Trusts: Basic Principals of Living Trusts

Applicable Law

A Texas “trust may be created for any purpose that is not illegal” (Prop. Code Sec. 112.031). The law applicable to trusts and trustees is found in a mixture of that portion of the Property Code known as the “Texas Trust Code” (Prop. Code Chaps. 112-117 contained in Title 9 of the Code); the Restatement of Trusts (second and third versions), a body of authoritative academic literature that states common-law principles applicable to trusts; and case law as it is reported from the Texas courts.

Trust Basics

While trusts can be used flexibly with many variations, especially in real estate transactions and investing, there are certain basic legal principles that do not change:

(1) The trustor (sometimes called the settlor or grantor) is the person or entity who transfers property into the trust.

(2) The trust corpus (or trust estate) is the asset—in this case investment property—that is conveyed into the trust.

(3) The trustee controls the trust with authority to manage, maintain, lease, and sell the trust property. An LLC cannot usually be designated as trustee.

(4) The successor trustee serves if the trustee dies, resigns, or cannot otherwise serve.

(5) The beneficiary is the ultimate party in interest for whom the trust is being operated—the one with “ownership” to use that term loosely. An LLC can be a beneficiary.

(6) The contingent beneficiary or successor beneficiary acquires the beneficial interest if the primary beneficiary dies.

In order for an attorney to draft a trust, the client needs to specify which persons or entities will be acting in each role. Note that “a trust terminates if the legal title to the trust property and all equitable interests in the trust become united in one person,” known as the doctrine of merger found both in common law and in Property Code Section 112.034. So the person or persons acting in each of the three main roles cannot exactly match. As a practical matter, particularly when dealing with lenders and title companies, it is better if these actors overlap as little as possible. This enhances the perceived legitimacy of the trust.

Once the principals are identified, the next steps are to (1) formally establish the trust by means of a signed and dated trust agreement, and then (2) convey the real property into trust by means of a warranty deed (usually a general warranty deed).

Trust Property

A trust cannot be created unless there is trust property (Prop. Code Sec. 112.005). The trust property (or trust estate or corpus) may be of any type, whether personal or real, tangible or intangible, and wherever located (even if it is located outside of Texas). Additional property may be transferred into trust at a later date after the trust is established. Real property is conveyed into trust by general or special warranty deed recorded in the county clerk’s real property records. Title to trust property is typically in the name of its trustees, e.g., “John and Jill Smith, Trustees of the Smith Living Trust.” Another formulation is “John and Jill Smith in their capacity as Trustees of the Smith Living Trust.”

Must a trust agreement be in writing?

The short answer is yes if it pertains to real property. Whenever real estate is involved the statute of frauds must be observed. Otherwise, as to non-realty, it is possible for a trust to be oral based on what the Trust Code calls a “declaration of trust.”

These are the operative Trust Code provisions in this area:

Sec. 112.001. METHODS OF CREATING TRUST. A trust may be created by: (1) a property owner’s declaration that the owner holds the property as trustee for another person; (2) a property owner’s inter vivos transfer of the property to another person as trustee for the transferor or a third person; (3) a property owner’s testamentary transfer to another person as trustee for a third person; (4) an appointment under a power of appointment to another person as trustee for the donee of the power or for a third person; or (5) a promise to another person whose rights under the promise are to be held in trust for a third person.

Sec. 112.002. INTENTION TO CREATE TRUST. A trust is created only if the settlor manifests an intention to create a trust.

Sec. 112.003. CONSIDERATION. Consideration is not required for the creation of a trust. A promise to create a trust in the future is enforceable only if the requirements for an enforceable contract are present.

Sec. 112.004. STATUTE OF FRAUDS. A trust in either real or personal property is enforceable only if there is written evidence of the trust’s terms bearing the signature of the settlor or the settlor’s authorized agent.

As a practical matter, it is always difficult to prove the existence of an oral agreement, whether technically permissible by law or not.

Trust Situs

The trust situs, or its home jurisdiction, is (1) the state in which the trust is formed or (2) the state law to which the trust is expressly made subject by means of a choice of law provision in the trust agreement. Making a trust involving Texas property subject to the laws of a state other than Texas (South Dakota, for example, which probably has the most favorable trust laws in the U.S.) may or may not be successful, if challenged, based on whether or not the trust or its participants have sufficient minimum connections to the other state. These connections could include residency of the trustee, any trust property that may be located there, or a non-nominal trust bank account in the foreign jurisdiction.

Regardless of whether or not sufficient minimum connections can be demonstrated at the time the trust is established, it is nonetheless the best practice for the trust agreement to include among a trustee’s powers the express prerogative to change the legal situs of the trust.

Are Trusts legal entities?

No. A trust is a contractual relationship between and among its participants, not a legal entity. Only natural persons and registered entities (i.e., that require filing and approval by the secretary of state) such as LLCs, corporations, and limited partnership are considered to be legal entities.

In many respects, however, this is a distinction without a difference since trusts often behave like legal entities in real estate and business transactions. Texas, which follows the entity theory of transactions, requires that transactions be among legal entities. This is the reason, for instance, that real property cannot be bought or sold in an assumed name. The key item to note in the trust context is that it is the trustee, acting on behalf of the trust, who is the relevant legal “person” carrying out a transaction. Because a trust has no liability barrier (as does an LLC, for instance) this creates potentially serious vulnerability and liability to anyone who accepts the role of trustee.

Duties of a Trustee

When serving as trustee for others, a trustee is a fiduciary and has certain duties with respect to both the beneficiaries and the property held in trust, and these are significant, as is the potential liability for failing to perform these duties. Fiduciary standards may not be very important if the trustee is also the sole beneficiary of the trust (not a recommended set-up), but otherwise such considerations are very relevant indeed.

The duties of a trustee include:

(1) a duty of loyalty;
(2) a duty of competence;
(3) a duty to exercise reasonable discretion;
(4) a duty of disclosure with respect to the beneficiaries; and
(5) a duty to comply with the prudent investor rule contained in Property Code Section 117.003.

Section 113.053 of the Property (Trust) Code provides that except in limited circumstances “a trustee shall not directly or indirectly buy or sell trust property from or to: (1) the trustee or an affiliate; (2) a director, officer, or employee of the trustee or an affiliate; (3) a relative of the trustee; or (4) the trustee’s employer, partner, or other business associate.” An old supreme court case puts this succinctly: “[A] trustee, or person occupying a fiduciary relation to another, is incapacitated, in equity, to buy from himself property committed to his care, or secure to himself an advantage in a purchase of such property by another from him.” Tenison v. Patton, 67 S.W. 92, 93-94 (Tex. 1902). Note that in cases where this duty is breached, it falls to the beneficiary (and really no one else) to raise the issue. Harvey v. Casebeer, 531 S.W.2d 206, 208 (Tex.App.—Tyler 1975, no writ).

Trustee’s Duty to Manage the Trust Productively

The law makes it clear that a trustee has an active duty to take reasonable measures to protect trust property and make it productive. The exact extent of this duty can be argued in any particular case; however, at the very minimum, a trustee is obliged to ensure that property belonging to the trust is not subject to unnecessary waste, loss, or other diminishment. Central to this is the “prudent investor rule” found in the Restatement (Third) of Trusts which sets forth core principles: (1) a preference for lower risk to achieve a beneficial rate of return; (2) applied as an overall strategy (which does not mean that any single investment needs to comply with this concept); plus (3) reasonable diversification to manage risk and avoid unnecessary loss; along with (4) a view toward increasing returns over time if that is reasonably feasible; (5) and, having said the foregoing, a trustee should nonetheless retain flexibility to actively take advantage of unique or special opportunities as they may arise.

A “Uniform Prudent Investor Act” is included within the Texas Trust Code (Chapter 117 of the Property Code). This law takes the general principles of the Restatement of Trusts and gets more specific, stating that “a trustee shall invest and manage trust assets as a prudent investor would, by considering the purposes, terms, distribution requirements, and other circumstances of the trust. In satisfying this standard, the trustee shall exercise reasonable care, skill, and caution.” Prop. Code Sec.117.004(a). The same section goes on to list specific items that a trustee should consider: “(1) general economic conditions; (2) the possible effect of inflation or deflation; (3) the expected tax consequences of investment decisions or strategies; (4) the role that each investment or course of action plays within the overall trust portfolio, which may include financial assets, interests in closely held enterprises, tangible and intangible personal property, and real property; (5) the expected total return from income and the appreciation of capital; (6) other resources of the beneficiaries; (7) needs for liquidity, regularity of income, and preservation or appreciation of capital; and (8) an asset’s special relationship or special value, if any, to the purposes of the trust or to one or more of the beneficiaries.”

The extent of a trustee’s obligations and liabilities are such that no one should just casually agree to be a trustee. It can be fearfully easy for a beneficiary to sue and win against a trustee for breach of duty, especially in cases of alleged trustee self-dealing. While a trust agreement can attempt to reduce or mitigate some of the liability risk, it cannot eliminate it entirely, at least not as to intentional, bad faith, or reckless actions by the trustee (Prop. Code Sec.114.007).

Real Estate Professionals as Trustees

Note that if a real estate investor has considerable experience and knowledge of the business, then he or she will be held to a higher standard when acting as trustee for another: “A trustee who has special skills or expertise, or is named as trustee in reliance upon the trustee’s representation that the trustee has special skills or experience, has a duty to use those special skills or expertise.” Prop. Code Sec. 117.004(f). Real estate professionals (and that would include professional real estate investors) are expected to display a professional level of trust management.

Lawyers are often asked to act as trustees for their clients’ trusts. Considering the extensive duties and liabilities, it is not surprising that lawyers are reluctant to do so without substantial compensation, especially since trustees are sued all the time. In fact, when the trust is sued, it is the trustee who is named as the primary defendant.

Trust Protector

There is another possible player in the structure of a trust: the trust protector, a new role recognized by the Texas Trust Code in 2015. According to Property Code Section 114.0031(d), the trust protector (also referred to as an advisor in the statute) “has all the power and authority granted to the protector by the trust terms, which may include: (1) the power to remove and appoint trustees, advisors, trust committee members, and other protectors; (2) the power to modify or amend the trust terms to achieve favorable tax status or to facilitate the efficient administration of the trust;  and (3) the power to modify, expand, or restrict the terms of a power of appointment granted to a beneficiary by the trust terms.” A trust involving a trust protector may be referred to as a “directed trust.”

The rationale for having a trust protector or advisor is that the appointed trustee (also referred to as the “directed trustee”) may not have the expertise to manage certain specialized investments such as real estate or oil and gas . . . which begs the question: if the trustee is not qualified and needs to be directed by some other individual, then why is he appointed in the first place?

Another issue: the statute provides that the trust protector may or may not be a fiduciary–which raises an additional question: if a person with such critical powers is not going to be one’s protector in a fiduciary capacity, then what is he doing in the mix at all?

Consider the case of a trust protector gone rogue in Suzanne Ron v. Avishai Ron, et al, No. 20-40248 (5th Cir. 2020). In this case, the trust protector not only added another beneficiary to the trust but also fraudulently transferred $1.3 million to legal counsel–all against the wishes of the trustor. Notwithstanding that (1) the statute states that an advisor [protector] “is a fiduciary regardless of trust terms to the contrary….”; and (2) the trust agreement expressly stated that the trust protector’s authority was “conferred in a fiduciary capacity,” the court bizarrely concluded the no fiduciary relationship existed, either formal or informal, and dismissed the case.

If nothing else about the trust protector statute stands out to you as problematic, then the result in Ron should be more than sufficient reason to avoid trust protectors.

Duration of Trusts

Historically and at common law, the duration of a trust was governed by the Rule Against Perpetuities which states that a trust interest must vest, if at all, “within a life or lives in being at the time of the testator’s death and twenty-one years thereafter, and when necessary, the period of gestation.” Foshee v. Republic Nat’l Bank of Dallas, 617 S.W.2d 675 (Tex. 1981). This has changed in an attempt to make the trust business in Texas more competitive with other states that are aggressively pushing the boundaries of traditional trust law (South Dakota, for example).

For trusts executed after September 1, 2021, an “interest in a trust must vest, if at all: (1) not later than 300 years after the effective date of the trust, if the effective date of the trust is on or after September 1, 2021; or (2) except as provided by Subsection (d), not later than 21 years after some life in being at the time of the creation of the interest, plus a period of gestation, if the effective date of the trust is before September 1, 2021.” Prop. Code Sec. 112.036(c). However, Section 112.036(f) provides that real property may not be tied up in a trust for more than 100 years.

From Our Case Files

Ernesto’s widow, Evangelina, arrived at her late husband’s lawyer’s offices in great distress, not only from the passing of her husband but because of confusion as to his estate, which consisted of his share of the homestead, a rental property in Galveston, a profitable general contracting company, and a collection of gold coins worth well into the six figures. Lina (as she preferred to be called) explained that she had asked Ernesto many times about making a will. His response was “I don’t need no stinkin’ will. All my property is in trust.” He told her not to worry but she continued to raise the issue over the years. The answer was always the same. Now, faced with Ernesto’s demise, Lina had come to ask the lawyer for a copy of the trust.

The lawyer was surprised. He knew nothing about a trust agreement, a will, or anything else. He had last worked with Ernesto on a business contract a year previously. He had taken that opportunity to remind Ernesto that he should consider doing some estate planning, especially since Ernesto was taking pills for a heart issue. “I’m a horse!” Ernesto had replied. “You hear me? Un caballo muy fuerte! Besides, everyone in my family, we trust each other.” The lawyer had let the matter drop.

It was discovered that Ernesto had surreptitiously obtained a deed from the internet (a generic form designed for use in Illinois, not Texas) and had recorded it in Harris County. This “deed” purported to convey Ernesto’s real property into “The God and Family Trust.” The document provided no further details about the trust and no trust agreement could be found.

Matters worsened when Ernesto’s adult children from a previous marriage also contacted the lawyer and demanded their share of the trust. His ex-wife also made a claim, saying that she had been told repeatedly by Ernesto not to worry: “I will take care of you. Call my lawyer if I die—he is the trustee and knows everything. Trust me!” Ernesto’s former wife did not believe the lawyer’s protestations that he knew nothing about a trust. She promptly filed suit against him for theft of Ernesto’s estate along with a complaint to the State Bar.

Ernesto’s family spent the next three years in probate litigation accusing one another of various forms of treachery. Several refused to ever speak to each other again. Their aggregate attorneys’ fees exceeded $150,000.

The lawyer became the subject of social media gossip where the consensus was that he could not be trusted. Although he eventually prevailed against the ex-wife’s lawsuit (and defeated the State Bar complaint), his reputation in Houston was ruined. Everyone knew he was a crook since it said so on Facebook. Google removed his website as disinformation. His wife divorced him. With nothing to lose, the lawyer fulfilled his lifelong dream of moving to the Hill Country where he happily opened a new law practice dealing with farm and ranch law.

DISCLAIMER

Information in this article is provided for general educational purposes only and is not offered as legal advice upon which anyone may rely. The law changes. Legal counsel relating to your individual needs and circumstances is advisable before taking any action that has legal consequences. Consult your tax advisor as well since we are not tax practicioners and do not offer tax advice. This firm does not represent you (i.e., no attorney-client relationship is established) unless and until it is retained and expressly agrees in writing to do so.

Copyright © 2023 by David J. Willis. All rights reserved worldwide. Reproduction or re-use of any this material for any purpose without prior written permission and full attribution is strictly prohibited. David J. Willis is board certified in both residential and commercial real estate law by the Texas Board of Legal Specialization. More information is available at his website, https://www.LoneStarLandLaw.com.