Are indemnity clauses a Trustee’s best friend or worst nightmare?

A trust is not a separate legal entity like a corporation or a partnership, therefore the trustees act in a personal capacity. Because the trustee is acting in a personal capacity, he or she is exposed to personal liability for all of his/her actions regarding administration of the trust. Settlors can mitigate such personal liability exposure by including a limiting provision in the trust to protect the trustee. Such provisions are known as indemnity or exculpatory clauses. Samples if such provisions include “except for gross negligence or willful misconduct, Trustees shall not be liable for any act or omission or error of judgment.” Courts have interpreted these clauses in holding that only acts of the trustee that constitute gross negligence, willful misconduct, or bad faith would give rise to personal liability.  In Martin v. Ward, the Court held that “as long as the exculpatory clause does not attempt to completely relieve the trustee of the duty to act in good faith, it may relax the standard of care. Exculpatory clauses are to be strictly construed, but not to the point that they are unenforceable. Therefore, the exculpatory clause in this case relieves the Bank of liability for discretionary decisions unless they constitute gross negligence, willful default, or bad faith.”  Martin v. Ward, 132 Wash. App. 1025 (2006). In New York, the Court ruled that  “no matter how broad [an exculpatory] provision may be, the trustee is liable if he [or she] commits a breach of trust in bad faith or intentionally or with reckless indifference to the interests of the beneficiaries, or if he [or she] has personally profited through a breach of trust” (O’Hayer v. de St. Aubin, 30 A.D.2d 419, 423, 293 N.Y.S.2d 147) In re Mankin, 88 A.D.3d 717, 719, 930 N.Y.S.2d 79, 80 (2011).

Given the interpretation of indemnity clauses by courts, trustees may feel they are relatively safe from being held personally liable. However, given the diverse and broad variety of duties for which a trustee has responsibility, which include: 1) administering the trust according to its terms; 2) prudently managing trust assets in alignment with investment objectives and fulfilling the trust terms regarding beneficiary distributions; 3) making distributions of trust assets to the beneficiaries for the purposes outlined in the trust; 4) accounting for and reporting trust assets, including preparing necessary tax filings; and 5) Managing professionals involved to fulfill the trustee’s responsibilities and to educate the beneficiaries in the matters of managing family wealth – a novice trustee may inadvertently cause harm to one or more of the beneficiaries. This harm, if it includes a financial loss, could give rise to a lawsuit brought by a beneficiary seeking to be made whole.

Let’s look at three areas that affect every trust and present fertile ground for plaintiff attorneys seeking a payday. These areas are income tax management, investing of trust assets, and trust distributions among various beneficiaries and between classes of beneficiaries.

Income tax management:

We live in a country, the U.S.A., where we currently have the government spending 2.966 TRILLION dollars more than their annual revenue, the total accumulated debt at almost 29 TRILLION dollars, and the total unfunded debt at a whopping 85 TRILLION dollars. (As of 11/16/2021 I would venture a guess that no one reading this article believes this can continue in perpetuity. So, what are the options available to the government? That’s common sense, right: first – Spend Less; second – Raise Revenue, and third – do a combination of the first and second options. Ok, by a show of hands, how many of you believe the federal government will close the annual deficit by merely cutting expenditures? What!! No hands up, I totally agree with you. I believe the government will opt to Raise Revenue to some extent, a.k.a. Raise Taxes. This means income tax planning will take on a new level of importance and focus for all income taxpayers, including trusts and beneficiaries.

A trustee (fiduciary) must walk a fine line when it comes to the administration of trusts.  There are competing interests among the various classes of beneficiaries, particularly income beneficiaries vs remainderman beneficiaries. The trustee (fiduciary) must understand that every transaction incurred by the trustee (fiduciary) on behalf of the trust, (payment of expenses, management of and investing trust assets, and distributions) has an income tax effect, therefore stressing the need for trustees (fiduciaries) to be proactive regarding income tax planning before making trust decisions.

Let’s review two fiduciary duties that a trustee has. First, there is a duty to keep adequate records and maintain the segregated identification of trust property.  UTC § 810.  The first part of this duty is to keep sufficiently detailed and adequate records, which enable the trustee to fulfill his/her fiduciary duty to inform and report to the beneficiaries as discussed above. UTC § 810 (a).  Secondly, there is a duty of impartiality. Whenever there are two or more beneficiaries, a trustee is under a duty to deal impartially with them. Restatement of Trusts 3d: Prudent Investor Rule at 183 (1992). This rule applies whether the interest of the beneficiaries in the trust are concurrent or successive. If the terms of the trust give the trustee discretion to favor one beneficiary over another, a court will not control the exercise of such discretion, except to prevent the trustee from abusing it. Id. at 183, Comment a.

In the context of the above-stated fiduciary duties, let’s review common decisions that a trustee (fiduciary) must make on a yearly basis.  Typically, each year the trust will have income (dividends, interest, capital gains and potentially other income such as rent) and expenditures, such as trustee, CPA, attorney, registered investment advisor, and asset custodial fees, income taxes, and many other potential expenses that may be incurred. Each one of those income or expenditure items must be allocated between the income and principal of the trust. This allocation is critical for two reasons, which include income taxes and beneficiary benefits.

For simplicity’s sake, let’s assume the trustee allocates dividends and interest to trust income and capital gains to trust principal. The trustee must then allocate trust expenditures between trust income and principal.  Such allocation will then be used to prepare the trust income tax return. The basic formula is trust income minus deductible expenses, minus trust distributions to the beneficiaries results in taxable income to the trust. Any income retained by the trust would then be subject to income taxes.  Any income taxes due would then be paid from trust assets, effectively diminishing such assets from future income and capital appreciation earnings. This is significant because of the high rate of trust income taxation.  According to the IRS, for the 2022 income tax year, the highest income tax rate for those filing married joint returns is 37% on incremental income above $647,850.  The comparable IRS rate for trusts it is 37% on incremental income above $13,450.   In comparison, for 2022, the highest capital gains tax rate for couples filing married joint returns is 20% on incremental income above $517,200.  However, the 2022 rate or trusts is 20% on incremental income above $13,700.  Such a  significant difference in the taxation rates has a profound effect upon the potential accumulated value of the trust. To quantify the difference between taxable and tax managed pure growth accumulation, $10,000 taxed at the 20% maximum capital gains rate, net of taxes invested for 20 years at a 5% annual rate of return, would be the difference between an accumulated balance of approximately $560,000, as opposed to $409,000 taxed at 20%.  The resulting difference in tax treatment is approximately $150,000.  At a 10% annual rate of return, the difference would be between an accumulated balance of approximately $1,803,000, as opposed to $1,173,000 taxed at 20%.  The resulting difference in tax treatment in this equation is approximately $630,000.  That resulting difference of $630,000 is only as to  $10,000 annually of capital gains taxed at 20%, accumulated annually for twenty years.  If the trust was larger and the capital gains were 10 times larger at $100,000 per year, the resulting difference would now be 10 times greater, $1,500,000 at 5% and $6,300,000 at 10%.

It is simply astounding how small and perhaps even reasonable, decisions on an annual basis could wind up costing the beneficiaries millions when compounded over a longer time horizon.  This stark difference captures the quintessence of the complexity of trust administration and demands the integrated and coordinated management of taxes, investing, and distribution management.

Investing of trust assets:

The Uniform Prudent Investor Act of 1994 (UPIA) states in § 1 (a) “a trustee who invests and manages trust assets owes a duty to the beneficiaries of the trust to comply with the prudent investor rule set forth in this [Act]” except (b) “the prudent investor rule, a default rule, may be expanded, restricted, eliminated, or otherwise altered by the provisions of a trust. A trustee is not liable to a beneficiary to the extent that the trustee acted in reasonable reliance on the provisions of the trust.”

The most important section of the UPIA is § 2, the heart of the UPIA.  This section provides that a prudent investor should manage trust assets by considering the purposes, terms, distribution requirements, and other circumstances of the trust while exercising reasonable care, skill, and caution. UPIA § 2(a). This section is modified in the event the trustee has special skills or expertise, which then places a duty upon the trustee to utilize those special skills or expertise in managing the trust. UPIA §2(f).  Thus, the standard of prudence is relational – the standard for professional trustees is the standard of prudent professionals; the standard for amateur trustees is that of prudent amateurs.  The investment decisions and considerations outlined should not be made based on individual assets, but on the overall investment strategy of the portfolio having risk and return objectives reasonable suited to the trust.  §UPIA 2(b).  The other circumstances a trustee should consider relevant to the trust or its beneficiaries are 1) general economic conditions; inflation or deflation; tax consequences; 2) the role each investment plays within the overall portfolio; 3) expected return from income or appreciation; 4) other resources of the beneficiary; 5) needs for liquidity, income, and the preservation or appreciation of capital; and 6) if an asset has a special value to the purposes of the trust or to one or more of the beneficiaries. UPIA §2(c)

What investment strategy should be used by the trustee as an investor? The trustee should diversify to reduce risk. The current standard in diversification is an investment process called the theory of efficient markets, or Modern Portfolio Theory (MPT). Four Nobel prizes in economics have been awarded for the academic research that identified and verified the theory of efficient markets, which include those given to Franco Modigliani of MIT (1985), Harry Markowitz of CUNY (1990), Merton Miller of The University of Chicago (1990), and William Sharpe of Stanford (1990).  In essence, MPT divides risk into two  categories, compensated and uncompensated risk. The more diversification you have, the less uncompensated risk your portfolio would contain, and therefore be more prudent. By accepting only risk that you would be compensated for, your portfolio would be more efficient by maximizing the projected return for a given level of accepted risk.  The main investment vehicles used to achieve such diversification in MPT are usually index funds or mutual funds for the vast majority of trusts. Such pooled investment funds would offer greater diversification and lower cost than one could achieve purchasing individual stocks and bonds in the trust.

But what if the trust terms specify a specific type of investment only?  For example, restricting the trustee to only making investments in investment grade corporate and U.S. bonds.  What can the trustee do to allow him/herself to invest in a broadly diversified portfolio in accordance with the UPIA and MPT?  To deviate from the administrative and investment provisions of the trust instrument or from the administrative provisions of the Trust Code, the trustee must obtain judicial authority. Read v. U.S. ex rel. Dep’t of Treasury, 169 F.3d 243, 251 (5th Cir. 1999).  Courts have been reluctant to second-guess a settlor’s  wishes as to the type of investments allowed as written into the trust document.  Only in exceptional circumstances or in cases of emergency, urgency, or necessity, will courts sanction deviation from a settlor’s intention as to the scope of investment of trust funds.  This cardinal rule is evidenced by the language of the trust instrument, and even if the settlor could not have foreseen changed circumstances, courts will not authorize deviation from such trust terms, unless it is reasonably certain that the purposes of the trust would otherwise be defeated or impaired in carrying out the settlor’s dominant intention. In re Trusteeship under Agreement with Mayo, 259 Minn. 91, 105 N.W.2d 900 (1960).  Courts have placed significant emphasis on fulfilling the purposes of the trust, The Missouri Supreme Court, per Justice Hyde, held that authorization for deviation from investment restrictions in trust agreements that required trustees to invest trust funds, accumulated from deposit of a portion of cemetery lot sales, in government bonds and notes secured by first mortgage on real estate was not justified (although trust was perpetual, the investment return did not exceed 3.10% in last six years, and investment in such real estate mortgages was virtually impossible during the time the settlor established the trust) in the absence of a showing that income was not sufficient to accomplish the purpose of trust,  which was to maintain and beautify the cemetery. Troost Ave. Cemetery Co. v. First Nat Bank of Kansas City, 409 S.W.2d 632 (Mo. 1966).

Due to the difficulty in deviating from any investment restrictions contained in the trust document, the best cause of action when reviewing a trust that could still be altered by the Settlor, is to allow the trustee flexibility to change investment strategies or mandate adherence to MPT for a broadly diversified long term investment portfolio.

Trust distributions: 

The trustee shall distribute trust assets according to the terms contained in the trust document. Traditionally, the trust terms provided what named or class of beneficiaries could receive distributions for both income and/or principal distributions. Beneficiaries typically consist of a spouse and/or descendants. Common trust distribution patterns are either: 1) all income to a specific beneficiary (a surviving spouse), with the trustee also having the discretion to distribute principal to either the income beneficiary alone or coupled with the ability to make discretionary distributions to the remainder beneficiaries also; and/or 2) allowing the trustee complete discretion to distribute income and/or principal to any beneficiary.

There is always a tension between income and principal beneficiaries. The trustee must find the appropriate balance between different classes of beneficiaries in order to fulfill the trustee’s duty to protect the interest of each class. The Trustee faces a heightened level of potential liability in this context.  For example, it is common for a surviving spouse as the sole income beneficiary to request from the trustee more trust income distributions so as to meet the lifestyle needs of said surviving spouse.  In response, the trustee might invest all trust assets in bonds to increase current trust income, which would be greater than the income generated by a balanced diversified portfolio of stocks and bonds. However, the trustee must analyze the cost of such a solution.  The maximization of income for a surviving spouse would result in preventing the remaining principal to grow with inflation.   Such a result would harm the remainder beneficiaries, because their remainder interests would decrease over time by not keeping pace with inflation. In such a scenario, the remainder beneficiaries may have a cause of action for breach of fiduciary duty, because the trustee did not protect their interests and instead favored the income beneficiary.  The Court in New York opined “[n]o matter how broad [an exculpatory] provision may be, the trustee is liable if he [or she] commits a breach of trust in bad faith or intentionally or with reckless indifference to the interests of the beneficiaries, or if he [or she] has personally profited through a breach of trust” (O’Hayer v. de St. Aubin, 30 A.D.2d 419, 423, 293 N.Y.S.2d 147[internal quotation marks omitted]. In re Mankin, 88 A.D.3d 717, 719, 930 N.Y.S.2d 79, 80 (2011).

The scenario above might be considered gross negligence and as such not covered by an indemnity clause to limit the personal liability of a trustee. That would be a question of fact for a jury, unless the trust document specifically stated the trust must invest in bonds only. Otherwise, a reasonably prudent person would realize that investing solely in bonds would not have any inflation protection and potentially put the remainder beneficiaries at risk. This could also put the income beneficiary at risk due to a decrease in the value of the income being distributed annually because of inflation.

As detailed above, a trustee has an enormous responsibility to balance these areas of income tax management, investment of trust assets, and trust distribution among various beneficiaries and between classes of beneficiaries. In making such decisions, the trustee is facing personal liability, and so  must consider doing whatever possible to mitigate personal exposure. From a financial planning standpoint, such risk of liability can be substantially limited, if not eliminated, by the purchase of fiduciary insurance, such as that offered by The Private Trust Consortium.

Transferring retained risk.  From a financial planning standpoint, with the risk and personal liability inherent in serving as a trustee, the purchase of fiduciary insurance is undoubtedly worth a quarter of 1% to protect the other 99.75% of a trust’s assets AND protect the trustee from personal liability in the event a claim is made for the trustee’s alleged failure to fulfill a fiduciary duty. Litigation cost can be a substantial burden if they must be paid out of pocket by the trustee BEFORE the trustee can possibly be reimbursed by trust funds. The trustee must keep in mind that all states give courts tremendous latitude in determining whether a breach of fiduciary duty occurred and who should bear the cost of litigation. A court can rule that even though the trustee prevailed in a litigation, the trustee must bear the cost of litigation personally, because there was a reasonable basis for the beneficiaries claim. The Uniform Trust Code provides that reimbursements may include attorney fees and expenses incurred by the trustee in defending an action. However, a trustee is not ordinarily entitled to attorney fees and expenses, if it is determined that the trustee breached his/her fiduciary duty to the trust. See 3A Austin W. Scott & William F. Fratcher, The Law of Trusts § 245 (4th ed. 1988). Uniform Trust Code (2010) § 709 Comment.

Limiting a trustee’s risk. A trustee is highly recommended to do the following:

  1. Keep detailed records and provide an accounting at least annually to the beneficiaries;
  2. Retain a competent tax professional to prepare the necessary tax returns AND to proffer tax advice;
  3. Retain a competent investment advisor to create an investment policy statement based on the modern portfolio theory, so as to maximize the return, given the risk assumed, and
  4. review that performance of the investment advisor and in so doing compares his/her performance to the industry standards, factoring the cost (which should be reasonable) to achieve those rates of return;
  5. Have an annual meeting with the beneficiaries, both current and contingent, to review the trust assets, investment policy, income, expenses and distributions, to keep them informed of the decisions involving the trust.

The modern world is more complex and specialized than ever before.  Thus, it would greatly benefit a trustee to make use of the resources of an organization such as The Private Trust Consortium for assistance and education regarding a trustee’s fiduciary duties.  The purchase of fiduciary insurance and an Onboarding Report specifically tailored to the trust to be administered by the trustee is a great place to start!!!