Directed Trusts
Although the trustee is responsible for managing the trust assets, allocating trust powers among multiple persons (individuals or organizations) can provide a trust with greater flexibility and oversight. Appointing co-trustees to serve jointly or splitting trust powers between interested and independent trustees, as determined by the trustee’s relationship to the trustor and/or beneficiary, are common techniques available to allocate trust powers. In addition, the North Dakota legislature recently provided additional options for allocating trustee powers when the legislature adopted a statute authorizing the use of investment trust advisors, distribution trust advisors, and trust protectors.
This statute, North Dakota Century Code (NDCC) §§ 59-16.2-01 through 59-16.2-08, known as the “Directed Trust” statute, creates a framework of laws allowing trust terms to allocate specified powers to a “directing party.” Under these powers, the “directing party” has the authority to direct the trustee to take or refrain from taking certain actions and/or to take or direct certain actions on behalf of the trust. The investment trust advisor, distribution trust advisor, and trust protector are the three types of directing parties under the statute.
An investment trust advisor refers to “one or more persons given authority by the . . .[trust] to direct, consent to, or veto the exercise of all or a portion of the investment powers of the trust.” See NDCC § 59-16.2-02(6). These powers may include directing: (1) transactions with trust assets, (2) the investment and reinvestment of income and principal, (3) the management and control of trust assets, (4) the selection and compensation of additional advisors and consultants, and (5) the frequency and methodology for valuing trust assets.
A distribution trust advisor refers to “one or more persons given authority by the . . . [trust] to direct, consent to, veto, or otherwise exercise all or a portion of the distribution powers and discretion of the trust, including authority to make discretionary distributions of income and principal.” See NDCC § 59-16.2-02(2). For example, if the trust terms allow for the discretionary distribution of trust income to the trustor’s children, the distribution trust advisor would have the authority to direct when and to what extent these distributions to the children would occur.
Although referred to as “directing party” in the statute, the trust protector is one or more persons given specified powers in the trust to take direct actions involving the trust. The purpose of these powers is to “protect” the trust, the beneficiaries, and/or the trustor’s intent by allowing the trust protector to respond to future events and conditions. NDCC § 59-16.2-05 provides a nonexclusive list of some of these potential trust protector powers including, but not limited to, the power to change the interests of a beneficiary, the power to review and replace a trustee or other advisor, or the power to terminate the trust.
Each directing party above, in its sole discretion, may elect whether or not to exercise any of its powers. Nevertheless, unless the trust terms state otherwise, a directing party is a fiduciary of the trust and is subject to the same duties and standards of a trustee. Even if the trust terms state that a directing party is not considered a fiduciary, the trust terms cannot exonerate the directing party from acting in good faith. These standards are important given that the directing party’s decisions are binding on the trustee, the trust beneficiary/beneficiaries, and any other party having an interest in the trust.
The statute refers to an “excluded fiduciary” as a trustee, who by the trust terms is directed to act in accordance with the directing party’s exercise of its specified powers. The trust grants the directing party specified powers, and thereby excludes the trustee from exercising the powers. Consequently, if the trust terms require the excluded fiduciary to comply with the direction of a directing party, the statute absolves the excluded fiduciary (the trustee) from liability for complying with the directing party, except for cases of willful misconduct. Furthermore, an excluded fiduciary has “no duty to monitor, review, inquire, investigate, recommend, evaluate, or warn with respect to a directing party’s exercise of or failure to exercise any power granted to the directing party by the . . . [trust].” See NDCC § 59-16.2-07(2).
The following situation provides some context to the concept of a “directing party”:
Mr. Johnson decides to create an irrevocable trust for his adult son Joel. Mr. Johnson designates Bank X as the trustee of the trust. Since Joel is an avid investor, Mr. Johnson decides to name Joel as the investment trust advisor for Joel’s trust. Mr. Johnson wants Bank X to oversee the trust accountings, trust tax returns, and distribution decisions but also wants to empower Joel to be able to make financial decisions regarding assets in Joel’s trust. Additionally, Mr. Johnson wants someone to monitor Joel’s and the Bank X’s activities in order to ensure the trust assets are utilized for Joel’s best interests and appoints his certified public accountant, Mr. Anderson, to serve as the trust protector with the power to remove and replace the investment trust advisor and/or the trustee.
As shown by Mr. Johnson’s situation above, the use of directing parties can provide additional trust oversight and flexibility in trust actions, including, but not limited to, trust investments, trust disbursements, and trust management. The North Dakota legislature’s adoption of a “directed trust” statute will provide individuals and their estate planners with additional options when formulating trust terms and allocating trust powers. Although the inclusion of “directing parties” in the trust terms will increase trust complexity, the benefits of allocating trust powers among these individuals may allow the trust to better achieve the trustor’s objectives and intent.
Power to Adjust and Total Return Unitrust
After her phone call with the trustee, Mrs. Johnson wondered how she would continue to pay the costs of insurance, taxes, and maintenance for her home in Stanley, North Dakota. Her second husband Frank had passed away eight years ago and had left an income-only marital trust with Mrs. Johnson as the income beneficiary and Frank’s three adult children from a previous marriage as the remainder beneficiaries. A trust officer from Bank X serves as the trustee. Mrs. Johnson, as the Personal Representative of Frank’s estate, made a QTIP election for the marital trust under Internal Revenue Code (IRC) § 2056. The trust did not contain any guidance on the determination of trust principal and trust income or any terms about favoring one beneficiary over another. The trust assets had provided a sufficient stream of income for Mrs. Johnson’s standard of living in the first five years but the amount of trust income had significantly decreased in the last three years. Despite having significant assets in the trust, Mrs. Johnson now faced the possibility of having to move – a situation Frank would have never intended nor desired.
Pursuant to the Prudent Investor Standards of North Dakota Century Code (N.D.C.C.) § 59-17, the trustee’s performance is not evaluated in isolation “but in the context of the trust portfolio as a whole and as part of an overall investment strategy having risk and return objectives reasonably suited to the trust.” (N.D.C.C. § 59-17-02(2)) Additionally N.D.C.C. § 59-17-02(3)(e), requires a trustee to consider the “total return” from income as well as the appreciation of capital. After analyzing the investment markets, the trustee transferred more of the trust assets into equities and less into fixed-income investments in order to capitalize on an upswing in the stock market. Although the trust’s stocks had seen positive growth, the trust’s fixed-income investments had been producing less interest and the trust’s stocks had experienced a constant decline in dividends.
Given that the trust terms were silent on partiality, Mrs. Johnson raised her concerns to the trustee about fair treatment of all of the trust beneficiaries. In trusts with multiple beneficiaries, N.D.C.C. § 59-16-03 requires a trustee to “act impartially in investing, managing, and distributing the trust property, giving due regard to the beneficiaries’ respective interests.” Additionally, Mrs. Johnson has asserted her demands to the trustee to make the property productive for her benefit as the trust’s current income beneficiary.
In order to address irrevocable trust situations similar to Mrs. Johnson’s, the North Dakota legislature adopted two new statutory approaches:
- the power to adjust and the total return unitrust
- which became effective August 1st, 2017
These two statutory changes will help trustees address problems caused by declining income yields, investing for total return, and balancing requirements between the needs of current beneficiaries and remainder beneficiaries.
The power to adjust is set forth within the North Dakota Uniform and Principal Income Act (UPIA) of 1997 (N.D.C.C. § 59-04.2). The intent behind the power to adjust is to allow a trustee to adjust trust assets between principal and income in order to better serve current beneficiaries and remainder beneficiaries. For example, application of the power to adjust in Mrs. Johnson’s case could allow the trustee to designate some of the trust’s stock, which would normally be considered trust principal, as trust “income” and distribute this additional “income” to Mrs. Johnson.
Pursuant to N.D.C.C. § 59-04.2-03(1), in order for the trustee to utilize the power to adjust, the trustee must invest and manage the trust as a prudent investor, the trust terms must specify the income beneficiaries, and the trustee must determine that the trustee is unable to comply with subjection 1 of 59-04.2-02 of the UPIA, which lays out rules for a trustee to apply in allocating receipts and disbursements between principal and income. For example, the first rule is that the trustee shall allocate the principal and income according to the trust terms, if applicable. Although the power to adjust provisions refer only to “subsection 1 of 59-04.2-02”, it would be reasonable to assume that the drafters also intended “subsection 2 of 59-04.2-02” to apply, which requires a trustee to “administer a trust or estate impartially, based on what is fair and reasonable to all of the beneficiaries, except to the extent that the terms of the trust . . . clearly manifest an intention that the [trustee] shall or may favor one or more of the beneficiaries.”
Even after the trustee satisfies the legal requirements of N.D.C.C. § 59-04.2-03(1) in order to exercise the power to adjust, N.D.C.C. § 59-04.2-03(2) outlines a list of nonexclusive factors a trustee may consider in deciding whether and to what extent to exercise the power. For example, some of the factors include the size of the trust, the settlor’s intent, the beneficiaries’ circumstances, the regularity of income, the appreciation of capital, inflation, tax consequences, etc. Although the statute states that a trustee “may” consider all relevant factors, a trustee should, at a minimum, document its consideration of the factors outlined in the statute. For example, Frank’s intent to ensure Mrs. Johnson had sufficient resources to remain in the family home in Stanley would be a relevant factor for the trustee’s consideration.
Although the power to adjust is a significant tool in the trustee’s tool bag, the power to adjust is not without its limitations. For example, under N.D.C.C. § 59-04.2-03(3)(a), a trustee may not make an adjustment “[t]hat diminishes the income interest in a trust that requires all of the income to be paid at least annually to a spouse and for which an estate tax . . . marital deduction would be allowed, in whole or in part, if the trustee did not have the power to make the adjustment.” Therefore, in Mrs. Johnson’s situation, the trustee could not adjust some of her income to principal because under IRC § 2056 the surviving spouse is entitled to receive all of the income from the trust property in order for trust to qualify as a QTIP trust. N.D.C.C. § 59-04.2-03(3) provides a list of other circumstances prohibiting an adjustment. The challenging aspect of the power to adjust is that the trustee must conduct the above analysis for each and every separate adjustment the trustee makes between principal and income.
In addition to the power to adjust described above, the newly adopted total return unitrust statute provides another mechanism for a trustee to affect the allocations of income and principal among the beneficiaries. Under N.D.C.C. § 59-16.3-02, a “trustee, other than an interested trustee . . . may convert an income trust to a total return unitrust, reconvert a total return unitrust to an income trust, or change the percentage used to calculate the unitrust amount and the method used to determine the fair market value of the trust . . . . “ A total return unitrust requires a percentage of the trust assets to be distributed to certain beneficiaries annually.
In order to make the conversion, N.D.C.C. § 59-16.3-02 outlines specific procedures for the trustee to follow. For example, the trustee must adopt a written policy for the trust with regard to the conversion/change and provide written notice of the proposed action and adopted policy to the settlor (if living), the income and principal beneficiaries, the remainder beneficiaries, and the any trust advisor or trust protector. These individuals have an opportunity to object. Additionally, the statute provides the trustee with the same optional factors, as the power to adjust, to apply in deciding when, and to what extent, to exercise this power.
Although the statute refers to a trustee who is not an interested trustee, the total return unitrust statutes do not bar a trust with an interested trustee from reaping the benefits of this statute. Instead, the statute allows an interested trustee to make the same conversions/changes as an uninterested trustee but requires an interested trustee to appoint a “disinterested person”, acting in a fiduciary role, to determine the following for the trustee: (1) the unitrust percentage; (2) the method to value trust assets; (3) which assets, if any, will be excluded from the unitrust amount; and (4) the completion of the written policy and notification requirements.
Under N.D.C.C. § 59-16.3-01(4), an interested trustee is defined to include: (a) a trustee to which trust net income or principal could be distributed now or if the trust were to terminate, and (b) a trustee whose legal obligation to support a beneficiary may be satisfied from distributions of trust income or principal. Under N.D.C.C. § 59-16.3-01(1), a disinterested person refers to a “person who is not a related or subordinate party, as defined in section 672(c) of the Internal Revenue Code [26 U.S.C. 1. et seq.], with respect to the person then acting as trustee of the trust and excludes the settlor of the trust and any interested trustee.”
The statute specifically limits the unitrust amount to 3-5% of the net fair market value of the trust assets held at the time of valuation date and requires an annual valuation of the trust assets. N.D.C.C. § 59-16.3-06 provides explicit guidance to the trustee on how to determine the unitrust amount for each accounting period. However, the statute allows the trustee to determine the effective date of conversion, the timing and manner (i.e., cash, in kind, or both) of distributions, assets excluded from the unitrust amount, the effective time of reconversion (if applicable), and other necessary administrative issues.
Applying the total return unitrust statutes to Mrs. Johnson’s situation, the trustee could analyze the relevant factors and make the determination that Mrs. Johnson would be better served by receiving 3-5% of the total trust assets each year instead of only the trust income. The trustee would have to draft a written policy and send the appropriate notification to Mrs. Johnson and Frank’s three children about the policy and proposed conversion. Assuming Frank’s children did not object and the conversion was implemented, the trustee would value the assets each year and then multiply this value by Mrs. Johnson’s unitrust percentage (3-5%) to determine how much trust property she should receive for the year. The statutes provide Mrs. Johnson with the authority to compel the trustee to reconvert the total return unitrust back to an income trust, if necessary.
As demonstrated by Mrs. Johnson’s situation, North Dakota’s adoption of the power to adjust statute and total return unitrust statute provide increased flexibility for trustees to adapt trust terms to changing circumstances. Given the many compliance requirements briefly summarized above and possible trustee liability associated with these powers, trustees should strongly consider contacting legal counsel for assistance with navigating these new powers.
Trust Decanting
The word “decant” literally means to pour a liquid from one container to another container. Just like decanting a bottle of wine – from one container to another – decanting a trust involves the transfer of trust assets from one trust to another. Although the basic concept of decanting is fairly simple, the implications of whether and how a trust is decanted can be particularly consequential to the trust beneficiaries.
With North Dakota’s adoption of the Uniform Trust Code, trustees have a number of tools at their disposal to ensure trusts are administered in a manner consistent with the original intentions of the settlor, while at the same time being flexible enough to account for the numerous factual, legal, and tax law developments which may occur after a trust’s creation.
A tried and true method which has traditionally been available to modify an irrevocable trust is a formal court petition process. While this approach remains an important tool in certain circumstances, the availability of nonjudicial methods to address trust administration matters can now allow avoidance of the significant time and expense associated with court petitions. Trust mergers and nonjudicial settlement agreements are two nonjudicial methods codified within North Dakota’s adoption of the Uniform Trust Code.
Decanting provides yet another tool in the trustee’s toolbox. But what exactly is decanting? Decanting is, at its core, a trustee’s exercise of its discretionary principal distribution authority granted under the terms of a trust. If a trust does not allow for distributions of trust principal, then decanting is simply not an option.
If, however, the trustee has discretion to distribute trust principal to, or for the benefit of, one or more current beneficiaries, then the trustee possesses what would ordinarily be considered a limited power of appointment exercisable in favor of the trust beneficiaries. The holder of a power of appointment may generally exercise such power by “appointing” the property subject to such power to the fullest extent authorized (an outright transfer to an individual) or to a lesser degree than authorized (a transfer restricted in some manner). The underlying rationale for decanting is that the trustee of a trust with discretion to distribute trust principal outright to trust beneficiaries ought to be able to distribute trust principal in further trust for the same beneficiaries – something less than outright – unless the trust instrument expressly prohibits such a transfer.
A number of instances when a trustee might consider decanting include: (a) changing a trust’s governing law, (b) modifying a trust’s beneficial terms, (c) converting a trust’s income tax status from non-grantor to grantor status, or vice versa, (d) dividing a common trust into separate trusts or separate shares, (e) extending the term of the trust beyond the original termination date, (f) modifying provisions concerning trustee succession, (g) modifying investment protocols to be consistent with modern fiduciary investment strategies, (h) converting the trust to a supplemental needs trust, and (i) rewriting a poorly drafted trust instrument.
The decanting of trust assets from one trust to another has arguably existed under North Dakota law for decades under the judge-made “common law” of trusts. However, given the uncertain nature of the existence and bounds of such “common law,” and the lack of any on-point North Dakota case law, many trustees and their legal counsel have been skeptical of the advisability of decanting trusts under the North Dakota common law.
Freedom of contract and honoring settlor intent have always been of paramount concern in North Dakota trust law. As such, the drafter of a trust could provide a trustee with broad decanting powers by simply including such powers as express provisions within the trust instrument. While some drafting attorneys utilize this approach to decanting, the lack of a comprehensive body of law concerning the implications of, and procedures relating to, decanting has likely impeded broader adoption of this approach.
In 1992, the State of New York was the first state to adopt a decanting statute. In 2015, the State of Minnesota adopted a decanting statute based largely upon the New York statute. In 2017, the State of North Dakota adopted a decanting statute based primarily upon the Minnesota statute. The North Dakota decanting statute is set forth at N.D.C.C. Chapter 59-16.1 (the “Act”). The Act states that the existence of such statutory decanting regime does not preclude a trustee from decanting under an express trust provision or the common law of trusts, as discussed above.
The Act allows decanting by an “authorized trustee” – specifically defined at N.D.C.C. § 59-16.1-02(2) to exclude the settlor and any current or future beneficiary of the trust. N.D.C.C. § 59-16.1-02(5) defines the trust from which assets are being transferred as the “invaded trust.” N.D.C.C. § 59-16.1-02(1) defines the trust to which assets are being transferred as the “appointed trust.”
Under the Act, whether a trustee has “unlimited discretion” to distribute trust principal to the beneficiaries has a significant consequence as to whether and how a trustee may decant the trust. N.D.C.C. § 59-16.1-02(8) defines “unlimited discretion” as “the unlimited power to distribute principal” and states that “[a] power to distribute principal which includes words such as best interests, welfare, comfort, or happiness may not be considered a limitation of the power to distribute principal.” One notable aspect of decanting under the Act is that a trustee may decant whether or not there is a current need to invade the trust principal for the benefit of the beneficiaries.
When a trustee has unlimited discretion to distribute trust principal, the Act gives the trustee fairly liberal authority to decant the invaded trust for the benefit of one or more of its current beneficiaries and the trustee is given unfettered discretion concerning who the successor and remainder beneficiaries of the appointed trust will be. When a trustee has the discretion to distribute trust principal, but such discretion is limited, then the trustee’s authority to decant under the Act is more restricted. In such a case, the appointed trust must have the same current and remainder beneficiaries as the invaded trust and must contain the same income and principal distribution provisions.
The Act requires a trustee to exercise its decanting powers in the best interests of one or more of the current beneficiaries and in a manner that a prudent person would exercise under the circumstances. While not explicitly stated in the Act, a trustee likely remains subject to its other fiduciary duties with respect to trust decanting, including duties to: (a) act in good faith, (b) act in accordance with the terms and purposes of the trust, (c) act in the interests of the beneficiaries, (d) act in accordance with other governing laws, (e) act in accordance with their duty of loyalty, (f) act with impartiality, giving due regard to the various interests of the trust beneficiaries, and (g) exercise reasonable care in administering the trust, considering the trust purposes, terms, distribution requirements, and other relevant circumstances.
To effectuate a statutory decanting under the Act, the trustee is required to exercise the decanting in writing and must provide such writing and copies of both the invaded trust and the appointed trust to all of the qualified beneficiaries and to any individuals with the power to remove or replace the trustee. The decanting is effective sixty days after these notices are given unless there are objections or waivers of such time period.
The Act contains a number of prohibitions concerning a trustee’s exercise of the power to decant, including prohibitions on: (a) modifying any mandatory distribution or withdrawal right of a current beneficiary, (b) limiting the trustee’s liability for its administration of the trust, (c) modifying a person’s right to remove or replace the trustee, unless notice has been given to such person, (d) fixing the value of an asset for distribution or allocation purposes, (e) effecting the validity of any prior tax elections or benefits received, (f) increasing the trustee’s fees, and (g) receiving a commission with respect to decanting.
Decanting provides significant flexibility by giving trustees the authority to transfer trust assets from an invaded trust to be held and administered under the terms of an appointed trust. While this basic concept is simple, whether and how a trust is decanted could have a significant effect on the beneficiaries of the invaded trust. While the Act provides trustees with broad authority, it is incumbent upon each trustee to ensure that any exercise of such decanting power complies with the various requirements outlined in the Act. It would be wise for a trustee to retain legal counsel before seriously considering whether and how to decant a particular trust.
*The information provided in this letter is of a general nature and should not be acted upon without prior discussion with your Ohnstad Twichell, P.C., attorney.