Charting a Course for Family Security

Trust Administration Basics

A. Standard of Trust Management
As Trustee, you will be acting in a fiduciary capacity. As such, you owe certain legal duties to the beneficiaries. In managing the trust property, you must use at least ordinary business ability. However, if you have special skills, you will be held to a higher standard of care. In any event, your management will be judged in light of the circumstances existing at the time transactions occur, rather than with the benefit of hindsight. If you exceed your Trustee powers, you may be held liable for loss or damage to the Trust Estate.

B. Source of Trustee Powers
It is important that you understand the rules under which you must operate. These rules are derived from three sources: (1) the Trust  itself, (2) statutory law (the "Trust Law" found in the Hawaii Revised Statutes; and (3) decisional law created by the courts.
The principal source of your Trustee powers is the Trust Agreement itself. You should therefore read the Trust Agreement carefully. In doing so, you will see that the Trust Agreement contains two types of provisions: "despositive provisions" that govern the distribution of property and "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 Agreement is made up of these administrative provisions.

The provisions of a Trust may override general provisions of the trust law, except where the law expresses a paramount public policy. Wherever the Trust instrument does not provide for a given situation, the trust law applies. Each Trust Agreement is drafted differently and there are no standard forms that all attorneys use. Accordingly, a Trustee, no matter how experienced, should initially very carefully and very thoroughly read the entire Trust Agreement. This may seem like common sense, but it is surprising how often mistakes are made that could have been avoided by simply reading the Trust Agreement. In this regard, as Trustee, you should assure yourself that you have a complete copy of the Trust Agreement together with all amendments.

C. General Duties of the Trustee
Your basic duties as Trustee involve the collection, management, and investment of Trust assets and the accumulation and distribution of income and principal pursuant to the Trust Agreement. Another important set of duties relates to tax matters, which are explained in detail elsewhere in this memo.

It is a fundamental principle of trust law that you must be faithful to the interests of the Trust and its beneficiaries. You occupy a position of trust and confidence and owe a duty of care to the beneficiaries. You have a duty to administer the Trust solely in the interest of the beneficiaries and to deal impartially with them. You cannot use trust property for your own profit or for any non-trust purpose. You must not engage in any transaction that will result in a conflict of interest between you and the Trust or a beneficiary.

You have a duty to take reasonable steps to take and keep control of trust property and to preserve the trust property and make it productive. You must not commingle trust property with your own property under any circumstances. You must not engage in any transaction that will result in a conflict of interest between you and the Trust or a beneficiary. (For example, you cannot purchase an asset from the Trust for less than fair market value). You also have a duty to take reasonable steps to enforce claims of the Trust and to defend lawsuits brought against the Trust.

You must carry out all Trustee activities personally. In other words, you may not delegate your responsibilities to others. For example, you cannot give someone a power of attorney to handle your Trustee duties except perhaps for ministerial (non-discretionary) duties. Only a duly authorized Trustee has the power to transact business on behalf of the Trust. However, you may hire attorneys, accountants, investment advisors, and others to consult with you concerning your administration of the Trust, and you may pay such advisors from the assets of the Trust.

D. Trust Investments
The Trust grants you 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 beneficiaries. This broad grant of investment discretion may not shield you from liability if you do not exercise this power reasonably. As Trustee, you have an obligation not only to the income beneficiaries, but also to the remainder beneficiaries. In making decisions regarding the administration of the Trust (for example, whether to invest in assets likely to produce high income versus high capital appreciation), you may find yourself in the position in which the interests of the current beneficiaries conflicts with those of the remainder beneficiaries. Please be aware of this potential conflict whenever you deal with the trust assets. One of the more important duties of the Trustee is to keep the Trust appropriately invested to be both productive and growing while at the same time secure in order to minimize the chance of loss. While your investment policies may legitimately differ for the various trusts, you have an obligation to both the income and the remainder beneficiaries of the Trusts. In determining whether a Trustee has properly administered the trusts, Hawaii law applies the "prudent investor" standard and takes into account the purposes of the trust, the prevailing economic conditions, and the anticipated needs of the trust and its beneficiaries.

Many Trustees find it desirable to employ independent investment counsel to supervise the investment of Trust funds. Others rely on brokers in whom they have confidence. In any event, the investments should be those which a person of prudence, discretion and intelligence exercise in the management of their own affairs, not in regard to speculation but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of their capital.

You should review the Hawaii Uniform Prudent Investor Act for specific details on your investment responsibilities.

A common investment device for many people is a dividend reinvestment program. Do not use an automatic dividend reinvestment program for any asset of a trust which requires that income be distributed. If you do, you will make it very difficult, if not impossible, to determine what income should be distributed and will complicate raising the cash to make the distributions.

E. Accounting and Record-Keeping
Adequate records of your activities as Trustee of the various Trusts are essential for at least two reasons. First, it is necessary in order to prepare the annual income tax returns which are required for each trust. Second, Hawaii law requires that you keep each beneficiary of each Trust reasonably informed of the Trust and its administration. You must account annually to any beneficiary who is currently entitled to income or principal, and even those beneficiaries who are not currently entitled to income or principal have a right to demand an accounting by you as the Trustee. We have seen relationships deteriorate for many reasons and have watched Trustees struggle to reconstruct poorly kept trust records covering decades of transactions in order to comply with demands being made long after the fact. Because of the legal requirements and because of our other experiences, we urge you to keep good records. There is a discussion below designed to help you set up and maintaining those records.

We recommend that you give at least an annual accounting of the trust activity to all beneficiaries, both current and future. Providing an accounting serves several purposes. First, it will give the beneficiaries a better understanding of the complexities of the trust administration process and the amount of work involved. Second, it will help avoid misunderstandings by showing that you are not trying to "hide" anything. Third, you can limit your liability by obtaining Approvals of your accounting from the beneficiaries. The Trust accounting should contain at least the following information:
  1. A list of the assets in the Trust at the beginning of the accounting period. 
  2. A list of the assets in the Trust at the end of the accounting period. 
  3. A summary of the income received, e.g., the amount of dividends, interest, rent, etc., by category. 
  4. The net gains and losses incurred from sales during the year. 
  5. A list of the disbursements made from the Trust, by category.
I suggest you have your accountant prepare the accounting for you. It is your responsibility, as Trustee, to decide what information you want to supply, when and in what form.

You must keep careful records of all trust transactions, including an accurate bookkeeping ledger with descriptive notations of all trust income and receipts, noting for each entry the date, the person to whom 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, i.e., you should never pay cash for any trust expenses. You should set up a filing system to keep track of any trust documents and your 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, you may find it helpful to set up a more sophisticated bookkeeping system. Many people now own personal computers, either for personal use or in their businesses. If you own or have access to a personal computer, you might consider using a household or business accounting software package or general spreadsheet program to keep track of trust transactions. There are also commercial fiduciary services who assist individual trustees in keeping trust records and accounting firms sometimes offer these services.

F. Bookkeeping Tips
Following are some suggested guidelines in keeping the Trust records.

First Important Rule:
Keep the records of each trust separate.

Second Important Rule:
Each trust should have its own "operating" checking account. Use that account to make every disbursement from the trust and be sure that every receipt into the Trust is first deposited there before being distributed or otherwise invested.

Do not personally cash any checks received by you as Trustee and never deposit dividends, interest or other income directly into other bank accounts for the Trust. First deposit them into the operating checking account; then make whatever withdrawals or transfers are appropriate. For example, if you plan to make distributions of income to a beneficiary, first deposit the income into the operating checking account for the Trust which earned the income and then write a check from that account to the beneficiary for the income that you wish to distribute. By using this method, you will greatly simplify gathering information at both Trust accounting and income tax time.

When you write a check from an operating checking account, be sure to note on the check register not only the amount, the date, the check number and the payee, but also the purpose of the check (e.g., income distribution, preparation of income tax returns, etc.). When you make deposits to the operating checking account, we recommend that you use duplicate deposit slips in order that you can list the items on the front page for the bank) and then note on the carbon page the source of each item. For example, if you are depositing 10 checks, note next to each check on the carbon the payor (e.g., AT&T, GM, maturing CD#789, rent, August payment on Smith promissory note). It is advisable to duplicate this information also in the check register, but if you find that doing so is too difficult, you can rely solely on your duplicate deposit slips so long as you keep them all in a safe place.

You may find it desirable to maintain ledger cards for each asset held. Such a card shows the name of the company, or asset, the number of shares or units held or the par value of the bonds or a legal description of the real property. It also shows the carrying value, which is usually the cost basis for income tax purposes and can be either the date of death value, if on hand at the death of the decedent, or the purchase price, if bought later. In the back of each sheet there can be a form to show the dividends or interest or rent as received during the year so that it is very convenient to pick off the information for income tax purposes. Such ledger cards can be purchased at any stationary store which carries office supplies.

You should also keep a file folder each year for annual income tax information into which you should put any communications from the companies, such as 1099 information forms or other details relating to the taxability of dividends or interest.
We also recommend that you maintain a file containing all broker's confirmation slips on any assets purchased. When you sell a particular asset, take the purchase confirmation slip and put it together with the sale slip and place them both in the income tax file for the year in which the sale occurs.

If you do not want to handle the record-keeping for these trusts, you have several alternatives. You can employ an accountant to keep the records and prepare the income tax returns. You can employ a bookkeeper only to keep the records for you so that you can deliver the records to your accountant at income tax time. You can open a custodian account with a bank, and they will keep track of everything and give you a periodic print-out which you can give to your accountant. In each case you will have to pay for this service, but such an expenditure, if reasonable, is appropriate for a Trustee.

G. Pay All Net Income
A problem which I see frequently is this: Where an income beneficiary is serving as Trustee, he will tend to leave net income in the sub-Trusts if it is not needed for living expenses. This should not be done. It is our opinion that, even though the Trust document may state otherwise, it would be unwise for an income beneficiary who is also serving as Trustee to accumulate net income and add it to principal. To do so would risk disqualifying the Marital Trust and making the Exemption Trust taxable upon the beneficiary' s death. Only an independent Trustee should make the decision to accumulate income in the Exemption Trust.

Be sure that you do not transfer any of the principal of the Trust to a Trust beneficiary without following carefully the guidelines set forth in the Trust Agreement. Do not assume that "net income" is exactly the interest, dividends and rent. Life in the accounting and trust circles is not so simple. "Net income" is an accounting concept which takes into account expenses of the trust, some of which should be charged to income and some to principal. Some are charged one-half (1/2) to each. Have your accountant calculate net income.

H. Discretionary Payment of Principal
A standard discretionary clause to distribute principal to the current beneficiary would provide for "health, education, support or maintenance." Since the principal of the Exemption Trust will pass estate tax free after the current beneficiary dies, it would be wise to not draw principal from the Exemption Trust until the current beneficiary's other resources are exhausted. If it does become necessary to distribute principal from the Exemption Trust, you should be careful to write a memorandum, to be kept with the Trust records, explaining why the principal distribution was made. The reason for distributing principal must fall within one of the following categories:

The term "health" includes all routine medical care, medication, mental health care, surgery and hospitalization, as well as expenditures for long term nursing care and during rehabilitation.   This standard may also include health club membership and recreational activities depending upon circumstances.

Generally includes college, but does not include graduate level or professional education unless the Trust specifically provides otherwise.

"Support" and "Maintenance"
Support and maintenance encompasses more than bare subsistence. These terms include the beneficiary's normal living expenses, such as housing, clothing, food, and medical care, as well as general welfare consistent with the station in life and standard of living enjoyed by the beneficiary during the settlor's life and the financial condition of the Trust estate. This standard may also include support for spouse and children. Support and maintenance, however, may not extend to extensive travel, luxury automobiles or jewelry where these were not consistent with the beneficiary's station in life.

I. Allocating Receipts and Disbursements to Income or Principal
You need to keep records allocating each receipt and each disbursement to income or to principal. You must know at all times how much income cash and how much principal cash is in the Trust because those figures determine what must or can be distributed. The fact that there may be cash in the operating checking account does not necessarily mean that any of it is income. Cash does not equal income.

Only as an approximation, all dividends, interest, rents and similar income items are income. All capital gains (including capital gains dividends) are principal. Whether an expense reduces income cash or principal cash depends upon the nature of the expenditure and the amount of discretion you have under the trust instrument to allocate between the two.

VI. Tax Matters
A. Taxpayer Identification Number
Your accountant will obtain a taxpayer identification number for the decedent's Revocable Trust. Until the administration of this Trust is completed and the division between the Marital Trust and the Exemption Trust takes place, you should use this number on all assets in the Trust. After the division takes place, the Marital Trust will obtain and use its own EIN; and the Exemption Trust will obtain and use its own EIN.

B. Estate Taxes
If a decedent's estate exceeded the applicable exclusion ($675,000 for the year 2000), at the time of his/her death, the filing of federal and Hawaii estate tax returns will be required. As Trustee, it is your responsibility to file these estate tax returns. The estate tax returns (and tax payments) are due nine (9) months following the date of a decedent's death.  In connection with the preparation of the estate tax returns, your accountant will need to know the fair market value of all assets, including accrued interest and dividends of record but not yet paid, in which the decedent had any interest at the time of his/her death, whether in the Trust or otherwise, including any assets which pass by joint tenancy, by death beneficiary designation, or otherwise.

Some people are under the misconception that assets which pass through a living trust are not subject to estate taxes because they pass outside of probate. This is not true. All of a person's assets, whether passing under a will, through a revocable living trust, by joint tenancy, by payable on death or beneficiary designation, or otherwise are includable in a person's "gross estate" for tax purposes. Thus, there is a difference between the "gross estate" for estate tax purposes and the "probate estate" for probate law purposes.

For real property, closely held business interests, tangible personal property, (if of unusual value, collectibles or art work) and other items, qualified appraisals will be required.

C. Income Taxes
For federal and state income tax purposes, one-half of property held jointly or as tenants by the entirety with a surviving spouse and all of a decedent's separate property, whether inside or outside the Trust, (except items which constitute "income in respect of a decedent") will receive a new income tax basis equal to the fair market on the date of the decedent's death.  An exception is property held jointly or as tenants by the entirety with a spouse which was purchased prior to 1976.   Such property receives a new income tax basis on the proportion of the property attributable to the deceased spouse's contribution.

A new depreciation schedule can be used for all such assets which are depreciable for income tax purposes.  In addition, if you sell any such assets which have appreciated or depreciated in value since the date purchased, all gain or loss is forgiven, except for appreciation or depreciation occurring from the date of death forward. Thus, during the period of post-death administration of the Trust, all assets of the Trust will have a basis equal to the date of death value.  Any assets distributed to the Marital and Exemption Trusts at the conclusion of the administration will take the same basis as the Administration Trust.

 The surviving spouse may file a joint income tax return with his/her deceased spouse for the year of death.  All income attributable to assets of the Trust prior to the date of a decedent's death is reportable on that return.  However after that date, all trust income must be allocated between the Trust and the surviving spouse, individually.  The income allocated to the surviving spouse is reportable on his/her personal return.  However, the income allocated to the Trust from date of death through the date of distribution must be reported on the Trust's state and federal fiduciary income tax returns. This income could in turn be passed through to the Trust beneficiary if the Trust makes distributions of income to the Trust beneficiary during the period of administration.

The Trustee is required to file income tax returns for the decedent's Trust. These are called fiduciary returns and are made on federal form 1041 and Hawaii form N40. These may be filed on calendar year basis or on a fiscal year basis for the first two years if the Trust elects to be treated as part of the "estate". The election must be made within six months after a final determination of the estate tax liability. The Trustee should discuss this option with your accountant. Each Trust has its own tax identification number which will be used on the returns. Do not ever use your social security number in connection with assets in the Trusts. To the extent the income from the Trusts is distributed, unless there are capital gains in a given tax year, no income tax will have to be paid by the Trusts with respect to distributed income because that income will be taxed on the beneficiary's personal return. Capital gains will generally be taxed to the Trusts.

When trust distributions are made to a beneficiary during a calendar year, or during the 65-day period following the end of a calendar year if a special election is made on the fiduciary return, such distributions will carry out taxable income to that beneficiary. In essence, the Administration Trust, the Marital Trust or Exemption Trust, as the case may be, gets a deduction against taxable income for its distributions. The beneficiary will then pay the tax on this income rather than the Trusts. Forms K-1 will be issued showing the amount passing to each beneficiary each year from the Trusts to report on that beneficiary's personal 1040.

You will want professional assistance with the income tax returns, even if you do not use professional help on your own personal returns. Normally a Trustee who is also the beneficiary prefers to use the same tax preparer for the Trust as for his/her or her own personal return as this should result in some reduction of the cost since one person has all the information.

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