Focus on managing both wealth and risk.
Many factors influence whether and the extent to which a family’s prosperity thrives over multiple generations. Increasingly, wealthy families are establishing their own private trust companies (PTCs) in an effort to preserve and grow their families’ collective wealth for future generations. The primary purpose of a PTC is to establish a family-controlled structure to oversee investment of the family’s assets, administration and distribution of its trusts and all related costs, such as investment fees and trustee fees. With a PTC, a combination of respected family members and trusted advisors, hand-selected by family members in control of the PTC, run the PTC and sit on all committees. A PTC can be especially attractive when a family’s wealth is concentrated in a single business or as the family considers increasingly complicated investment vehicles. Concentrated positions, even in a profitable and established operating family business, can make corporate or individual trustees nervous due to the lack of diversification and marketability of a trust’s assets and the trust’s potential resulting risk of illiquidity. Likewise, corporate and individual trustees may resist investing trust assets in more exotic investment opportunities, even if the prospective investment is relatively modest. A PTC will often be more risk tolerant, and thus more nimble, responsive and flexible, than a corporate or individual trustee. Furthermore, PTCs can pool smaller accounts, which can allow a family increased access to investments with required minimums. Additionally, because the operation of a PTC involves only select non-family members, a PTC can afford a family increased control over the flow and dissemination of sensitive information regarding the family’s assets, its investment opportunities and the structure of its overall wealth plan.
Upside Potential
The upside potential of a PTC is significant for a family. Often, when there’s no PTC, family members or advisors (or a combination of the two) serve as trustees of some or all of a family’s trusts. This can result in conflicting positions being taken with respect to family assets owned by different trusts with different trustees, as well as complications resulting from trustee turnover. A well-functioning PTC can harness a family’s collective wealth and increase the family’s investment opportunities, provide unified decision making regarding family assets, anticipate succession issues to provide longevity and consistency in trust administration and offer enhanced liability protection for individuals participating in the decision-making authority. Additionally, an effective PTC is typically in a better position than individual trustees to have access to and capitalize on institutional family memory and to ensure that investment, distribution and administrative processes are documented and records are preserved. However, establishing and operating a PTC is far from a risk-free undertaking. Whether a PTC proves to be an effective part of a family’s long-term wealth legacy plan can only be determined in hindsight. Odds of success increase if the PTC is conceived, designed and implemented with a focus not only on wealth maximization but also on risk management.
Creating and Maintaining a PTC
Creating and maintaining a successful PTC is a multistep and ongoing process, and as with any prosperous business, requires careful planning and monitoring. As a threshold matter, the family must agree that a PTC is a vehicle that will coalesce with the family’s overall wealth plan. In light of the significant start-up and ongoing operational costs for a PTC, the general rule of thumb is that a family should have assets in excess of $100 million before considering creating a PTC. However, anticipated costs must be viewed in light of the potential direct financial benefits to the family. For example, with a PTC, the trustee fee structure (hourly versus percentage of trust assets) is within the family’s control and can be unbundled or allocated in a way to maximize the value of available deductions for income tax planning. More significantly, a PTC may be able to establish an advantageous nexus for income tax purposes for the family’s trusts that will reduce income or capital gains taxes (although some states, like Illinois, may tax a trust based on the grantor’s residence).
Once the decision is made to proceed with a PTC, the family must decide where to establish the PTC and whether the PTC should be regulated or unregulated. Jurisdiction decisions typically reflect expectations regarding the relative benefits of operating in that state. Often the family has no other ties to the chosen state, but instead selects the state because of its touted PTC friendliness and its favorable trust and tax laws. To establish nexus, the PTC is required to maintain a physical office in its home state. Although the landscape is evolving, it appears that South Dakota and Nevada continue to be among the most popular jurisdictional choices for PTCs.
In deciding between a regulated or unregulated PTC, families often choose to create regulated PTCs to minimize risk exposure. A regulated PTC receives a state charter, is subject to supervision and periodic audit by the applicable state’s oversight agency (for example, once every three years in both Wyoming and South Dakota), and, because it’s excluded from the definition of an investment advisor, doesn’t have to register with the Securities and Exchange Commission (SEC). An unregulated PTC that qualifies as a “family office” under the Dodd-Frank Act (based primarily on how closely related the family members are) is also exempt from registration with the SEC. Unlike the state audits a regulated PTC undergoes, audits of an unregulated PTC are under the control of the PTC’s directors. While regulated PTCs are more time consuming and expensive to create because of the heightened level of state supervision, unregulated PTCs are viewed as riskier to operate because the external oversight is less robust.
Regardless of whether a PTC is regulated or unregulated, routine audits of the PTC are necessary. For regulated PTCs, audits are mandated by state regulation. For unregulated PTCs, they’re necessitated by best practices. In either case, each PTC audit should result in a written report outlining required structural or operational modifications to the PTC and suggesting additional, optional changes that reflect best practices. As changes are implemented, they should be thoroughly documented and reflected in the PTC’s organizational files.
PTCs can be created at different moments in a family’s wealth generation history. In some cases, the original wealth creators establish the PTC and have sole decision-making power in all matters related to the formation of the PTC. However, it’s not unusual for family members several generations removed from the original wealth creators to consider PTCs, especially when interests in common investments are held across multiple family trusts for different beneficiaries or different family lines. In this case, relatives may not know each other well, may be geographically spread out or may have divergent philosophical and political views, which in turn can influence their views on the propriety of investments and the importance of stewardship of family wealth. Often, existing trusts with similar distribution provisions have different trustees and have been administered differently to accommodate varying investment returns, lifestyle issues and beneficiary spending rates. Gathering these trusts under a single trustee may be met with resistance from some family members or even from advisors who have conflicting personal interests. In these families, decisions that must be made early in the process, such as where to establish the PTC and in what form, are often made by the family’s de facto leaders before the extended family has fully considered the implications of a PTC for themselves and the larger family. To minimize potential conflict down the road, it’s important to carefully consider and document these issues.
Running the PTC
While a PTC allows the family at large to oversee the administration of the trusts held for its benefit, not all of the family members will actively participate in running the PTC. Whether due to interest, skill set or capacity to take on the role, certain family members will take on leadership positions in the PTC while others assume more passive roles as trust beneficiaries.
A PTC structure can offer significantly greater protection for family members and the family’s advisors who are involved in the PTC than would be the case if they were serving in their individual capacities. For example, individuals acting through a PTC are typically indemnified for personal liability by the PTC’s organizational documents. Furthermore, directors and officers insurance, which is generally less expensive and easier to obtain than the errors and omissions coverage available to trustees, can provide an additional layer of protection. Additionally, the typical PTC is thinly capitalized (a selling point when families are considering where to base their PTC). Perhaps most importantly, while there’s no case law discussing a PTC’s liability in the event of a breach of fiduciary duty or its improper operation (if any intra-family disputes have occurred, they’ve been resolved privately), it’s generally believed that the business judgment rule, which isn’t applicable to individuals serving directly as trustees, would apply to the PTC and further insulate the PTC’s directors against personal liability for decisions made in the course of operating the PTC. In the corporate context, a business decision maker is shielded from personal liability and presumed to have satisfied the duty of care to the company so long as the following requirements are satisfied: (1) a judgment was made; (2) the directors or managers were informed to the extent reasonably believed appropriate; (3) the decision was made in subjective good faith; and (4) the directors or managers have no financial interest in the subject at hand.
Privacy
Some trust beneficiaries are concerned about personal information being shared among the wider family. Although a PTC is a family affair, organizational measures can be instituted to protect the privacy of the trust beneficiaries from the family members who actively operate the PTC. For example, the PTC’s organizational documents could require that all non-investment discretionary decisions that affect a trust beneficiary be made by a committee comprised only of independent (non-family) persons. This committee would determine who qualifies as a beneficiary of a trust, whether to make discretionary distributions from the trust to a beneficiary, how the trust’s receipts and disbursements are allocated between income and principal, issues related to unitrust or total return trust conversions, the trustee’s power to adjust between income and principal and other non-investment related discretionary matters. With this limitation on who can participate in non-investment related discretionary decisions, family members involved in running the PTC will be screened from sensitive matters a trust beneficiary might want to keep private, such as a trust beneficiary’s spending habits and lifestyle choices. Trust distribution requests, and the information required to make necessary and appropriate discretionary determinations, would be available to and considered only by select independent advisors.
Adverse Tax Exposure
Limiting discretionary non-investment related decisions to independent trustees should also protect the family against potential inadvertent adverse tax exposure. For example, a trust’s grantor trust status could be triggered if members of a distribution committee are related or subordinate parties under Internal Revenue Code Section 672(c). Likewise, an estate, gift or generation-skipping transfer tax issue could result if a family member in a management position with the PTC is deemed to control trust distributions. Although a PTC should periodically conduct a thorough review to identify potential tax, privacy and conflict issues, especially in anticipation of a shift in ownership interests in the PTC, a change in committee memberships, the onboarding of additional trusts or other significant events, these issues and their attendant risks can be significantly mitigated by effectively screening family members from discretionary non-investment related decision-making authority.
A thorough process for onboarding new trusts is also important to limit the PTC’s potential exposure. As part of the procedures for onboarding new trusts, the appropriate committee or committees should review the trust document thoroughly to identify potential issues. They should prepare a detailed report of the trust’s terms and history and analyze and document the estate, generation-skipping and income tax (federal and state) attributes of the trust. If the trust is part of a larger family plan, then that information should be included in the report. Special assets should be noted and a plan of action formulated.
Security
For a PTC to be successful, much of a family’s personal and financial information must be centralized and accessible. As the risk of data security breaches grows, wealthy families are obvious marks, and a PTC would be an attractive target. A successful data breach would compromise individual and trust documents and income tax returns, detailed information regarding each family member’s personal holdings, the operation of the PTC, sensitive intra-family communications, communications between the family and their advisors and much more. The resulting damage to the family, financial and otherwise, could be difficult to remediate. To avoid this, a PTC should engage reputable experts in the security field to assist in designing and implementing formal security policies and procedures. The PTC’s information technology and security systems will require continual monitoring, maintenance and regular investments for upgrades. The PTC’s policies should require that sensitive physical files be kept in secure areas, with access limited on a need-to-know basis. All digital files, including all documents making up the family’s trust records and all documents related to the governance and operation of the PTC, should be regularly backed up and stored in a separate location. In addition, the PTC’s policies and procedures should require that all personnel be screened and undergo periodic formal training appropriate to their positions at the PTC to stay apprised of current risk threats and best practices.
Minimize Risk
Ultimately, a PTC is an entity designed to aggregate and manage a family’s wealth to ensure the family’s long-term prosperity and facilitate a unified investment strategy. While a PTC can offer a family a tremendous amount of control and privacy, it’s far from a risk-free undertaking. To minimize risk, it should be well-designed and implemented. It should have a forward-thinking, comprehensive formal governance structure that allows the PTC to adapt to changing legal, political, philosophical, regulatory, family and individual circumstances. The PTC principals must anticipate and manage the PTC’s ongoing regulatory, legal and fiduciary risk through an effective governance and administrative structure that establishes comprehensive policies and procedures. Managers of the PTC must require diligent adherence to those policies and procedures. Appropriate committees should be established to review and onboard trusts, consider investment opportunities and beneficiary distribution requests, oversee audits and address stakeholder complaints and comments. All committee considerations and decisions should be reviewed and documented by appropriate members of the PTC’s management at regularly scheduled and attended meetings. The PTC should be in regular communication with and responsive to both regulatory authorities and stakeholders. Outside advisors should be involved in the operation and administration of the PTC as appropriate to ensure ongoing compliance with all regulatory requirements and state and federal law, to mitigate risk exposure to the PTC, its managers and directors, advisors and stakeholders and to protect the privacy of the trust beneficiaries. Finally, the PTC must be appropriately staffed to ensure that all aspects of the PTC’s business run smoothly.