Trust Planning

Trust Planning

Estate Planning and Wealth Management

What Laws Govern Trusts?

> This is Part 3...Go back to start of Quick Guide to Trusts

All trusts are governed by state laws, federal laws, the law of unintended consequences, Murphy's Law, and the Second Law of Thermodynamics. This may sound funny, but is not meant as a joke. And it is critical—very, very critical—that you understand how each of these laws will govern your trust.

State law. There is an overarching theory of how private trusts should work, and this has been codified by a national body of academic lawyers as the Uniform Probate Code. However, this Code does not have, in most states, the force of law—only 16 states adopted the entire original 1969 Code; the rest did their own thing some of the time and used the Uniform Probate Code other times in their probate legislation. It is state law that governs the holding of property, such as your home, or rights to minerals that lie underneath your home. Therefore, in a sense, it makes sense that state law covers the transfer of your personal property to the next generation. And by extension it may make sense, although less so, that state law governs your will and the formation and governance of the trusts into which your personal property is placed as it is transferred to and administered for your heirs. However, this really is somewhat archaic, and should, in my opinion, be changed to federal law and made completely uniform (constitutional issues aside). State law is bizarre and diverse: for example there are two completely different methods of dealing with common marital property, depending on which state you live in. And one state, Louisiana, adopts an entirely different legal system from the other 49 states, that is not based on the common law system that all. People change their state residence much more than ever; a truly uniform set of laws would really help everyone.

If there is some uncertainty, or if any individuals contest how the trust should be run, then courts will intervene. Sometimes this takes place in federal court, but usually it is in state court. In some states there are special courts known as probate courts (sometimes going by other names such as surrogates court) that deal specially with trusts and estates. In other states, the regular courts handle trust matters. If you do not have a will (you die intestate) then a probate court will have to figure out what to do with your assets, according to state laws of succession. Even if you do have a will, if you have assets of any value (in Hawaii this is defined as anything over $100,000) and you have not successfully used probate avoidance strategies (see page on probate avoidance strategies) then a court will verify your will and be sure that someone carries out its intentions (and be sure that someone gets well paid). Note that if you have to sue a trustee, you will probably end up in a state court, possibly held hostage to that state's common law court case precedents. And some states will allow you to get rid of a bad trustee if all beneficiaries agree, but most states still won't let you.

Federal laws impact trusts most powerfully in terms of taxation. The IRS determines (of course it is the legislation that really determines) how much trusts are taxed on their annual income and how much estate tax (and generation-skipping tax) will be taken out when the person who set up the trust dies. The federal government (through the IRS) also limits how long a trust can operate, although some states have tried to create laws to allow trusts to exist in perpetuity.

When you write your trust, you need to think like the event planner of a very large and very long event, in which you brainstorm every possible thing that could possibly go wrong... EVER, in any potential situation or scenario. This is why Murphy's Law governs trusts: in time, anything that can go wrong will go wrong.

It is that time element that brings in the Second Law of Thermodynamics, which states that, over time, a system will tend to increase in entropy, with order and intelligence of the system tending to dissipate. Stated in terms of trusts, we could say that the Second Law of Thermodynamics means that eventually your trust will become hell to your heirs. What the Third Law of Thermodynamics does not include is that systems governed by human intelligence tend to evolve and become centers of joy and prosperity for everyone evolved – if, and only if, there is constant input of human intelligence. Somehow, in the design of your trust, you have to allow human intelligence to be involved at every step and not allow the entropy of the system to govern the evolution of your trust.

The law of unintended consequences. This is an area that is almost never discussed in books on trusts, websites on trusts, or by trustees, lawyers or financial planners (who are often the beneficiaries of this law of unintended consequences). What happens to society when all trustees invest in exchange traded funds? (Companies just have to push into that top tier of stocks and then as a part of an ETF, their shares are effectively held in place, without much analysis about whether the company is benefiting society, is sustainable long-term, is good to its employees, will survive a downturn, etc.) Do trusts—as a large investment system that chose stocks without reference to social responsibility or social justice—result in a society that is a place you would like you grandchildren to live in? What is the effect on your children of knowing they will inherit significant amounts of money? What is the effect on your behavior, knowing an insurance premium is going to kick in if you die, giving your children a lot of money—do you neglect the social and familial contracts (say of a godmother/godfather for your children), so your children end up with money, but not the ethical guidance you would really like? These, to me, are the really important decisions and questions to ask.

Back to Quick Guide to Trusts (and the final section "Show Me the Money")