Clients frequently establish trusts for tax, asset protection, privacy and estate-planning reasons. Over the last 20 years, however, trusts have gained enormous popularity due to the design of the modern trust, which promotes administrative efficiency, flexibility, control and reasonable trustee fees.1 According to Richard Oshins, a prominent West Coast lawyer, “Trusts are no longer vehicles that lawyers and banks create to keep what is rightfully the beneficiaries.”2 Despite the advantages of the modern trust, many families establishing trusts typically don’t choose corporate trustees.3 Instead, they choose family, friends, advisors and business colleagues to be trustees or co-trustees, subjecting them to personal liability, as well as sacrificing many of the key advantages of the modern trust.
Modern trusts, however, if efficiently designed and administered, can reduce many family concerns including: the personal liability of family, friends, advisors and business colleagues as co-trustees and fiduciaries; the concentration of assets or lack of diversification; conflicts with business interests; improper due diligence; monitoring of assets; and environmental issues. Along with increasing flexibility, control and administrative efficiency, modern trusts also can maximize tax, asset protection and privacy advantages.4 Given the flexibility to reform or decant existing trusts to modern trusts, the question now turns to how to maximize their administrative efficiency.
Full Service Trustees
Generally, one of the first questions regarding the structuring of a trust is whether it should be drafted as a directed5 or delegated6 trust or whether it should be administered by a full service, “one-stop shopping” trustee.7 The full service, one-stop shopping trustee generally handles custody, taxes, investment management, trust administration and trust accounting.
This full trustee service model, although popular in its day, has lost quite a bit of momentum since the mid-1990s with the advent of the modern directed trust and the flexibility and control modern directed trusts provide.
The delegated trust is another option and is available in all 50 states and Washington, D.C. This structure typically involves a family trustee and requires that any trustee delegating his responsibilities must conduct due diligence on whom he’s delegating to and why he believes that the delegation is prudent. The delegating trustee is generally responsible for ongoing monitoring of the co-trustees and/or fiduciaries to whom he’s delegated. Delegating is typically done with investment management, particularly if the delegating trustee is a family member who doesn’t have the capability to do the investment management himself or provide investment advisory services for the trust.
The liability standard for delegating and the related monitoring is very high in most states; however, many of the modern trust states have attempted to minimize trustee liability.8 Delegation, however, often limits the investments or investment strategies as a result of both the up-front due diligence and ongoing monitoring required by the delegating trustee, as well as the associated liability.
The modern directed trust provides for an administrative trustee to take direction from an investment and/or distribution committee. Because of the many benefits a modern directed trust offers, many families prefer it to the full service, one-stop shopping trustee or the delegated trust. For example, directed trusts generally involve more family members and advisors in fiduciary and non-fiduciary trust functions incurring less liability but promoting more administrative efficiency, flexibility and control. Additionally, most states with directed trust statutes also provide powerful tax, asset protection and privacy advantages.
Directed trusts generally trifurcate the traditional corporate administrative trustee function: there’s a directed administrative corporate trustee that provides the required trust administrative functions in the directed trust state; this administrative corporate trustee takes direction from an investment and/or distribution committee that’s usually comprised of family members and family advisors in the family’s resident state. Many families prefer this type of structure because they typically have confidence in their own family members and advisors to make proper decisions as fiduciaries for both the trust investments and distributions. Additionally, families can obtain the guidance and oversight of the directed administrative corporate trustee. Consequently, the directed trust structure is exactly what many ultra-wealthy families desire.
Most modern directed trust jurisdictions allow for a trust to own one asset without diversifying, for example, owning a limited liability company (LLC), family limited partnership, closely held stock or a large concentration of publicly traded stock. Additionally, residential real estate and vacation homes are popular investments for long-term trusts and can easily be accommodated with a modern directed trust.9
On the other hand, most delegated trust jurisdictions don’t allow a trust to hold one asset or asset class without requiring diversification; therefore, some trustees may be uncomfortable with their role in diversifying due to the perceived risk and liability involved.10 Such limitations can be burdensome as many families may want to diversify as broadly as a Yale or Harvard endowment-type asset allocation that typically involves large concentrations in direct private equity (not funds), alternative investments and domestic and international real estate. And, the due diligence and monitoring required by a delegating trustee generally makes the trust administration costs very high.
A directed trust typically doesn’t have these limiting factors; a trust can hold one asset or diversify broadly. Trustee fees are lower, and the family co-fiduciary liability associated with full service and delegated trusts is reduced.
Grantor Trust Status
Modern directed trusts are easier to administer as grantor trusts, and as such, many modern trusts begin as grantor trusts11 and automatically convert to non-grantor trusts12 on the grantor’s death. Conversion to a non-grantor trust prior to the grantor’s death is also a possibility and may be desired in certain circumstances. A grantor trust provides many planning techniques, including the allowance for the popular promissory note sale strategy, which has the ability to powerfully leverage a client’s $5.43 million gift and generation-skipping transfer tax exemption. The grantor is responsible on his personal income tax return for the income taxes generated by the grantor trust. To minimize these income taxes, a trust can invest in growth-oriented investments during its grantor trust status or structure a private placement life insurance (PPLI) wrapper for the investments.13 Additionally, a trust provision can allow the trustee to reimburse the grantor on a discretionary basis for taxes personally paid by the grantor on behalf of the grantor trust.14
When the grantor trust converts to a non-grantor trust on the grantor’s death or before, the non-grantor trust becomes a separate taxpayer and will be responsible for quarterly estimated payments that the trustee pays. The non-grantor trust can potentially avoid state income taxes and reporting if it’s sitused in a modern trust state where there’s no state income tax, such as Alaska, Delaware, Nevada, New Hampshire, South Dakota and Wyoming. Note that the ability to save state income taxes also depends on the state of residency of the grantor.15
Moreover, you can eliminate both federal and state income taxes not only on the trust income and capital gains, but also on the distributions to beneficiaries, if the trust has a PPLI wrapper around its investments.16 The PPLI wrapper also reduces a trustee’s administrative burden of tax reporting.17 However, the PPLI wrapper used within a delegated trust may require higher administration fees as a result of the required due diligence and monitoring.
Investment Management LLCs
A directed trust also promotes administrative efficiency through the use of an investment management LLC.18 Most directed trust jurisdictions have excellent supporting LLC statutes that allow for a sole member LLC; thus, the trust can be the sole owner of the LLC. Most of the LLC statutes also provide for advantageous asset protection with charging order protection as the sole and exclusive remedy.19 Note that a charging order only gives a creditor a distribution right of an LLC interest and doesn’t give a creditor any voting rights. It’s simply a right to a distribution, if one is ever made; however, it doesn’t give the creditor a right to force a distribution.
A grantor can sometimes be the manager of the LLC without incurring estate tax or state income tax issues.20 However, it’s best for a grantor not to serve as the manager of the investment management LLC, particularly with asset protection trusts. A better alternative is to appoint a family member or family advisor as the manager of the investment management LLC owned by the trust as the sole member. The investment committee of a directed trust would generally direct the administrative trustee to hold the investment LLC, which in turn provides the investment management for the trust. The investment accounts are titled to the LLC, which in turn is titled and owned by the trust as the sole member. Consequently, these investment management LLCs are excellent for administrative efficiency purposes by streamlining the investment management for the trust, reducing trustee fees, as well as providing a beneficial second layer of asset protection for the trust assets.
Furthermore, many families with multiple trusts sometimes use LLCs and partnerships as the main investment vehicles for their trusts by centralizing investing in the LLCs and/or partnerships and then allocating the units/interests to each trust. This strategy is common with family office clients and provides for administrative efficiency and lower trustee fees. Many families often subadvise the investment management for the LLC and or limited partnerships to outside investment managers. This strategy also works with common trust funds and business trusts for families with private family trust companies.
The type and frequency of trust distributions are also a factor to consider in trust administrative efficiency. Distributions are generally either: 1) mandatory (that is, for income and/or principal or health, education, maintenance and support); or 2) support or discretionary. Most modern dynasty trusts are discretionary to maximize asset protection and to allow the family and family advisor distribution committees to properly perform their duties.21 Tax-sensitive distributions generally require an administrative trustee or trustee distribution committee to determine the appropriateness and the rationale for each distribution so as to prevent estate tax inclusion issues. The more tax-sensitive distributions required, the more documentation and trust committee meetings required. Thus, to reduce trustee fees, many families try to hold quarterly or annual distribution committee meetings instead of monthly meetings. Families may still reserve the right to have emergency meetings for crucial distributions, if necessary.
A non-binding letter of wishes from a grantor can be very helpful regarding distributions because a grantor’s intent is critical. Most corporate trustees and distribution committees will follow a grantor’s letter of wishes.
The frequency and number of trust statements also impact trust efficiency. A grantor and the trust beneficiaries often get monthly statements regarding trust investments from investment consultants, advisors and managers of the directed trust. Administrative trustees also send trust statements regarding trust administration, distributions and taxes. Depending on the situation, many families will be well served with quarterly statements, rather than monthly statements, from the directed administrative corporate trustee. Some clients may require only annual statements, which are usually the minimum required for most directed administrative corporate trustees for situs purposes. Less frequent statements increase efficiency and lower trustee fees. Note that online account access is generally available to the family and their advisors.
Using a trust protector22 can also be of great assistance to a directed administrative corporate trustee, as well as to other fiduciaries. The trust protector generally has many important personal and/or fiduciary powers, which increase trust administration efficiency. Those powers include the ability to:
• Remove or replace trustees/fiduciaries;
• Veto or direct trust distributions;
• Add or remove beneficiaries (or appoint someone to do this);
• Change situs and the governing law of the trust;
• Veto or direct investment decisions;
• Consent to exercise power of appointment;
• Amend the trust as to the administrative and dispositive provisions;
• Approve trustee accounts; and
• Terminate the trust.
The modern trust states, such as Alaska, Delaware, Nevada, New Hampshire, South Dakota and Wyoming, have very good trust protector statutes. It’s helpful if there’s a well-established supporting detailed statute for the function of trust protector versus merely a statutory reference for the function of trust protector, although advisors may draft the function of trust protector into the trust even without a statute authorizing such function.
Additional factors affect the efficiency of trust administration. For example, the existence of offshore assets or accounts; the number of beneficiaries; and the citizenship and residency of beneficiaries, all can increase the work, reporting and compliance associated with both trust administration and trust distributions. A beneficiary quiet statute, which is a statute that provides the settlor with the flexibility to waive beneficiary notice of trust assets and keep trust information silent to one or more beneficiaries, may be used for problematic beneficiaries.23
The number of trust shares in a trust also impacts its administration efficiency. Often, a trust will begin as a single pot trust and as time goes on, divide into separate shares for each family line (this generally occurs when distributions commence). Separate shares increase trust administration complexity; for example, each share may have its own tax identification number and reporting requirements. Hence, it’s important for the trust not to divide into separate shares until absolutely necessary.
1. G. William Domhoff, “Wealth, Income, and Power,” www2.ucsc.edu/whorulesamerica/power/wealth.html. Note that 40 percent of the top 10 percent of U.S. households are using trusts. This statistic is up from 12.5 percent in 1995. See E.N. Wolff, The Asset Price Meltdown and the Wealth of the Middle Class (2012).
2. Richard Oshins, Oshins and Associates, http://www.oshins.com/.
3. Al W. King III, “Selecting Modern Trust Structures and Administration Based Upon a Family’s Assets,” IPI Advisors Roundtable (March 10, 2015).
4. See supra note 3.
5. Ibid. Some directed trust states follow Section 185 of the Restatement (Second) of Trusts; others follow Section 808(b) of the Uniform Trust Code; other states have statutes further limiting trustee and fiduciary liabilities generally to gross negligence and/or willful misconduct. Delaware had the first directed trust statute in 1986, and South Dakota was second in 1997. Many other states followed: Wyoming (2007), New Hampshire (2008), Nevada (2009) and Alaska (2013). See also Al W. King III and Pierce H. McDowell III, “Delegated vs. Directed Trusts,” Trusts & Estates (July 2006) at p. 26.
6. Delegated trust statutes generally allow a trustee to delegate certain responsibilities to other professionals and co-trustees. All directed trusts, on the other hand, vest control for the investing with someone else, for example, the investment committee. All delegated trusts are generally invested pursuant to the provisions of the trust document, as well as an agreed-on Investment Policy Statement with the trustees. As with directed trusts, many of the modern trust states also have statutes that reduce trustee liability for delegating.
7. See supra note 3.
8. Alaska, Delaware, Nevada, New Hampshire, South Dakota and Wyoming.
9. See supra note 3; see also Al W. King III, “Trust Options for Residential Real Estate,” Trusts & Estates (August 2015).
10. See supra note 3.
11. A grantor trust is generally excluded from the estate, but the grantor is treated as the owner of the trust for income tax purposes. Consequently, the grantor pays the income tax liabilities for the trust, allowing it to grow at a greater rate than if the trust paid the income taxes.
12. A non-grantor trust is generally excluded from the estate and is treated as a separate entity for income tax purposes.
13. The states with the lowest premium tax: South Dakota (8 basis points), Alaska (10 basis points), Illinois (50 basis points) and Wyoming (75 basis points). The national average is 200 basis points.
14. See Revenue Ruling 2004-64. In this ruling, the Internal Revenue Service stated that when the trust’s governing instrument or applicable local law gave the trustee the discretion to reimburse the grantor for his portion of the grantor’s income tax liability, that discretion, by itself, wouldn’t cause inclusion in the grantor’s gross estate under IRC Section 2036. Many of the directed trust states also have statutes protecting these discretionary tax payments.
15. Generally, a state’s taxation of trusts is based on one or more of the following factors: residence of the grantor of an inter vivos trust; residence of an individual who created a trust by will; situs of the trust administration (the state where the trust is administered); residence of the trustee(s); and/or residence of the beneficiaries.
16. A private placement life insurance policy is typically a privately issued variable universal life insurance policy that has both a cash value and death benefit component. The policy is available strictly for accredited investors and qualified purchasers as defined under federal securities law. The insurer provides the policyholder with the ability to customize the investment options within the policy. The range of investment options can include a customized fund managed by the client’s existing advisors. The costs are very economical.
17. Note that generally, a family’s tax advisor can prepare the tax returns associated with the trust as long as the directed corporate trustee reviews and signs all returns, which can reduce trustee fees.
18. Al W. King III, “Myths About Trusts and Investment Management: The Glass is Half Full!,” Trusts & Estates (December 2015) at p. 9.
19. Some states, like Alaska, Delaware, Nevada and South Dakota, provide that the charging order is the sole and exclusive remedy for creditors. This restriction means that other remedies, including equitable remedies, may not be available to the creditor.
20. See State of New York Commissioner of Taxation and Finance Advisory Opinion N.Y. TSB—A002I—March 29, 2000; Jennings v. Smith, 161 F.2d 74 (2d Cir. 1947); IRC Section 2036(a)(2) (right to designate who will enjoy the trust property); IRC Section 2038 (power to alter a beneficiary interest).
21. A few key modern trust jurisdictions, such as Alaska, Delaware, Nevada and South Dakota, have enacted statutes stating that a discretionary interest isn’t a property right or enforceable right; rather, it’s a mere expectancy. This distinction can be important not only from a grantor’s standpoint, but also from the standpoint of other trust beneficiaries.
22. See supra note 3.
23. Al W. King III, “Should You Keep a Trust Quiet (Silent) from Beneficiaries?” Trusts & Estates (April 2015) at p. 9.