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GUIDELINES FOR THE INDIVIDUAL TRUSTEE (Revocable Living Trust--Two Settlors)

INTRODUCTION

Now that you are Trustees of your own revocable living trust, you will want to manage it to maximum advantage. While this is not difficult to do, you should remember that a Trustee cannot always do everything that an individual can do, particularly after the death of a Settlor when a trust has become irrevocable.

This memorandum is intended to give you some general information and guidelines concerning the management of the trust during a trust's three phases: (1) When both Settlors are living; (2) when only one of the Settlors is living and, finally; (3) when no Settlor is living. The memo covers such diverse areas as record keeping, tax returns, proper investment and allocation of assets (upon division into separate trusts). Because each trust document is different and each case has its own special facts, the general rules set forth in this memo will not always be applicable and this memo cannot substitute for specific advice on specific legal questions as they arise. Nor can this memo substitute for common sense and caution. Each Trustee must read and be familiar with the terms of the trust, and must carefully comply with those terms. If questions arise respecting the interpretation of the trust, record keeping, forms of title, whether a particular investment or sale can be made, etc., we should be consulted. While the revocable living trust is a useful and flexible estate planning tool which, in many instances, can save substantial estate and income taxes, it demands careful administration if its tax and other benefits are to be achieved.

MANAGEMENT DURING LIFE OF SETTLORS
 

General

A revocable living trust commences the moment the trust has been executed (signed) and funded (or named as the recipient of property by your will). Complete funding of the trust is not necessary, but transfer of assets to it during your lifetime is far more efficient than waiting until death to do so. Different types of assets require different procedures to effectuate transfer of title from the names of the Settlors into the name of the Trustees, and the length of time necessary to transfer title into the name of the Trustees will vary depending upon the particular asset involved. Assets not transferred into the trust initially may be transferred into the trust at a later date, even at or after the death of a Settlor. No matter when an asset is transferred into the trust, the Trustees must take care to properly collect the asset, have title registered in the name of the trust (i.e., the name of the Trustees), allocate the asset to the proper account and then keep proper records of the transactions concerning that asset.

The benefits of a revocable living trust, such as avoidance of probate proceedings, accrue only to the assets held in the name of the Trustees. Therefore, it is important, as assets are sold and new assets purchased, that the Trustees handle all transactions as Trustees and that the Trustees be certain that new assets are registered in Trustee names. The Execution and Funding Memorandum furnished by me at the time of signing your revocable living trust generally explains the manner in which assets are transferred to the trust. However, if types of assets not covered by the memo are acquired, or if there is any question as to proper registration, my office should be contacted.

Protecting Trust Assets

Once assets have been transferred to the trust, the trust agreement is fully operative as to those assets. So long as both Settlors are alive and competent, they may control the manner in which assets are invested and the manner in which the income and principal of the trust is distributed. The Settlors will have this control even if they are not Trustees. Thus, it is conceivable that the Trustees may have no significant responsibilities during the first phase of the trust, i.e., when both Settlors are living. Nevertheless, any assets that have been transferred to the trust and that should be covered by insurance (such as your home), should also be protected by insurance while they are within the trust. If insurance is already in force, the insurance policy should be amended to add the Trustees as an insured party. This can usually be done at no cost.

Valuable trust assets, like stocks and bonds, should be placed in safekeeping, such as a separate safe deposit box. This safe deposit box should be used only for trust assets and should be held in the name of the Trustees. In this manner, bearer securities (such as older municipal bonds) can always be identified as trust assets. Moreover, since the death of a Trustee, even of a sole Trustee, does not require that access to a safe deposit box be "frozen" in most states, the successor Trustees, upon presentation of a true copy of the trust and a death certificate, will usually be able to obtain access to the safe deposit box.

Actions of the Trustee

The Trustee is the legal owner of the trust assets. If there is more than one Trustee, the Trustees own the assets with survivorship rights similar to those of joint tenants. Property held in the name of multiple Trustees will pass to the surviving Trustees upon the death of one of the Trustees. If more than one Trustee is acting, the Trustees must act together (unanimously) unless the trust instrument expressly provides to the contrary. The Trustee is not the agent of the beneficiaries; the Trustee is an independent party who is responsible for his or her own actions. However, when both Settlors are living and directing the actions of another person acting as Trustee, this responsibility is only to the Settlors. A Trustee has no responsibility to persons who might take an interest in the trust in the future so long as both Settlors are living and the trust is revocable. As indicated below, once a trust becomes irrevocable, future beneficiaries may have enforceable rights and the Trustee then may act only after considering these rights.

While both Settlors are living, the Trustee should segregate the trust assets (from his or her own personal assets) and keep trust records sufficient to allow the Settlors to prepare normal personal income tax returns.

Tax Returns

Although a revocable living trust is a separate tax entity, it is not required to file a tax return or to apply for an employer identification number for so long as it is revocable and one (or both) of the Settlors is acting as a Trustee. As soon as no Settlor is acting as a Trustee, the Trustee should apply for an employer identification number. We will normally do this as part of the trust funding process if no Settlor is a Trustee initially and the federal form SS-4 used to obtain the I.D. number will usually be signed contemporaneously with the execution of the trust. When a non-Settlor takes over as sole Trustee, a form SS-4 should be prepared and filed to obtain a taxpayer identification number for the trust.

When no Settlor is acting as Trustee, the trust must file annual income tax returns. These returns, however, simply state that all of the trust's income is taxable to the Settlors and is reported on their return filed at Fresno, California (or such other regional service center as is appropriate). Treasury Regulation Section 1.671-4 states that items of income, deduction or credit of a revocable trust should not be reported by the trust on the income tax return itself, but should be shown on a separate statement attached to the return. This may be done by listing each item of income and deduction or, preferably, by grouping items (such as dividends -- $500; interest -- $1,000; etc.).

Investments

During the first phase of the trust, investment of trust assets is handled in the same manner as the Settlors would have were there no trust in existence, except that the trust transactions should be undertaken in the name of the Trustees and not in the name of the Settlors as individuals.

PROCEDURES ON DEATH OF SETTLOR

When a Settlor dies, a portion of the living trust (usually consisting of all or part of the deceased Settlor's separate property and his or her share of the community property) will usually become irrevocable. The duties of the Trustees with respect to the irrevocable trust then become more important and the Trustees' responsibilities become substantially greater.

At the death of a Settlor, trust assets must be valued, death tax returns must be filed, assets must be allocated to the proper accounts or subtrusts, appropriate books (records) must be established so that the income and principal receipts of each trust that has become irrevocable can be recorded accurately, and investments must be more carefully made because the Trustees are now responsible to all of the trust's beneficiaries, even if they are not yet born or identified.

MANAGEMENT DURING LIFETIME OF SURVIVING SETTLOR

Allocation of Assets

Upon the death of one of the spouse Settlors, the living trust is usually divided into two or three separate subtrusts, the "Survivor's Trust," the "Family Trust" and, in some cases, the "Marital Disclaimer Trust." To the Survivor's Trust is allocated property equal in amount to one-half of the Settlors' community property, all of the surviving Settlor's separate property, and, in some instances, a portion or all of the deceased Settlor's separate and community property. The balance of the trust property, often an amount equal to the amount that may pass free of death taxes, is allocated to the Family Trust. (The amount that may pass free of death taxes is $1,000,000 in 2002 and increases over the next several years.)

Because federal law allows the Trustees to minimize taxes by valuing the decedent's share of trust assets either at date of death or six months thereafter (unless they have been distributed or sold) if such will reduce the tax payable, allocation of trust assets to the various subtrusts established on the death of the first Settlor to die is not normally made until at least six months after the decedent Settlor's death. Prior to allocation, the income, expenses, and capital gains and losses are usually allocated ratably to the trusts. Once the Trustees have determined the extent and value of the total assets held by the trust, the Trustees will allocate those assets in the manner required by the trust document itself. Generally, a pro rata portion of each asset is required to be allocated to each trust. However, most trust documents allow (and almost all trusts drafted by us specifically allow) the Trustees to allocate various whole assets (rather than undivided interests) to each trust -- to achieve better management, to encourage future estate planning, and to meet the varying needs of the different beneficiaries. For example, if the home and its contents are held by the trust, it is quite common to allocate them to the Survivor's Trust (rather than a one-half interest to the Survivor's Trust and a one-half interest to the Family Trust) so that the surviving spouse has not only their continued use, but the complete freedom to dispose of them as his or her needs dictate. It should be remembered that the Survivor's Trust usually remains subject to revocation by the surviving spouse after the death of the first Settlor to die, or, if it is not revocable, is almost always subject to a general power of appointment (the power in the surviving spouse to designate how the assets of the trust are to be distributed); thus, property allocated to the Survivor's Trust almost always remains subject to the control of and disposition by the surviving Settlor.

The actual allocation of the trust assets may be accomplished by book entry in the accounting records of the trust rather than by actually registering title to the assets in the name of the specific subtrust (i.e., Survivor's or Family Trust). Banks and trust companies do this by holding all securities in one "nominee" name. This allows the assets of the trust to be managed as a unit for purposes of economy. For example, if 40 shares of General Motors stock are allocable to the Family Trust, and 60 shares of the same stock are allocable to the Survivor's Trust, the actual certificate will probably be for 100 shares held in the name of the Trustees. If it becomes appropriate to sell the shares held by one trust and retain the shares held by the other trust, this can always be done so long as accurate accounting records are kept. Frequently, however, the assets allocated to each trust are registered in the name of the Trustee of the particular trust, as, for example, "Janet Jones, Trustee of the Jones Survivor's Trust dated June 6, 1995." In this case the date of the trust is the date that it was established, such as the date of death of the first spouse to die, or the death of the surviving spouse or other trust beneficiary that causes a termination of an existing trust and establishment of a new trust or trusts.

The mathematical computations governing allocation of trust assets are quite complex because of the many factors that may be present. For example, death taxes, funeral expenses and expenses of last illness are chargeable only against the decedent's property; debts, such as unpaid bills outstanding at the time of the deceased spouse's death, are usually chargeable to all of the trust estate or in varying proportions to the various trusts depending upon the nature of the debt and the amount of separate or community property available to satisfy the debt. Certain types of debts (such as real property tax liens) follow the assets to which they are attributable; if the asset is allocated to one or more trust, so will those debts. Thus, it is most important when allocating trust assets for the Trustees to consult with me or with accountants skilled in fiduciary accounting (as opposed to business accounting) so that the all-important "starting figures" for each trust may be determined. The importance of proper asset allocation and generally getting off to a good start cannot be overemphasized.

Record Keeping

After the death of one of the spouse Settlors, the accounting records for the Survivor's Trust are kept in the same fashion as the revocable living trust records were kept prior to the death of the spouse. However, the accounting records for each irrevocable trust must, of necessity, be kept in greater detail and with greater accuracy. Because each irrevocable trust is a separate taxpaying entity and because the Trustees have responsibilities to both the income beneficiaries (usually the surviving spouse and sometimes other members of the family) and the remainder beneficiaries (those who will receive the property on termination of the trust), careful records must be kept of the transactions of each trust that has become irrevocable. These records must distinguish between income and principal receipts and income and principal disbursements. For example, if the trust holds a note received on the sale of an asset and the note is being paid on an installment basis, each payment will likely include an interest portion and a portion representing a repayment of some of the principal of the note. These items must be separately accounted for as each payment is received: The interest is allocable to the income account while the note repayment portion is allocable to the principal account. (This treatment may or may not be the same for income tax purposes, as fiduciary accounting and fiduciary income taxation are not always parallel.) Similarly, careful treatment must be accorded expenses chargeable to principal and expenses chargeable to income. In some instances, the Trustees have the discretion to determine the manner of allocation as between principal and income or, in less frequent instances, the allocation is not clear. When any question of allocation arises, I should be consulted.

To assist you as Trustees in understanding the basic allocation between principal and income amounts, a copy of the Uniform Principal and Income Act is attached to this memorandum. Please note, again, that fiduciary record keeping differs substantially from normal bookkeeping or even from corporate or personal income tax record keeping. A fiduciary is responsible for every penny that passes through his or her fingers and must therefore account to the penny. Thus, the Trustees are required to keep a precise record of every receipt and disbursement, every gain and loss, every distribution to a beneficiary, and every change in the nature of an asset of the trust. This is not difficult if good records are kept from the inception of each irrevocable trust. However, failure to keep good records will require time consuming and costly reconstruction of trust records for both tax and accounting purposes, and will raise adverse inferences against the Trustees should a dispute arise at a later date.

Tax Returns

As indicated above, each irrevocable trust is a separate taxable entity. As such, it is required to obtain its own taxpayer identification number, file its own tax return and make estimated tax payments. Even if all of the income of an irrevocable trust is distributable to the surviving spouse, some "income" may still be taxable to the trust itself, and capital gains generated by sales or exchanges of assets held by an irrevocable trust are almost always taxable to it. Fiduciary income taxation is a highly specialized field and most accountants are not familiar with its intricacies. Therefore, it is extremely important that an accountant familiar with fiduciary income taxation be employed to prepare income tax returns for irrevocable trusts. Another, more expensive, alternative is to have us supervise the accountant in his or her preparation of the return. The Survivor's Trust fiduciary income tax return is prepared in the same manner as the fiduciary income tax return for the revocable living trust was prepared when both of the Settlors were alive, if the surviving Settlor is not acting as a Trustee. If the surviving Settlor is acting as a Trustee, no income tax return need be filed for the Survivor's Trust.

Powers of the Trustees

The powers of the Trustees are generally set forth in detail in the trust document. Depending upon the terms of the trust, the powers given the Trustees may be very restricted or almost unlimited. However, even when the Trustees are specifically granted absolute or sole discretion the Trustees must always act in good faith, considering the interests of the income beneficiaries and the remainder beneficiaries. Unless specifically authorized otherwise by the trust, joint Trustees must act unanimously. Sometimes a Trustee may delegate powers to another Trustee or to an agent. However, a Trustee should be very cautious about the types of functions that he or she delegates to a person who is not a Trustee. For example, "ministerial" functions may be delegated, such as the trust accounting work or management of a farm property or a business. Nevertheless, notwithstanding the delegation of authority, the Trustees are responsible to oversee the delegated work and are responsible for the actions of the ministerial agent. Discretionary powers (for example, determining whether or not to distribute income or principal) may not be delegated. All decisions concerning trust distributions should be made by the Trustees. Decisions concerning trust investments should usually be made by the Trustees unless the trust expressly provides for the retention of separate investment counsel or vests the investment decisions in one particular Trustee. However, even then the delegating Trustee probably has the responsibility to see that the delegated power is used prudently.

Generally, the Trustees have broad powers to sell, lease, borrow, pledge, and otherwise manage the assets of the trust in a businesslike fashion. If a question arises as to the existence of exercise of a power that is not clear from the terms of the trust, I should be contacted. In those cases where no ready answer is available (whether it concerns Trustee powers or other terms of the trust) a petition may be filed with the Probate Department of the Superior Court and the matter usually can be resolved within a short time.

Duties of the Trustees

Loyalty. The Trustees have an absolute duty of loyalty to the beneficiaries of the trust. This means that although the Trustees are the legal owner of the trust assets, all actions taken in connection with the administration of the trust must be with the sole interest of the beneficiaries in mind. Any self-dealing by the Trustees is a breach of trust. The Trustees cannot deal with the trust assets in any way that would personally benefit the Trustees (as for example buying assets from the trust or selling assets to the trust) even if such action would also be advantageous to the beneficiaries. If there is any possibility of a claim of self-dealing, court approval should be obtained.

Investments. The Trustees have the responsibility for administering the trust in a manner most beneficial to the beneficiaries in accordance with the terms of the trust agreement. Normally, the Trustees will be given power to invest as would a "prudent investor", namely, to manage the trust funds with regard to their permanent disposition while considering the probable income to be earned and the probable safety of the principal. Such a standard recognizes the Trustees' duty not only to the income beneficiaries but also to the remainder beneficiaries. Thus, for example, if the Trustees invest in a wasting asset, such as an oil royalty interest subject to depletion, a portion of the income received must usually be set aside as a reserve to replace the depleting principal; otherwise, the interests of the remainder beneficiaries would be prejudiced. Conversely, the Trustees may be required by the terms of the trust to establish no reserves or even to retain certain assets although they produce no income. Thus, you can see that paying close attention to the terms of the trust is of great importance. If there are questions, I should be contacted without fail.

Record Keeping and Accounting. The Trustees are usually required to furnish the beneficiaries of a trust an annual accounting of their actions. This accounting shows the starting balance of the trust assets, adds the receipts and gains and deducts the distributions, losses and disbursements and then shows the remaining balance on hand at the end of the accounting period. The starting and closing balances will generally be at the "carrying value" of the trust assets which is most often their income tax basis. A good account will also show market values for the assets so that the investment decisions of the Trustees can be more accurately measured.

Summary. A Trustee must act with the highest good faith towards the beneficiaries and use ordinary care and diligence whether the Trustee is paid or not. The Trustees may not deal with the trust property for their own profit, or for any purpose not connected with the trust. The Trustees may not obtain any advantage over a beneficiary or take part in any transaction with a beneficiary unless the beneficiary, with full knowledge of the transaction and having the legal capacity to enter into the transaction, specifically consents to it and permits the Trustees to do so. Similarly, the Trustees may not commingle their own property with the trust property; thus, separate accounts and accurate record keeping are an absolute necessity. A Trustee always has the duty of care. Unless the Trustees pay close attention to their "duty to be done" it is likely that the Trustees' lot will not "be a happy one."

Trustee Liabilities

In many ways, a Trustee is an insurer. If the Trustees are negligent, they may be surcharged (i.e., fined) for that negligence. Thus, penalties (and perhaps interest) for failure to file tax returns will normally be borne personally by the Trustees. Moreover, the tax laws make a Trustee personally liable for unpaid death taxes to the extent of the assets coming into the Trustee's possession. Thus, most trusts allow the Trustees to withhold distribution of trust property until all death taxes are determined and paid so that the Trustees will not later be required to pay the taxes from personal funds. Failure to invest the trust property will subject the Trustees to liability for simple interest on the uninvested funds. If a court finds that the Trustees willfully failed to invest the trust property, the Trustees will be liable for compound interest and perhaps additional surcharge.

Fees

Trustees are entitled to reasonable compensation for the services performed for the trust. Often the trust document will specify an amount or a limitation. If it does not, a Trustee is entitled to compensation in the same manner as would anyone else performing similar management or investment services. This usually depends upon the time involved, the responsibilities undertaken, the results achieved and the magnitude of the problems encountered. A good rule of thumb, generally used by corporate trustees in California in estimating Trustees' fees, is one percent of the principal balance of the trust per annum.

MANAGEMENT OF TRUST AFTER DEATH OF BOTH SETTLORS

The discussion of the activities, duties and liabilities, set forth in Section D above, also applies to the management and distribution of assets after the death of both Settlors. Often the terms of the trust will then require specific allocation of certain assets to specified beneficiaries or trusts, as, for example, all of the stock in a family business to those children involved in the business; or will charge a beneficiary's share with loans previously made to that beneficiary or with prior gifts, etc. Obviously, the terms of the trust must be examined carefully to see that all of the Settlors' directions are carried out.

If there are continuing trusts for children or grandchildren, these trusts may be separate trusts (i.e., separate tax entities each requiring its own tax returns) or separate shares (i.e., one trust with varying interests requiring only one tax return). Normally, the trust document will specify that separate trusts are to be used as they are usually most advantageous from an income tax standpoint.

The need to be familiar with and understand the terms of each trust cannot be overemphasized.

SUMMARY AND CONCLUSION

The revocable living trust is a flexible and useful device for managing property and, in many instances, saving death and income taxes. However, like a partnership or corporation, it must have adequate management and record keeping procedures. Once these procedures are properly established their continued maintenance is relatively easy. Most trusts can be managed by individual Trustees, after they are successfully under way, with minimal assistance from accountants and attorneys, thus achieving numerous benefits for the Settlors, their children, and other beneficiaries, at minimal cost. Nevertheless, being a Trustee is a substantial responsibility and a Trustee should not hesitate to seek professional investment, accounting or legal assistance whenever questions arise. An ounce of prevention is worth a pound of cure.
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