FEBRUARY 17, 2014 VOLUME 21 NUMBER 7
When Albert Findlay (not his real name) died in 2002, he left a trust for the benefit of his wife Sharon. Sharon was named as trustee, and the trust document directed that she was to receive “the entire net income” from the trust for the rest of her life. Albert specifically directed that, as trustee, Sharon would not have any right to take principal out of the trust, but he left at least a half million dollars of investable assets in the trust, so it could be expected to produce some income for Sharon. In addition, the trust included several pieces of investment property — Albert appears to have been a moderately wealthy and successful man.
Albert also had three daughters from his first marriage (that is, they were not Sharon’s children). One of the significant assets in the trust was a 20.28% interest in an apartment building in downtown Prescott, Arizona. Albert’s daughters owned the remaining interest and managed the building.
Already the description of Albert’s estate plan should give some clues about what ended up going wrong. In our experience, clients have a hard time imagining what the family dynamics will actually look like after their deaths. We can guess that Albert might have had such a failure of vision. Would Sharon handle the trust properly? Would she get along with her step-daughters? Would any of them, financially enmeshed as they were, seek to take advantage of the others? Would all of them understand their obligations to one another, providing information and responding reasonably when asked?
It is not clear from the court record (you predicted that there would be a court proceeding, didn’t you?) who acted first, but in the few years after Albert’s death several things happened:
- Two of his daughters, as managers of the apartment complex, took out a loan against the building. They did not put the proceeds into the limited liability company running the rental building. The building did not generate sufficient income to make the loan payments, and the property was ultimately lost to a foreclosure.
- Sharon began automatically transferring $3,000 per month from the trust to her personal checking account, regardless of how much income the trust produced. The value of the stocks held in the trust began to decline.
- Albert’s daughters requested accounting information for the trust, but Sharon did not comply for months. In fact, she did not provide any detailed account information until court proceedings had been filed.
- The daughters attempted to sell one of the other assets held jointly among them and Sharon’s trust; Sharon objected to some of the terms of the proposed sale and it did not go through. The daughters then formed a new limited liability company and transferred their share of that asset to the new LLC. Meanwhile, they received an offer on the struggling apartment building (before the foreclosure) but rejected it without consulting Sharon.
- Once litigation began, Sharon hired an attorney and paid about $70,000 in legal fees from the trust. She actually initiated the lawsuit, seeking damages for her stepdaughters’ handling of the apartment building. They countersued, asking that she be removed as trustee, ordered to account and ordered to return money she should not have taken from the trust.
- Meanwhile, Sharon was receiving trust checks for rental payments on another trust asset, a commercial rental building. She deposited those checks into her personal account directly, and reported the income on her own income tax return rather than showing it as trust income. In fact, Sharon didn’t even have a trust checking account set up for most of the time she acted as trustee.
The trial court heard testimony from the warring parties, and ended up removing Sharon as trustee (a non-family member took over after her removal), ordering her to return trust money she should not have received, and directing her attorney to return $70,000 in legal fees paid by the trust. Sharon appealed.
The Arizona Court of Appeals affirmed most of the trial judge’s findings, but disagreed about how much Sharon should have been entitled to receive from the trust. The trial judge had ordered Sharon to return everything she had received above the “distributable net income” (DNI) of the trust — that calculation was wrong, said the appellate court. DNI is a tax-related calculation — it is the maximum amount of the income tax deduction available to a trust for distributions to an income beneficiary — and “income” for trust accounting purposes is a different (and often somewhat larger) number, according to the Court of Appeals.
The appellate court sent the dispute back to the trial judge for further hearings to calculate the amount that Sharon owes back to the trust. It also directed the trial judge to conduct proceedings to determine whether Albert would have wanted his trust used to pay for administrative items like legal fees. In the first hearing, the judge had refused to allow Albert’s lawyer to testify about what he might have intended in that regard.
Two other holdings by the Court of Appeals are worth mentioning. First, the appellate judges noted that Sharon’s decision to sell the stocks held in the trust when she took over is not, by itself, evidence of any wrongdoing. Even though the value of the stock holdings had apparently gone down during her administration, that is not necessarily actionable. A trustee is not an insurer, but has a duty to manage trust assets prudently. The trial judge will need to inquire further into the kinds of changes made before deciding to order Sharon to return funds.
Finally, the appellate court noted that there is not necessarily any problem with naming a trustee who has an interest in the trust’s administration. In fact, it is common to name beneficiaries as trustees — they then have a duty to the other beneficiaries, but that does not mean that someone in Sharon’s position is precluded from seeking to assert her own interests in the trust. The trial court will need to review the earlier ruling to make sure that the “conflict of interest” analysis was not too sweeping in its application. Favour v. Favour, February 11, 2014.
It is a challenge to describe a court opinion like the Favour holding without dropping into technical jargon. But perhaps it is more useful and interesting to think about how the litigation — and the outcome — might have been avoided in the first instance. We have a few ideas to suggest — though we are quick to note that we never discussed Albert’s wishes with him, and he might have rejected any or all of these:
- Naming a beneficiary as trustee is not at all objectionable, and (as the appellate court notes) it is commonly done. But if the trust’s author intends that everyone be treated scrupulously fairly, it might make more sense to name a disinterested person (or organization) — even a professional — as trustee.
- It is uncommon to see modern trusts that require distribution of all income but preclude distribution of any principal. That is an invitation to this kind of dispute, since the characterization of income and principal can be subject to interpretation. It also puts the income and remainder beneficiaries at odds — income beneficiaries are not interested in growth of investment value, and remainder beneficiaries would rather skip current income in favor of that growth.
- Putting fractional shares of investment assets into the trust is another way to encourage disagreement — particularly when other trust beneficiaries have management authority over the fractional interests.
- Once any level of conflict arose, it might have been appropriate for Sharon to consider application of Arizona’s “total return unitrust” statutory authority. Using that approach, she might have set a presumptive rate of distribution from the trust regardless of the actual income — and reduced the possibilities of disagreement between herself and her stepdaughters.
- Including some sort of dispute resolution mechanism in a trust — especially a trust like this one, involving a surviving spouse and stepchildren from an earlier marriage — might make sense as a way of minimizing conflict, avoiding court proceedings and reducing legal expenses.
- A trustee has a duty to report to remainder beneficiaries. Someone should have explained that to Sharon early, and pushed her toward satisfying that obligation. Delaying or avoiding her duty did not work to her benefit in the long run.
With remand to the trial court, it may not be too late for Sharon and her stepdaughters to work out some less-costly resolution of their dispute. But some part of the cost (and the breakdown in the interpersonal dynamics) has to be laid at Albert’s door — he could have reduced the conflicts and helped his family avoid disputes by a little more careful thought about the drafting, funding and future of his trust plans.