A practical guide to trustee selection: a review of the most common tax (and nontax) traps.

• Author: Parthemer, Mark R.

When it comes to modern-day estate planning, trusts invariably are an integral part of the structure. In the authors' daily reviews of trusts, they have found that thoughtful planning can at times be rendered problematic due to trustee selection. The consequences can range from inefficient income taxation to gift and estate tax inclusion. Some overt; others lurk in the shadows. There are three perspectives embedded in designing an effective trust strategy: the settlor, the beneficiary, and the trustee. This article touches on the beneficiary and trustee perspectives, but focuses on six key issues from the settlor's perspective when advising clients on trustee selection.

Before assessing these issues, it is important for advisors to be familiar with four fundamental Internal Revenue Code (I.R.C.) sections. (1)

What You Must Know About I.R.C. [section][section] 672, 2036, 2038, and 2041

I.R.C. [section] 672 provides a frequently used and effective safe harbor. It indicates who will be deemed independent if appointed as trustee, cleansing certain potential inclusion concerns (e.g., absolute discretion and trustee removal). To fit within this safe harbor, one first must determine if the individual is adverse, and if not, then if they are related or subordinate. An "adverse party" is someone who has a substantial beneficial interest in the trust that would be adversely affected by his or her exercise or nonexercise of the power impacting the trust and has a general power of appointment over trust property. (2) A "related or subordinate party" is a nonadverse party who is 1) the grantor's spouse, if living with the grantor; 2) the grantor's father, mother, issue, brother, or sister; 3) an employee of the grantor; 4) a corporation or any employee of a corporation in which the stock holdings of the grantor and the trust are significant from the viewpoint of voting control; or 5) a subordinate employee of a corporation in which the grantor is an executive. (3)

I.R.C. [section][section] 2036 and 2038 cause inclusion in the gross estate under certain circumstances. I.R.C. [section] 2036 causes inclusion in the gross estate the value of all property to the extent the decedent has made a transfer outright or in trust and "retained" the possession or enjoyment of, or the right to the income from, the property, or the right (either alone or in conjunction with any person) to designate the persons who shall possess or enjoy the property or the income from the property. I.R.C. [section] 2038 requires inclusion in the gross estate of the value of all property to the extent the decedent made a transfer outright or in trust and either retained power, either alone or in conjunction with any person to alter, amend, revoke, or terminate enjoyment of the property, or relinquished such a power within three years of his or her death. For both I.R.C. [section][section]2036 and 2038 there is a key exception for a bona fide sale for a full and adequate consideration. (4)

I.R.C. [section]2041 provides that the gross estate includes the value of all property to which the decedent at death had a general power of appointment or at any time exercised or released such a power by a disposition, which if it were a transfer of property owned by the decedent, would be includible in the decedent's estate under I.R.C. [section][section] 2035-2038, inclusive.

A general power is one that can be exercised in favor of the decedent, the estate, creditors, or the creditors of the estate. Exceptions include 1) a power limited by an ascertainable standard relating to the health, education, support, or maintenance; (5) and 2) a power only exercisable in conjunction with the grantor of the power or someone with an adverse interest. (6)

The Beneficiary

A beneficiary/trustee's power to distribute to self should be limited by an ascertainable standard and prohibit satisfying self's support obligations of another. Additionally, a beneficiary/trustee's power to distribute to others should also be limited by an ascertainable standard. With respect to removal and replacement of a trustee, a beneficiary's power, whether or not the beneficiary is a trustee, should either be under a trust with distributions limited by an ascertainable standard or limited to the successor being independent per I.R.C. [section]672(c).

The Trustee

The trustee must have legal capacity--age of majority for an individual and trust powers if an entity. Being organized as a bank does not automatically provide trust powers, and being state chartered restricts the powers to such state. A trustee should also have all the proper attributes, including sound judgment, impartiality, financial ability, loyalty, and trustworthiness and be excused from self-dealing, when appropriate. The optimal trustee would be located in a state with laws in furtherance of the purpose of the trust, such as income tax, creditor rights, and rule against perpetuities. This suggests that "situs" shopping when picking a trustee can be important.

The Settlor

The settlor must relinquish control to ensure funding is a completed gift. The transfer to a trust may or may not be a completed gift, based on the trust terms and the identity of the trustee. (7) If there is a completed gift initially, immediate gift tax could be due, based on the size of the gift. However, if the gift is not complete initially, the assets--including subsequent appreciation --will be included in the settlor's estate upon completion of the gift. (8)

The gift tax is applied to "direct or indirect" gifts of property whether in trust or otherwise. (9) The Treasury Regulations add that a gift may be complete even if, at the time it is made, "the identity of the donee may not ... be known or ascertainable." (10) However, the Treasury Regulations provide that a gift will not be complete for gift tax purposes if certain powers are retained by the settlor as a trustee, or in some situations as a co-trustee, until the retained interest or power is relinquished.

The settlor must not retain possession, enjoyment, or income, regardless of who is trustee. A transfer is a completed gift only to the extent that the settlor "has so parted with dominion...