Misappropriation of Trust Funds by Trustee in California
In this course we will discuss a trustee’s failure to make distribution of trust assets to beneficiaries as required under the terms of the trust.
Let’s start with a basic understanding of the trust law we will apply to this problem.
The Basics of California Trust Distributions
Under Probate Code section 16000, a trustee has a duty to administer the trust according to the trust instrument. This duty requires the trustee to distribute trust assets to the beneficiaries as mandated by the trust document.
Sometimes a trustee is granted “absolute” discretion over trust distributions. This means the trustee has the right to make, or not make, any distribution they like. Even when the trustee is granted “absolute” discretion, their power to distribute must be exercised in accordance with fiduciary principles and not in bad faith or in disregard of the purposes of the trust. “Fiduciary principles” essentially means a trustee is supposed to act like a reasonable person would in similar circumstances—in other words: be fair.
Trust Distribution Hypothetical: Brian as Abused Beneficiary
Let’s consider a hypothetical situation to demonstrate the problems that arise and the options you have when confronted with a California trustee who fails to distribute trust assets. After the hypothetical, we will discuss trust distributions in more detail.
Brian was the youngest son of a family that had two children. Brian’s father, Frank, built four apartment buildings in Los Angeles that had between ten to fifteen apartment units per building. The apartment buildings were built in the 1960s and were owned by Frank until his death in March 2014.
Prior to his death, Frank created a revocable living trust that named his oldest son, Tom, as the successor trustee. The trust terms stated that after all the debts and expenses of the estate were paid, the remaining assets were to be distributed outright to Tom and Brian equally. The trust did not provide any instructions on how to deal with the four apartment buildings.
After Frank’s death, Tom quickly took control of the four apartment buildings but used the same property manager that Frank had used for years. Two of the apartment buildings had mortgages against them, and the other two were owned free-and-clear of any mortgages.
Brian assumed that his brother would simply sell the apartment buildings and split the cash between the two beneficiaries. Based on the appraisals obtained by Tom, the total value of all four apartment buildings equaled $14 million. The two mortgages against two of the apartment buildings equaled $4 million total, leaving a net estate of $10 million. After estate taxes and expenses were paid, Brian assumed he would receive close to $4 million.
Tom had other ideas, however, on how to handle the estate. Tom thought that Brian was foolish with his money and would simply spend everything he received from the trust. As a result, Tom decided not to distribute any assets to Brian. Tom also did not want to sell the apartment buildings. Instead, he wanted to continue managing them as his father had and receive the income.
Tom did disclose his plan to Brian. Tom also refused to provide Brian with any financial information (other than the appraisals). Instead, Tom sent $1,000 per month to Brian and told him that was all he was going to receive from the trust. Tom also told Brian that if he hired a lawyer or attempted to challenge anything, then Brian would be disinherited and receive nothing further from the trust.
Brian was frustrated but also afraid to lose his trust share. He believed his brother’s threat of being disinherited. Brian never received an accounting or any financial reports, and did not know how to obtain them.
It appears that Tom intentionally decided to withhold Brian’s share of the trust and prevent him from ever receiving his $4 million.
What can Brian do to force a distribution of his inheritance? Here are his options:
- File for removal of trustee. File a petition with the California probate court asking the court to remove Tom as the trustee.
- File to obtain a trust accounting. Demand an accounting in writing, and then file a petition with the California probate court asking the court to order Tom, as the trustee, to account.
- File to force a distribution of trust assets. File a petition for instructions asking the court to force the trustee, Tom, to account.
- File for breach of trust against Tom. File a petition for redress for breach of trust that would seek monetary damages against the trustee, Tom.
- Ask Tom to distribute more money without filing in court. Send an email to Tom asking him to make a proper trust distribution.
Our Expert Recommendation
Having a bad trustee who refuses to make distributions as required by the trust document is not unusual—it happens more often than you might think. Luckily, in this case Brian is supposed to receive an outright distribution of one-half of the trust estate. There are no restrictions or trusts created for Brian; it is an outright gift. As such, Brian has a right to receive his half of the trust estate within a “reasonable” amount of time.
So why is Tom not honoring Brian’s rights? Sounds like Tom is enjoying the status quo. Tom is keeping all of the rents, he does not have to sell any of the properties, and he is keeping money out of Brian’s hands. But Tom does not have the right to judge whether or not Brian can properly manage money. If the trust requires an outright distribution, then that must occur. It does not matter if Brian is wasteful with money; half the estate belongs to Brian and Brian must receive it.
Option 1: the first action we at Albertson & Davidson, LLP, would recommend is for Brian to send Tom a written demand for a trust accounting and a trust distribution. A trust accounting refers to a detailed description of all assets received by Tom as trustee, all expenses paid from the trust, all distributions made to beneficiaries, and all assets still held by Tom as trustee. A trust accounting gives the beneficiaries full transparency of trust finances. A trust distribution is the transfer of money or other assets to the beneficiaries. The trustee has sixty days in which to comply and provide a trust accounting. The trust accounting is important because it will allow us to determine how much back rent should go to Brian. Since Tom has been keeping all the rents, that means Tom has failed to give Brian his one-half share of those rents. As a fifty percent beneficiary, Brian is entitled to half of all rents going to back to the date of Frank’s death.
Option 2: in most cases, the trustee will refuse to provide an accounting and will also refuse to make a trust distribution. Our next step would be to file a petition for accounting and for a trust distribution. Our goal here would be to have as much money distributed to Brian as possible. We want to get assets into Brian’s hands, so Tom cannot continue to abuse the trust assets.
In most cases, the court will agree to order an accounting and also order a trust distribution. Once the accounting is obtained, we can review the information to determine what other damages are due to Brian (such as one-half of the back rent). We can also use the financial information to subpoena records directly from the bank. The bank records will help to substantiate or refute the information provided to us in the trust accounting.
Option 3: the problem with trustee removal is it takes time to remove a trustee. Ultimately, we have to go to trial and present evidence to remove a trustee. We can ask for temporary suspension of the trustee, which may be a good idea, but removal takes time and costs money. The real goal in this case is to force a total trust distribution to Brian, which can be achieved with Tom as trustee. In fact, we may have more leverage to achieve that with Tom as trustee because the trustee owes Brian substantial fiduciary duties—meaning Tom is under a legal obligation to act reasonably towards Brian even after Brian files his lawsuit in court. Once Tom is removed as trustee, he no longer owes Brian fiduciary duties.
There are some cases where we do bring a removal petition along with the accounting and trust distribution petitions, but we have to evaluate that option carefully. Remember, every petition we bring takes time and money to prosecute, so you may want to spend your time and money on a trust distribution rather than trustee removal.
Option 4: a petition for breach of trust may be possible, but we typically wait until after we receive the trust accounting. The accounting will provide a financial road map that will allow us to find the breaches of fiduciary duties, if there are any. By waiting for the accounting (and the subpoenaed bank information) we can prepare a more targeted petition for breach of trust. This petition can always be filed later after further evidence is located.
Option 5: it never hurts to ask for a trust distribution, but it rarely accomplishes your goal. Many people believe a letter from a lawyer will convince a bad trustee to act appropriately. In our experience, letters rarely work because letters can be ignored. A court lawsuit, with an angry judge staring at the trustee or the trustee’s lawyer in court, cannot be ignored. But if you are thinking about emailing the trustee to ask for a distribution, by all means you should do so. And if that works for you, be sure to send us an email to let us know that you are the first person we have ever heard of getting a bad trustee to do the right thing outside of court action.
A Word on No-Contest Clauses
A no-contest clause refers to a provision in a contract that seeks to prevent a contracting party (or beneficiary) from challenging its terms. In Brian’s case, Tom’s threat that Brian will be disinherited if he hires a lawyer and challenges the trustee is the no-contest clause—and it is completely false. No-contest clauses in California are narrowly enforced, meaning they only apply to challenging the validity of the trust document. Also, no-contest clauses never apply to any action a beneficiary might take to force a trustee to account or to distribute according to the trust terms, or to sue the trustee for breach of trust. As a beneficiary, you will never be disinherited for questioning a trustee or taking actions to force the trustee to act appropriately.
The Law of Trust Distributions in California
The law of trust distributions is fairly straightforward. Under Probate Code section 16000, the trustee must follow the trust terms. In Leader v. Cords (182 Cal. App. 4th 1588(2010)), the California Appellate Court held that the duty to account is inseparable from the duty to distribute. In other words, a trustee must make a distribution of trust assets in order to meet their duty to administer the trust according to its terms.
The bottom line: the trustee must follow the trust terms. If the trust provides for an outright distribution to a trust beneficiary, then the assets must be distributed outright to that person—no other options are available. Even if the trustee believes the beneficiary is foolish with money or will spend all the money on something bad like drugs, alcohol, or gambling, the distributions must still be made.
If the trust provides for assets to be held in trust and only to make distributions where a need arises, like for health, education, support, or maintenance, then the trustee must make reasonable distributions on that basis. Under no circumstances can a trustee unilaterally decide to keep something that belongs to a beneficiary because the trustee believes it better to do so. The trust terms must be followed. And the overriding guideline is that the trustee act in the best interests of the beneficiary.
The problem is that many private trustees fear making a mistake when distributing large sums to beneficiaries. As a result, trustees would rather hold onto trust assets than make a mistaken distribution. The other fear is that an unknown trust liability will be discovered, like unpaid taxes, an unknown credit card bill, or any other random expense, and the trustee will be responsible for payment after all assets have been distributed. And finally, some private trustees think they can do whatever they like since they, as the trustee, are “in-charge.” That’s false, but it can be hard to convince a bad trustee of this point.
A Reasonable Trust Reserve
A trust reserve refers to holding money in the trust to pay final trust expenses, such as tax preparation fees, trust taxes, trustee’s fees, any debts or bills, and any final attorneys’ fees. Every trustee has the right to retain a reasonable trust reserve. The court talks about this point in Leader v. Cords (and there are other cases on the subject as well). Of course, the problem comes down to: what is “reasonable”? If you have a trust with a total value of $10 million, would it be reasonable to withhold a reserve of $1 million? If you have a trust with a total value of $1 million, would it be reasonable to withhold a reserve of $250,000?
That all depends on what is expected to occur after distribution of trust assets. For example, if the trust is subject to a creditor’s claim worth $250,000, then a reserve for that amount may be reasonable—even if the claim is disputed. The reserve is reasonable because if the claim is challenged, but ultimately lost, then the trustee would have to pay $250,000. That amount should be set aside until the claim is finalized.
If, however, a trust has no debts or claims against it at all, and the only expected expense is the preparation of a final tax return, then a reserve of $250,000 would be unreasonable for estates of any size. In this case, a reserve of $1,500 may be more than enough to cover any expenses to prepare and file a tax return. Of course, a trustee in this situation will probably ask for a $5,000 reserve to be on the safe side, but that would be more than enough to cover possible expenses.
The reserve, to be reasonable, must be based on a realistic expectation of possible debts and expenses. If a trustee cannot clearly articulate the reason for a given amount in reserve, then the amount they’ve designated is considered fabricated and should not be allowed.
A Reasonable Timeframe for Distributions
Trustees always make distributions too slowly, and beneficiaries always expect distributions too soon. This is how trustees and beneficiaries view each other. The law presumes that distributions will be made in a “reasonable” time, but what does that mean?
The amount of time that is “reasonable” can vary greatly from case to case. For example, a distribution that takes place a year after the settlor’s death could be reasonable if the trust has real estate (homes, apartments, commercial buildings, etc.) that has to be repaired and then sold. Tax issues or disputed debts can also delay distributions. Alternatively, a trust holding cash with no debts should make distributions within a few months.
There are a few statutory or required timeframes to consider as well. For example, under Probate Code section 16061.7, the trustee is required to give notice to all trust beneficiaries after a trust becomes irrevocable, meaning the trust can no longer be amended or changed. The beneficiaries then have 120 days in which to object to the terms of the trust (i.e., to bring a trust contest). After the 120-day period runs, there can be no contest of the trust terms. Therefore, it may be reasonable for a trustee to wait until after the 120-day period expires before making any trust distributions—especially where a trust contest is a concern. In fact, Probate Code section 16061.9(c) specifically allows a trustee to consider this 120-day period in deciding when to make trust distributions.
A trustee also has the right, but not the obligation, to use the creditor’s claim procedures provided in Probate Code sections 19400 to 19403. These Probate Code sections allow a trustee to notify all potential creditors of the trust estate and force them to either file a claim or be forever barred from collecting their debt. Once the creditor’s claim time period expires, which is four months after it begins, the trustee can make distributions without fear of an unknown creditor’s claim.
The bottom line: trust distributions must be made within a reasonable timeframe, but the term “reasonable” is not defined. Each case will be different depending on the type of assets owned by the trust and the type of debts and expenses of the trust.
A quick note on distributee liability: for those situations where a trustee fears some future claim by an unknown creditor, it may be helpful to point out Probate Code sections 19400 to 19403—distributee liability. These sections provide that if a creditor comes forward at a later date (and if the trustee did NOT use the creditor claims procedure described in the previous section), then any liability on the creditor’s claim flows through to the beneficiaries. In other words, the beneficiaries will be liable to pay a creditor to the extent the beneficiaries received distributions from the trust.
To be clear, this does NOT mean that you, as a beneficiary, are liable for the debts of the trust. It just means that if a creditor is discovered, and the trust has distributed all the assets to you, then you have to use those distributed assets to pay the trust creditor. The debt follows the assets that were distributed. Once you pay everything you received from the trust to a creditor, then you are not obligated to pay anything else. It is only the distributed assets that the creditor can obtain, not your own personal money or assets.
The next time a trustee tells you a distribution cannot be made because some unknown creditor may arise in the future, point them to distributee liability. “Not to worry,” you can say, “because the debt will be paid by me, the beneficiary, from the distributed assets, if that should occur.” Another trustee excuse deflated, thanks to the California probate code.
Death and Taxes
Two further issues can delay a trust distribution: death and taxes.
Death of a beneficiary: by death, I am referring to the death of a beneficiary after the settlor has died. Naturally, none of the trust assets are distributed (usually) while the settlor is living. But once the settlor dies, then distributions must take place within a reasonable time.
When a beneficiary dies, there can be a further delay for a number of reasons. The first question is whether the beneficiary’s estate is entitled to the deceased beneficiary’s distribution. Typically, a beneficiary’s estate will receive the beneficiary’s distribution if the beneficiary survived the settlor. But that can vary based on the trust terms.
For example, if the trust requires a beneficiary to survive a settlor for a certain amount of time, then that must occur. Some trusts will state that a beneficiary must survive the settlor for sixty days (or ninety days or 120 days). If the beneficiary dies before sixty days of the settlor’s death, then the beneficiary’s gift is extinguished.
Some trusts will require a beneficiary to survive until the assets are distributed (this is very rare, but I have seen it). In that case, a beneficiary’s death prior to distribution of trust assets will extinguish the beneficiary’s gift.
If the beneficiary’s estate is still entitled to a distribution after death, then the next question is—where does the distribution go? For example, should the distribution be paid to the beneficiary’s executor or trustee, the beneficiary’s wife, or directly to the beneficiary’s children? That all depends on how the beneficiary set up their estate plan (trust, will, or whatever they have).
The wonderful world of taxes: There are numerous types of taxes you have to consider: estate tax, income tax, and real property tax, just to name a few. As of 2018, federal estate tax only applies to estates valued in excess of $11.2 million for a single person or $22.4 million for married couples. Most estates do not exceed these amounts; therefore, no federal estate tax is due.
Some states have an inheritance tax, but not California. Therefore, once you pay any federal estate tax, there will be no further estate or inheritance tax due to the State of California.
Income tax applies to any income received by the trust or estate. Bear in mind that anything you receive as an inheritance is NOT subject to income tax. But any income received by the trust estate (such as investment income, bank interest, dividends, gain on real estate sales) is subject to income tax. That income must be reported by the trust using IRS form 1041 (and California Form 541). Any income tax is then paid either by the trust or passed through to the beneficiary(ies) to pay. The tax payment depends on the type of trust and the amount of distributions made to trust beneficiaries during the tax year.
Property tax can be an issue for beneficiaries who are given a gift of real estate. If you intend to keep the real estate, then there may be a significant increase in property taxes. There are ways to avoid an increase in property taxes, such as filing a parent-to-child exclusion for the transfer of real estate. But there are deadlines by which this type of exclusion must be requested from the tax assessor’s office. Be sure to request any property tax exclusions promptly.
All of these tax issues must be addressed and properly reported (plus any taxes paid) before final distributions can take place. But some money/assets can be distributed before taxes are finalized. It all depends on the amount of tax liability expected and from whom the tax payments will be required.
Trustee Removal and Suspension
If you fail to receive a trust distribution, you may want to consider filing a petition to remove the trustee. A trust beneficiary has the right to file a petition with the court seeking to remove the trustee. A beneficiary can also ask the court to suspend the trustee pending removal. Removal usually requires a trial to be conducted so the court can hear evidence. Since it can take anywhere from eight months to a couple of years to have a trial, suspension may be necessary to safeguard the trust until the removal trial is finalized.
Removing a trustee is not so easy. For starters, the trustee is presumed to be the settlor’s chosen person, so the burden rests with the beneficiary to prove why the trustee cannot act.
Under Probate Code section 15642(b), a trustee may be removed from office where:
- The trustee has committed a breach of the trust;
- The trustee is insolvent or otherwise unfit to administer the trust;
- Hostility or lack of cooperation among co-trustees impairs the administration of the trust;
- The trustee fails or declines to act;
- The trustee’s compensation is excessive under the circumstances;
- The sole trustee is a prohibited beneficiary (for example, the person who drafted the trust cannot act as sole trustee);
- The trustee is substantially unable to manage the trust’s financial resources or is otherwise substantially unable to execute properly the duties of the office;
- The trustee is substantially unable to resist fraud or undue influence; or
- For other good cause.
While this list of removal grounds seems ominous, it is up to the beneficiary to prove the existence of one of them before removal will occur. Further, the court has discretion to excuse whatever breach occurred and allow the trustee to continue acting if the court chooses to do so. That means the beneficiary must not only prove the existence of a ground for removal, but it also helps for them to establish that future harm will result to the trust if the trustee is not removed.
Under Probate Code section 15642(e) the court can suspend the trustee and appoint either a receiver or temporary trustee to act until trial on the removal issue occurs.
The most likely grounds for removal of a trustee is theft. Anytime you can show with financial evidence of misappropriation of trust funds by the trustee, you are far more likely to obtain both suspension and removal of the trustee.
Failure to distribute can also lead to suspension and removal, provided that, the distribution is substantially overdue.
But removal is not your only option. A beneficiary also has the right to seek instructions from the court if you encounter misappropriation of trust funds by trustee.
Petition for Instructions
Under Probate Code section 17200, a trust beneficiary has the right to petition the probate court regarding the “internal affairs of the trust.” In other words, you can ask the court to order the trustee to do (or not do) something. Lawyers generally refer to this as a “petition for instructions.”
Using a petition for instructions, you can ask the court to order the trustee to do anything the trust requires. For example, if you are owed a $500,000 trust distribution but the trustee refuses, you can ask the court to order the trustee to distribute. If the trustee has a reason to withhold distribution, they can make that argument to the court. But the court will ultimately decide what amount will be distributed. Once you have the court order, then the trustee must comply, and you no longer have to argue over the distribution.
The same goes for things like providing copies of trust documents, financial information, accountings, investment decisions, and the creation and funding of sub-trusts. Anytime the trust (or the Probate Code) requires an action, and the trustee fails to do so, the court can step in and order that action to take place. But the court will not do so on its own. It is up to you, the beneficiary, to bring a petition for instructions seeking a court order.
The benefit of a petition for instructions is that you don’t have to prove a breach of trust exists. Whether the trustee breached a duty or not, the requested action can be ordered. And at the end of the day, that is what you want—a distribution to occur. This is a much easier petition to prove and it can achieve your result a bit more quickly, at times, than a lawsuit to remove a trustee, or suing for breach of trust.
In the end, trust assets must be distributed to the trust beneficiaries. Especially in the case of Tom and Brian, where the trust required an outright distribution of assets. In trust law, outright means to give the money, real estate, stocks, bonds, jewelry, whatever else is in the trust to the beneficiaries. Tom’s act of holding onto the trust property, and thinking he can hold onto it indefinitely, is just wrong. But notice: no one is going to make Tom comply with the terms of the trust, except Brian. Brian can combat trustee abuse here by taking action in court.
Unfortunately, it is Brian’s burden to bring this abuse to light. Yes, Tom should comply with his legal obligations and distribute trust assets out to Brian without Brian having to force the issue in court. The whole purpose of trusts is to allow a smooth transfer of assets after death without court supervision. And yet, Tom, like many bad trustees, refuses to obey the law and chooses instead to ignore Brian. That’s where our court system comes into play. Tom can ignore Brian, but Tom cannot ignore a judge once the matter is filed in court. It takes effort to stand up and fight against a bad trustee, but it can be done, and done successfully.
Along with distribution of trust assets, a trustee also has a duty to account to the beneficiaries. The next topic of beneficiary abuse: a trustee’s duty to provide trust financial information and a trust accounting to the beneficiaries.