Trusts: Basic Principals of Living Trusts

Applicable Law

The law applicable to trusts and trustees is found in a mixture of that portion of the Property Code known as the Texas Trust Act (Prop. Code Chaps. 112-117); 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 and federal courts.

TRUST PARTIES

Trust Terminology

While trusts can be used flexibly with many variations, especially in real estate transactions and investing, certain basic terminology does 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. It also needs to be determined if the trust will be revocable or irrevocable. In Texas, a trust is revocable unless the trust agreement expressly states otherwise (Prop. Code Sec. 112.051(a)).

Nearly all trusts formed for the purpose of owning a family homestead are revocable living (inter vivos) trusts.

Trust Protector

There is another possible player in the structure of a trust: the trust protector, a newer role recognized by the Texas Trust Act 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 (trust 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 as problematic, then the result in Ron should be more than sufficient reason to avoid trust protectors.

Merger of Trust Parties

The common-law doctrine of merger can arise if the trustor, trustee, and beneficiary are the same person. The common law viewed such situations as not constituting a trust at all. The capacities of these three parties were deemed to be merged and the trust evaporates as a matter of law. The result? Fee simple ownership.

Texas has narrowed the scope of the common-law merger rule as follows:

Prop. Code. Sec. 112.034. MERGER

(a) If a settlor transfers both the legal title and all equitable interests in property to the same person or retains both the legal title and all equitable interests in property in himself as both the sole trustee and the sole beneficiary, a trust is not created and the transferee holds the property as his own. This subtitle does not invalidate a trust account validly created and in effect under Chapter 113, Estates Code.

(b) Except as provided by Subsection (c) of this section, a trust terminates if the legal title to the trust property and all equitable interests in the trust become united in one person.

(c) The title to trust property and all equitable interests in the trust property may not become united in a beneficiary, other than the settlor, whose interest is protected under a spendthrift trust, and in that case the court shall appoint a new trustee or co-trustee to administer the trust for the benefit of the beneficiary.

As a practical matter, particularly when dealing with lenders and title companies, it is better if the trust actors overlap as little as possible. This enhances the perceived legitimacy of the trust.

ESTABLISHING A TRUST

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.

Going forward, this article presumes that Texas law applies.

Purpose, Intention, and Consideration

A Texas “trust may be created for any purpose that is not illegal” (Prop. Code Sec. 112.031). Intention to create a trust is required:

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

Consideration, however, is not required:

Prop. Code 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.

Trust Property

A trust cannot be created unless there is trust property (Prop. Code Sec. 112.005). Initial trust property (or the 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. Most trusts provide that additional property may be transferred into the trust at later dates after the trust is established.

Real property is conveyed into a 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.” If an individual is acting in a specific or limited capacity, it is always better legal draftsmanship to spell out what that capacity is.

In any case, it is important to recall that a trust (which is a contractual arrangement and not a legal entity) cannot own anything in its own name; true ownership of such property is always in the name of a person who is acting in the capacity of trustee on behalf of the trust. “The trustee of a trust is considered for all purposes to be the named party to an instrument that names the trust as a party” to a real estate transaction (Prop. Code Sec. 114.087).

“In any active trust the legal title and right of possession are vested in the trustee, and the beneficiary has the equitable title only, without possession or right of possession. . . . The trustee is vested with the legal title and the right of possession of the trust property, but holds it for the benefit of the beneficiary.” Long v. Long, 252 S.W.2d at 247 (Tex. Civ. App.—Dallas 1952, no writ).

Note that Section 114.087 does not actually prohibit a conveyance of real property into the name of a trust without mentioning the trustee (a common anonymity technique); but it does clarify that the true party in interest is the trustee. Why? Because title cannot legally reside in the trust itself. A trust is a contract, not an entity, and a contract cannot own real estate in Texas.

How is a trust created?

The Trust Act specifies five methods for creating a trust:

Prop. Code 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.

Acceptance of the trust by the trustee is required. The signature of the trustee on the trust agreement conclusively signifies acceptance; however, acceptance may be presumed by the trustee’s course of conduct in performing trust duties and exercising trust powers (Prop. Code Sec. 112.009).

Must a trust agreement be in writing?

Yes, as to real property. The Trust Act contains its own specific Statute of Frauds (that is, in addition to similar provisions found in Bus. & Com. Code Sec. 26.01(a), (b)(4) and Prop. Code Sec. 5.021).

Prop. Code 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.

There is narrow carve-out for situations where only personal property is involved and the trust is created by “a transfer of the trust property to a trustee who is neither settlor not beneficiary if the transferor expresses simultaneously with or prior to the transfer the intention to create a trust. . . .” (Prop. Code Sec. 112.004(1)).

Spendthrift Trusts

It is typical for a living trust to contain a spendthrift provision that protects both income and principal from a beneficiary’s creditors. This is an example of a spendthrift clause:

No beneficiary, whether a minor or an adult, shall have the right, power, or authority to sell, transfer, convey, alienate, encumber, or hypothecate his or her interest in the principal or income of this trust in any manner, nor shall any interest of a beneficiary be subject to the claims of his or her creditors, nor shall any such beneficial interest be liable to attachment, execution, or other process of law.

Spendthrift trusts are valid in Texas but a trustor cannot establish a trust merely for the purpose of avoiding debts:

Prop. Code Sec. 112.035. SPENDTHRIFT TRUSTS. (a) A settlor may provide in the terms of the trust that the interest of a beneficiary in the income or in the principal or in both may not be voluntarily or involuntarily transferred before payment or delivery of the interest to the beneficiary by the trustee. (b) A declaration in a trust instrument that the interest of a beneficiary shall be held subject to a “spendthrift trust” is sufficient to restrain voluntary or involuntary alienation of the interest by a beneficiary to the maximum extent permitted by this subtitle. . . . (d) If the settlor is also a beneficiary of the trust, a provision restraining the voluntary or involuntary transfer of the settlor’s beneficial interest does not prevent the settlor’s creditors from satisfying claims from the settlor’s interest in the trust estate.

Are Trusts legal entities?

No. A trust is a contractual relationship by, between, and among its participants, not a legal entity. Only natural persons, general partnerships, and registered entities that require state filing (such as LLCs, corporations, and limited partnerships) may own title to property.

This is sometimes known as the entity theory of transactions, and this rule prevails in Texas. The entity theory is also the reason that real property cannot be bought or sold in an assumed name. An assumed name is neither a person nor a legal entity, thus it cannot hold title.

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.

TRUSTEE POWERS, DUTIES, AND LIABILITY

Powers of Trustees

Statutory powers of trustees are outlined in Subchapter A of the Texas Trust Act (Prop. Code Sec. 113.001 et seq.). These statutory powers are a baseline; they can be expanded or limited by the written trust agreement. Generally, unless a particular power is contrary to law, a court order, or the trust agreement then the Trust Act grants it:

Prop. Code 113.002. GENERAL POWERS [OF TRUSTEES]. Except as provided by Section 113.001, a trustee may exercise any powers in addition to the powers authorized by this subchapter that are necessary or appropriate to carry out the purposes of the trust.

What trustee powers are authorized by the Trust Act? Quite a few. Unless contravened by Section 113.001, Subchapter A of the Act empowers a trustee to:

(1) generally manage trust property, including the ability to invest and reinvest same;
(2) invest or participate any form of business or investment enterprise;
(3) manage real property assets;
(4) sell and lease personal and real property, including mineral assets;
(5) purchase and maintain insurance on trust property;
(6) acquire and manage securities investments;
(7) have employees and agents;
(8) advance, contest, and settle claims relating to trust property; and
(9) exercise such additional and implied powers, duties, and responsibilities that are not inconsistent with the Texas Trust Act.

Most trust agreements state that the trustee shall have all powers set forth in the Texas Trust Act plus a long list of specifically-enumerated powers that are listed in the agreement. The result is that most Texas trustees have very extensive powers in dealing with the trust property.

Duties of Trustees

The Trust Act states:

Prop. Code Sec. 113.051. GENERAL DUTY [OF TRUSTEES]

The trustee shall administer the trust in good faith according to its terms and this subtitle. In the absence of any contrary terms in the trust instrument or contrary provisions of [the Trust Act], in administering the trust the trustee shall perform all of the duties imposed on trustees by the common law.

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 Trust Act 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 Act. 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.

The Naked Trustee Problem

The key item to understand is that it is the trustee, acting on behalf of the trust, who is the relevant legal person carrying out any transaction involving the trust.

The way trusts are structured creates potentially serious liability and legal vulnerability to anyone who accepts the role of trustee (the naked trustee problem). Because a trust has no liability barrier (as does an LLC, for instance) a trustee stands unprotected against claims and lawsuits. When a trust is sued, it is the trustee who is the named defendant. The trustee must then scramble to assert that whatever actions taken were taken in a specific, limited capacity that should not result in his personal liability. So the trustee has a high level of exposure and is very much on the defensive from the outset of any trust-related litigation.

TRUSTS AND REAL ESTATE CLOSINGS

Proving Existence of a Trust

Following the 2008 real estate recession (when trusts were prolific) title companies acquired an almost automatic resistance to any transaction with the word trust connected to it, so the trust agreement should be a solid, proper document. Be prepared to offer sufficient evidence that a valid trust exists.

Certification of Trust

In any transaction concerning a trust, it is common for title companies to request a copy of the trust agreement. In the interest of privacy, the trustee may instead offer to provide what is known as a certification of trust or in former days a memorandum of trust. This is essentially a summary of key terms and provisions.

Even though certifications of trust are condensed versions of the original, third parties receiving a certification of trust have a legal right of reliance. So long as the information required by the statute is contained in the certification, “A person who acts in reliance on a certification of trust without knowledge that the representations contained in the certification are incorrect is not liable to any person for the action and may assume without [further] inquiry the existence of the facts contained in the certification.” Prop. Code Sec. 114.086(f).

Added protection accrues if the certification is recorded in the real property records: “A document purporting to be a certification of trust under Section 114.086 that is recorded in the county in which real property of the trust is located is presumed to correctly identify the trust and the trustee and may be relied upon by a good faither purchase or lender for value.” Prop. Code Sec. 114.087(d).

A title company is not compelled under this law to accept a certification of trust in lieu of the actual trust agreement, but liability to third parties may be mitigated if the title company chooses to do so.

A title company will likely require that a certificate of trust contain (at least) the following items:

(1) a statement that the trust exists and the date the trust agreement was executed;
(2) the name of the trustor (or settlor or grantor);
(3) the name(s) and address(es) of the trustee or trustees;
(4) a statement that that the trustee’s powers include at least all of the powers granted to a trustee under the Texas Trust Act (Prop. Code Chap. 113, Subchapter A);
(5) a statement as to the revocability of the trust and the name of any person who has the power to revoke;
(6) a statement as to the extent of the authority of any co-trustees and whether unanimity among the co-trustees is required in order to exercise trustee powers;
(7) the manner in which the trust will take title to any real property; and
(8) a statement that the trust has not been revoked, modified, or amended.

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 instrument 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.