Pennsylvania Trusts and Estates Blog

Surviving Spouse as Trustee

One of my pet peeves about estate planners is that they often announce their personal prejudices as if they were the law. (Of course, I never do that.) Who can be a trustee is one of those subjects on which the personal opinions of planners get in the way of what the law permits.

Do you remember The Lucy Show where Lucy Carmichael is begging, or trying to dupe, the banker, Mr. Mooney, trustee of her deceased husband's trust, into giving her more money? If you have, you know that who is trustee after a spouse dies is very important. Horror stories about heartless, tight-fisted, parsimonious trustees abound. Every family has a story about a trustee who won't let a beneficiary have "his" money. I put "his" in quotes, because, of course, it isn't the beneficiary's money. If it were, no trustee would be involved. Nevertheless, how a trustee handles his or her responsibilities can make a big difference in the quality of life of the beneficiaries.

In general, all lawyers would agree that the lawyer should not advise a course of action that provides the client little or no benefit and affects others adversely. Nevertheless, many estate planning lawyers routinely advise clients to implement estate plans that provide little or no benefit and, in fact, cause much heartache to the survivors such as spouses and children. Often, because of the "form" that is used, a one-size-fits-all document is used as a Procrustean bed for all clients. (In Greek mythology, Procrustes had an iron bed on which travelers who fell into his hands were compelled to spend the night. He stretched the ones who were too short until they died, or, if they were too tall, he cut off as much of their limbs as would make them short enough to fit the bed.)

A very common estate planning technique to reduce federal estate tax is for a married couple to divide assets between them and create estate plans with by-pass trusts. Taxation is avoided (not just deferred) by the first spouse to die placing assets up to the exclusion amount ($3.5 million this year) into a bypass trust. The trust income can be paid to the surviving spouse, and there are various rights to trust principal that the surviving spouse can be given depending on each individual situation.

These rights can include the right to invade principal in any amount if invasion is for "health, education, maintenance, and support." They may also include withdrawal for any reason up to an annual limit of the greater of $5,000 or five percent of the trust corpus. Neither of these rights has adverse tax consequences, even if the surviving spouse is the Trustee.

Who is to be the trustee of this trust? Many planners insist on a bank or trust company, either as sole trustee or as co-trustee with a family member. There may be advantages to a bank or trust company acting as trustee in some situations, but it is not a legal requirement. Some planners insist on only family members, usually adult children, as trustees. Again, while this may be a good idea in some situations, it is not a legal requirement. Some planners urge clients to appoint the planner's themselves as trustees - again, this may be appropriate, but it is not a legal requirement and probably should not be "sold" to the client because of the inherent conflicts of interest unless these are appropriately dealt with.

This trustee, whoever it is, is going to control up to $3.5 million in assets during the spouse's period of survivorship. He or she is going to have to deal with this trustee, possibly for a long time, and this trustee is going to be a huge factor in the surviving spouse's financial and personal life. The choice of who fills this position is very important.

The most obvious choice is for the surviving spouse to act as the trustee, yet this option is rarely presented to the client.

Henry M. Ordower wrote an article for the Real Property and Trust Journal called, "Trusting our partners: An essay on resetting the estate planning defaults for an adult world." Ordower points our that clients commonly assume that there is some standard for selection of trustees and will look to their estate planning lawyer for a recommendation. Rarely will the clients ask probing questions concerning the selection of a trustee. If they did, they would find out that there are no legal and tax constraints that limit choices unduly.

Ordower goes on to say that many estate planning lawyers remain uncertain as to the tax and legal impact of the designation of specific classes of trustee. The best choice of a trustee is someone whom the client believes will act as the client would if he or she were still living. Given that, a bank or trust company is not a very logical choice. An individual who knows and understands the decedent's thinking would be best. Who better than the decedent's spouse?

Surely sometimes the surviving spouse is not an appropriate choice, but as Ordower suggests, the spouse ought to be the "default setting."

If the client truly does not want the spouse as trustee, it is a signal to the lawyer of flaws in the marital relationship that may need to be addressed in another manner. For the estate planning lawyer, these flaws enhance the likelihood that the estate planning lawyer will have a conflict of interest in planning for the couple. For example: Wife wants to be trustee. Husband doesn't want Wife to be Trustee. Whom does the lawyer represent?

Increasingly, individual trustees are appointed in numerous estate planning structures. From a surviving spouse's perspective, however, the selection of an individual trustee may be more unfortunate than the selection of a corporate trustee. As humiliating as financial control by an impersonal trust department may be, control by a child, an in-law, or a personal friend of a deceased spouse is frequently worse.

The surviving spouse as trustee must respect the trust. That is, he or she cannot commingle assets, must invest the assets, keep books and file tax returns. Professional help from money managers to accountants is readily available for all of these things.

Consider all of the options: banks, trust companies, spouses, adult children and professional advisors. Understand the pro's and con's of each choice before making a selection.

Next week's column will review the functions, responsibilities and duties of a trustee.

"Near this spot are deposited the remains of one who possessed Beauty without Vanity, Strength without Insolence, Courage without Ferocity, and all the Virtues of Man, without his Vices. This Praise, which would be unmeaning Flattery if inscribed over human ashes, is but a just tribute to the Memory of Boatswain, a Dog."

                                                         Lord Byron

According to the Humane Society of the United States, sixty-two percent of U.S. households have a pet. Many pet owners treat these pets as true members of their families. They buy them special clothing, get them professionally groomed at day spas, buy gourmet pet food, and take their animals for frequent check-ups at the vet. As put by Henry David Thoreau, " It often happens that a man is more humanely related to a cat or dog than to any human being."

Small wonder, then, that these pet owners want to make sure these pets are cared for after the owner dies. Traditionally, the pets themselves could not be beneficiaries of the owner's will. The pet itself could be bequeathed to someone since the pet is tangible property, but any money for the pet's care had to be given to the new owner with the hope that it would be used to take care of the pet.

One solution was for the pet owner to set up a trust with the pet's caretaker as the beneficiary. The caretaker received trust distributions so long as the pet was living and the caretaker was taking adequate care of the pet. Another party acted as trustee to enforce the terms of the trust by managing the funds and by having the power to move the pet from one caretaker to another.

The Uniform Trust Code (UTC), adopted by Pennsylvania recently to be effective on November 4, 2006, introduces a new concept and makes it possible to make a trust for the benefit of a pet where the pet is treated as the beneficiary. Under the terms of the UTC, a trust may be created to provide for the care of an animal alive during the settlor's lifetime. The trust terminates upon the death of the animal or, if the trust was created to provide for the care of more than one animal alive during the settlor's lifetime, upon the death of the last surviving animal. The law provides that the trust property is to be applied only for the care of the animal. It is very important to make a gift of the remainder to some other person or charity. If the trust terms do not provide for remaindermen, the remainder interest will be distributed through a resulting trust to the settlor, if living, or the settlor's estate. There won't be any millionaire kitties eating out of crystal on silver trays. According to Marilou Gervacio, writing for UTC Notes, the average amount put into such trusts has been said to be about $25,000 per animal.

Who pays the income taxes on the trusts investments? If the caretaker is considered a beneficiary of the trust (which is the case for common law trusts, not pet trusts under the UTC) then the caretaker reports distributions from the trust as income on his or her personal 1040 to the extent they carry out trust income. Revenue Ruling 76-486 provides that if the pet is considered the beneficiary of the trust (which is the case in a pet trust under the UTC), the trust gets no deduction for amounts distributed for the pet's care and the trust must pay income taxes on earnings. Note that the trust does not qualify as a charitable trust even if the remainder beneficiary after the death of the pet is a charity.

Your pet needs care if you become incapacitated, too. Your power of attorney can include language directing the agent to care for the principal's pet and expend amounts necessary to provide such care. This could be important if the agent's actions are challenged as violating the duty of the agent to expend sums only for the benefit of the principal.

Professor Gary Beyer, of the Texas Tech University School of Law wrote an article called "Estate Planning for Non-human Family Members" in which he advises that in addition to setting aside funds for the care of your pet, you need to make sure the relevant people know what should be done with your pets if something happens to the owner suddenly.

Professor Beyer next recommends that the owner should prepare an "animal document." This document should contain information about the animals, their care needs, and who will take care of them, and perhaps additional details as well. This document is intended to be kept in the same location where the pet owner keeps his or her estate planning documents.

Finally, the owner can provide signage regarding the pets on entrances to the owner's home to alert individuals entering the home that pets are inside. The signage is also important during the owner's life to warn others who may enter the dwelling (e.g., police, fire fighters, inspectors, meter readers, friends) about the pets. The Humane Society of the United States supplies cards and signage alerting others of the existence of pets and information regarding their care.

How do you know the pet that is the trust beneficiary is still alive? Certainly, the pet needs to be identified. Beyer cites a report that "[a] trust was established for a black cat to be cared for by its deceased owner's maid. Inconsistencies in the reported age of the pet tipped off authorities to fact that the maid was on her third black cat, the original long since having died." Veterinary records and photographs are helpful. It has been suggested that the pet could be tattooed. Although this could later "cause problems" for the pet because a pet thief could mutilate the pet to remove the tattoo, such as cutting off an ear or leg, if the pet's primary function is breeding. (Indeed!)

A microchip can be implanted in the animal and the trustee can then have the animal scanned to verify that the animal the caretaker is minding is the same animal. But, an enterprising caretaker could surgically remove the microchip and have it implanted in another physically similar animal.

How far can this go? It is suggested that the best, albeit expensive, method to assure identification is for the trustee to retain a sample of the animal's DNA before turning the animal over to the caretaker and then to run periodic comparisons between the retained sample and new samples from the animal. (Whew!)

Is your retirement plan invested in your employer's company stock? If so, there is a tax strategy available to you that is often overlooked.

Normally, all withdrawals from a retirement plan are taxed as ordinary income, at ordinary income tax rates. However, if you take distribution of your employer's company stock from your retirement plan and hold it in a taxable investment account, you may be able to significantly reduce taxes on plan distributions. This strategy is called the Net Unrealized Appreciation ("NUA") approach. It is authorized by Section 402(e)4 of the Internal Revenue Code.

NUA is the difference between the cost basis of the stock inside the plan and the stock's current market price on the distribution date. Using the NUA approach, only the cost basis of shares is subject to tax at the time of the distribution from the qualified plan. The difference between the basis and the fair market value--the net unrealized appreciation--is taxed at long-term capital gains rates only when the stock is sold, regardless of the holding period. This can be a better result than rolling the stock into an IRA where all of its value will eventually be taxed as ordinary income when it is distributed to you or to your beneficiaries.

When the stock is sold, NUA is treated as a long-term capital gain, even if it is sold immediately after distribution. Any appreciation of the employer stock that occurs after it is distributed will be considered a short-term capital gain if the employer stock is held for less than one year. If the stock is held for at least one year after the transfer, it is then characterized as a long-term capital gain.

If you never sell the shares of stock with the NUA, when your beneficiaries sell the stock they inherit, they will owe long-term capital gain tax on the unrealized appreciation portion of any gain. However, since the stock receives step-up in cost basis on your death, any additional appreciation between the date of distribution and the date of your death is never subjected to income tax.

If you take the NUA approach, the shares of company stock are outside the plan and not in an IRA. They are in a regular investment account. There are no minimum distribution requirements. The higher your income tax bracket and the more the stock has appreciated, the more you may benefit from this strategy.

If you are considering this technique, ask your plan administrator for the cost basis of various lots of employer stock in your plan. It makes sense to take out shares with the lowest cost basis. You don't have to take out all the shares. You can rollover part of the shares - choosing the ones with a higher cost basis to rollover. The special NUA treatment is lost for shares that are rolled over into an IRA.

Unfortunately, many retirees and advisors assume that rolling a retirement plan distribution into an IRA is the only option available. On the surface, this seems like the standard operating procedure, but it could cost thousands of dollars in additional taxes that could have been avoided.

In order to use the NUA approach, the employee must elect a lump-sum, in-kind distribution from the plan (a complete distribution of all plan assets in a single calendar year). A lump-sum distribution can be received on the employee's death, on the employee's attaining age 59 l/2, on the employee's separation from service, or on the employee's becoming disabled. If there is company stock in your retirement plan when you die - your spouse or other beneficiaries can use the NUA strategy.

With capital gains rate at an historical low, the increased use of company stock in retirement plans, and the long-term gains of the stock market, using the NU approach makes good sense for many plan participants.