Trust Us – It's Not As Simple As You Think: Fundamental Issues in Trustee Litigation

Authors: Jerome C. Wegley and Neal R. Devlin

Originally published in October 2018

Copyright © 2018 Knox McLaughlin Gornall & Sennett, P.C.

This article has not been updated for current law since the date of its posting on the website. This article is not intended to provide any legal advice. Please seek advice of your professional council.

Any U.S. federal and state tax advice contained in this communication is not intended or written by the Knox Law Firm to be used, and cannot be used by you, for the purpose of: (i) avoiding penalties under the Internal Revenue Code that may be imposed upon you, or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.

Trustee's Duties

Summary of Duties

A trustee has many duties. The specific acts required of a trustee are spelled out in a few sections of the Pennsylvania’s Uniform Trust Act. However, most are derived from the broad language contained in the sections of Chapter 77 of Pennsylvania’s Uniform Trust Act and many more are created when a trustee exercises its powers. The Pennsylvania’s Uniform Trust Act imposes on a trustee the:

1. Duty to Administer
2. Duty of Loyalty
3. Duty of Impartiality
4. Duty of Prudent Administration
5. Duty to Use Special Skills
6. Duty to Control and Protect Trust Property
7. Duty to Keep Records and Identify Trust Property
8. Duty to Enforce and Defend Claims
9. Duty to Inform and Report
10. Duty to Exercise Discretionary Powers in Good Faith

Origin of Duties

A trustee’s duties originate from the statutory laws. In Pennsylvania, the law is found in Title 20, Chapter 77, Subchapter H.

Uniform Trust Code (“UTC”). The Uniform Trust Code is a codification of all of the states’ common law dealing with trusts and consists substantially of default rules.

Pennsylvania Uniform Trust Act (“UTA”). Pennsylvania enacted the Uniform Trust Act on July 7, 2006. The UTA incorporates most of the UTC provisions.

Modifying Duties By Agreement

The UTA provides that, with exception to a few sections of the Act, all provisions of the Act may be modified by the trust instrument. Neither the trustee’s duty to act in good faith and in accordance with the purposes of the trust (Duty to Administer) nor the trustee’s duty to inform and report to beneficiaries can be modified.

Enforcement of Duties

The beneficiaries, including the Attorney General for charitable beneficiaries, have the standing to hold the trustee accountable to meet the standard of each respective duty. Claims against a trustee by beneficiaries for breach of a duty are most appropriately brought in the Orphans’ Court. Trustees may have to resort to legal proceedings to fulfill their obligations. Claims by a trustee necessary to carry out its duties are brought in the appropriate court (e.g. bankruptcy, criminal, state, federal) depending on the underlying claim and parties involved.

Duty of Loyalty

Scope of Duty

A Trustee shall administer the trust solely in the interests of the beneficiaries. A transfer of property between the trust and the trustee (or an affiliate of the trustee) is voidable by a court unless the instrument permits, the court approved, the beneficiaries consented, or did not timely object to the transfer. A transaction between a trustee and a beneficiary regarding non-trust property is also voidable by a court unless the trustee can prove that such transaction was fair. A trustee cannot usurp an opportunity and must act in the beneficiary’s best interest when exercising control over business interests.

Exculpatory Provision

A provision relieving a trustee of liability for breach of trust is enforceable unless, it relieves breaches committed in bad faith or reckless indifference to the purposes of the trust or the interest of the beneficiaries, or was improperly inserted by the trustee.

Self-dealing. A corporate trustee was surcharged for purchasing mortgages which it formerly held in its commercial department. The court noted that the prohibition against self-dealing is absolute and cannot be excused by good faith or fair consideration.

The line between self-dealing and appropriate commissions: Often focuses on intent.

Duty to Administer

Scope of Duty

A trustee shall administer the trust as a prudent person would, by consideration of the purposes, provisions, distributional requirements and other circumstances of the trust and by exercising reasonable care, skill and caution. This is considered a fundamental duty of a trustee. It does not depend on whether the trustee is receiving compensation.

The standard employed is meant to give due consideration to the purpose of the trust, which is a deviation from the previous standard contained in the Restatement (Second) of Trusts.

This duty can be modified by the settlor, but the settlor cannot exculpate a trustee from liability for actions committed in bad faith or in reckless indifference to the purposes of the trust or to the interests of the beneficiaries. The trustee must keep adequate records of the administration of the trust, and must keep trust property separate from the trustee’s own property.

Relationship to Prudent Investor Rule

The standard used for trustees is intentionally similar to the prudent investor rule, which requires a fiduciary to exercise reasonable care, skill and caution in implementing investment and management decisions. This standard also requires that a fiduciary who holds itself out as having special investment skills (e.g. a corporate trustee) shall exercise those skills.

Case Study 1: The Opportunistic Beneficiary: A family trust was being administered during the stock market crisis of 2008. As a result of the corporate trustee’s investment decisions, the trust’s corpus suffered $9,500,000 in losses. The beneficiaries sought to surcharge the corporate trustee. Because the language of the trust granted the trustee significant discretion, and because the trustee did not abuse that discretion or act in dereliction of its duties, there was no surcharge.

Case Study 2: Know your beneficiaries: A trust was originally funded with certificates of deposit and a significant number of shares of one publically traded company. After the settlor died, her spouse became the life tenant of the trust, with the trust terminating upon the spouse’s death, and the assets being liquidated to be distributed to the couple’s children. A corporate trust officer took over the management of the trust, which then had an objective of safety and income. He immediately changed that objective to balanced. This change resulted in him converting dividend producing assets, and assets with significant cash value, to investments with a longer term horizon. The Trust Officer was not aware that, shortly before he took on management responsibilities, the life tenant experienced a severe decline in his health. Shortly after the trust officer made the changes, the life tenant died. His changes resulted in a material reduction in the present value of the trust, which, per its terms, had to be liquidate. The corporate trustee was surcharged for this action.

Duty of Impartiality

Scope of Duty

The trustee shall act impartially in investing, managing and distributing the trust property, giving due regard to the beneficiaries’ respective interests in light of the purposes of the trust. A trustee does not have to treat the beneficiaries equal, but rather equitably in light of the purposes of the trust.

This duty applies to all aspects of trust administration and to decisions by a trustee with respect to distributions. An identical duty is included in the Prudent Investor Act but deals only with respect to the investment and management of trust property. “The differing beneficial interests for which the trustee must act impartially include those of the current beneficiaries versus those of beneficiaries holding interests in the remainder; and among those currently eligible to receive distributions. In fulfilling the duty to act impartially, the trustee should be particularly sensitive to allocation of receipts and disbursements between income and principal and should consider, in an appropriate case, a reallocation of income to the principal account and vice versa”.

Courts will not disturb a trustee’s exercise of discretionary powers unless the trustee abuses that discretion through dishonesty, improper motive, failing to use his judgment, or acting beyond the bounds of reasonable judgment.

Settlor Intent and Other Factors Affecting the Trustee’s Duty

Settlor’s intent undetermined: Absent any indication to the settlor’s intent, trust assets are to be used before the beneficiary’s resources. In Richey’s Estate, Pennsylvania’s Supreme Court upheld that the trial court’s decision to reimburse the deceased lifetime beneficiary’s estate from the trust created by her deceased husband for costs of her “comfortable maintenance and support” not paid by the trust over the 37 years of its existence; despite the fact that she was able to provide for own maintenance and support.

Settlor’s intent interpreted: In re Trust under agreement of John H. Ware, John Ware IV was the beneficiary of seven different trusts by his parents and grandparents. Three trusts required that all income be paid to Ware and that principal may be distributed at the trustee’s discretion for the welfare, comfort, support and education of Ware or Ware’s children. The other four trust’s provided that income and principal may be distributed at the trustee’s discretion for the welfare, comfort, support and education of Ware or Ware’s children. Ware’s children were the remainder beneficiaries of all seven trusts. All seven trusts contained identical spendthrift provisions.

The trustees historically distributed all of the income from all seven trusts to Ware; approximately $600,000 quarterly. Ware and his wife divorced and entered into a property settlement agreement in which Ware agreed to pay his wife $3,440,000 in full settlement. Ware requested the trustees distribute income and principal from the trusts to satisfy this obligation. The trustee declined this request and ceased all distributions except mandatory income distributions required by the three trust. The trustee further insisted that Ware submit invoices for payment for all future requests for distributions. Ware quickly defaulted on his obligations and was subsequently held to be in contempt for such default.

The trustee argued that the spendthrift provision prevented the distributions of income because the distributions would not be in Ware’s “welfare” because the property settlement agreement was an alienation of the trust’s income and Ware’s contempt could not result in incarceration (as Ware alleged). The Superior Court held that this was a misinterpretation of the spendthrift rule and that the trustee acted beyond the bounds of reasonable judgment. The spendthrift clause protects the income and principal from creditors only until delivered to the beneficiary; and Ware could absolutely go to jail for contempt.

The Superior Court however further ruled that the trustee acted properly and within reasonable judgment in not distributing, for the identical purposes, the principal of the trusts. The trustee’s interpretation of the settlors’ intent of all seven trusts – based on the “general scheme which is assumed in these kinds of trusts” – was that Ware receive the income and his children receive the principal; and that distributions of principal to Ware, even though permitted, would compromise the remainder beneficiaries.

Thus, a settlor’s intent can be gleaned from the “general scheme” of a trust and control distributions of income and principal. A Settlor’s intent being paramount to almost all other factors a trustee must consider, leads to the conclusion that principal distributions to prevent potential incarceration of a beneficiary are outweighed by the harm to remainder beneficiaries due to the reduction in principal available for the remainder beneficiaries.

This is not to say that this is the rule in every case with similar facts. It is consistent with the rule that the courts will not interfere with the trustee’s discretion if its judgment is within the bounds of reasonable judgment, and not driven by dishonesty or improper motive. In fact, a different trustee could conclude principal distributions are appropriate and still be within the bounds of reasonable judgment.

Costs of Administration

Scope of Duty

In administering a trust, the trustee may incur only costs that are reasonable in relation to the trust property, the purposes of the trust and the skills of the trustee. Also, a trustee is entitled to reimbursement for i) expenses incurred in the proper administration of the trust and ii) expenses not properly incurred, if necessary to prevent the unjust enrichment of the trust. Payment by the trustee of such costs creates a lien on trust property to secure reimbursement to the trustee.

A trustee must not incur unreasonable costs when considering which, if any, administrative functions to delegate or incur costs of professional advisors. This would include legal, accounting, and investment management. The trustee must balance the costs against the potential benefits of having another perform the given task. If necessary, the trustee’s compensation should reflect the level of assistance or delegation of administrative functions.

Trustees have always been permitted to incur only costs that are necessary to fulfill the administration of the trust in accordance with the trust agreement and the law. Due to the trustee’s duties to administer and inform, the trustee must secure and invest the trust assets, account for the activity of the trust, and navigate legal requirements. Often, one or more of these functions are performed by agents on behalf of the trustee, and common acceptable costs include legal, tax and accounting, and investment fees.

Costs Payable from Trust Assets:

• Legal fees incurred by trustees to protect and defend trust assets are normally acceptable costs.
• Fees incurred to examine the mental condition of a beneficiary to assess the beneficiary’s ability to handle large sums of money were acceptable, even though the beneficiary was entitled to the income. The court concluded that the trustee proceeded with the assessment in good faith and at the cooperation and consent of the beneficiary.
• In re Landis, the trustee (a bank and trust company in Wellsboro) was the creditor of a trust prior to becoming trustee of the trust. During its administration, the trustee (i) paid unsecured promissory notes of a closely held company owned partially by a beneficiary of the trust and by the trust itself and for which the trust had no obligation to pay and received no benefit of the payment, (ii) applied payment of another note by an unrelated party to a commercial loan from the bank to a trust beneficiary, (iii) acting as the bank, received dividends on stock held as collateral for loans to the trust, deposited the dividends in its commercial department for loans to customers, and did not apply the dividends toward the loans or interest, and (iv) at the conclusion of the administration, the trustee sold the last parcel of real property, but then refused to transfer the property and refused to distribute the proceeds to the beneficiaries. The court found the trustee at fault and surcharged the trustee for the payments (i and ii) for the accrued interest on the loan (iii) and for the costs incurred by the trustee and beneficiary for not transferring the property or distributing the proceeds (iv).
• The bank (acting as the bank) caused the sale of the trust’s primary holdings (Landis Machine Company) to pay down outstanding loans from the bank instead of using other assets. The stock appreciated in value by 50% at the time of the trust’s termination. The court held that the bank acted appropriately and in response to the banking regulations, and did not order the trustee be surcharged.
• The beneficiaries also claimed “that the derelictions of the … trustee were such as … to disentitle it to compensation, pointing out the surcharges made against it; they claim that it administered the trust primarily for its own benefit and only cursorily for the benefit of the [beneficiaries] and asked the court to further surcharge the trustee for the commissions the trustee was paid. The court acknowledged the bank’s self-interest concern, it stated that the “trustee had not been guilty of any fraud or bad faith in its management of the trust, but only of the mistakes, errors of judgment, and misinterpretations of the agreements for which it was surcharged” and is entitled to commissions.
• Finally, the beneficiaries requested that the trustee’s attorney’s fees for the matters at hand be paid by the trustee and not from the trust funds. The court permitted the payment from the trust funds relying on the same rational as the approval of commissions.

Cost Not Payable from Trust Assets:

• Accounting fees of a second accountant to audit the trust account were denied as unnecessary when trustees failed to keep accurate and timely records.
• Trustee is entitled to reimbursement for successful defense of beneficiary’s attempt to surcharge the trustee. However, the trustee in Lessig could not pay from trust assets, the costs of defending a usury claim by a third party, even though the defense was solely for the preservation of trust assets. The Court would not permit use of trust funds to pay counsel fees for the trustee’s violation of the National Banking Act. Had the trustee been successful in defending the usury claim, such fees would likely have been payable from the trust.
• Legal fees incurred by a trustee who violated her duty of loyalty and impartiality to certain beneficiaries was denied reimbursement of legal fees she paid to defend her actions.
• In re Thomas G. Goodwin Revocable Living Trust, a trustee was found liable for costs and damages incurred for unreasonably, incorrectly interpreting a trust document and deed. The trustee’s position was that because the deed referred to the Thomas “A.” Goodwin Revocable Living Trust, the deed was invalid, and the property transferred by operation of law to Mr. Goodwin’s surviving spouse (who was also the trustee). Because the trustee’s actions were determined to completely disregard the reasonable interpretation of the documents and her actions benefited herself, the court denied use of trust property to reimburse the trustee for her legal fees in defending her actions.

Trustee's Duty Regarding Claims

A trustee shall take reasonable steps to enforce claims of the trust and to defend claims against the trust. When one of several trustees is individually liable to the trust, the other trustee or trustees shall take any legal action against that trustee necessary to protect the trust.

The standard of determining whether to enforce a claim is the reasonableness of the likelihood of recovery, the cost of the suit and enforcement of the judgment.

Claims against Trustees. There are no “trust police”. The beneficiaries (and the Attorney General for charitable beneficiaries), are the only parties with standing to protect their interests and ensure the trustee carries out its duties.

Tax Deductibility

This is an extremely broad area of law. The relevant or more common categories of deductions include:

• Trade or business related expenses. Costs incurred in carrying on a trade or business are generally deductible.
• Income producing activity, costs of administration, and tax advice expenses. Costs related to the production of income or pursuit of profit are generally deductible. Specifically, ordinary and necessary expenses paid or incurred (i) for the production or collection of income, or (ii) for the management of property that is held for the production of income, including administration expenses such as fees for executors, trustee, attorneys, and accountants.
• Whether legal fees are deductible expenses under section 212, or are capital expenses under section 263, requires an examination of the origin of the claim giving rise to the legal fees.
• Attorney’s fees of the trustee and of the beneficiaries to modify the trust to conform to the settlor’s intent were deductible expenses because the origin of the claim from which the legal fees arose was the uncertainty as to the proper beneficiaries and because the proceedings benefited the trust.
• In Herman A. Moore Trust v. Commissioner, the Service challenged the trustee's deduction of certain attorneys' fees in computing the trust's income. These fees arose from an action brought by the testator's children to accelerate their beneficial interests in the trust. Pursuant to state law, the court ordered that the attorneys' fees for the trustee, the beneficiaries, and the guardian ad litem be paid from trust income. The court decided that (i) the state court decision aided the trustee in its management of the trust property, and (ii) the trust benefitted by the involvement of the beneficiaries and the guardian ad litem in the litigation. Thus, the court held that all of the litigants' attorneys' fees paid from trust income were deductible under section 212(2).
• Legal expenses relating to the final distribution of trust funds are a function of the management of the trust property and are deductible if they are ordinary and necessary.

Authors: Jerome C. Wegley and Neal R. Devlin

Originally published in October 2018

Copyright © 2018 Knox McLaughlin Gornall & Sennett, P.C.