Trusts have gained enormous popularity over the last 20
years. The top 1 percent of the wealthy have 38 percent of their
investment assets in trusts, and the next 4 percent have 43 percent of their investment
assets in trusts. This powerful trend is largely due to the fact that the
modern trust can provide a family not only with powerful tax and asset
protection advantages, but also with the flexibility and control of several key
non-tax trust functions, including investment management. Here are some of the
key investment management factors contributing to this growth.
Grantor Can be
Co-Trustee
The grantor can, generally, be a co-trustee or co-fiduciary
to handle investment management for the trust without an estate tax inclusion
issue. However, it could result in possible asset protection and/or state
income tax issues, depending on state as well as trust design. Consequently,
usually a family member or family advisor, other than the grantor, will be
chosen as investment management trustee and/or investment committee fiduciary
of a modern directed trust.
Additionally, a limited liability company (LLC) that’s owned
by the trust and the grantor may handle the investment management of a trust,
and/or a member of his family can be named as the manager of the LLC.
Sophisticated Asset
Allocation
Most state statutes require the proper asset allocation and
diversification of a trust. These statutes emanated from the Prudent Investor
Act in the early 1990s, which most states have adopted in some form. These
statutes also generally allow for a trustee to delegate some or all of the
investment responsibilities of a particular trust. The delegation is
usually to qualified professionals, and these professionals monitor the
investment management. Additionally, many wealthy families desire very
sophisticated asset allocations, but trustees may lack sophistication regarding
private equity, alternative investments and foreign investments and,
consequently, need to delegate these investment management functions to
qualified investment professionals.
But, many trustees are reluctant to delegate investment
management for some of the more sophisticated asset categories due to possible
liability, coupled with their lack of experience and inability to do the proper
due diligence as to whom to delegate and to monitor the delegation. On the
other hand, if the trust is sitused in a directed trust jurisdiction, the
family can be on the investment committee and work with investment managers and
advisors of their choice. The family can be protected from a liability
standpoint to properly implement a Harvard or Yale Endowment
asset allocation model.
No Need to Diversify
As previously mentioned, most delegated trust states require
that a trust be properly diversified. Consequently, many families look to
situs their trusts in directed trust states. Directed trusts can be very
beneficial for families who may not want to diversify their trusts but may,
instead, want the trust to hold just a few or even one asset, such as a closely
held family business, large position in a public stock or family limited
partnership. The directed trust structure provides a family the utmost
flexibility either to diversify as broadly with as much sophistication as
desired or to be as simple as desired.
State Income Tax
Savings
There are two general types of irrevocable trusts: grantor
and non-grantor. Grantor trusts are taxed to the grantor for income tax
purposes. However, a discretionary tax reimbursement provision16 can be
added so that the grantor can be reimbursed for trust income tax paid. These
taxes paid by the grantor effectively are tax-free gifts to the trust. A
non-grantor trust, on the other hand, is a separate taxpayer. Depending on
the trust situs, there may be both federal and state income taxes. If the situs
of the trust is in a no-state income tax jurisdiction for trusts, state
income and capital gains taxes may be saved on trust assets, assuming the trust
is properly drafted, sitused and administered in the no-state income tax trust
state or that situs is effectively changed from a jurisdiction with state
income taxes on a trust to one without them.
Once the trustee makes distributions to the trust
beneficiaries, the distribution will, generally, be taxed to the beneficiaries
in the year they receive it in their resident state, assuming they’re residents
in a state with a state income tax. These distributions would also be subject
to federal income taxes.
One of the few strategies to avoid both federal and state
income taxes paid by either the grantor of the grantor trust or the non-grantor
trust itself is life insurance. Life insurance can provide both federal and
state tax-free growth within the trust, as well as federal and state tax-free
distributions when distributions are made from the trust, if the trustee of an
insurance policy owned by the trust makes the distributions. It’s a
powerful leveraging strategy. Private placement life insurance (PPLI) is
commonly used for this purpose.
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