Trust Protectors
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The use of a “Trust Protector” in trusts for maximum flexibility and protection is becoming increasingly common. For a good explanation of what trust protectors do, when they are often used, and what to risks to be aware when using a trust protector, take a look at this article from Capital Trust of Delaware’s website (click Continue reading):
The Good, The Bad, & The Ugly
Authorship: Edwin P. Morrow, III, J.D., LL.M., RFC
Many advisors and sophisticated clients have heard of the term “trust protector”, but very few know exactly what such a person or entity does or why they should have one in their trust. This article will help define what a trust protector is, outline the uses (and abuses) of naming a trust protector, and provide a general guideline for using them, focusing on standard domestic trusts.
It is difficult to precisely define the position of a trust protector. Black’s Law Dictionary does not have a definition for a trust protector. Neither do many treatises on trusts. The concept is certainly well-known, though, if not well defined – especially in the foreign trust arena, where the trust protector is essential to Foreign Asset Protection Trusts. Tax Management Portfolio describes the trust protector as a third party vested with powers to modify a trust that the grantor is unable or unwilling to retain personally, which may include the ability to change trustees, regulate trust investments, amend the trust, change beneficiaries, change situs or revoke the trust and cause funds to revert to the grantor.
A trust protector is generally someone with a special power over the trust or over the trustee, but with no day-to-day fiduciary responsibilities. The trust protector may also be a committee of several people with such power and may effectively serve as a kind of board of directors overseeing the management of the trust. A trust protector can add flexibility to the trust and serve as a check and balance to trustee abuse. Some trusts may have such a provision, but reference it as a “special trustee” or “independent trustee.” Using a trust protector provision may be limited and relatively conservative, or it may be closer to a “bleeding edge” technique. You need to recognize the difference.
First, why do people consider having such a person or power? In three words: control, flexibility and security. People who transfer their hard-earned dollars to a trust for their family often want as much flexibility for the trust as possible – without adverse tax or asset protection consequences. Those who execute trusts (a.k.a. settlors, grantors or trustors) cannot generally be trustees or keep the right to amend the trust without adverse estate tax or asset protection consequences, but want the trust operation to accommodate future circumstances and protect their original intentions.
Foreign Asset Protection Trusts have long used trust protector provisions because people are naturally reticent about naming a foreign trustee and prefer provisions to enable changing the trustee and changing jurisdiction to a country more favorable to debtors/defendants. This article will not focus on foreign trusts, but remember that generally you cannot be trust protector of your own trust and still have any asset protection benefits, despite what many offshore “experts” claim. If the courts find that you keep unlimited power over the trust or trustee, they will naturally consider the funds to be under your control. Recent fraud cases dealing with offshore entities highlight this point (e.g., FTC v. Affordable Media LLC).
Take the standard irrevocable life insurance trust holding a survivorship policy. The grantor/insureds must name another party as trustee to avoid Code Sections 2036/2042. These sections do not prohibit a grantor from naming a competent child, family member or other beneficiary as trustee. For many reasons, however, a grantor may not want to initially name a family member: the children may be young, irresponsible or spendthrifts; they may have a manipulative spouse (or the parents fear it); the trust may have substantial discretion better exercised by an independent trustee; or maybe the parents simply do not want them to know much about their finances. In addition, many asset protection experts believe that spendthrift provisions give more effective protection when a beneficiary is not also the sole trustee. Thus, the insureds prefer to name a trust company, attorney, accountant or other professional. A recent revenue ruling (Rev. Rul. 95-58) allows grantors to retain the right to change one trustee for another trustee only if the replacement is a sufficiently independent trustee who is neither related nor subordinate to the grantor. This cuts out the possibility of later naming family members, however, and it may be appropriate to later appoint family members as trustee once they reach a certain level of maturity.
The parents could use Uncle Bob, for instance, as a trust protector who could fire the trustee and name anyone but the grantors, including the children. Uncle Bob could also have the right to demand an accounting from the trustee, require a bond to be posted, remove a Trust Financial or Investment Advisor (who may be different than the trustee), approve any changes in trustee compensation, approve any self-dealing with the trustee, change the trust situs to achieve better state income tax or asset protection treatment, amend the trust for the benefit of the beneficiaries or merge the trust with any other trust with substantially identical terms.
If a beneficiary is also a trustee or co-trustee, the trust protector might also have the power to approve distributions to a trustee/beneficiary not bound by an ascertainable standard, or execute incidents of ownership over an insurance policy insuring a trustee/beneficiary, in effect, acting as a limited co-trustee. These powers help to prohibit IRC Sections 2041 and 2042 from causing the trust corpus or policies to be added to a trustee/beneficiary’s estate and is important for dynasty-style trusts that do not immediately distribute funds on the death of the grantor.
Some instruments even give a trust protector the right to add or delete beneficiaries, but this may push the edge of such flexibility and would not normally be recommended. Just as one should be careful with giving the trustee too much power, one should think twice about giving a trust protector too much power.
With careful drafting, however, a trust protector can provide substantial oversight and flexibility without any adverse tax consequences. The limits of such flexibility largely are set by the limits of giving a third party an inter vivos limited power of appointment over the trust assets, which is a well established trust and tax law concept. What are the “outer limits” of such flexibility? For instance, Uncle Bob as trust protector might be given the power to appoint the assets to a new trust or even terminate the trust and distribute the assets directly to the beneficiaries. Care must be exercised to avoid giving the trust protector in such case a general power of appointment and any such ability to amend or appoint must be limited to exclude the trust protector, their estate, or creditors of either from benefiting from such a power. A general power of appointment causes any funds subject to that power to be included in the power holder’s estate and perhaps also be subject to creditor attack. IRC 2041. It may also cause gift tax consequences. IRC 2514. Limiting the permissible beneficiaries of this power prevents a general power of appointment from being created and these sections from applying.
Usually any limited power of appointment would only be permitted to benefit the descendants of the grantor (or perhaps include spouses, charities or other specific beneficiaries). However, the grantors could give Uncle Bob the limited power to appoint the trust assets back to any family member of the grantors, including themselves. This maximum flexibility definitely pushes the envelope, and certainly goes much further than a simple oversight power. However, absent the Service proving some kind of pre-planned collusion, there is no tax law or regulation that would cause this limited power of appointment to cause estate tax inclusion in the grantor or trust protector, since there is no retained benefit, control or incident of ownership, and such a power would not come under IRC 2041 or 2514.
There are various advantages to having a trust protector be able to appoint/amend the trust or change trustees for the benefit of the beneficiaries. It can be difficult and expensive to remove a trustee for cause through the court process. It can also be costly and difficult (if not impossible) to approve even minor administrative changes to typical irrevocable trust documents. A trust protector provides an easier and cheaper mechanism for this.
Of course, care should also be taken to prohibit changes that would, for instance, disqualify a marital or QTIP trust from the marital deduction, or disqualify Crummey gifts from the annual exclusion. Care should also be taken to recognize that if a vested beneficiary executes a limited power of appointment (or substantial amendment), they may be considered to have made a gift of their share of the trust. Thus, if Uncle Bob were a vested beneficiary of the trust, he would be making a taxable gift by appointing his share to another party. This issue most often comes up when a spouse is given a limited power of appointment over a credit shelter trust and wants to then give away his or her share while still living.
Thus, a trust protector should ideally be an independent party who is not a beneficiary. A trust protector may serve without fee, as is typical with a family member. Professionals may charge a modest annual fee, or more typically charge an hourly fee based on the time actually spent. Usually provisions do not call for extensive annual reviews of trustee performance, but the rather for review only under extraordinary circumstances. Depending on the client, such flexibility may be worth the extra cost and care.
By having a trust protector (and, of course, provisions for successor protectors) named in a trust, many people will feel more comfortable in creating an irrevocable trust or establishing one that may become irrevocable at death. This is especially true for the increasing use of dynasty trusts. The trust protector offers a powerful tool in the estate planning arsenal and greater assurance that the original intentions of the client will be carried out – no matter what events transpire in the future.