Recent developments have provided an opportunity to highly customize trust administration, which can confer significant benefits to clients, as well as permit administration to more closely align with clients’ objectives and desires.
When discussing the creation of a trust, lawyers and their clients focus almost entirely on the dispositive provisions of the contemplated documents and largely ignore any consideration of the intricacies of trust administration, other than addressing trustee succession issues. This is largely because, other than selecting the appropriate governing law, trust administration provisions were largely static and rarely deviated from traditional norms. Similarly, not too long ago, it was infrequent to encounter concepts like a trust advisor or a trust protector when discussing trusts. But, the past several years (if not decades) have seen significant advancement and growth in trust laws, specifically those pertaining to trust administration. These advancements have provided grantors and their families an expansive range of options for how trusts can be administered and more opportunities to tailor such administration to meet grantors’ and their families’ specific needs and objectives. Recently, one of the most useful ways trust laws have evolved is the ability to use a statutorily authorized directed trust structure.
Bifurcated Roles
Historically, a trust was subject to the exclusive control and oversight of a trustee (or co-trustees) who was charged with all facets of trust administration. Recently, many states have enacted laws that now statutorily authorize the bifurcation of these traditional trustee roles by permitting the appointment of a trust advisor (also referred to as a “trust protector”) who’s expressly authorized to direct an exercise of a fiduciary power traditionally held by the trustee. Most common is a trust advisor who’s authorized to direct a trustee concerning investment decisions (including voting equity interests), as well as discretionary distribution decisions. Given the power of a trust advisor to direct the trustee, the trust is referred to as a “directed” trust and the trustee who’s relieved of a specific power as an “excluded fiduciary” with respect to such power. As with a trustee, the role of a trust advisor can be filled either by a single individual or multiple individuals serving in a committee structure. This ability to grant certain powers concerning the administration and the management of a trust to a trust advisor provides significant planning opportunities.
For example, while a grantor may wish to use a corporate trustee, the grantor may prefer that investment decisions be controlled by a long-time trusted financial advisor. Or, a grantor may wish for all administrative functions of a trust to be the responsibility of a corporate trustee while granting a specific individual(s) (for example, family members, other advisors) the power to make discretionary distributions or veto an exercise of the trustee’s discretion to make a distribution. It’s become more common to encounter hesitation, if not resistance, from corporate trustees who are concerned with administering trusts that hold heavily concentrated positions and/or unique assets. In these situations, the use of a directed trust structure is more appealing than a delegation of the power (either to a co-trustee or an agent) because of the complete elimination of liability arising from any actions of the trust advisor. As such, it’s not uncommon for a corporate fiduciary to request that a trust agreement carve out responsibility for the administration of a unique asset, such as a family lake house, to a family member, while remaining responsible for all other trust administration matters. Similarly, a corporate trustee might request that a separate individual be responsible for exercising voting rights over equity interests in the family business.
Investment Committee
Recently, a trend has emerged in which high-net-worth individuals seek to impart investment acumen on children and grandchildren. The use of a trust advisor can further this desire by permitting the creation of an investment committee comprised of grandchildren and trusted advisors who, as committee members, can be given responsibility for, or participate in, determining investment decisions, thereby creating an opportunity for the trusted advisors to mentor those serving on the committee. Moreover, involving younger generations provides an opportunity for them to appreciate the family wealth, become better stewards thereof and become more engaged beneficiaries. Another extremely powerful benefit of the directed trust structure is that it permits an owner of a closely held business to identify an individual(s) who’ll have the sole power to vote the equity interests of the business that’s held in trust and thus potentially indirectly influence the business. For business owners concerned with succession planning, the ability to select trusted advisors, both inside (for example, directors) and outside the business to oversee the management of the business is invaluable and provides a self-perpetual management structure to continue the business for generations.
Liability Exposure
Nonetheless, the full implementation of this alternative administration structure has been more gradual than anticipated. While there may be numerous reasons for this, we believe a major barrier to implementing a directed trust is concern over the potential liability exposure of the trust advisor, especially when the trust advisor is acting in a fiduciary capacity. Until recently, it appeared that the laws of most states provided that if a trust advisor was to act in a fiduciary capacity, only individuals or regulated corporate trustees (including private trust companies (PTCs)) and unregulated PTCs authorized to act as a fiduciary under applicable state law were permitted to serve.1 Typically, a client wants an individual to serve as the trust advisor rather than have a corporate trustee serve in this capacity. This creates an obstacle to using a directed trust structure because the individual(s) asked to serve as a trust advisor(s) is often concerned with a lack of liability protection for serving.
Special Purpose Entity
The advent of the special purpose entity (SPE) to serve as a trust advisor provides a solution to this liability concern, as well as several other benefits. Specifically, South Dakota and Tennessee now statutorily provide for the creation of an SPE to exercise fiduciary powers.2 Likely organized as a limited liability company (LLC), the SPE can serve as a trust advisor and be statutorily authorized to exercise fiduciary powers.3
The SPE is designed to use a directed trust structure by permitting the SPE to serve as trust advisor for a trust of which a corporate fiduciary is otherwise serving as trustee. Often, applicable state law requires the corporate fiduciary to be located in the state where the SPE is organized. In addition, state law usually permits a single SPE to serve as a trust advisor for any number of trusts, so long as there’s a prerequisite family connection among the grantors and beneficiaries (potentially, up to 12 degrees of lineal kinship or 11 degrees of collateral kinship, and including spouses, some former spouses and some family members of such spouses). Therefore, provided the corporate trustee is serving, a single SPE may exercise fiduciary powers with respect to all trusts benefiting the family members without being subject to the more onerous laws and regulations typically applicable to trust companies and banks. As noted above, a primary benefit of an SPE is that it can be organized as either an LLC or as a corporation, giving the owners and officers the same general liability protection typically afforded with these types of organizations. This liability protection makes serving as trust advisor, indirectly via serving at the SPE level, significantly more appealing to potential prospects who are otherwise wary of the liability exposure. Furthermore, there are several other significant benefits to incorporating an SPE in a directed trust structure.
State Income Tax Savings
Commonly, states seek to impose taxes on a trust based either on the residency of the trustee (that is, situs of trust administration) or other fiduciary within such state. In these states, the fact a trust advisor is a resident of such state might be the sole justification for the state taxing the trust. But, an SPE should be classified as a resident of the state where it was organized and not a resident of the state otherwise seeking to impose its tax. Consequently, provided all the SPE’s activities (such as committee meetings and execution of documents exercising powers) occur solely in the state where the entity was organized and the corporate fiduciary is outside the state, it may be possible to avoid subjecting the trust to a state’s income tax regime that’s imposed solely on the residency of a fiduciary in such state. This will permit a resident of such a state to engage at the SPE level and, therefore, be involved in making decisions concerning the underlying trust without subjecting the trust to the other state’s income tax regime. This relief from such aggressive state income tax regimes can provide significant tax savings. Moreover, depending on the applicable law of the state where an SPE is organized, if the beneficiaries of a trust aren’t residents of the organization state, the trust might not be subject to tax in such state. Consequently, the use of an SPE may not only avoid any additional tax burden but also could provide significant tax savings. Additionally, the use of an SPE could be appealing to families seeking the benefits provided by a PTC, but who are leery of undertaking such a structure and incurring the costs to operate it.
PTCs
For families with shared goals, values and purposes and who have trusts that are consistent therewith, or for families seeking a tailored family governance solution, a PTC can provide significant benefits to the administration and enhancement of the family wealth. Families with trusts are often very concerned with ensuring there’s collaborative administration of such trusts. A PTC provides an opportunity to centralize and to harmonize the investment and/or distribution functions of the administration of such trusts. When ownership of the family business is spread over several trusts, families often wish to ensure there’s some uniformity in how such trusts are administered to avoid unnecessary impact on business operations and, historically, these families have chosen a PTC to address these concerns. Additionally, the use of a PTC could minimize state income taxes by locating trust administration in more tax-friendly jurisdictions. A PTC can also provide unique/customized services that aren’t practical or profitable for a corporate trustee, while providing liability protection for individuals who were formerly trustees and will be making distribution decisions on behalf of the PTC. Also, a PTC provides a succession plan for transitioning from one individual trustee to another, while permitting the family to have input on the selection of the ultimate decision makers (that is, investment advisors, membership on various PTC committees, etc.). A full discussion of the benefits of a PTC is beyond the scope of this article. Notwithstanding its benefits, the creation and administration of a PTC requires giving significant consideration to the ultimate viability for a PTC for several generations because, beyond its costs, the administration of a PTC involves all the complexity of serving as a trustee, as well as administering a separate operating and governing body.
SPE vs. PTC
For those clients desiring the benefit afforded by a PTC but wishing to avoid all that comes with a PTC, an SPE can provide most benefits of a PTC but at a fraction of the complexity and cost. Rather than forming a PTC, these clients can use a directed corporate trustee and form an LLC (or corporation) to serve as an SPE. The LLC will have a board, and the board will appoint members to various committees, which are responsible for making distribution and/or investments decisions and/or other powers the SPE, in its role as trust advisor, is granted.
Consider a three-generation family with an operating business, ownership of which is split among the eldest generation (G-1) and family trusts benefiting younger generations. Often, in this situation, G-1 desires a customized structure to govern the administration of the business using existing or former corporate officers and executives. Simultaneously, G-1 may wish each family branch to be independent regarding distributions. By using an SPE in a directed trust structure, G-1 can provide for an investment committee that would be solely and exclusively responsible for exercising voting rights of equity interests in the business held by the family trusts, thus controlling the operation of the business. This strategy will enable the advisors (who may or may not be family members) to focus on the business via the investment committee. The SPE can be structured so that a separate distribution committee exists for each family branch and directs the corporate trustee regarding distributions from trusts benefiting such branch, while the corporate trustee handles all other facets of trust administration. See “Incorporation of an SPE in Directed Trust Structure,” this page, for an example of how an SPE might be structured.
Another illustration of how an SPE can provide a similar benefit as a PTC involves state taxes. Consider a resident of State X (with a significant state income tax) who wishes to participate in the administration of a non-grantor trust unless it would expose the trust to State X’s taxes. This individual should be able to serve on a board of an SPE in a foreign state without exposing the trust to a tax liability in State X.
Thus, in situations in which a family might be drawn to create a PTC but wishes to avoid investing in forming, operating and administering it, the alternative of creating an SPE will often permit the family to identify specifically which element of a PTC it wishes to replicate. Likely, an SPE can serve the family’s purposes and be created and operated at a fraction of the cost and complexity.
Various Options
In light of the significant evolution of the law regarding trust administration, practitioners should counsel clients on the various options now available for trust administration. Importantly, when the underlying trust owns unique assets, the directed trust structure allows for greater flexibility in trust administration. Also, the ability to integrate an SPE into a directed trust structure provides the opportunity to highly customize trust administration to align more closely clients’ needs and wishes, while also providing significant ancillary benefits. As with any good craftsman, the more tools in one’s toolbox, the more equipped he is to assist clients with preservation of family wealth.
Endnotes
1. See generally Tennessee Annotated Code Section 45-2-1001, South Dakota Codified Laws Section 51A-6A-66.
2. We acknowledge that, while not specifically authorized by applicable law, it might be possible to create a special purpose entity (SPE) under the laws of other jurisdictions, and such SPE may exercise fiduciary powers.
3. Note, any application of the Investment Advisers Act of 1940 to the SPE based on advice it gives on the retention or disposition of business interests that constitute securities is beyond the scope of this article and should be discussed with the SPE’s legal counsel.