Tax News & Comment — March 2015 View or Print

I. Introduction

A trust is a relationship whereby a trustee holds property for the benefit the beneficiary, or cestui que trust. A division of ownership occurs between the trustee, who holds legal title, and the beneficiary, who holds equitable title. Trusts evolved in England because of the inherent limitations of law courts to provide equitable relief. Courts of Chancery (also known as Courts of Equity) which could provide equitable relief became an attractive forum for cases which would be doomed in Courts of Law. Since trusts were creatures of equity, their evolution was naturally suited to Courts of Equity. The predecessor of trusts were “uses,” which were essentially legal fictions implemented to accomplish the transfer of property that could not be accomplished under normative legal rules. The problem with uses was that their effectiveness depended upon the integrity of the person entrusted with the “use.” If that person refused to fulfill an obligation, the aggrieved party had no recourse, and the “use” would be defeated. Trusts evolved from uses to ameliorate this problem. How the common law of England become the common law of the United States is important in understanding the evolution of trusts in American jurisprudence. Justice Story in 1829 observed that “our ancestors brought with them its general principles and claimed it as their birthright, but they brought with them and adopted only that portion which was applicable to their condition.”

New York’s Constitution of 1777 provided that “such parts of the common law of England shall be and continue to be the law of the state.” Although common law of England after American independence on July 4, 1776 continued to be “persuasive” authority in the nineteenth century, Justice Cardozo remarked that “the whole subject of the reception of English law, both common and statutory, was not thought out in any consistent way.” Both the common law of England, decided by the King’s courts of law as well as the principles of equity, decided by courts of chancery, became the law of the Colonies (later States), except to the extent that those jurisdictions disavowed those portions of English law that were not deemed suitable. One early New York decision, Parker & Edgarton v. Foot (19 Wend. 309; 1838), rejecting the precedent of English law in a particular dispute, rationalized: “It may well do enough in England; and I see that it has recently been sanctioned by an act of parliament. But it cannot be applied in the growing cities and villages of this country, without working the most mischievous consequences. It cannot be necessary to cite cases to prove that those portions of common law of England which are hostile to the spirit of our institutions . . . form no part of our law.”

In 1848, cases involving law and equity were “merged” into a single court in New York and, to a lesser extent, a single procedure was implemented to govern legal and equitable actions. However, the principles of law and equity themselves never merged. The distinction between legal and equitable principles is as vivid today as it was in 16th century England. For example, when a plaintiff pleads an equitable cause of action (e.g., an injunction) the complaint must state that the plaintiff “has no adequate remedy at law.” The Uniform Trust Code has been adopted by New York and applies to trusts ““created pursuant to a statute, judgment, or degree. . .” A trust depends upon the existence of a trustee with active duties. Otherwise, the trust is “dry” and will fail. No one can be compelled to act as trustee; yet a trust will not fail for want of a trustee, since a court may appoint one.

Trusts involving land must satisfy the statute of frauds. Trusts not required to be in writing must be established by “clear and convincing evidence.” Unlike other legal entities, there is no requirement in most jurisdictions that a trust be registered with a state or filed with a court to have legal significance. In fact, subject to the statute of frauds, a trust may even be oral. A person creating a trust may not even realize it at the time, since a trust may be implied by law. Some trusts, such as testamentary trusts, are filed with the Surrogates court, but in that case it is because they form part of a will, which must be filed. Treasury Reg. §301.7701-4(a) emphasizes that a trust, for federal income tax purposes, must not engage in business activity. Rather, the regulation states that the trust is an arrangement created by will or inter vivos declaration whereby trustees take title to property for the purpose of protecting and conserving it for the beneficiaries.

Although most trusts are express, a trust may be implied. Thus, where property is transferred gratuitously to someone who pays nothing for it, that person is implied to have held the property for the benefit of the transferror. The trust res is said to “result” back to the settler. Equity may also imply the creation of a constructive trust, which occurs where it would be unjust for the legal owner of property to declare a beneficial interest in the property. Constructive trusts may arise where unjust enrichment would result if left uncorrected. However, since once must approach equity with “clean hands,” equity will not intervene to impose a constructive trust where property has been fraudulently transferred.

II. Trusts Distinguished From Other Legal Forms

Trusts bear similarities to other legal forms, but possess unique attributes. An agent, such as one acting under a power of attorney — like a trustee — may have fiduciary obligations. However, whereas an agent is not vested with title, a trustee takes legal title to property. An agency terminates upon the death of an agent, whereas a trust survives the death of a trustee. A trustee, but not an agent, may become a party to a contract. A trust is distinguished from a bailment in that only a trustee acquires an ownership interest. A trust is also a creature of equity; a bailment is a legal concept. Finally, only a chattel (tangible property) may be bailed. Any property, real or personal, tangible or intangible, may constitute the res of a trust. A person possessing an equitable charge has a security interest in property which may be enforced by a court. However, an equitable charge does not grant an ownership or posessory interest to the creditor. A trust, in contrast, confers upon a beneficiary equitable ownership in the trust res.

Property given upon condition may or may not create a trust for a third party. For example, father devises farm to son on condition that son maintain father’s daughter. If son fails to maintain daughter and a trust is established, daughter as trust beneficiary will have an interest in the farm. If no trust were created, then daughter could seek only equitable compensation for breach of the condition subsequent. Whether a trust was created depends upon the intent of the father. A trust is distinguishable from a debt in that a borrower becomes the absolute owner of money loaned, even if the purpose of the loan was to benefit someone else. In the event of a default in repayment, the lender would become merely an unsecured creditor, and the intended beneficiary would have no legal recourse. On the other hand, if money is transferred to trustee for the benefit of ascertainable beneficiaries, and the trustee were to become bankrupt, the trust funds would still be held inviolate for the beneficiaries.

A trust should also be distinguished from a contract. A contract may provide benefits for a third party, who may be unable to enforce the contract under the doctrine of privity. A trustee may enforce claims on behalf of a trust beneficiary. For example, A and C (a contractor) enter into a contract for completion of a new roof on B’s house. C breaches. B cannot sue C, because B was not a party to the contract. Assume instead that A places $1,000 in trust for B, naming T as trustee. T contracts with C to complete a new roof on B’s house. C breaches. T may commence a breach of contract action against C to enforce the rights of B as trust beneficiary.

III. Trustees as Fiduciaries

Chief Judge Cardozo, in Meinhard v. Salmon, 164 N.E. 545 (1928), in an oft-quoted passage, remarked: “A trustee is held to something stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior… the level of conduct for fiduciaries [has] been kept at a level higher than that trodden by the crowd.” Thus, under the “no further inquiry” rule, a trustee who engages in self-dealing or who evidences a conflict of interest cannot interpose a defense of good faith or reasonableness. The Prudent Investor Rule, which emanates from King v. Talbot, 40 N.Y. 76 (Ct of App. 1869) and is now ratified in EPTL 11-2.3, provides that a trustee “has a duty to invest and manage property held in a fiduciary capacity [requiring] a standard of conduct, not outcome or performance. Compliance with the prudent investor rule is determined in light of facts and circumstances prevailing at the time of the decision or action of the trustee.”

A trustee has a duty of loyalty to the beneficiaries, and must resolve conflicts between lifetime and remainder beneficiaries equitably. A trustee who breaches a fiduciary obligation may be required to pay compensatory damages to make the beneficiary “whole,” or may be required to disgorge any gain. A trustee may be required to determine whether a distribution made under a ““HEMS” (i.e., health, education, maintenance and support) standard should consider a beneficiary’s other resources. In In re Trusts for McDonald, 953 N.Y.S.2d 751 (4th Dept. 2012), the Court upheld a trustee’s decision not to distribute to a beneficiary for whom a college account had been established. The Restatement of Trusts, 3rd, is in accord, finding that the “usual inference” should be that the settlor intended the trustee to consider other resources of the beneficiary. However, the trust should be explicit on this matter.

IV. The Future of Trusts

Trusts have a pervasive influence in modern law. The uses of trusts are limited only by the imagination of the settlor or attorney. Most courts will strive where necessary to divine the settlor’s intent, but will not question it. Thus, the New York Surrogate enforced a testamentary trust of Leona Helmsley leaving $12 million to her Maltese, Trouble. Poignantly, Helmsley left nothing to two of her grandchildren and nothing to any of her great grandchildren. While some might question the bequest, Donald Trump observed: “The dog is the only thing that loved her and deserves every single penny of it.” Helmsley’s bequest was valid under New York’s statute, which authorizes trusts for pets, but permits a reduction if the trust “substantially exceeds the amount required for its intended use.”” The Court found that $2 million was sufficient. Trouble died in 2010, three years after Helmsley, at the age of 12.