Grantors are usually comfortable establishing revocable trusts as part of their estate plans because they’re often named as the trustee until their death or incapacity, and therefore, they can retain control over both the investment and distribution decisions of the trust. Although an important part of an estate plan, revocable living trusts aren’t generally enough to accomplish many of a grantor’s estate-planning and wealth preservation goals. Consequently, many grantors are required to establish inter vivos irrevocable trusts. These trusts generally provide more extensive tax, asset protection and trust planning opportunities. One of the reasons that grantors often struggle with the concept of an irrevocable trust is the requirement that they part with control over the trust assets during their lifetime. As a result, advisors over the years have continued to find unique ways to provide grantors with various options to directly and indirectly remain involved with the assets. However, planning for these options can sometimes result in many potential pitfalls.
Investment Powers
Grantors frequently ask whether they can be named as trustee or co-trustee of a third-party inter vivos irrevocable trust that typically benefits their spouse, children and/or other family.1 Advisors generally avoid such an appointment due to the Internal Revenue Code Section 2036(a)(2)2 (that is, right to designate who’ll enjoy the trust property) and IRC Section 20383 (that is, power to designate who’ll enjoy the trust property) estate tax inclusion issues, particularly when there are distribution powers attached to the appointment.4 Sometimes, a non-binding letter of wishes from the grantor may be used as an acceptable alternative. A grantor’s letter of wishes typically details both current and future distributions, which provides guidance to the trustee. Though non-binding, most corporate trustees will usually follow a grantor’s letter of wishes because the grantor’s intent is critical with most trusts. Alternatively, a family member or advisor close to the grantor may be named.
Power to be Trustee/Fiduciary
Although naming the grantor as a co-trustee or fiduciary with powers over distributions is generally a problem, the grantor can usually retain powers over the trust investment management decisions without any Section 2036 or Section 2038 estate tax inclusion issues. Modern directed trusts allow for a grantor to establish a trust with an administrative trustee in a state with a directed trust statute.5 These directed trusts provide for the appointment of a trust advisor or investment committee, who directs the administrative trustee regarding the investment management of the trust. This investment direction may include asset allocation and advisory services, as well as the selection of outside investment advisor(s) or manager(s).6
By serving as a member of the investment committee or a trust advisor to direct investments,7 the grantor can then use and deploy a broad and sophisticated Harvard or Yale endowment-type asset allocation if desired. This setup would require directing the administrative trustee to acquire alternative investments, private equity, real estate, art and other illiquid assets to be titled and held by the trust. It’s important to note that the grantor wouldn’t be allowed to provide investment direction regarding certain assets, such as closely held business interests owned by the grantor or insurance with the grantor as the insured. These types of assets would typically require independent co-trustees, trust advisors or investment committee members. The grantor may also serve as a member of the investment committee with his family and other trusted advisors, which is a great way for the grantor to help educate the children and grandchildren regarding investments and asset allocation.8 Although the grantor serving as co-trustee, trust advisor or a member of the investment committee regarding investments shouldn’t trigger estate tax inclusion issues, such appointments could possibly result in asset protection and/or income tax issues.9 Consequently, the most conservative approach isn’t to appoint the grantor to these roles, but instead appoint other family members or family advisors.
IM LLC Alternative
Another option for the grantor to remain involved with the investment management of a trust is an investment management limited liability company (IM LLC). IM LLCs are often used in combination with a directed trust.10 Generally, the investment committee of a directed trust would direct the administrative trustee in a directed trust state to hold an LLC, with the sole member (that is, owner) of the LLC being the trust.11 The LLC owned by the trust is then responsible for the oversight of the investment management of the assets held under the LLC, as well as the management and operations of the LLC. The grantor can be named as manager of the LLC. If desired, each asset class may have its own IM LLC owned by the trust. Additionally, as manager of the LLC, the grantor may be able to trade his own securities portfolios. The LLC also provides the trust with another important layer of asset protection.12 Consequently, the IM LLC is a powerful option for the grantor to remain involved with the investment assets of the trust. However, it’s generally best to name a family member or family advisor versus the grantor as the manager of the LLC due to possible issues that could arise.
One possible issue is state income taxes. Many states tax a trust if a trustee is located within the state or use the trustee’s presence as a factor for determining the state taxation of a trust. One common solution may be to set the trust up in a favorable trust boutique state without any income taxes13 and forego appointing the grantor as trustee and/or fiduciary. In a New York tax advisory opinion, a New York City grantor established a trust with a Delaware trustee with New York resident beneficiaries. The trust held a 99% interest and the grantor held a 1% interest in a Delaware IM LLC. The grantor acted as the manager of the LLC, which owned an investment management portfolio with intangible assets. Ultimately, the advisory opinion decided that the trust wasn’t subject to New York income tax.14 California, on the other hand, doesn’t appear to have a direct opinion supporting a California grantor being appointed as manager of a non-California IM LLC owned by the trust. Nevertheless, some advisors point to In the Matter of the Appeal of Robert M. and Ann T.Bass15 and a California Franchise Board Ruling. In Bass, the California Franchise Tax Board attempted to require two Texas resident limited partners to pay California personal income tax on their distributive shares of the income of a Texas investment limited partnership, Idanta Partners (Idanta), which maintained its principal office in California. Idanta maintained four employees at its leased office space in La Jolla, Calif. to keep books and records and to assist with the management of Idanta’s investment activities. The securities portfolio of Idanta was traded through a securities trading room that the Bass family maintained in Fort Worth, Texas and through securities brokers in California. Ultimately, the California State Board of Equalization determined that Idanta wasn’t engaged in a trade or business for federal and California income tax purposes because “Idanta’s securities were not bought and sold in order to profit from short-term swings in market prices but rather were held for long-term capital appreciation and income.”16 As such, an examination of state law regarding the taxation of trusts is critical prior to any appointment.
Another possible issue as a result of the grantor serving as co-trustee and/or fiduciary for a third-party trust17 may be asset protection. Whether the trust is sitused in the client’s resident state or in a boutique trust state, the grantor serving as co-trustee could possibly pose jurisdiction issues. This is less likely if the grantor serves as an investment committee member, trust advisor or manager of an IM LLC. Nonetheless, if asset protection is an important goal, it may be best if the grantor doesn’t serve in these roles, but instead names family and/or family advisors.
Power to Remove Trustee
In addition to possibly being named as co-trustee or fiduciary for investment purposes, the trust document can grant powers to the grantor that provide the grantor control over the trustee while limiting exposure to estate tax inclusion and other risks. In Revenue Ruling 95-58, for example, the Internal Revenue Service confirmed that a grantor may possess the power to remove a trustee and appoint an individual or corporate successor trustee without being deemed to have retained discretionary control over trust income, provided the grantor doesn’t have the power to appoint a successor that’s related or subordinate within the meaning of IRC Section 672(c). As such, the power to remove and replace a trustee, an investment/distribution committee or trust protector may be something the grantor wishes to include in the trust. Grantors can also provide these powers to a trust protector18 or family advisor19 whom they trust.
Swap Power
Another power providing comfort to the grantor regarding the establishment of an irrevocable trust is the substitution or swap power that may be included in the trust document. The swap power allows the grantor to swap personal non-trust assets with trust assets without any negative income, gift or estate tax consequences, if properly planned and executed. The swap can also be helpful for income tax basis planning by swapping high basis assets to the trust in exchange for low basis assets.20 This swap power is generally considered a grantor trust power resulting in the trust being taxable to the grantor for income tax purposes but still removed from the estate for estate tax purposes.21
Grantor as Beneficiary
Another opportunity for a grantor to gain comfort with the establishment of an irrevocable trust is to draft the trust as self-settled. A self-settled trust is a discretionary irrevocable trust in which the grantor is a permissible discretionary beneficiary (a domestic asset protection trust (DAPT)).22 These trusts are used both as tax-neutral irrevocable grantor DAPTs includible in the estate (that is, by the grantor retaining a power of appointment), as well as irrevocable dynasty DAPTs excluded from the estate. With the federal estate gift and generation-skipping transfer tax exemptions at $11.4 million, many grantors may also gain comfort that they can be a permissible discretionary beneficiary of the trust. Note, many advisors take the position that if a grantor has to live off an irrevocable self-settled trust that’s established to be excluded from the estate, then this could result in a possible estate tax inclusion.23 Whereas if the grantor only needs infrequent and sporadic distributions from the trust for hardships, then many advisors maintain that there shouldn’t be any estate tax inclusion problems. However, some advisors consider this a possible gray area. Obviously if the grantor doesn’t need or doesn’t receive any distributions from the trust, then there shouldn’t be any estate tax inclusion issues.24 Also, naming the grantor as co-trustee or fiduciary regarding investments could weaken a DAPT from an asset protection standpoint. Consequently, a grantor isn’t generally appointed to any of those positions in a DAPT, whether or not it’s includible in the estate.
Conservative Strategy
Grantors have to realize that although their involvement with investment management and asset allocation of a trust won’t generally trigger any Section 2036 or Section 2038 estate inclusion issues, this involvement may instead result in negative income tax, asset protection and other issues. Consequently, the most conservative strategy is for the grantor not to serve as co-trustee or in any fiduciary capacity for an irrevocable trust. A better alternative would be to appoint a directed administrative trustee (for example, a corporate fiduciary) in one of the top-rated asset protection and non-income tax boutique trust jurisdictions along with family and family advisors, while at the same time minimizing ties to the grantor’s resident state. Generally, the fewer direct contacts that the grantor has to the trust, the better. Alternatively, grantors may be willing to accept any potential issues so they can be involved with the investment management of the trust. Additionally, the grantor can retain swap powers, trustee replacement powers, as well as the possibility of becoming a permissible beneficiary. All of this flexibility, combined with the modern trust statutes, has resulted in irrevocable trusts gaining enormous popularity over the last 25 years. In 1995, only 12.5% of all gifts were to irrevocable trusts compared to 40% today for the top 10% of the wealthy.25
Endnotes
1. Note, in Jennings v. Smith, 161 F.2d 74 (2d Cir. 1947), a grantor was named as co-trustee with his sons for two trusts that benefited each son’s family. The trusts in Jennings stated that in the trustees’ absolute discretion, the trustees may use “all or any part of it [trust assets] for the benefit of the son or his issue provided the trustees shall determine that such disbursement is reasonably necessary to enable the beneficiary in question to maintain himself and his family, if any, in comfort and in accordance with the station in life to which he belongs.” The court ultimately held that because the trustees weren’t free to exercise untrammeled discretion, but were governed by determinable standards, the power to invade capital conditioned on contingencies didn’t result in estate inclusion. In addition, the court held that trust assets weren’t includible in the grantor’s gross estate because the grantor trustee retained no beneficial interest in the trust property nor the power to designate who shall possess or enjoy the property. The grantor was given a fiduciary power, the exercise or nonexercise of which was limited to a “fixed or ascertainable standard.”
2. Internal Revenue Code Section 2036(a)(2) sets forth the right to designate the persons who shall possess or enjoy the property or income therefrom, creating an estate inclusion issue.
3. IRC Section 2038 sets forth the power to alter, amend, revoke or terminate and includes a power affecting the time and manner of enjoyment, creating an estate inclusion issue.
4. Mark Merric, “Who Can Be Sole Trustee—Part III,” Leimberg Services (February 2010).
5. Selected states with flexible directed trust statutes include: Colorado, Delaware, Georgia, Michigan, Nevada, New Hampshire, New Mexico, South Dakota, Tennessee and Wyoming.
6. Additionally, a distribution committee may be established to determine when trust distributions should be made and to direct the administrative trustee accordingly. See Al W. King III, “Drafting Modern Trusts,” Trusts & Estates (December 2015); Al W. King III and Pierce H. McDowell III, “Selecting Modern Trust Structures Based on a Family’s Assets,” Trusts & Estates
(August 2017).
7. See generally Jennings v. Smith, 161 F.2d 74 (2d Cir. 1947).
8. Al W. King III, “Are Incentive Trusts Gaining Popularity?” Trusts & Estates (October 2017); Al W. King III, “Preserving Family Values by Encouraging Social and Fiscal Responsibility with Modern Trust Structures,” Allied Professionals, Orange County, Calif. (September 2017).
9. While advisors typically strongly advise against appointing the grantor as the distribution advisor, other advisors maintain that if appointed, the grantor’s distribution authority should be limited to an ascertainable standard (that is, health, education, maintenance and support), as the same IRC Section 2036(a)(2) and 2038 issues discussed. An independent distribution advisor could then be appointed with the authority to make any tax-sensitive distributions (that is, fully discretionary distribution decisions). Typically, an independent distribution advisor wouldn’t include: the grantor’s spouse (if living with the grantor); the grantor’s father, mother, issue, brother or sister; an employee of the grantor; a corporation or any employee of a corporation in which the stock holdings of the grantor and the trust are significant from the viewpoint of voting control; and a subordinate employee of a corporation in which the grantor is an executive.
10. Three conditions of N.Y. Tax Law Section 105.23(c) not met: (1) the trustee was domiciled outside of New York; (2) the corpus of the trust consists of intangible assets and deemed to be outside of New York; and (3) none of the assets carried on business in New York, and all income and gains of the trust were derived from sources outside of New York. The limited liability company’s (LLC) activities of managing bank deposits/trading securities didn’t constitute the carrying on of a business, trade, profession or occupation in New York.
11. Most of the popular boutique trust situs states (for example, Delaware, Nevada, South Dakota and Wyoming) have sole member LLC statutes allowing for a single owner (that is, the trust).
12. Certain states have charging order protection for their LLCs as the sole remedy against the entity, which is generally considered the most desirable. A charging order only gives a creditor the rights to an LLC interest; however, it doesn’t give a creditor any voting rights. As such, a charging order is simply a right to a distribution (if and when one is ever made), and it leaves a creditor without any means to force a distribution. Selected states with charging order protection as the exclusive remedy include: Alaska, Delaware, Nevada, South Dakota and Wyoming. See Al W. King III, “Attacking, Defending & Fortifying Domestic Asset Protection Trusts: A Trustee’s Perspective,” Desert Estate Planning Council (April 2016); Al W. King III, “Defend Against Attacks on DAPTs,” Trusts & Estates (October 2014).
13. For example, Alaska, Delaware, Nevada, New Hampshire, South Dakota and Wyoming.
14. Note this opinion came before New York modified its laws to provide for a throwback tax on accumulated income. Specifically, New York now imposes a throwback tax on accumulated income distributed to a New York resident beneficiary. This means that when a distribution of accumulated income is made, the beneficiary will be taxed as if the income had been subject to New York tax in the year that it was earned. The structure in the advisory opinion would be subject to the throwback tax.
15. In the Matter of the Appeal of Robert M. and Ann T. Bass, No. 87A-1552-CB:DB (Cal. SBE Jan 1989).
16. Ibid.
17. A third-party trust is typically one established by a grantor for the benefit of another individual or individuals, for example, the grantor’s spouse, children and/or grandchildren. The grantor isn’t a beneficiary of these trusts.
18. A trust protector is generally an individual (though a committee of individuals or an entity may serve) with specified powers over the trust. The typical purpose of a trust protector is to provide flexibility to an irrevocable trust. Common trust protector powers include the power to remove or to replace trustees; the power to veto or direct trust distributions; the power to add or remove beneficiaries; the power to change situs and the governing law of the trust; the power to approve, veto or direct investment decisions; the right to consent to exercise a power of appointment; the power to amend the trust as to the administrative and dispositive provisions; the power to approve trustee accounts; the power to add a grantor as a beneficiary from a class of beneficiaries; and the power to terminate the trust.
19. Some states allow for the appointment of a “family advisor,” which is a non-fiduciary appointment that authorizes such individual to consult or advise on fiduciary or non-fiduciary matters. In addition, such family advisor may have the power to remove and appoint a trustee, fiduciary, trustee advisor, investment committee member, trust protector or distribution committee member.
20. See Martin M. Shenkman and Bruce D. Steiner, “Swap Powers,” Trusts & Estates (December 2015).
21. Generally, a grantor trust is one in which trust income is attributable to the grantor instead of the trust. Thus, the grantor pays the trust income tax instead of the trust. This is achieved by the grantor retaining certain powers under the trust that trigger the grantor trust status. If structured correctly, the trust wouldn’t be includible in the grantor’s estate.
22 A self-settled trust is generally a discretionary irrevocable trust in which the grantor is a permissible discretionary beneficiary. If properly structured and established in a state with such laws, creditors can’t reach the assets in the trust to satisfy the grantor’s legal obligations. Only 19 states have self-settled trust statutes; this includes all of the modern trust jurisdictions including Alaska, Delaware, Nevada, New Hampshire, South Dakota and Wyoming.
23. See Roy Adams, “The Impact of The New Bankruptcy Laws Upon Estate Planning,” Cannon Financial Institute, Inc. (June 2006).
24. Note, many self-settled trusts are structured so the grantor isn’t named directly as a beneficiary in the trust document. Instead, the trust protector typically is given a power to add the grantor back in general by way of a class of individuals that includes the grantor. If later down the road, the grantor needs to be added back into the trust to receive distributions, for example for hardship or for tax planning purposes, then the trust protector can do so. Until such event, which may never occur, it reduces exposure to potential estate inclusion and/or asset protection issues. For example, the trust protector may add a beneficiary who’s a descendant of the grantor’s grandparents.
25. See Al W. King III, “The Next Tsunami—Charitable Giving with Non-Charitable Trusts—How the Wealthy are Using Modern Trust Structures to Promote Social & Fiscal Responsibility,” Financial Planning Association, Tax and Financial Forum (October 2019); Al W. King III, “Drafting Modern Trusts,” Trusts & Estates (December 2015).