Modern trust laws make possible much of what clients want out of their estate plans, such as keeping some degree of flexibility and control while minimizing taxes, protecting the assets, furthering family values and legacy wishes and, of course, retaining privacy.
Often, the plans are more limited by a failure to diversify the estate’s assets and coordinate the appropriate trust structure or administration for each component. Whether that is because a trustee doesn’t want to risk a fiduciary breach by getting it wrong or doesn’t have the expertise to craft an optimal investment strategy for the assets funding the trust, the end result is a non-diversified estate plan that’s not as optimal for a family client as it could be.
Asset Diversification and Trust Laws
Like all investors, family offices view asset diversification as a key to both increasing return and reducing risk. But for high net worth clients, the portfolios get complex, and will typically involve cash, a portfolio of domestic and international equities and fixed-income securities, hedge funds, real estate, private equity (directly invested or through a fund) and natural resources (see “Average Global Family Office,” below).
Many of these investments can pose issues for trustees based on how the trust is administered. A trustee is subject to very high standard of fiduciary liability, as well as personal liability. A trustee can delegate the duty, but not the risk.
The Uniform Prudent Investor Act (UPIA) requires trustees to pursue an overall investment strategy considering various factors when formulating an investment program, including the size of the portfolio; the likely duration of the trust; liquidity and distribution requirements; the economic environment; tax consequence of investment and distribution decisions; expected total return; and the role of individual investments in the portfolio. It holds professional trustees to an even higher standard – so it’s no surprise that many trustees, often out of a lack of expertise, hesitate to implement as asset diversification plan on an estate.
Large institutional trustees run into similar issues. They are generally hired to provide full service trust administration. But many of these institutions may be reluctant to invest in anything but their own firms’ investment products that they’re familiar with and can easily monitor. They are reluctant to delegate investment management to outside providers, even though they can, out of fear of possible liability.
Non-Diversification of Trust Assets
But there may also be issues if the trust’s assets aren’t properly diversified. The UPIA provides for a general duty to diversify trust assets unless the purpose of the trust is better served without it (maybe the sale of low cost-basis assets would trigger a tax gain, or there is a large interest in a family business.) There are numerous cases indicating that holding an investment asset in a trust, even if mandated to do so, could result in trustee fiduciary liability.
Directed trusts are the most popular way to address these concerns. A directed trust generally trifurcates the traditional trustee role into an investment committee, distribution committee and directed administrative trustee. A directed administrative trustee has no discretionary investment duties regarding the trust. The selection of asset allocation, investment management and monitoring is generally the responsibility of the investment committee, which is usually run by the family and the family’s advisors. The members of the investment committee are typically subject to a gross negligence/willful misconduct standard of liability for serving in this role. This is a much lesser standard of liability than serving individually as a delegated trustee in most states. To further insulate the investment committee, a trust protector may be added with the power to approve and/or veto trust investments.
Investment Management LLCs/FIPs
Investment management limited liability companies (LLCs) are another modern trust administration concept that can be used in combination with a directed trust to limit liability and allow for creative diversification and investment of a trust’s assets. An LLC that’s owned by the trust can handle the investment management, and a family member or family advisor can be named as the manager of the LLC.
Some families also use family investment partnerships (FIPs). The investment management for a family is frequently done within one or more of the investment partnerships, with the partnership units then allocated to the family trusts. Generally, these FIPs also work best with a modern directed trust structure.
Many families go further and use separate investment management LLCs and/or FIPs for each type of asset class in the estate. Additionally, the investment management LLC may be of interest to families desiring an administratively convenient account to do their own trading within a trust. (Generally, this isn’t recommended, but sometimes required due to the family dynamic or circumstances.)
There are several trust-owned life insurance services and programs to monitor insurance companies and policies. Whole life, universal life, variable life and term insurance are frequently purchased—generally within an irrevocable life insurance trust structure—to pay estate taxes and debts, survivor income, and fund key person insurance or buy/sell agreements for family businesses.
Generally, these types of insurance policies are structured to maximize death benefits and minimize cash value and require both due diligence on the insurance company and the policy, as well as ongoing monitoring by the trustee or investment committee.
Alternatively, private placement life insurance (PPLI) is generally structured to minimize the death benefit and maximize the cash value. PPLI is purchased to provide a tax-efficient wrapper for investments such as publicly traded securities, alternative investments, hedge funds and private equity, many of which are tax inefficient – the PPLI policy wrapper can eliminate taxable interests on the investment income and capital gains.
Residential Real Estate
Qualified personal residence trusts (QPRTs) are popular estate-planning vehicles for residential real estate (primary and secondary homes). Additionally, many families use trust funds to purchase residential real estate for the beneficiaries. The beneficiaries can use the home tax-free, and the home is protected from creditors. If the home is going to remain in trust for several generations, families may consider establishing a family time share. Revocable trusts are also used for privacy purposes as well as avoiding ancillary probate.
Many other types of family assets, such as pets, gravesites, antiques, cars, art, jewelry, memorabilia, royalties, digital assets, land, property and buildings, may be best suited for a purpose trust. Purpose trusts first gained popularity with pets, which are considered “property.” Purpose trusts don’t have beneficiaries. They have a trust enforcer to enforce the purpose, as well as a trust protector to oversee the trust and administrative trustees. Their sole purpose is to care, protect and/or preserve an asset. The trust protector can convert the trust to a beneficiary trust at some point in the future, after the trust’s purpose is served. Also, family members can use the assets of a purpose trust if structured properly.
Aligning a diversified estate’s assets with the proper trust structure for each component can help trustees and administrators avoid fiduciary liability while enhancing the effectiveness of the estate plan for its beneficiaries.
This is an adapted version of the authors' original article in the August 2017 issue of Trusts & Estates.