Excerpted from The Biggest Legal Mistakes Physicians Make: And How to Avoid Them
Edited by Steven Babitsky, Esq. and James J. Mangraviti, Esq. (©2005 SEAK, Inc.)
Download Free 646 Page E-book: The Biggest Legal Mistakes Physicians Make and How to Avoid Them
Trusts are a legal relationship in which a trustor places legal title to property in the name of a trustee for the use and benefit of persons named as beneficiaries. They can be revocable or irrevocable. A revocable trust may be changed at any time by the trustor prior to the trustor’s death and is very often used in estate planning for physicians. An irrevocable trust is not changeable by the trustor and is typically used in special situations in which it is desired to make a gift or otherwise part with control over trust assets. The trustor, trustee, and beneficiary may be the same person (at least for awhile) but typically are (eventually) different persons. For example, a typical revocable trust is set up by a trustor during the trustor’s lifetime (a “living trust”) and during the trustor’s life, the trustor is also the trustee and sole beneficiary. On death, a successor trustee assumes fiduciary responsibilities to use the trust for the benefit of the persons the trustor has specified. Trusts are flexible tools that can be used for many purposes, but unless they are properly established, funded, and administered, they will not be able to accomplish their intended purposes. There are a number of common mistakes physicians can make regarding trusts that will limit or eliminate their benefit.
Mistake 1 Not Funding the Trust Properly or at All
Trusts are only effective as to assets transferred in trust to the trustee. Merely signing a trust instrument generally does not cause any particular asset to become subject to the trust. Rather, the trust must almost always be funded by separate transfers of property to the trustee, which is accomplished through deeds, assignments, beneficiary designations, and other methods used to transfer assets generally. If this is not done, the trust has nothing to work on. The physician must remember that the transfer is to the trustee, not to the trust; this is because a trust is a relationship, not an entity legally treated as a person. To put property into a trust, the transfer documents typically title property something like this: “John Jones, Trustee under agreement dated January 1, 2004”; or as abbreviated: “John Jones, Trustee U/A 1/1/04.”
Action Step Physicians should be sure to fund their trust and title assets properly, and ensure that future replacement assets remain titled properly.
Mistake 2 Using a Revocable Trust to Protect Assets From Creditors
Some physicians are under the mistaken impression that a revocable trust will protect assets from creditors. This is not so. Certain, rather specialized, irrevocable trusts may be used for creditor protection, but a revocable trust is inappropriate for such use. As long as the trust may be revoked by the physician, the assets of the trust will be treated as being the assets of the physician for purposes of being reached by creditors. Revocable trusts provide a number of benefits for a physician in estate planning, but creditor protection is not one of them.
Action Step Physicians should use revocable trusts where appropriate for estate planning, but not for asset protection from creditors.
Mistake 3 Believing That the Use of a Trust Will Alone Save Taxes
Trusts have no tax-saving magic. Trusts are perhaps the most flexible of the tools in the estate planning lawyer’s toolbox, and as such, most tax-saving plans will sooner or later make use of trusts. However, it is the overall arrangement itself that saves taxes, not the mere use of the trust vehicle. For example, revocable trusts can be drafted with formula clauses designed to maximize the tax benefits against the estate tax of the marital deduction and the unified credit. Other ways to obtain such benefits are also possible; they are just typically much more cumbersome to use. The assets of the revocable trust will be included in the gross estate of the deceased physician for estate tax purposes, but the trust terms can be structured to help achieve tax savings. Irrevocable trusts may be used to achieve tax savings; the key, however, is that such trusts constitute true gifts that irrevocably remove from the trustor physician control over the assets and benefits from the assets. There are other ways to give away assets irrevocably, but the use of a trust can add desirable restrictions with the most ease.
Action Step Physicians should use revocable and irrevocable trusts where appropriate to structure transactions for tax savings, remembering that the savings come from the structure, not merely from the use of a trust.
Mistake 4 Selecting the Wrong Trustees
One of the most important decisions in setting up a trust is the selection of an appropriate trustee. An inappropriate trustee can cause enormous harm in myriad ways. Trustees must:
- Be impeccably honest and honorable and unwilling to violate their honor, even under strong financial or psychological pressure;
- Have good financial ability, be prudent in financial dealings, and be able to take good financial advice;
- Be willing to follow the trust document and applicable law and seek and take good legal advice concerning the trustee’s duties under the governing instrument;
- Have strong people skills, including having the trust and confidence of the beneficiaries, having the backbone to say “no” when necessary, not having any interests in conflict with the goals of the trust, and not having any prejudices or family axes to grind that may affect their performance as trustee;
- Be likely to be able to serve through the term of the trust, which may be for a considerable length of time, in order to provide consistency in management and reduce the disruption of transition; and
- Be able to deal effectively and collegially with any co-trustees, including, on the one hand, not having animosity toward a co-trustee and, on the other hand, having the ability to exercise independent judgment not overly influenced by a co-trustee.
If a trustee lacks even one of the necessary attributes or abilities, the physician setting up the trust should probably consider someone else. Where appropriate, trust companies or bank trust departments should be considered. They are highly regulated, and they recruit, train, and supervise people to be responsive to the needs of beneficiaries. Also, they can respond in damages if they do wrong; they have track records and reputations for results and service that can be reviewed; they seldom make significant financial errors; they have experience in tax reporting and providing beneficiary accountings; and they are likely to be around for the long term.
Action Step Physicians should carefully select the trustees or co-trustees of any trust. They should consider using a professional trust company or bank trustee department as the trustee or as a co-trustee with an individual as the other co-trustee. In addition, they should avoid unworkable relationships among co-trustees.
Mistake 5 Expecting Full Privacy From Use of a Trust
One reason physicians establish trusts during their lives (rather than by will at death) is to avoid having the terms of the trust made public through the probate of the will. This is a valid reason to use a trust, but the privacy provided will not be perfect. In case of a dispute, the trust will become part of a public court file. At least some information about the trust must be recorded in the real estate records in order for the trustee to take title and effectively exercise trust powers, and must be provided to bankers, brokers, and others dealing with the trust. Fortunately, seldom is the full trust required for these purposes, and bankers and brokers will generally honor the confidentiality of the trust information provided. Perhaps more significantly, beneficiaries generally will be able to see how the trust has been changed by the physician over time. They will see how some benefits have been added and subtracted as circumstances changed. This aspect is something some physicians would rather not have known. However, in the circumstance where a revocable trust has the physician as the sole trustor, sole trustee, and sole beneficiary, restrictions in the latest trust instrument have a good chance of preventing prior trust instruments and amendments from being disclosed.
Action Step Physicians should not expect full privacy from using a revocable or irrevocable trust. They should have restrictions against disclosure of prior instruments included in amendments to revocable trusts.
Mistake 6 Not Being Aware of the Duties as a Trustee
Physicians sometimes act as trustees to administer trusts established by themselves or others. Trustees have fiduciary duties that are imposed by law and the trust instrument. The physician as trustee must never lose sight of such duties because to do so may lead to costly litigation and liability. The three major duties of a trustee are:
- Loyalty: The trustee must be loyal to the beneficiaries under the trust. This means that the trustee must place the interests of the beneficiaries first above his or her personal interest, avoid conflicts of interest with the trust, and not engage in self-dealing with the trust.
- Obedience: The trustee must act in accordance with the trusts’ governing instruments, within the bounds of the law. Among other things, the trustee must be familiar with the terms of the trust.
- Care: The trustee must in good faith use the care that a prudent person would exercise in a like position under similar circumstances, which includes exercising care in both fiscal and operational matters of the trust.
Generally, the trustee will have the burden to demonstrate that he or she met the applicable standards with respect to these duties. Taken together, these duties require more of the trustee than ordinary business honesty; they require a high degree of honor and integrity and a sensitivity to potential conflicts of interest. Co-trustees generally cannot divide these duties among themselves, but each one is fully responsible ultimately for the administration of the trust, even when certain functions are delegated among co-trustees for convenience.
Action Step Physicians should be fully aware of their duties when acting as trustee and seek and follow competent legal advice when appropriate.
Mistake 7 Not Obtaining and Following Adequate Investment Advice
A physician acting as trustee has the duty to manage and invest trust assets prudently. The standard for prudent investments will vary somewhat from state to state but generally requires consideration of relevant investment factors, such as income, growth, safety of principal, and so on. Few physicians are investment experts and thus will need to have competent investment advice. A trustee cannot simply pick the safest, lowest return investment and then forget about it. Trustees are generally required to actively monitor and manage investments in light of the needs and goals of the trust. Failing to obtain proper advice can be costly to the trust and lead to liability on the part of the physician-trustee.
Action Step Physicians should obtain and follow competent investment advice and keep records of having done so.
Mistake 8 Failing to Obtain and Follow Competent Legal Advice When Acting as Trustee
Physicians acting as a trustee of a trust are obliged to follow the terms of the trust and the law. Even a trust drafted in reasonably readable English, rather than in incomprehensible legalese, will be a technical instrument with many nuances and meanings not readily apparent to an untrained reader. Also, the trust needs to be read in the context of applicable law, which is likely to be even less readily apparent to a reader. Thus, any trustee, and particularly a busy physician, should plan on obtaining legal advice any time a substantial matter arises with respect to a trust. A simple telephone call with a knowledgeable lawyer and an hour or two of legal time can save the physician-trustee from endless wasted hours in litigation, the cost of litigation, and the liabilities that can result from litigation. Far better to be safe than sorry. Too often the trustee will, to his or her regret, act without obtaining legal advice.
Action Step Physicians should engage and obtain advice from competent legal counsel any time they serve as trustee of a trust and any significant issue arises.
Mistake 9 Failing to Obtain Court Approval of Certain Transactions
The physician acting as a trustee may find it desirable to enter into a transaction between the trustee and a person related to the trustee or even with the trustee himself or herself, to take action not clearly authorized by the trust instrument, or to otherwise take action that may produce an issue with respect to the trustee’s duty. In such event, particularly where unanimous consent of all beneficiaries cannot be obtained (e.g., future beneficiaries may be unascertained), it may be wise to have counsel help the trustee seek court approval of the transaction so that the trustee and the trust can be protected. Not all trustees are aware of this possibility. Even when they are aware of it, some trustees are unwilling to submit to court scrutiny. It may be a very serious mistake, however, to proceed with such a transaction without having obtained court approval.
Action Step Physician-trustees should seek court approval of transactions raising substantial questions about the trustee’s duty.
Mistake 10 Failing to Take Account of Tax Ramifications
Trusts are often used to help save taxes, but even when tax savings are not one of the trust’s primary goals, trusts will have tax implications that can be quite significant. A physician acting as trustee will need to be sensitive to the tax effects of what he or she does or does not do. For example, irrevocable life insurance trusts may be a good way to remove life insurance proceeds from a trustor’s taxable estate by making a gift of the insurance, in trust, when it has a low value. The premiums are also gifts and in order to obtain a gift tax annual exclusion for the premiums, certain withdrawal powers are often included in such trusts. In paying the premiums on such insurance, the trustee must give notices of such withdrawal rights and the failure to do so can be costly. Also, as another example, trusts reach the highest income tax rates much more quickly than do individual taxpayers. Thus, the trustee may desire to maximize current distributions in order not to incur the higher tax that would result by retaining income in trust. As these two examples illustrate, the physician acting as trustee will need to consult with his or her counsel, accountant, or other qualified tax adviser about the tax implications of the administration of the trust. The failure to do so may cause additional tax expense for the trust or its beneficiaries and may also cause potential liability on the part of the trustee.
Action Step Physicians should consult counsel about the tax implications of trust administration. Where possible and legal, they should try to obtain exculpation from certain tax-sensitive decisions under the terms of the trust instrument.
Trusts are very useful tools that must be properly set up, funded, and administered to accomplish their goals. Physicians following the suggested action steps will have gone a long way toward making the trusts, with which they may be involved in one role or another, effective for themselves or others.
Langdon T. Owen, Jr., Esq.
Peer reviewed by:
John Parsons, Esq.