The interplay among tax laws, investment performance and a beneficiary's wellbeing shapes a fiduciary's responsibilities. When a trustee distributes assets from a trust to meet a beneficiary's needs, the question of how to satisfy that distribution requires a deep understanding of the appropriate federal and state income and transfer tax laws, as well as the economic environment. While these crucial factors, which dictate a fiduciary's responsibility, have always been hard to forecast, they've become virtually impossible to predict in the current economy. Rumors and speculation drive tax planning; the markets have experienced unprecedented levels of volatility and understanding and planning for a beneficiary's needs have become increasingly challenging.

Tax Laws

Since 2001, the transfer tax laws have been in a state of flux. The trusts and estates community watched each year pass knowing that on the stroke of midnight on Dec. 31, 2009, the estate tax would evaporate. Nevertheless, no one believed that we would actually see that result. We did — and then, unexpectedly, on Dec. 23, 2010, our government reinstated the estate tax. It passed a two-year law with exemptions and rates that were unprecedented in their generosity. Fast forward to November 2011, when a rumor circulated that these generous tax laws could be rescinded as early as Nov. 23, 2011 by a recommendation of the deficit reduction “Super Committee.” This rumor generated an avalanche of activity with clients rushing to give away enough assets to use what they perceived to be vanishing $5 million exemptions. The rumors proved to be unfounded. But, we still face the prospect of these exemptions vanishing at the end of 2012, with no clue of what will happen next. We continue to wonder how to best advise clients.

Another area of uncertainty involves the deductibility of trustee commissions and the Internal Revenue Service's interpretation of the income tax rule of Knight v. Commissioner.¹ This rule says that investment advisory fees incurred in connection with managing a trust are deductible for income taxes as a miscellaneous itemized deduction, subject to the 2 percent floor, but trustee commissions are fully deductible and not subject to the 2 percent floor. For several years, the IRS has asserted that it wouldn't enforce this rule because it couldn't understand how to separate the services of a professional fiduciary into neat, quantifiable buckets. Specifically, many professional fiduciaries “bundle” their fees to include both commissions and investment management. The IRS would like these fiduciaries to “unbundle” their fees — a project that's akin to unscrambling an egg. The IRS regulations are incapable of appropriately defining this process.

Investing

Volatility has been extremely high and monthly fluctuations of 10 percent to 12 percent in market indices have become commonplace. It's difficult to see an end to the economic factors that have led to these current market conditions. Investing in this environment requires discipline, patience and a long time horizon. Some trusts fit that profile and others don't. Understanding the risk profile and tax implications of various trusts and their beneficiaries has never been more important. The Prudent Investor Act, which has been enacted, in whole or in part, in most jurisdictions, specifically requires trustees to consider these factors in determining how to invest trust assets. Fortunately, the standard is conduct-based and not performance-based, simply requiring the trustee to have a reasonable process.

Beneficiaries' Needs

With unemployment and underemployment rates soaring, we've found that many beneficiaries need to draw upon their nest eggs in larger amounts to replace or supplement lost income. When this increased need is coupled with volatile markets, a fiduciary's role becomes increasingly difficult as the value of the trust may diminish. As a result of these factors, the trustee's duty to communicate is more important than ever.

Clear Direction

While trustees navigate through these troubled waters, they can stay on course by keeping an eye on their well-defined duties: to invest prudently; to communicate; to act impartially; and to act loyally.

Endnote

1. Knight v. Commissioner, 128 S.Ct. 782 (2008).

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Gail E. Cohen is vice chairman and general trust counsel at Fiduciary Trust Company International in New York