Directed Trusts vs. Traditional Trusts: Similarities and Differences

The concept of what one would consider a “traditional” trust can trace its beginnings back to the 13th century. By comparison, the directed trust structure is a relatively new development; however, it may be surprising to learn that practitioners began using directed trusts in Delaware over 100 years ago and Delaware’s directed trust statute was enacted about 40 years ago.

In this article, we’ll explore the similarities and differences between traditional trusts and directed trusts, including the role of a trustee in both structures and finally, when it may be more beneficial to use a directed trust instead of a traditional trust.

Differences Between Traditional Trusts and Directed Trusts

Let’s start with a discussion on the differences between a traditional trust and a directed trust. A traditional trust is what one typically thinks of when contemplating a trust. A traditional trust has one trustee who is responsible for all of the standard trustee roles, including but not limited to safeguarding and managing the trust’s assets, making distribution decisions, making investment decisions, communicating with beneficiaries and preparing the trust’s tax filings.

As discussed in detail in our article explaining directed trusts, a directed trust splits away one or more of the powers or discretionary responsibilities held by a traditional trustee and gives that specific power to another party, either a co-trustee or a trust advisor. This structure is extremely flexible and allows for any number of powers to be vested in parties other than the trustee. These powers often include discretion over investment decisions (often held by an investment advisor), discretion over distribution decisions (often held by a distribution advisor) and discretion over a Trust’s ownership of certain, closely held, or hard to manage, assets (often held by a special holdings advisor).

While the directed trustee’s role is narrower than that of a traditional trustee, it is no less important. The directed trustee holds legal title to trust property, just like a traditional trustee, and is charged with both implementing the actions that are directed by the trust advisors and discharging the non-directed trustee duties retained by the directed trustee. These responsibilities can range from making discretionary distribution decisions (if only an investment advisor is appointed) to purely administrative trustee responsibilities, such as record keeping (if an investment advisor and distribution advisor are appointed).

As mentioned above, a directed trust can vest any number of trustee responsibilities with advisors; however, when establishing a directed trust in a favorable trust jurisdiction such as Delaware, and when the directed trustee is the primary connection to that jurisdiction, one should consider which duties will remain with the directed trustee to ensure sufficient nexus to that jurisdiction. If too many fundamental trustee duties are taken away from the resident trustee and allocated to co-trustees or advisors residing outside the directed trust jurisdiction, a trust may face challenges to its situs. Responsibilities such as trust record keeping, preparing or arranging for the preparation of the trust’s tax returns, and maintaining accounts for the custody and safekeeping of trust assets are some of the administrative tasks that are often given to a resident directed trustee to create a nexus to that jurisdiction.

When a trust divests a trustee of a certain responsibility and permits the trustee to exercise a power solely at the direction of another party, the trustee’s liability is adjusted accordingly. For example, in Delaware, if a trust instrument provides that a trustee is to follow the direction of a trust advisor and can only act upon the direction of a trust advisor, when the trustee acts upon a direction, the trustee is only liable for a loss resulting from that trustee’s willful (i.e., intentional) misconduct.

Similarities Between Traditional Trusts and Directed Trusts

An important similarity across all trusts is that a trustee has a responsibility to act as a fiduciary on behalf of the trust’s beneficiaries. As a fiduciary, a trustee must uphold certain duties to those beneficiaries, including a duty of good faith and loyalty, a duty of care, and a duty of impartiality. Generally speaking, this means a trustee must prudently manage the trust, act in the best interests of the trust beneficiaries and treat the beneficiaries in an unbiased manner.

Even though a directed trust has stripped certain responsibilities away from the directed trustee, it does not absolve that trustee of having fiduciary duties owed to the trust beneficiaries. In addition, trust advisors appointed in a trust instrument holding the power to direct a Trustee are generally held to the same fiduciary standards. Under Delaware law, a trust advisor, who is taking over responsibilities typically held by a trustee, is presumed to be acting in a fiduciary capacity unless the trust instrument explicitly says otherwise.

Additionally, as mentioned above, a directed trustee still holds a number of key functions that a traditional trustee holds, including any discretionary or administrative functions not given to a trust advisor.

When May a Directed Trust Fit into Your Estate Plan?

The fiduciary duties mentioned in the previous section of this article are an important consideration when determining whether a directed trust may fit into an estate plan. The trustee’s duty of care in managing trust assets includes a duty to diversify those assets to protect against a significant decrease in value of one particular asset causing the trust to lose substantially all its value.

A settlor can waive the trustee’s requirement to diversify assets; however, this waiver is often not sufficient for a trustee (especially a corporate trustee subject to various federal and/or state regulations) to feel comfortable holding a significantly concentrated position in a small number of assets. This can conflict with a settlor’s desire to create a trust with assets composed primarily of legacy stock or real estate.

In addition, even the most sophisticated of trustees may not be the best choice to handle investment decisions for certain hard-to-manage assets such as hedge fund investments or a family business.

Both situations could be resolved using a directed trust that appoints an investment advisor to direct the trustee with respect to holding the trust’s assets and taking any necessary action regarding those assets. The directed trustee can be directed to hold the concentrated positions as intended. The settlor may even be able to serve in the investment advisor role and not have to relinquish control over decisions regarding those assets.

For another example, consider a settlor who wishes to establish a dynasty trust for her children and descendants. One of her children has a history of substance abuse and the settlor wants to ensure certain prerequisites are met before the child receives a distribution. A trustee may be able to ensure these prerequisites are met but perhaps there is a family friend or colleague who interacts with the child and the family on a regular basis and is better equipped to assess whether a distribution to the child is appropriate. The trust could appoint this family friend or colleague as a distribution advisor to direct the trustee regarding the distribution of trust assets.

Additional Considerations

Because a directed trust structure is, by its nature, more complex than a traditional trust, one should take additional care during the planning and drafting phases. Directed trusts operate most smoothly (i) when the trust instrument clearly defines the roles and responsibilities of the various parties, and (ii) when the parties holding fiduciary roles communicate openly and regularly with each other.

Directed trusts have become a powerful and flexible tool that can be utilized for a variety of purposes. However, given the complexity, one should consult with an attorney when considering whom to appoint in various trust advisor roles to avoid any unintended tax consequences. One should also take care when considering whom to appoint as a directed trustee. Appointing someone who understands the responsibilities associated with the role and has experience serving in that role can help all of the parties both during the planning process and during the life of the trust.

While the concept of directed trusts may be a relatively new development in the centuries-old history of the use of trusts, they have existed for a surprisingly long period of time, especially in Delaware. During this time, the courts and legislature of leading trust jurisdictions, such as Delaware, have helped to fine-tune and enhance the guidance and laws surrounding directed trusts. In addition, corporate trustees, like Commonwealth Trust Company, have led the way in providing first-class specialized directed trustee services.