., selling a business interest or real property, commencing litigation). In such cases, it may be advisable for the Trustee to petition the court for instructions whether to proceed in a certain way. The beneficiaries will be given notice of the hearing and will be given a copy of the petition that describes the proposed action. The matter will then be addressed in open court, and the beneficiaries will have an opportunity to appear in court and be heard. By obtaining an order from the court in this manner, the Trustee may be able to cut off the beneficiary’s right to complain about the particular action if he or she fails to appear in court. Such a petition provides protection for the Trustee if there is a fear that the Trustee’s decision will be second-guessed by a beneficiary. Also, if relations between the trustee and the beneficiaries are hostile, it may be advisable for the Trustee to seek court approval of the Trustee’s accountings to minimize potential arguments with the beneficiaries.

Pour-Over Wills

In addition to the trust, the Trustor should have signed what we call a “pour-over” will. The purpose of the pour-over will is to provide for the distribution of assets that were omitted from the Trust, either intentionally or inadvertently. One of the Trustee’s first tasks is to determine what assets, if any, were omitted from the Trust. If any such assets exceed $100,000 in gross value, a probate may be required to transfer these assets to the Trust. If these assets do not exceed $100,000 in value, the Trustee can collect such assets under a declaration procedure authorized by the Probate Code. At least 40 days must elapse after the date of death before the Trustee can use this declaration procedure. Whether or not a probate is required, the original will must be deposited for safe keeping with the County Clerk within 30 days of the date of death.

Distributions of Property

One of the first questions the Trustee and other beneficiaries usually ask us is when all the trust property will be distributed. Many people, having heard that living trusts avoid probate, assume that all estate administration procedures are avoided and that the property in the living trust somehow passes to them automatically. This simply is not true. As a result of this misunderstanding, many beneficiaries are disappointed to learn that the trust administration process is often measured in weeks or months (and in some cases longer), rather than in hours or days.

Typically, distribution will take place in several stages. Depending on how quickly assets and liability information can be assembled, a Trustee may be able to make preliminary distributions of a portion of the trust estate within a few weeks.

Provided the beneficiaries are in agreement, the distribution of tangible personal property may be handled quickly and informally and attorneys need not get involved. If any disagreement develops, however, the division of property should be handled in a more formal manner. It is recommended that Trustees carefully document and inventory the items of property available for distribution and the disposition of each. One efficient way to document the property on hand is to videotape or photograph the household property before distribution.

Before allowing the distribution of any items of personal property, however, it is important to note that the Trustee is responsible for reporting such items on a federal estate tax return, if required (see below). Furthermore, if any items of property (or group of items that constitutes a single collection) have a fair market value of $3,000 or more, these items must be separately appraised for federal estate tax purposes. A Trustee must therefore keep careful records of what assets are distributed and to whom, and obtain any required appraisals before distributing particularly valuable items.

After all necessary appraisals have been obtained and we can project the expected tax liabilities and expenses with more accuracy, the Trustee may distribute more of the trust estate, making certain to reserve sufficient funds for payment of estate taxes, income taxes, administrative expenses, attorney and trustee fees, debts and liabilities, etc. If any litigation arises concerning the Trust (e.g., a “contest” of the Trust), the Trustee may have to withhold distribution until such problems have been completely resolved. Our office has had cases in which a living trust that provided for distribution “at death” was not actually distributed until more than a year after death because of disagreements among the beneficiaries and the ensuing court procedures.

It is important to remember that living trusts do not avoid estate taxes. If it is determined that estate taxes or fiduciary income taxes are payable in a Trust, we that the Trustee retain a further reserve in the Trust after payment of such taxes until all audits are completed or until the period for assessment of a tax deficiency passes (three years). This reserve is for the Trustee’s protection. Any legal fees, accounting fees, and the Trustee’s own fees incurred in connection with the audit process, and any tax deficiencies that might be assessed by the IRS, are chargeable to the Trust. If a Trustee has already distributed all of the trust assets, the Trustee may have to bear these expenses and taxes if the beneficiaries are unwilling or unable to contribute their fair share. If this situation applies during trust administration, we assist the Trustee in determining an appropriate amount to hold as a reserve.

Duties, Powers, and Compensation of a Trustee

A Trustee must act in a fiduciary capacity. As such, a Trustee owes certain legal duties to the beneficiaries. In managing the trust property, a Trustee must use at least ordinary business ability. Under California law, a Trustee with special skills (such as a real estate agent) could be held to a higher standard of care. In any event, a Trustee’s management is judged in light of the circumstances existing at the time the transactions occur, rather than with the benefit of hindsight. If a Trustee exceeds their trustee powers, the Trustee may be held liable for loss or damage to the trust estate.

A Trustee has certain rules under which the Trustee is required to operate. These rules are derived from three sources:

  1. The Trust itself.
  2. Statutory law (the “Trust Law” found in the California Probate Code.)
  3. Decisional law created by the courts.

The principal source of a Trustee’s powers is the Trust itself. A Trustee should therefore read the Trust carefully. In doing so, a Trustee will see that the Trust contains two types of provisions:

  1. “Dispositive provisions” that govern the distribution of property.
  2. “Administrative provisions” that govern the powers of the Trustee, payment of taxes and expenses, rules for interpreting the trust instrument, and other procedural issues.

The bulk of the Trust is made up of these administrative provisions.

In creating a trust, the Trustor may include any lawful provisions that he or she wishes to govern the trust relationship. Because tax considerations are often important in creating a trust, the rights and duties of the Trustee are often limited by the tax results desired by the Trustor. The provisions of a trust may override general provisions of the Trust Law, except when the law expresses a paramount public policy. Whenever the trust instrument does not provide for a given situation, the trust law applies.

One of the basic duties of the Trustee involves the collection, management, and investment of trust assets and the accumulation and distribution of income and principal under the Trust. Another important set of duties relates to tax matters, which are explained in detail later.

  • The Trustee must be faithful to the interests of the trust and its beneficiaries.
  • The Trustee occupies a position of trust and confidence and owes a duty of care to the beneficiaries.
  • The Trustee has a duty to administer the Trust solely in the interest of the beneficiaries and to deal impartially with them.
  • The Trustee cannot use trust property for the Trustee’s own profit or for any nontrust purpose.
  • The Trustee must not engage in any transaction that will result in a conflict of interest between the Trustee and the Trust or a beneficiary.
  • The Trustee has a duty to take reasonable steps to take and keep control of trust property and to preserve the trust property and make it productive.
  • The Trustee must not commingle trust property with the Trustee’s own property under any circumstances.
  • The Trustee also has a duty to take reasonable steps to enforce claims of the Trust and to defend lawsuits brought against the Trust.

The Trustee must carry out all Trustee activities personally. In other words, the Trustee may not delegate responsibilities to others. However, the Trustee may hire attorneys, accountants, investment advisors, and others to consult with concerning the administration of the Trust. Nevertheless, it is the Trustee who will ultimately be held responsible for his or her acts or omissions.

Trust Investments

The Trust grants a Trustee broad discretion in investing trust assets. Even though these broad powers are granted to you, you must exercise these powers in the best interests of the Trust. This broad grant of investment discretion may not shield you from liability if you do not exercise this power reasonably. If you have any question about the propriety of any investment, you should seek legal advice before making or continuing the investment.

Providing Information to Beneficiaries

Under the Trust Law, the Trustee owes a duty to the beneficiaries to make them aware of the existence of the trust and to keep them reasonably informed of the Trust and its administration. SRP assists trustees with what specific actions need to be taken to fulfill this duty.

State law also requires that a Trustee provides beneficiaries with certain information on reasonable request and that the Trustee gives a full accounting and report of all trust transactions not less often than annually or at the termination of the Trust, unless the Trust instrument or a beneficiary waives this requirement in writing. (While these provisions of law technically apply only to trusts created on or after July 1, 1987, it is good practice to follow these laws regardless of the date the trust was executed.) The subject Trust does not waive this requirement.

Even if a formal accounting is not required, SRP strongly recommends that such accountings be prepared and presented to beneficiaries. In any event, internal accountings are needed to provide a permanent record of trust transactions, to distinguish between principal and income transactions, and to provide a single source of data for preparation of income tax returns. Because this information must be recorded and assembled anyway, it makes sense to give this information to the beneficiaries for a number of reasons:

  1. It gives the beneficiaries a better understanding and appreciation for the complexity of your job as Trustee and the amount of work involved.
  2. It helps to avoid misunderstandings by disclosing all relevant transaction.
  3. It starts the running of a three-year statute of limitations for all matters the Trustee discloses in the accounting. If no accounting is made, there is no statute of limitations and the Trustee’s liability exposure continues indefinitely.

A trust accounting is a legal document that should be prepared by a lawyer to make certain that it meets the format required by the trust law. Only in this way can a Trustee be assured that the three-year statute of limitations begins to run. CPAs are not always experienced in fiduciary accounting standards and a Trustee should not rely on financial statements prepared by an accountant to satisfy the fiduciary accounting requirements of the Probate Code.

Although making formal accountings will add to the expense of administration, the cost is payable from the Trust and is tax deductible. Because the cost is payable from the Trust, it is spread among all the beneficiaries. All of the beneficiaries share the cost of protecting the Trustee from subsequent liability. The Trustee should give serious consideration to taking advantage of this benefit even if the Trust does not require accountings or the beneficiaries are willing to waive this requirement. Although SRP recommends that formal trust accountings be prepared, if a Trustee preferes to request that the beneficiaries waive the requirement of a formal trust accounting, SRP will prepare the appropriate waiver forms.

Record Keeping

Whether or not a Trustee intends to make a formal accounting to beneficiaries, the Trustee must keep careful records of all trust transactions. If the Trustee does not prepare a formal accounting, the Trustee should probably keep the records forever, because there is no statute of limitation and the liability exposure will continue indefinitely.

In particular, the Trustee must keep an accurate bookkeeping ledger, with descriptive notations of all income and receipts, noting for each entry the date, the person to or from whom payment was made or received, the nature of the payment, and the amount. All disbursements for Trust expenses should be made by check. The Trustee should never pay cash for any trust expenditure. A file or set of files should be kept by the Trustee with a copy of the trust instrument and all financial records for the trust, including bank statements, statements of income received, bills for expenses, bank deposit receipts, canceled checks, copies of tax returns, and copies of correspondence relating to the Trust.

If the Trust has a large number of assets or transactions, the Trustee may find it helpful to set up a more sophisticated bookkeeping system. If the Trustee owns or has access to a personal computer, a household or business accounting software package or general spreadsheet program can be helpful to keep track of trust transactions.

Whatever bookkeeping system is chosen, it is essential that the Trustee keep SRP informed of all financial activities by sending us copies of the checkbook register, ledger sheets, computer printouts, bank statements, securities account statements, etc., on a regular basis so that we can monitor whether the Trustee is keeping adequate records and properly handling trust accounting procedures.

It is essential that the Trustee open a checking account with a financial institution of the Trustee’s choice in the the Trustee’s name as Trustee of the Trust. To do this, the Trustee will need to take an original Certificate of Trust to the bank. SRP prepares these documents. The Trustee shouldn’t use his or her own Social Security number or that of decedent on this account. Instead, SRP will obtain an employer identification number for the Trust that should be used. All trust expenses should be paid from, and all trust income should be deposited to, this trust checking account. No checks should be written against or used in any account standing in the name of Trustor for any trust transaction.

Trustee Compensation

Being a Trustee can entail a great deal of work and under the terms of the Trust and the trust law, Trustees are entitled to reasonable compensation for their services. In determining reasonableness, factors such as the amount of time spent in trust administration and the size of the trust estate are considered. A Trustee does not have to accept a Trustee’s fee, but if he or she does, the Trustee should know that it is reportable as taxable income.

SRP recommend that Trustees keep a log or diary of the time spent on trust matters, including the date, amount of time expended, what occurred, the decisions made and the basis for the decisions. If a Trustee incurs miscellaneous expenses for which he or she expects reimbursement from the Trust, these expense should be carefully recorded. This log or diary will not only support a request for trustee’s fees (if the Trustee decides to accept a fee), but will also serve as a written record of the actions and thoughts surrounding those actions in the event the Trustee’s activities are ever questioned by a beneficiary of the Trust.

Tax Matters

Taxpayer Identification Number

As mentioned above, a taxpayer identification number is required to administer a trust. SRP assists in obtaining the tax identification number so the Trustee can transfer the title on all bank and brokerage accounts standing in the name of the Trustor to the name of the Trustee.

Notice Concerning Fiduciary Relationship

Federal and state laws require that the respective taxing authorities be notified of the existence of a new trust or a change in fiduciary relationship. Once the Trustor dies, the Trust becomes irrevocable and has in essence become a separate taxable entity. SRP prepares the necessary “Notice Concerning Fiduciary Relationship” (IRS Form 56) to notify the taxing authorities of its existence.

Estate and Gift Taxes

Depending on the size of the estate, estate tax returns may be required and estate taxes may be payable. Under current law, an estate tax return (Form 706) is required in any case in which a decedent’s gross estate exceeds (e.g., $1,500,000 in the year 2004) in value. The “gross estate” includes any property interests of the decedent at the time of death, including but not limited to property in a probate estate, property in a living trust, and joint tenancy property. In other words, the gross estate for tax purposes is not the same thing as the “probate estate.” In fact, someone could avoid probate altogether by having a fully funded living trust, but that does not mean that no estate taxes will be payable.

If a Trustor made any gifts during the year of death (or any prior year for which no gift tax return was filed) that exceed $10,000 per donee, the Trustee (or the executor of the estate if there is a probate) will be required to file a gift tax return to report such gifts.

Alternate Valuation Date

For federal estate tax purposes, the Trustee may elect to use the values of the assets of either the date of death or at the “alternate valuation date,” which is either six months after death or, for assets sold or distributed before that date, the date of sale or distribution. The Trustee must use either date of death values or alternate valuation date values for all assets or no assets (i.e., the Trustee cannot pick and choose). In addition, the Trustee can use alternate valuation date values only if the effect would be to reduce the estate tax liability. (For example, if there is no estate tax payable, the Trustee cannot use alternate valuation simply to get a higher income tax basis.) If the Trustee wishes to use the alternate valuation date, each asset will have to be appraised not once but twice: once at the date of death and again at the date that is six months later or the date of distribution.

Income Taxes

For federal and state income tax purposes, all of the property in the Trust will receive a new income tax basis equal to the fair market value at the date of death (or the alternate valuation date, as explained above). This new basis is the measuring point for any capital gains in the event the Trustee sells any property of the Trust or for any depreciation deductions pending administration.

All property received by inheritance, including property distributed from a living trust is received income tax free. However, some income tax consequences to the beneficiaries should be noted. One such consequence is that the basis of assets received on distribution will be the date of death value (or alternate valuation date value) received, as explained above. The income tax basis of assets received will determine the capital gain a beneficiary will realize if and when the beneficiary sells an inherited asset.

In addition, the beneficiaries must be aware that the distribution of trust assets will carry out to the beneficiaries income earned by the Trust during the period of trust administration, which income will be reportable on the beneficiaries’ own individual tax returns. The trust will supply the beneficiaries with K-1s reporting the amount of income passed through to the beneficiaries. If the beneficiaries have already filed their returns for a taxable year before obtaining K-1s, they will be required to file amended returns.

Decedent’s Final Returns

Final state and federal personal income tax returns will be required for the period of January 1 through the date of the Trustor’s death. Such returns will include income generated by the assets of the Trust before the date of death. Income generated by the assets in the Trust after the date of death is reportable on the fiduciary returns (see below).  

Fiduciary Returns

All trusts may file fiduciary tax returns (state Form 541 and federal form 1041) on a calendar- year (tax date ending December 31) or fiscal-year basis. Thus, the Trust’s first taxable year will be a short taxable year commencing with the date of trustor’s death and ending on December 31, or earlier date if trust administration is completed before that date. The returns for this period will be due on April 15 of the year following the year of death.

SRP’s Role in Trust Administration

Our job is to assist the Trustee in carrying out the duties as Trustee as described above. We help collect and value assets, pay debts and taxes, and prepare the necessary transfer documents in connection with the eventual distribution of trust property to the appropriate beneficiaries. We will also prepare any accountings and reports to be given to the beneficiaries, if required, and we will give advice concerning tax matters and prepare any required estate tax returns. If a Trustee requests, we will also prepare fiduciary income tax returns for the various trusts. If any court action is necessary, we will represent the Trustee in that action.

This information is intended to serve as an overview of the trust administration process and the duties of a Trustee. It is not intended to anticipate every possible question or problem that may arise during the course of administration of the Trust.