Chapter 13
Paying Trust Beneficiaries
IN THIS CHAPTER
Establishing who the trust’s beneficiaries are (and getting the info you need from them)
Setting up the distribution schedule
Making proper distributions at the proper times
Handling beneficiaries who ask for or need unscheduled distributions
Going through all the song and dance of creating the trust, funding the trust, and then investing the trust assets is basically pointless unless you do it to benefit someone else: the trust beneficiary. The trust beneficiary is the person or institution who’s named in the trust instrument to receive income and/or principal from the trust.
In this chapter, we explain how, when, and why you make distributions over the lifetime of the trust to the trust beneficiary or beneficiaries. We give you the lowdown on the information you need from and about the beneficiaries before you can write that first check, and how to determine whether you should ever pay more than the absolute minimum the trust instrument directs you to pay. And when it’s time to completely discharge your duty as trustee, we tell you what you need to know to make those final distributions.
Notifying Beneficiaries of the Trust
Even though some trust beneficiaries, such as spouses or children, know well in advance of that first distribution that a trust has been established for their care and feeding, we’ve noticed that grantors (the person who establishes the trust) often fail to tell named beneficiaries that trusts exist for their benefit. Sometimes it’s because they want to encourage that person to strive and achieve without the knowledge that there’s a safety net securely fastened beneath them; other times, the grantor doesn’t want to discuss his or her own mortality with a child or grandchild. Whatever the reason, it often falls to you, the trustee, to inform the beneficiaries of the existence of the trust and the fact that they’ll reap some benefit from it.
Notifying a beneficiary doesn’t have any formal steps to follow; basically, it’s really up to you to figure out how best to impart the news. If you know the person, a telephone call can accomplish the task with very little fuss and bother, and gives the beneficiary an immediate chance to ask questions. If you’re not acquainted with the beneficiary, a simple letter suffices, advising him or her of the existence of the trust, and that he or she is a named beneficiary. Include all your contact info (telephone, e-mail, and snail mail), and urge the beneficiary to contact you at his or her earliest convenience. Remember: You won’t be able to begin making distributions until you set up a reliable form of communication with the beneficiary.
The next sections point out the necessary info you need to retrieve from the beneficiaries after you make contact with them.
Obtaining addresses and Social Security numbers
After you notify the beneficiary, you need to obtain his or her address and Social Security number. Beneficiary payments may, and probably will, contain elements of taxable income. Because he or she must pay the tax on that income, you shouldn’t make any payments without obtaining tax reporting information up front.
Trust beneficiaries often plead poverty or extraordinary circumstances, especially when waiting for that first trust distribution. Resist the temptation to play the nice guy — keep your hands on the cash and don’t make any payments until the beneficiary coughs up his or her address and Social Security number. If you pay before you have the information you need, you may still be waiting for it when you sit down to prepare the trust’s tax returns many months later.
Of course, you can’t force a beneficiary to give you his or her Social Security number, and you can’t withhold payments indefinitely. If you find yourself in a position where you made distributions without first receiving that all-important number, you may be forced to file a tax return for the trust (Form 1041) that’s missing this required piece of information. File the return anyway, making sure that you include as much information, such as the beneficiary’s address, as you can on Schedule K-1 (see Chapter 20). Provided you can show the IRS that you made a concerted attempt to obtain the information, you should be off the hook for filing an incomplete return.
Verifying dates of birth
Knowing the beneficiary’s birth date is important, and not just so you can send a card every year. Many trusts are created with payout schedules based on ages; as trustee, you need to know when the beneficiary has reached a certain age and adjust the mandatory payments accordingly. Obtaining third-party verification of a birth date isn’t necessary. Usually, beneficiaries are more than happy to provide you with their correct date of birth.
Knowing the trust beneficiary’s age is also relevant because it helps you choose appropriate investments, allowing you to minimize certain types of income at a time when the beneficiary is in a higher tax bracket. If a beneficiary’s under the age of 19 (or 24, if a college student), he or she may be subject to the so-called Kiddie Tax on investment income, which essentially charges tax on the child’s income at his or her parents’ highest applicable rate. Unfortunately, investment income is exactly what a trust produces, so all income received from a trust may be subject to this additional tax. After the beneficiary has left college and is earning, you can then change the investment mix to one that produces more income taxed at a lower rate.
Determining Scheduled Distributions
Although not every trust makes distributions to its beneficiaries on a continuing basis (either monthly, quarterly, or annually), all trusts are required to make distributions at some point in their existence, even if the only distribution made is the one that terminates the trust. As trustee, you have to figure out what that schedule should be and make sure that distribution dates are noted on a calendar somewhere. It doesn’t matter whether you write them on a chalkboard on the wall, enter them into your computer database, or arrange to have reminders sent telepathically on the appropriate dates. What does matter is that you have a plan in place to be certain that distributions required by the trust instrument are made when they’re due to be made. If you’re not sure where to begin when making distributions, the following sections can help ensure you know how much to pay and when.
Figuring out how much to pay
When trying to determine how much to pay beneficiaries, you first want to look at the trust instrument for direction:
- Fixed amount distributions: Sometimes, the trust instrument instructs you to pay a set dollar amount on a certain date. One of us, for example, prepares the tax returns for a family of trusts a grandmother set up for her grandchildren. Although Grandma is long gone, each of her grandchildren still receives $1,000 each and every year as a birthday gift.
- 5/5 provision: Often, a trust for the benefit of a surviving spouse contains a so-called 5/5 provision, where the surviving spouse may request a distribution of either 5 percent of the assets or $5,000 annually, whichever is greater.
- Trust accounting income: Far more usual than the fixed amount distribution, though, is a distribution that’s based on the net income of the trust, or trust accounting income. The trust may require all income to be distributed annually, quarterly, or even monthly. If the instrument contains this requirement, you need to be sure that the payments are made within a reasonable amount of time after the due date. You’re allowed to be a bit late — sometimes you can’t possibly calculate the actual income until after the supposed date you should have sent out a check. But you really should try to make that distribution as soon as you possibly can. Remember, in accepting the role of trustee, you’ve agreed to abide by the terms of the trust; failure to do so may give the beneficiary grounds to try to have you removed.
- Discretionary distributions: Although it’s by far more frequent for a beneficiary to come to you, hat in hand, to ask for more money (see the section “When Beneficiaries Request More Money: Paying Out Extra Distributions,” later in this chapter), sometimes you may see a need that the beneficiary doesn’t. He or she may be struggling financially but is too proud to ask for help. Or the beneficiary may have some medical problems that an injection of cash can help alleviate. Most trusts provide you, the trustee, with the discretion to make additional, unscheduled distributions. Often, the terms of the trust limit these distributions to issues of health or education. Sometimes, though, the trustee’s discretionary powers are extremely broad, and the trust instrument contains language to the effect that the trustee may act as he sees fit. Read your instrument closely to see how much discretion you’re allowed. In the case of discretionary distributions, you’re not limited to distributing only income, but may also make principal distributions if you, in your estimation, feel that they’re warranted.
Calculating trust accounting income
Trust accounting income, or TAI for short, is the formula that determines how much income is available to be distributed to the income beneficiary. You calculate it by adding together all items of income and then subtracting all expenses attributable to income. Here’s an example. The Albatross Trust owns principal assets that include both taxable and tax-exempt bonds, dividend-paying stocks, and an interest in a shopping mall. In addition to the trustee fees the trustee pays herself, she also pays an investment advisor to assist her in investing in the stock and bond markets and an Enrolled Agent to prepare the trust’s income tax returns.
To arrive at TAI, the trustee of the Albatross Trust adds up all the interest, dividends, and rental income earned, even if some of that income may be tax exempt on the trust’s income tax return. Then she subtracts whatever share of trustee, investment advice, and accounting fees she actually pays from the income earned (she may, and probably does, pay a portion of all these fees from the principal side of the account). In addition, she also subtracts any income taxes paid from the income side of the trust and any miscellaneous expenses (even if they’re not tax deductible).
In Table 13-1, you see how the Albatross Trust’s trustee assigns items of income between the income and principal sides of the trust, and also how she allocates the fees charged to the trust. Although the rules for allocating income are fairly rigid, the trustee may be much more flexible and use her judgment in allocating fees and expenses. However, that allocation must be a reasonable one that doesn’t unduly favor either the income beneficiaries or the principal remaindermen (the people who get the assets in the trust when the trust terminates).
TABLE 13-1 Calculating TAI
|
Description |
Income |
Principal |
|
Income received |
||
|
Ordinary dividends |
$1,000.00 |
|
|
Taxable interest |
$10,000.00 |
|
|
Tax-exempt interest |
$2,000.00 |
|
|
Rents and royalties |
$600.00 |
|
|
Long-term capital gain distributions |
$500.00 |
|
|
Short-term capital gains |
$1,000.00 |
|
|
Long-term capital gains |
$1,500.00 |
|
|
Total Income |
$13,600.00 |
$3,000.00 |
|
Deductions |
||
|
Trustee’s fee |
($500.00) |
($500.00) |
|
Tax preparation fee |
($250.00) |
($125.00) |
|
Investment advice |
($1,000.00) |
($1,000.00) |
|
Federal income taxes paid |
($500.00) |
|
|
State income taxes paid |
($350.00) |
|
|
Total deductions |
($1,750.00) |
($2,475.00) |
|
Net additions to principal |
$525.00 |
|
|
Trust Accounting Income |
$11,850.00 |
If you’re required to pass out all the income in the trust, calculating TAI gives you the exact number you need to pay to the beneficiary. If, on the other hand, you’re directed to make no payments, set payments, or purely discretionary payments, calculating TAI is something you need only do when preparing your annual Form 1041, U.S. Income Tax Return for Estates and Trusts; it doesn’t have any impact on the distributions you do make. Chapter 18 tells you how to complete this tax return.
We’re noticing that a lot more trusts are investing in foreign securities, and income earned from foreign securities often means paying foreign taxes. Although the U.S. has tax treaties with most of these countries that entitle you to claim a refund for these foreign taxes you’re paying, in most cases the amounts you’re chasing after don’t warrant the additional work required to collect the refunds. Instead, you may choose to claim a Foreign Tax Credit on Form 1116, which you then attach to your Form 1041. Foreign taxes paid are not income taxes chargeable to the trust. If you’re distributing the income from the trust, you’re probably also distributing the foreign tax credit to the trust’s beneficiary. If this is your situation, don’t subtract foreign taxes paid when calculating TAI. In fact, by passing the credit through to your beneficiary, you’re actually making a distribution to him or her that should be included in TAI.
Making distributions after the end of the year (Section 663(b))
What’s left after adding together income and subtracting all the income-related expenses is the trust’s TAI. If you’re administering a trust that requires all, or a percentage of, income to be paid out currently, you need to calculate TAI before you can make distributions. If you want to make distributions more frequently than annually, you can make an educated guess for the first three quarters of every year. Then in the fourth quarter, you have to calculate TAI for the entire year and adjust the fourth-quarter distribution accordingly.
Of course, because the fourth quarter doesn’t end until December 31, it’s basically impossible to have all the information you need before the end of the calendar year. The IRS understands (some of those agents have trusts, too), and accordingly gives you 65 days after the end of the calendar year to make your calculation and pay that final distribution. If you use this extra time to make a year-end distribution, be sure to tick the box on question 6 at the bottom of page 2 of Form 1041. You’ve just made a Section 663(b) election for the trust.
Creating a payment schedule
How can you be certain that you’ll have cash in the account when you’re required to make a payment, whether to the beneficiary, to pay fees, or to pay taxes? Simple. Just develop a payment schedule. Remember, with the exception of emergency discretionary distributions that no one knows about and no one can predict, the cash needs of the trust should be fairly easy to anticipate. Keeping the following pointers in mind will help you:
- Project what your income and expenses will be throughout the year, and when you expect to be making payments for fees and expenses in the trust. If the income generated by the trust is uneven, so that you receive large amounts in one or two months but very little the rest of the year, be sure to schedule your fee and expense payments after you receive the bulk of the trust’s income. Only after those payments have been made should you make payments to the income beneficiary. So, if you receive large payments in May and November but not much else for the rest of the year, for example, you should schedule your fee and expense payments for early June and December, and then you can safely pay whatever income is remaining to the beneficiary toward the end of June and December. You can create this schedule for your trust on a slip of paper or in a computer spreadsheet program.
- Make sure that you pay all other obligations before you ever write a check to the beneficiary. Income from interest and dividends posts most heavily into accounts around the 1st of each month, and most tax payments are due on the 15th. Service providers almost always bill you on or about the first of the month. After the trust pays these obligations, then you can arrange to make beneficiary payments, usually toward the very end of the month or quarter.
- Most important, don’t ever leave yourself short at tax time. Although accountants and attorneys may not be happy about having to wait for payment, and income beneficiaries may plead poverty endlessly in your ear, no one has the same ability to turn your life into a miserable wasteland as the IRS and the state tax authorities. In addition to tacking on penalties and interest for late payment or late filing, the IRS can also levy, or reach in and grab the taxes due directly from the trust’s bank or brokerage account. And good luck pleading hardship — this is a trust, after all, and as far as the IRS is concerned, anyone with the wherewithal to form a trust can’t be suffering that much financially!
Distributing When the Beneficiary Reaches a Specific Age
Trusts are often designed to keep large sums of money out of the hands of people who may not be able to handle them. Of course, people change over time, and most of us become more responsible the older we get. In recognition of this fact, many trusts contain provisions to distribute income and/or principal of the trust to the trust’s beneficiary at certain ages. The following are two of the most common scenarios:
- Income required: Trusts often don’t begin mandating distributions of income to the beneficiary until he or she reaches a certain age. On occasion, distributions may begin as young as age 18. More frequently, they start at age 21 or even age 25. Rarely (although it does happen), the grantor may delay the start of mandatory income distributions as late as age 30.
- Principal distributions: Because (in most states) trusts aren’t allowed to exist forever, a termination scenario is usually spelled out in the trust instrument. In many cases, the trust terminates when the income beneficiary dies. In other cases, where money is held in trust for a beneficiary who the grantor may not feel is mature enough to handle large sums at the time the trust is created, the principal distributes to that beneficiary as he or she attains certain ages. Depending on the grantor’s wishes, distribution ages may start as early as age 21; however, age 25 or even age 30 is far more common as a starting point. Principal is commonly distributed in shares at five-year intervals, so that a beneficiary receives, for example, one-third of the principal value at age 25, one-half of the remaining value at age 30, and the balance of the trust principal at age 35. These distributions come in two varieties:
- Cash: A cash distribution is by far the easiest type of distribution to make because all you need do is calculate the amount of the distribution required and then write a check. If you know when the distribution is due to be made (and you should know because you placed the date on your calendar when you began administering the trust), you may accumulate a war chest of cash and money-market-type investments if you’re not making a total distribution of the trust’s assets.
- Division of assets: If the trust has more than one beneficiary who is entitled to a share of the principal assets, you may have to distribute assets rather than cash, especially when the trust terminates. In this case, be certain that each beneficiary entitled to a share gets a share of the fair market value on the date of termination. In the case of marketable securities, or those assets that can be bought and sold on the major stock, bond, or commodities exchanges, obtaining market values on that date is easy (check out Chapter 7 for a quick refresher on how to value assets) and divvy up the assets accordingly. With privately held assets, such as a business or real estate, you need to obtain independent appraisals before making distributions. Be sure that each beneficiary receives an equally valued share, even though each may receive substantially different assets.
When Beneficiaries Request More Money: Paying Out Extra Distributions
The trust is now up and running. The principal is invested and generating income, you’ve figured out how to pay everyone who needs to be paid and still have money at the end of the month or quarter to give something to the income beneficiary, and all seems well in your world.
But wait! The phone rings — the beneficiary has just decided to return to school, buy a house, start a business, have that little medical procedure done that isn’t covered by insurance, or invest in a foolproof way to turn straw into gold. As long as we’ve been in this business, you’d think we’d heard all the excuses for wanting more money. We’ve posted bail for clients and even paid for them to sue us, the trustees.
In fact, the only certainty in administering a trust is that, as much money as you manage to pay out to the income beneficiaries that’s mandated by the terms of the trust, they’ll always want more. How much more varies, as does the worthiness of the requests. If you do receive requests for extra distributions from the beneficiaries, your job as trustee is to shovel through the rationalizations before handing out any money. You must determine:
- Does the request have merit? You’re not required to give in to each and every demand from the beneficiary, nor should you. Not every request deserves a positive response.
- Would the grantor have given the money for this purpose? You need to put yourself in the grantor’s shoes and make that determination. If, for example, the grantor wanted to encourage home ownership, and the beneficiary is asking for help with a down payment, your answer is clear. If, on the other hand, the beneficiary is asking for money to attend bartending school and the donor was a fervent teetotaler, you may want to think twice.
- If you make this extra distribution, how will it affect the ongoing purpose of the trust? If the purpose of the trust is to provide a safety cushion for an income beneficiary who is relying on that income to live, and depleting the principal of the trust in order to make this discretionary distribution would severely impact the trust’s ability to provide that ongoing financial cushion, you may want to think twice, or even three times, before writing that check. Be willing to ask for more information regarding how the beneficiary plans to use this distribution. For example, if the distribution would enable the beneficiary to reduce living expenses (perhaps by purchasing a house for cash rather than requiring a mortgage), the loss of future income may be more than offset by the long-term reduction in the beneficiary’s expenses.
- Are you being asked to make a distribution to a spendthrift beneficiary? In our experience, a fair number of trust beneficiaries are only trust beneficiaries because money runs through their fingers like water. When parents and grandparents place inheritances in trust for such heirs, it’s usually for the sole purpose of preventing them from frittering away the money. Unfortunately, because trusts for spendthrifts tend to restrict access to any of the money except at the trustee’s discretion, a beneficiary of one of these trusts can almost be guaranteed to live in your pocket, constantly asking for money for this, that, or the other. Weigh these requests carefully; some have merit, but many don’t. As we show in the section “Making the Decision to Distribute Discretionally: Eyeing the Trust’s Terms,” you have to place yourself in the grantor’s shoes to make that determination. And, should you choose to make a distribution, be certain to obtain proof that the money is being used for the purpose intended. Depending on the beneficiary, you may want to pay the beneficiary’s bills directly instead of giving the money to the beneficiary and relying on him or her to make those payments.
If you’re the trustee of a spendthrift trust, you want to carefully document all your dealings with the beneficiary. If possible, all requests that come directly from the beneficiary should come in writing so that you can see, on paper, the scope of the request. And, if the beneficiary is requesting money to pay a specific bill or fund a project, don’t rely only on the beneficiary’s say-so, but request a copy of any third-party documentation, such as the bill that needs to be paid. Don’t hesitate to contact that third party directly for verification.
And, if you choose not to make the distribution, be sure to notify the beneficiary, in writing, of your decision, referencing the part of the trust instrument that gives you the discretion to say no. In our experience, although many beneficiaries of spendthrift trusts are absolutely wonderful individuals who are merely challenged by money, some are merely looking for an excuse to make your life miserable. By keeping a well-documented paper trail, you protect yourself from having your past decisions rebound on you.
Making the Decision to Distribute Discretionally: Eyeing the Trust’s Terms
Very often, trust instruments give you, the trustee, a great deal of guidance as to what sorts of discretionary distributions the grantor thought you may be asked to make. Some of these so-called discretionary powers are quite narrow, but others leave you with almost completely unfettered range, both with regard to requests you receive from the beneficiary, as well as those needs of the beneficiary that you, yourself, identify. The following sections provide some guidance to help you make these decisions.
Ensuring health and well-being
Among the most popular of discretionary power standards is one that allows the trustee to make payments to ensure the health and well-being of the trust’s beneficiaries. Usually, this power extends the class of beneficiaries well beyond the stated income beneficiary: that person’s spouse, children, grandchildren, or other issue. And, unless explicitly stated in the trust instrument, it’s not just to cover medical expenses. Instead, the health and well-being standard can be used, if the trustee chooses to interpret it as such, to provide a wide variety of extras to the beneficiaries. In addition to paying doctors’ bills and providing health insurance for those who don’t have any, the trustee may also determine that vacations, ballet lessons, summer camps, and other such items add to the beneficiaries’ general health and well-being.
Of course, although the standard is broad, it’s not unlimited. Although most trustees would probably agree that replacing an aging, mold-infested residence with something that provided a cleaner environment meets the health and well-being standard, they probably would also agree that replacing one adequate residence with another, larger one doesn’t.
Paying for education
Saving money for education in a trust can be a very effective way to pay for college, and many people use trusts for this purpose. Saving for education inside a trust allows much greater flexibility when the time comes to pay for that education — and, should the child or grandchild named as beneficiary receive merit scholarships or choose not to go to college, the money can easily be used for other purposes at other times.
If the trust you’re administering allows you discretion to make distributions for education, you should be aware that education isn’t limited only to postsecondary schools. You may also use trust monies to pay for private primary and secondary education, for supplemental educational programs, for summer camps that have some sort of educational focus (we know of several trust beneficiaries who’ve attended summer music camps, thanks to discretionary trust distributions), for tutoring, or even to buy a computer. In fact, if you think the request is reasonable, and you can rationalize that it furthers the beneficiary’s education in some way, you’re most likely on safe ground in making that distribution.
Buying a home
Although not all trust instruments include specific language allowing you to make a distribution to a beneficiary so that he or she can purchase a house, very few trust instruments explicitly prohibit you from making distributions either for down payments or for the total purchase price of a house. This is one of those gray areas that you have to deal with and one of the places where you need to look not only at the trust’s resources but also at the beneficiary’s decision making.
When deciding whether or not to use trust assets to buy a home, be certain that the beneficiary will actually be able to afford to live there. He or she will now be responsible for the house’s ongoing expenses, maintenance (both major and minor repairs), and real estate taxes. If you’ve gone to the trouble of purchasing the house and distributing it outright to the beneficiary, you want to be certain that the beneficiary won’t turn around and try to drain it of cash. One of us worked on a trust that used almost all its assets to buy the beneficiary a house outright. A month after the closing, the beneficiary was already trying to raise a mortgage on the house; two years after the purchase, the city where the beneficiary lived foreclosed on his home for nonpayment of taxes.
If you think the beneficiary would be better off living in stable housing rather than going from rental to rental, but you’re not sure that he or she is likely to be able to afford the upkeep and taxes on a house, you always have the option of having the trust purchase, and own, the property. This way, you know that the necessary bills are being paid, and you can arrange regular inspections to determine what, if any, maintenance must be done. Although doing so is more work for you, at least you’ll rest assured that, whatever shortcomings the beneficiary may have in his or her life and financial dealings, at least he or she will have a stable and comfortable place to sleep each night.
Starting a business
In most cases, stifling the earning capacity of the trust’s beneficiary isn’t the grantor’s goal; still, you, the trustee, face a tough decision when the beneficiary comes looking to you for money with which to start a business or to additionally capitalize a business that may require a cash infusion in order to stay afloat.
Your decision to distribute trust funds for this purpose depends largely on your confidence in the abilities of the beneficiary and his or her business plan. Your job isn’t to be a nice guy; it’s to request and study a business plan and to make your judgment based on sound business principles, not pie-in-the-sky projections.
You may determine that you don’t want to deplete the trust’s assets in order to support the beneficiary’s business, but that the business plan has merit. If you feel that the beneficiary would be able to obtain a loan from a bank or other lender on the strength of the business plan, you may loan the money to the beneficiary, making sure to have the beneficiary sign a promissory note that requires repayment of the principal and payment of interest at market rates. If you’re not sure what interest rate to charge, the IRS issues Applicable Federal Rates every month, which tells you the minimum interest rate you can charge on a loan in order for it to be considered a fair market rate. You can find these rates at www.irs.gov under the Index of Applicable Federal Rate (AFR) Rulings.
Using trustee discretion
The grantor, in creating the trust, may have thought he or she’d covered every possibility, but life has a funny way of presenting situations you thought were impossible. Welcome to the world of the trustee’s discretion, where truth is often stranger than fiction. If a beneficiary asks for a distribution and the trust instrument isn’t clear about that request, you, Mr. or Ms. Trustee, need to decide. Remember that the grantor trusted you with making these types of decisions.
Keep your wits about you. Ask the beneficiary lots of questions and review third-party documentation, when available. Most of all, take your time and deliberate carefully. Put yourself in the grantor’s shoes as you weigh your decision, taking what you know about the beneficiary into consideration. Even though many of the requests you receive from beneficiaries will be valid, others may be creative attempts to separate the trust’s assets from the trust. On the small end, we’ve received requests to pay veterinary bills and buy new cars. On the larger side, we’ve helped buy major-league sports teams and financed blockbuster movies. Sometimes the distributions have been made and other times they haven’t. Remember, you’re not required to dispense money just because a beneficiary requests it.