Part one of this post explains generally what a trust is and how it works, including how current law allows traditional trustee powers to be separated and delegated among specialized fiduciary appointments, such as directing parties and trust protectors. Part two of this post will address the bold declaration in the post’s title by explaining why a trust is always the answer.
What is the question?
A trust can be the answer to many questions. For example, a living trust can be part of a plan to avoid probate administration of a settlor’s estate. A trust can be an essential way protect property for a minor beneficiary or a beneficiary who is under a guardianship. A trust can hold property for the benefit of multiple beneficiaries, with either concurrent or successive interests, including charitable beneficiaries. A trust can shelter assets from estate taxes and generation-skipping transfer (“GST”) taxes (see below).
For this post, however, the question is, “Should a parent who is transferring family business interests and other property to a competent adult child arrange for the child to receive the property outright or in a trust?” The answer is that the transferor should always consider using a trust.
Reasons to use a trust.
The primary advantage of passing property to a beneficiary in trust is that if the trust is “irrevocable” and if the beneficiary does not have power to withdraw the property, then the property is protected against claims of the beneficiary’s creditors.
● Contract Claims: If the beneficiary is obligated to a third party for a loan or other debt under contract, the trust is not also obligated unless the trustee has formally agreed that the trust will serve as a surety for such debt. For example, if the beneficiary borrows money from a bank for the family business and personally guarantees the loan, the trust will not be obligated as a guarantor unless the trustee independently executes a guaranty for the loan. Even if the beneficiary goes through bankruptcy, the trust’s property will continue to be protected against claims of the beneficiary’s creditors. (In some states, the only substantial exception is for claims for child support.)
● Tort Claims: Similarly, trust property is not subject to liability for claims arising out of a beneficiary’s negligence or wrongful conduct. This can be important because sometimes tort claims are not covered by insurance or the liability exceeds coverage limits. In such cases, the trustee could use trust assets to assist the beneficiary with legal costs or even contribute toward the costs of a settlement, but the trustee could not be forced to pay trust assets to the plaintiff.
● Divorce: If the beneficiary’s marriage terminates in divorce, assets held in the trust will not be subject to property division as part of the divorce proceedings. Further, in most cases, the trust cannot be required to pay spousal support (but, as mentioned above, a trust sometimes can be invaded for payment of child support). Generally, a trust is a more reliable means of protecting property at divorce than a prenuptial agreement, which can be successfully challenged by the spouse or modified by the court for a number of reasons.
● Transfer Taxes: The trust can be structured so that trust assets will not be subject to federal estate taxes on the death of the beneficiary. If the trust continues for the beneficiary’s children and further descendants, a substantial portion of trust property can be sheltered from estate taxes at each generation (while also avoiding an onerous federal tax on generation-skipping transfers).
These advantages are available in full for the beneficiary only if the trust is created and funded by someone other than the beneficiary. Generally, if a person places property in trust for his or her own benefit, that trust can be invaded for claims of his or her creditors, or in the event of divorce. Although the statutes of some states, such as South Dakota and Delaware, allow a person to create his or her own asset-protection trust, the protections such self-settled trusts provide are not as universal and well-tested as those that apply when the beneficiary is not the settlor.
Responses to common concerns about a trust.
Many concerns that family business owners may have about leaving family business interests and other assets in trust, and many concerns that their beneficiaries may have, can be addressed by a version of one of three responses: it’s worth it; the trust can be tailored; the trust can be changed or terminated. The following are some examples:
● Cost of the trustee’s fee. It’s worth it.
Generally, a trust of any substance should be administered by a corporate fiduciary, as trustee, to ensure full protection of the assets, proper construction and implementation of trust terms, and accurate record keeping and tax-reporting. Most corporate trustees will charge a negotiable fee based on a percentage of the value of trust assets. This fee, however, is a small price to pay when balanced against the value of the economic protection that the trust provides (described above) and the alternative costs of less thorough protection, such as insurance premiums, prenuptial agreements, and litigation fees. (See a future post on the advantages of working with a corporate fiduciary.)
● Loss of control. The trust can be tailored.
To be most effective, the trust should have an independent trustee, and the beneficiary should not have power to withdraw trust assets. Under the laws of many states, however, the beneficiary can serve as the trust’s “directing party” (or “investment advisor”), with full authority to control how the trustee manages trust investments, including family business interests. As directing party, the beneficiary can oversee management of the trust’s investment portfolio, cause the trustee to buy or sell assets, and exercise voting rights of the trust’s family business interests. The beneficiary also can serve as the trust’s “trust protector” (or “trust advisor,” “trust enforcer”) with authority to remove and replace the independent trustee with another independent trustee. Therefore, although the beneficiary will not hold legal title to trust assets or have power to withdraw them, the trust can grant the beneficiary broad authority over how the trust assets are managed and who has authority to make distributions.
● Irrevocability. The trust can be changed or terminated.
To be most effective, the trust must be irrevocable, which (for these purposes) means that the neither the settlor nor the beneficiary can revoke or terminate it. The laws of many states, however, allow a trust to be amended or terminated by an independent trust protector, and the beneficiary can have power to remove and replace the independent trust protector. Further, many states have adopted procedures by which an irrevocable trust can be broadly amended by judicial action or by a nonjudicial settlement agreement signed by the parties interested in the trust. Therefore, if the trust ceases to serve its purpose, if the trust is not consistent with tax planning for the family business, or if a change of law or circumstances renders the trust terms inappropriate, the trust terms can be changed or the trust can be terminated as to some of all of the assets it holds.
For the reasons discussed in parts one and two of this post, family business owners should always consider using a thoughtfully-drafted trust when they transfer family business interests and other assets to their adult children and other beneficiaries.