Entities Held in Trusts: Common Pitfalls in Trust Administration

Limited partnerships (LPs) and limited liability companies (LLCs) are common vehicles used in complex estate planning and are often preferred entity structures for privately held family businesses. For these reasons, among others, LPs and LLCs are frequently held in trusts. As mentioned in a previous article, directed trusts provide a flexible and customizable solution for individuals who wish to create trusts primarily composed of concentrated interests in one or more LPs and/or LLCs (for convenience, LPs and LLC will hereinafter sometimes be referred to as “underlying entities” or simply “entities”). 

While these trust structures are ostensibly simple to administer for both trustees and families, they can give rise to issues when transactions involving those underlying entities bypass the trust and information relating to those transactions is not shared with the trustee. This article is intended to highlight some common examples of those types of transactions, discuss why it is important for the trust (and trustee) to be involved, and finally, note some of the pitfalls created when the trust and trustee are bypassed.

This will be part one of a two-part series. Part two will discuss the various benefits to families and trustees of entity structures within trusts.

Common Examples

Funds Transferred Directly to an Underlying Entity From Outside the Trust

As previously mentioned, LLCs are frequently used in estate planning and interests in such entities can be held as trust assets for a variety of reasons. One common use of LLCs is as a holding company, owning interests in other private entities and/or investment accounts. This structure can prove useful for asset protection purposes, for ease of transferring ownership, or for giving the LLC manager (who is often also serving as the Investment Advisor of the trust) some additional freedom to move funds between LLC investments without having to involve the trustee for each transaction, as would be the case if the investments were held directly by the trust. 

When a settlor contemplates the initial funding of the trust, or subsequent additional funding (for example, to meet capital call requirements of an underlying investment, or to pay ongoing expenses of an underlying business), it may seem more convenient and practical to simply transfer those funds directly to the underlying entity’s investment or operating account. It is important to remember that, because these entities are direct, or indirect, assets of the trust, direct transfers to those entities represent gifts to the trust unless other treatment is warranted, such as loans made pursuant to a loan agreement or promissory note.

Additionally, an LLC may be utilized to hold residential real estate within a trust, which could be a vacation home or a primary residence of a beneficiary. That real estate is often the only asset of the LLC and, consequently, when expenses are owed for the property (for example, to pay property taxes or the cost of renovations), liquid funds are needed to cover those expenses. If the LLC is the only asset of the trust, those funds inevitably come from a source outside the trust. It is again important to remember that the direct payment of those expenses represents a gift to the trust.

Funds Transferred out of the Trust From an Underlying Entity

When an LLC or LP interest is the only asset of the trust, that entity, by default, becomes the source of funds for any transactions that require the movement of funds out of the trust. Examples of these transactions include distributions to beneficiaries, tax payments owed by the trust, reimbursements to the grantor for tax payments, or trust-related expenses.

It may seem more convenient and practical to simply transfer the funds out of the underlying entity’s account directly to the beneficiary or grantor (for a requested distribution or reimbursement), to a tax authority (for a tax payment), or to the attorney who was working on some trust-related matters. However, it is also important to remember that these types of transfers are also ultimately considered transfers out of the trust. Consequently, (i) the transfers must comply with the terms of the trust instrument, and (ii) the transfers have implications on the administration of the trust.

Use of Trust Assets

On some occasions, an entity held by a trust may need to borrow funds or enter into a line of credit with a financial institution. The lender of those funds may require collateral against that loan and one potential option available to that entity is pledging other trust assets against the loan. Having certain assets earmarked as pledged can have major implications on the administration of the trust. For example, trust assets that would generally be available for distributions to beneficiaries may now be encumbered and thus not available.

Why Does the Trustee Need to be Involved?

One may wonder why the trustee (especially a directed trustee) needs, or even wants, to be involved in the types of transactions mentioned above. The answer lies at the intersection of (i) the trustee’s responsibilities under the trust instrument and applicable state law, and (ii) the trustee’s limited role and involvement with respect to the activities of the trust’s underlying entities. 

The Trustee’s Responsibilities 

The trust instrument governs the responsibilities of the various parties serving in powerholder roles with the trust, such as the trustee, the direction adviser(s), and the trust protector. That trust instrument can give as much, or as little, power to the trustee as the settlor wants; however, one consideration drafters often consider is whether the trustee holds sufficient responsibilities to not jeopardize the trust’s situs. The Delaware Supreme Court has noted that, when determining which law governs the validity of a trust, one of the factors taken into consideration is the place where the trust is administered (see Lewis v. Hanson, Del. Supr., 128 A.2d 819, (1957)). The Court goes on to list several factors as likely relevant in determining where a trust is administered. Some of these factors are listed below and can often be found as part of a separate provision in the trust instrument as powers being exclusively held by the Delaware resident trustee when there are other powerholders residing outside of the state:

1. The maintenance of accounts for the purpose of custody and safekeeping of trust assets, receiving income and contributions to the trust and disbursing expenditures and distributions from the trust;
2. The maintenance of trust records, the creation and review of trust accountings, reports and other communications concerning the trust with the settlor, beneficiaries and third parties; 
3. The responsibility for responding to inquiries regarding the trust from the settlor, beneficiaries and third parties;  
4. The responsibility for execution of documents relating to, and on behalf of, the trust; and
5. The responsibility for the preparation and review of the trust’s tax returns and related tax filings.

These powers are above and beyond any discretionary powers given to a trustee, such as the power to make discretionary distributions or loan transactions, and additional administrative powers, such as the responsibility for sending Crummy withdrawal notices.

For the trustee to carry out these core responsibilities, it is imperative that the trustee not only have access to sufficient information but also be given the opportunity to be directly involved in such transactions. 

The Trustee’s Involvement in Underlying Entities

While there are many benefits to holding private entities in trusts, the structure can oftentimes leave the trustee reliant on other powerholders to obtain sufficient information to fulfill their duties. As an example, consider an LLC holding company. Though the trust holds a membership interest in the holding company and thus an indirect ownership of the holding company’s underlying assets, unless the trustee is also the LLC manager or managing member, the trustee has no direct authority over those underlying accounts or investments and likely has little insight as to what is occurring in those accounts or investments. Appointing a trust as the manager or managing member of an entity can produce additional pitfalls and is why most, if not all, corporate trustees will request that a trust not act in a managerial role for such entities.

Potential Pitfalls

Bypassing the trust during transactions that directly involve trust assets and failing to provide full and accurate information to the trustee could have unintended consequences. Some of those unintended consequences are described below.

Inaccurate Information

As noted above, a trustee (even a directed trustee) has fiduciary responsibilities that require the trustee to have a full and accurate understanding of the trust’s assets, including transactions occurring within or between entities held by the trust. Inaccurate information will inevitably lead to the creation of inaccurate trust accountings and trust records. A failure to have accurate trust accountings and trust records will result in the trustee, beneficiaries who are entitled to trust information provided to them through accountings, and other parties relying on such information with incorrect and/or incomplete information about the trust. This also inhibits the trustee’s ability to respond to inquiries about the trust from beneficiaries and others and can lead to incorrect tax filings for the trust.

The trustee, and others, are often relying on this information to make decisions about the trust. For example, a trustee needs to understand the value of trust assets and whether those assets are available for distribution considerations (as compared to pledged assets that need to remain in the trust as part of a pledge agreement) when exercising discretion whether to distribute funds to a requesting beneficiary.

Additionally, for certain investments, the trust must meet valuation thresholds to qualify as an Accredited Investor or Qualified Purchaser under federal regulations. In an investment directed trust structure, the trust’s Investment Advisor is responsible for making representations on behalf of the trust that the trust meets those qualifications; however, the trustee is the party signing those investment documents on behalf of the trust and must have a level of comfort that those representations are accurate before it can sign. Further, the trustee must ensure that the trust continues to meet those qualifications. If funds are distributed out of the trust from an underlying entity without the trustee’s involvement, the trustee has no ability to monitor these ongoing requirements.

Missed Reporting Requirements

The IRS requires trusts that meet the definition of a US Person under the Internal Revenue Code (a “domestic trust”) who receive gifts or bequests from non-US Persons that exceed $100,000 in any calendar year to report such gifts on a Form 3520. Failure to report such gifts results in extremely serious penalties. Notable for this article, this includes gifts made directly to a trust’s underlying entity. It goes without saying, but the trustee must know if and when a gift has been made before it can accurately complete and timely file such a form. Failure to involve the trust and trustee of such funding transactions can result in missed filings and result in significant penalties. 

The Financial Crimes Enforcement Network (FinCEN) requires any domestic trust that holds foreign financial accounts surpassing $10,000 in value at any point during the year to file a Report on Foreign Bank and Financial Accounts (also known as an FBAR). This includes accounts held within underlying entities and is also subject to penalties for failure to file or late filing.

The Foreign Account Tax Compliance Act (FATCA) has many reporting requirements. Relevant to this article, when a foreign trust makes a distribution to a US beneficiary, the trustee is required to produce a Form 8966 each year a distribution is made and provide it to that beneficiary along with a Foreign Grantor/Non-Grantor Trust Beneficiary Statement so that beneficiary can meet certain filing requirements on their own. If distributions are made directly to that US beneficiary from an underlying entity without the trustee’s knowledge, this can lead to missed filings and significant penalties.

Not Following Terms of the Trust

Trusts are complex arrangements and parties are selected to hold certain powers for specific reasons, depending on the structure and purpose of the trust. For example, certain trusts are established to ensure an independent party (e.g., a corporate trustee) has absolute discretion over distributions to beneficiaries. Others allow for distributions to be made to the grantor or grantor’s spouse but only if the distribution directed by an “adverse” party, meaning another individual who also has a beneficial interest in the trust.

Bypassing the trust and failing to adhere to the processes laid out in the trust agreement can have substantial unintended consequences, including invalidation of the trust and may have other negative implications on the grantor’s overall estate plan.

Situs Concerns

Under general conflicts of law principles, the enforceability of a trust and its provisions, such as spendthrift clauses, is determined under the law of the trust’s situs. As mentioned above, when determining the trust’s situs, one of the factors considered by Delaware courts is where the trust is administered. If the trust is being bypassed for transactions such as distributions to beneficiaries and contributions to the trust made directly to underlying entities, the trustee’s administrative duties could be undermined, causing potential issues if the trust’s situs were ever challenged, and potentially invalidating the trust’s connection to its intended situs, which may subject the trust to income tax in other states that could claim situs over the trust.

Tax Issues

There are additional tax-related issues that can arise when the trust is bypassed or when information is not shared with the trustee. One example presents itself when a grantor of a trust established as a non-grantor trust for federal income tax purposes borrows funds from an underlying entity of the trust. If that loan is not repaid by the end of the calendar year in which it is made, the trust could potentially be treated as a grantor trust, even if that loan is made for adequate interest (see IRC §675(3)). Failure to share information relating to the loan with the trustee could lead to inaccurate tax filings. Having a corporate trustee in place who specializes in trust administration can be an added benefit in these types of situations. The grantor trust rules are complex and a transaction as innocuous as a loan from the trust to the grantor could have significant consequences. A trustee who has sufficient information will be able to identify potential issues and help clients to resolve such issues.

Another example was briefly discussed above. Certain trusts only give full discretion over distributions to independent parties, in part to avoid estate inclusion issues for the grantor and beneficiaries. 

Conclusion and Best Practices

This article was intended to point out some of the potential pitfalls that may arise when the trust is bypassed during transactions involving underlying entities. Through experience, we have identified some best practices for working with a trustee to help that trustee to effectively and efficiently administer such trusts. These best practices are summarized below.

Send the trustee periodic statements for any investment account held by an underlying entity (or have statements sent automatically by the broker). At a minimum, a trustee should receive a financial statement for the entity on an annual basis. This gives the trustee the opportunity to review the statements and reach out with any questions regarding transactions to gain an understanding of how the relevant transactions impact the trust.

If available, provide organizational charts for underlying entities and their structures to be held by the trustee as part of the trust’s records. This is extremely valuable in helping the trustee to understand complex transactions.

Engage in regular and proactive communications with the trustee. As a professional corporate trustee, we are experts in trust administration and are available as a partner and a resource to ensure proper trust administration to meet estate planning goals. 

When providing draft documents for transactions requiring the trustee’s signature or review, provide them as soon as possible to allow for sufficient time to review the documents and provide any suggested revisions to comply with the trust instrument.

Commonwealth’s goal is to effectively and prudently administer trusts while also making the administration process as seamless as possible for clients. Through our decades of experience as a trust company, we have learned this is best achieved with regular communications with clients and their other trusted advisors, discussing upcoming transactions and the trust’s role in those transactions. As a directed trustee, Commonwealth is not in the position of questioning any investment decisions or providing legal, tax, or investment advice; rather the goal is to review transactions and documents with a view towards effective trust administration and compliance with the trust instrument.

As noted above, there are many potential pitfalls that can occur when transactions involving underlying entities bypass the trust or when the trustee is not properly involved in those transactions. The role of a trustee, such as Commonwealth, is to ensure the terms of the trust instrument are properly followed and that questions are addressed to avoid any unintended and, oftentimes, costly consequences.