3.1.5 Selecting the Trustee

There are three general options for trustee of a charitable trust. These are a corporate trustee, a charity serving as trustee or a private individual trustee. Before the trust is funded, the donor should understand the three options sufficiently well to make a reasoned decision. There are benefits of each of the three options and circumstances in which one of the three is preferred over the others. Advisors need to explain these options and benefits to donors so they can make a proper choice.

Corporate trustees include banks, trust companies and the trust departments of major financial firms. All three generally share the following advantages.

First, the corporate trustee is objective. If there are significant trust assets, several family members may be income recipients. There may also be some family members who are not income recipients or are discretionary income recipients. Finally, several charities could be remainder recipients.

The objective nature of a corporate trustee makes this choice very desirable for large trusts, particularly where there may be contentious family members. The corporate trustee has no vested interest in the income or remainder of the trust and being objective is a significant advantage in balancing interests of the various parties.

Corporate trustees also have expertise in taxation, investments and, in many cases, charitable trusts. Over the past decade, the competition in financial services has resulted in considerably improved rates of return. Corporate trustees also have a standard structure for sharing information with trust recipients.

Is there a cost for corporate trust services? Yes; corporate trustees will typically charge from 1% to 1.2% per year for their management, tax and investment services. For very large trusts, these rates may be negotiated to lower levels with some trustees. Given the cost structure of a corporate trustee, the lower limit for trusts is perhaps $300,000 and the trust administration fees become more sustainable with a trust corpus of $1 million or more.

Why would a charity desire to serve as trustee? When an organization serves as trustee, there is always potential liability. In addition, the charity has an obvious conflict of interest. The family will receive the income payments, while the charity will receive the remainder interest.

Charities who serve as trustee typically do so because they wish to have the opportunity to build a relationship with the donors. If the charity does a satisfactory job, then the donors will be pleased with the result and also will have regular and periodic contact with the charity.

Many larger charities do indeed serve as trustee. They have sufficient staff to provide good investment and tax services. The trustee/charity perceives it to be in its best interest to manage the trust well and produce growth in the trust. This growth both increases the income of the recipients and also potentially provides larger corpus for future distribution to the charitable remaindermen.

Many charities provide trust services at low cost. In addition, some charities that are irrevocably vested with 50% or more of the trust corpus will provide trust services at no cost.

A new or small charity should exercise great care before accepting the responsibilities of trusteeship. Most charities that are new to the gift-planning field will find that their resources are much more productively used in marketing, rather than trust administration. In addition, accepting the role of trustee is a major responsibility, with significant potential liability risk. A charity should not serve as trustee until the Board of Directors of the charity is committed to providing ample resources to fulfill all trustee functions and responsibilities.

The private trustee has historically been the least frequently used method, but it is growing in popularity. A private trustee permits the donor to have a great deal of flexibility and control over the administration and investments of the trust. However, it also involves a significant level of responsibility for the donor or other person serving as trustee of the trust. As noted below, there are significant risks and penalties if the trust is not administered appropriately.

Private trustees must have good counsel from their attorneys, CPAs and investment advisors. The private trustee needs to understand the numerous rules that apply to charitable trusts. For example, charitable trusts are subject to self-dealing rules under Sec. 4941. This means that the donor and children, grandchildren, spouse or other disqualified person cannot buy, sell, lease or otherwise transact business with the trust.

The trust should not make any investments under Section 4944 that jeopardize the charitable remainder. If the investment advisor recommends high quality stocks and bonds, this is typically a relatively innocuous rule. However, some investment advisors have suggested options, puts, calls, working interests in oil and gas, limited partnerships and other types of investments. With the exception of the covered call used with high quality stock, most of these other options should be avoided.

The trust CPA should make certain that the Form 5227, trust information tax return, is filed by April 15th after the close of each trust year. With good management, there will be no unrelated business taxable income and Form 4970 for trusts with unrelated business taxable income will not be required.

In Estate of Melvine B. Atkinson v. Commissioner, 115 TC. No. 3, No. 20968-97 (July 26, 2000), the Tax Court held that an estate tax deduction would be denied for an annuity trust that never made payments. The annuity trust was funded with $3,999,974 by Melvine B. Atkinson in 1991. She passed away approximately two years later in 1993. The Tax Court noted that a charitable annuity trust under Sec. 664(d)(1) must pay out at least 5% of the initial net fair market value of trust assets. The requirement for the payout was deliberately created by Congress to minimize the risk that donors would use a charitable remainder trust as a substitute for a private foundation. See S. Rept. 91-552 (1969), 1969 3 C.B. 423, 481. Thus, the Tax Court determined that an annuity trust that had made no payments failed to qualify under Sec. 664 requirements. A second status for disqualification was the invasion of the trust to pay estate taxes. Under Rev. Rul. 82-128, 1982-2 C.B. 71, charitable remainder trusts are not permitted to pay estate tax out of the trust. The beneficiaries must make tax payments out of other assets or out of the residue of the estate. Since no trust payments were made and since the trust corpus was invaded for payment of estate taxes, the trust was not qualified as an annuity trust.

In the Atkinson case, there was essentially zero compliance. The trustee did not make the trust payments, did not file the trust returns and for all intents and purposes acted as if the trust did not exist. Therefore, the Tax Court had ample grounds to disqualify or disregard the existence of the trust.

In Reg.1.664-3(a)(1)(i)(g), the Service notes that there is, in effect, a safe harbor created if the CRT complies with the payment requirements. The regulations also make explicit provision for overpayments and underpayments. See Reg. 1.664-3(a)(2).

While in Atkinson there was essentially no compliance, most trusts will have 85% - 95% compliance with the IRC and regulations. Since there is explicit authorization in Reg. 1.664-3(a) for correction of overpayments and underpayments, a trustee that takes action within a reasonable time to correct those payments should not be subject to penalties. While payments would normally be made by April 15th of the following year under Reg. 1.664-3(a)(1)(i)(h), the Code does not explicitly require payments within that time. Thus, a number of trustees faced with errors in payments have adjusted payments over 12, 24 or even 36 months. There is no explicit permission or prohibition for this practice.

For most trustees, the Atkinson decision should be cautionary, but will not dramatically change existing trust practices. Most annuity trusts are in substantial compliance. Corporate trustees normally invest in high quality stocks and bonds and have a very high level of compliance with all requirements. While larger charities approach the corporate standards in compliance; smaller charities tend to have greater diversity and more often make incorrect payments, fail to calculate makeup amounts correctly and may neglect to file the 5227 returns. Private trustees have the lowest levels of quality control, the greatest diversity and the least experience in this area. Thus, the private trustees are more likely to be in violation of the various rules.

While all private trustees and smaller charities should take the Atkinson decision seriously, it does not fundamentally change any law. The Atkinson case is very different from normal trust administration. Historically, there have been numerous trustees who make errors in calculation of payments, but these nearly always come squarely within the explicit provision within the regulations and revenue rulings for corrective payments. So long as corrective payments are promptly made, there should be no disqualification of the annuity trust or penalties assessed.