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 2004
Index (back)
Report 8
Tuesday, January 6 and Wednesday,
Jan 7
Reporter: John Warnick Esq.
Tuesday, January 6
11:30 a.m. - 12:15 p.m.
Old But Not Cold - Restructuring, Refocusing and Retiring
Irrevocable Trusts
Ronald D. Aucutt
Mr. Aucutt is the President of the American College of Trust
and Estate Counsel (ACTEC) and has been a frequent lecturer
at the Heckerling Institute.
Mr. Aucutt started his comments with a reference to the just
issued final regulations defining net income under Section
643(b) and mentioned that in his opinion the final regulations
have been drawn too narrowly and will put an undue amount
of emphasis on state law. Existing trusts in states that do
not have a unitrust statute will not have the planning flexibility
that is afforded under the final regulations to trusts with
a situs in states which do have a unitrust statute.
He then drew a distinction between "old" trusts
which are grandfathered from the GST Tax because they were
irrevocable prior to September 26, 1985 and those trusts established
subsequently. He noted that there is a tremendous amount of
wealth in these "old" trusts, and that there is
a tendency to ignore them. He suggested that planners need
to thoroughly comb these instruments and be sensitive to planning
opportunities which may prove valuable to the administration
of such trusts.
At the same time he suggested that there are a considerable
number of "old" trusts that have been established
or become irrevocable since September 25, 1985, and that planners
also need to be aware that there have been significant developments
in trust law, such as the UPIA and Prudent Investor Act, which
alter the administration and planning landscape. This category
of "old" irrevocable trust will become increasingly
important in the years ahead.
What are some of the common problems facing long-term irrevocable
trusts?
Many of these old trusts have beneficiaries in multiple generations
who often disagree, even within generations, about the direction
the trust is taking or should take. Often the trustee is caught
in the middle of this crossfire.
The trustee of an "old" trust may be handcuffed
by outdated boilerplate or by a less "trust friendly"
situs. There may be interest in changing the situs of the
trust to achieve greater privacy, a more favorable or cooperative
environment of court supervision, clearer or more advantageous
substantive rules, or a favorable income tax climate. Today
the pressures produced by the trustees' duty of impartiality
to successive beneficiaries, the prudent investor rule, new
principal and income rules, and declining investment yields
are combining in a "perfect storm" to suggest the
superiority of a "unitrust" approach to balancing
the interests of successive beneficiaries.
Another problem with "old" trusts can be the sheer
multiplicity of trusts created over a number of years, often
by different generations of grantors. This can lead to annoyingly
different distribution and administrative provisions which
compound the trustee's difficulties.
Outdated trustee succession regimes are frequent problems
encountered with "old" trusts. Sometimes grantors
depended on individual trustees and demonstrated an antagonism
towards corporate fiduciaries. Individual trustees grow old,
retire, die or become incapacitated. Family trustees may be
succeeded by younger generation family members, but this is
not always easy. The suitability and acceptability of corporate
trustees can also change over time.
Another aspect of the unique planning challenges of the old
trusts is termination. It is very ackward for a trust to distribute
illiquid real estate to multiple generations of beneficiaries.
Solutions such as contributing the illiquid assets to an entity
may not be clearly authorized by the instrument.
Ron Aucutt next spent a significant amount of time reviewing
the history and changes brought about by both the Uniform
Prudent Investor Act and the Revised Uniform Principal and
Income Act (1997). He noted that one of the stated purposes
of the Revised Uniform Principal and Income Act (the "Act")
is to ease the tension trustees face in satisfying both income
and remainder beneficiaries while adopting the modern portfolio
theory under the Uniform Prudent Investor Act. The power to
adjust under the Act can be used to liberate the trustee to
fully implement modern portfolio theory. It gives trustees
the power to correct situations where the income or remainder
beneficiaries are adversely impacted by the total return investment
strategy. But the trustee does not have power to adjust under
the Act unless the following three factors are satisfied:
1. the trustee invests and manages the trust as a prudent
investor;
2. the terms of the trust describe the amount that may or
must be distributed to the beneficiaries by referring to the
trust's "income"; and
3. the trustee determines that it cannot administer the
trust impartially based on what is fair and reasonable to
all of the beneficiaries unless the trust clearly manifests
an intention that the fiduciary favor one or more beneficiaries.
Thirty states and the District of Columbia have adopted the
Uniform Prudent Investor Act so the first factor is going
to be present in most trusts. Even in those states which haven't
adopted the Uniform Prudent Investor Act or similar legislation,
the prudent investor rule may be approved by the courts in
that state or the trust instrument itself may require it be
observed. Mr. Aucutt has concluded that this first factor
will be satisfied in virtually all states except those where
a trustee is permitted to invest only in assets set forth
on a statutory "legal list".
If a trustee of an old trust determines that all of these
factors are present, then the trustee must determine if it
is appropriate to resolve the conflict between income and
remainder beneficiaries by transferring principal to income
in order to increase the payout to income beneficiaries each
year. This can become a significant administrative chore and
require significant record-keeping and documentation each
time the trustee makes an adjustment under the Act.
To alleviate that administrative burden, Mr.Aucutt suggests
that conversion to a private unitrust may be appropriate.
By reforming the old trust to become a private unitrust the
trustee is creating a "partnership" among the income
beneficiaries, remaindermen, and the trustee that will enable
the trustee to invest the assets for long-term growth for
the benefit of all beneficiaries. This should give the trustee
and investment team a greater focus.
What considerations should the trustee make in converting
a traditional "income" trust to a private unitrust?
First, the trustee will need the consent of all affected
parties.
Second, the trustee may want to consider using a rolling
average to reduce potential fluctuations in unitrust distributions
due to short-term market swings. The trustee may also want
to consider placing a ceiling and/or floor on the distribution
amount from the unitrust that will satisfy the needs of all
beneficiaries and reduce the risk to the remaindermen.
Third, in the case of a trust with grandfathered IRS status,
careful attention needs to be paid to protect that status,
and it may be desirable to obtain an IRS ruling.
Fourth, the trustee should consider whether the conversion
is also an appropriate opportunity to divide inter-generational
trusts along family lines so as to allow individual families
to invest as they see fit.
Finally, the trustee must carefully consider the income tax
consequences of the unitrust distribution and conversion to
a private unitrust. This requires careful attention to the
regulations under Section 643(b) and navigating around the
Cottage Savings problem which Lloyd Leva Plaine covered previously.
There are special considerations that trustees must give
to the old trust that is about to terminate. Watch out for
special powers of appointment and be alert to planning opportunities
that may arise through careful exercise of these powers. In
exercising a special power in further trust, attention should
be paid to avoid the Delaware Tax Trap and to comply with
applicable rule against perpetuities constraints. Non pro
rata distributions upon termination may trigger a taxable
exchange if neither the trust instrument nor local law give
the trustee authority to distribute assets on a non pro rata
basis.
Mr. Aucutt briefly touched upon some practical problems with
dynasty trusts. He quips that a "pot" trust after
a few centuries will resemble a publicly owned corporationor
maybe even a public charity.
One practical problem is the record-keeping necessary to
track who the descendants are of some common ancestor if a
family line dies out 300 years from now. He promised that
more of these practical issues will be dealt with in tomorrow's
workshop.
Wednesday, January 7
Reporter: John Warnick Esq.
9:45 -10:30 a.m.
The Rules of Engagement:Managing Liability for Nonprofit
Boards
Kathryn W. Miree
Ms. Miree is the author of The Professional Advisors'
Guide to Planned Giving (Aspen Publishers, 2002) and
the co-author with Jerry McCoy of The Family Foundation
Handbook (Aspen Publishers, 2001).
Directors of nonprofit boards are facing incredible challenges
as they struggle to operate charities at a time when funding
is drying up, endowments are shrinking, criticism of nonprofit
misfeasance and malfeasance is high, and demand for accountability
is strident.
Nonprofit contributions are down in three areas: individual
gifts, foundation grants and government grants. Note: individual
contributions in 2002 were up .7% over 2001 but down .9% when
adjusted for inflation.
Investment markets have ravaged the reserves of charities.
Ms. Miree has seen the endowments of some charities shrink
by as much as fifty percent. Particularly hard hit have been
those charities whose boards weren't keeping a close eye on
their investment policy and investments
New nonprofits are emerging and old nonprofits are soliciting
funds for the first time. The number of traditional charities
has grown from 558,745 to 909,574 between 1994 and 2002.
The Sarbanes-Oxley Act reflects heightened expectations of
accountability for the corporate sector but these standards
may eventually be imposed on the nonprofit community. Ms Miree
suggests an excellent article on the Sarbanes-Oxley Act and
its
implications for nonprofit management is found at www.guidestar.org/news/newsletter/sarbanes_oxley.jsp
Ms. Miree uses the term "directors" to designate
the individual with responsibility for oversight and management
of a 501(c)(3) organization whether the charity's governing
documents refer to them as trustees or directors. The key
is the voting responsibility imposed upon the individual.
Ms. Miree's analysis and guidelines are not intended to apply
to "honorary" or "emeritus" directors
that do not have any voting power. Citing Black's Law
Dictionary, Ms Miree noted that directors are serving
in fiduciary capacities, managing the assets of the charity
for the public good. For the last several decades, the courts
have made a distinction between the trust and corporate form
or organization and have applied a less stringent standard
for nonprofit directors than trustees. See Stern v.
Lucy Webb Hayes National Training School for Deaconesses and
Missionaries, et. al., 381 F. Supp. 1003 (D.D.C. 1974).
There are two basic categories of duties that apply to directors:
codified and practical. The three primary codified duties
are: 1) duty of care; 2) duty of loyalty; and 3) duty of obedience
or adherence to the charity's governing documents and applicable
law.
Examples of the exercise of the duty of care include:
participation in board and committee meetings;
familiarity with the board's business plan and strategic
plan;
review of the charity's budget, fundraising results, financial
statements and investment returns;
review of minutes (which should be requested if not produced);
review of agents appointed by the charity to carry out delegated
duties and familiarity with policies governing the handling
of money and donations, asset management, employee management,
and other areas of risk; and
queries when necessary to clarify facts and form independent
judgment about decisions to be made.
Directors are not liable for decisionseven if such decisions
prove to be unwise in hindsightso long as the decisions are
informed, made in good faith, and without a conflict of interest.
The duty of loyalty requires a director not to vote on matters
affecting the nonprofit which in any way would benefit the
director personally at the expense of the nonprofit, not to
take excessive compensation, not to solicit or accept loans
from the nonprofit, and to reveal all conflicts or personal
benefits that may result from a vote of the nonprofit.
In addition to the duties imposed under state law, there
are four other sets of rules which impact a director's duty
of loyalty:
private foundation self-dealing rules under Internal Revenue
Code § 4941;
IRS intermediate sanctions for private inurement under §
4958;
state law governing nonprofit directors; and
state law governing trustees.
There are also practical duties incumbent on directors of
nonprofit organizations such as: 1)establishing the mission
and purpose of the entity; 2) selecting and evaluating the
executive officer(s); 3) ensuring continuity in operational
and strategic planning as well as perpetuation of the governing
body; 4) exercise of oversight of the organizational activities;
5) public relations; 6) ensure accountability to donors, the
public and the IRS; and 7) manage the charity's assets to
prevent theft, embezzlement or improper use of funds.
Ms Miree cited a recent article published in The Exempt
Organization Tax Review by Marion R. Fremont-Smith and
Andras Kosaras which compiled data regarding lawsuits and
similar proceedings brought against nonprofit directors and
managers for civil and criminal wrong-doing between 1995 and
2002. There were seven major categories or risk documented
in this survey.
1. Employee lawsuits are among the most commonly filed against
nonprofits. These suits ran the full gamut from ERISA, ADA,
Equal Pay Act claims, age discrimination, OSHA, COBRA, civil
rights claims, to Family Medical Leave Act violations.
2. Third-party liability for negligence or breaches of the
duty of care, conflict of interest, libel, slander, etc.
3. Investment management breaches.
4. Private inurement the use of charitable assets for the
personal benefit of directors.
5. State law violations such as failure to collect and submit
sales tax, pay property tax, satisfy audit requirements, register
under applicable charitable solication laws.
6. Failure to Comply with Federal Law such as IRS filings,
meeting employee obligations, substantiating gifts in excess
of $250 and complying federal postal laws.
7. Account for Funds. Directors are ultimately responsible
for oversight of the use of the charity's funds and for compliance
with the donors' instructions.
How can charities and their governing bodies manage these
risks? Four avenues of protection are available to the charity
and its directors: statutory protection; insurance, proper
policies and procedures, and proper operation.
In terms of managing risk through proper policies and procedures,
Kathryn suggested that nonprofits consider: 1) performing
an annual risk assessment by reviewing its internal and external
activities and exposure to list those activities creating
the greatest risk;
2) ensuring that policies and procedures are in place to manage
the identified risks; 3) adopt gift acceptance policies; 4)
annually review investment management policies in terms of
balancing risk and return, spending policies, asset allocation,
and return objectives; reviewing financial management policies
and controls on money movement; 5) adopting standards for
the confidentiality of records.
In terms of managing risk through proper operation, perhaps
the most important step is board structure. Kathryn thinks
that too large a board is not only unwieldy but promotes sleeping
through meetings. Reporting is also critical as is the director's
ability to ask questions and obtain meaningful answers. If
the charity is not willing to provide adequate information
or reports, the director should likely resign.
What is the legal advisor's role in advising clients on the
responsibilities for nonprofit management? The advisor should
help the director in understanding what his or her potential
liability is for serving on the board and assist in obtaining
protection for that service. The legal advisor should also
assess the liability, review policies, procedures and protections
that are in place and then guide the charity in obtaining
the necessary protection and safeguards to minimize the risks.
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