Private Family Trust Company Considerations:
Where should the PFTC be established?
Should the PFTC be Regulated or Unregulated?
Who should be the PFTC's South Dakota Corporate Agent?
What about a trustee agent for the PFTC?
Should the PFTC be established with a State or National Charter?
How are the Family Control issues juxtaposed to estate taxation?
Alternatives to the PFTC?
1. Where should the PFTC be established?
South Dakota has been the most favorable boutique trust state for the wealthy since 1983. The legislature has emphasized modern trust laws that answer the needs of wealthy families better than any other state. This has resulted in South Dakota having the best regulated PFTC statute in the country. Consequently, the legislative awareness, proactiveness and responsiveness combined with the experience and knowledge are just a few of the reasons why South Dakota is the most favorable regulated PFTC state in the U.S.. Some of the other compelling reasons are the unique South Dakota trust and tax statutes, which are discussed in the "Why South Dakota?" section of this website.
2. Should the PFTC be Regulated or Unregulated?
Whether a PFTC should be regulated or unregulated is an extremely important question. Many families chose the light regulation that South Dakota provides along with the assistance of SDTC so that they do not risk the possible penetration of the corporate veil that could result with an unregulated trust company as well as any possible negative estate tax consequences. Please see the website section on "Regulated vs. Unregulated jurisdictions" for additional information.
3. Who should be the PFTC's South Dakota Corporate Agent?
The South Dakota Trust Company (SDTC) can assist a family or a family office to establish a cost effective trust company pursuant to South Dakota law by serving as Corporate Agent. In this capacity, SDTC plays a de minims role that gives the families the “minimum statutory contacts” they need to get through the application process with South Dakota’s regulatory group, the Division of Banking and maintain an ongoing minimal relationship with SD. In this arrangement, SDTC enters into three contracts with the respective family office.
||A lease for space
||A service agreement (discussing installation of a phone line, answering the phone, vault space, forward mailing, et al)
||An arrangement for an officer of SDTC to serve as the South Dakota director
The role of Corporate Agent satisfies the South Dakota PFTC requirements but may not be sufficient to justify South Dakota trust situs for tax law purposes. Consequently, SDTC can also act as Trustee Agent to accomplish this objective. As Trustee Agent, SDTC can provide a number of back office trust administration services in working with the PFTC as trustee. SDTC, as trustee agent, can work with a family’s existing and/or preferred custodian and/or investment advisors in most cases. Please see the website section entitled "South Dakota Trust Company PFTC Services" for additional information.
4. What about a trustee agent for the PFTC as trustee?
Having SDTC as the corporate agent allows the family to meet the necessary requirements to establish a South Dakota trust company. The PFTC then serves as trustee for the family trusts. The trust administration, as a result of South Dakota's "Interstate" capability can typically take place anywhere in the U.S.. Generally, where the family office is located. There are, however, several advantages to having the trust administered in South Dakota i.e. the favorable trust and income tax laws, which are discussed in more detail in the "Why South Dakota?" section of this website. SDTC can serve as trustee agent for the PFTC to accomplish this objective without the need of the family having to hire South Dakota employees or relocate family members and advisors to South Dakota to administer the South Dakota law trusts. All trusts (i.e. both non-South Dakota law trusts and South Dakota law trusts) generally save state income taxes, with some exceptions.
5. Should the PFTC be established with a State or National Charter?
There are definite advantages to a state chartered PFTC rather than a national chartered with state powers due to the fact that the former generally provides a much greater nexus to a state i.e. South Dakota. This may be important for state income tax and trust law purposes, as well as other purposes. Additionally, most state chartered trust companies can administer trusts governed by the laws of most other states as a result of the reciprocity statutes existing between the states. National charters generally are better for financial institutions with multiple offices around the county. Many large institutions still retain state charters for their boutique trust jurisdiction like South Dakota for better nexus regarding state trust and tax laws. This subject is very misunderstood and often not addressed properly.
6. How are the Family Control issues juxtaposed to estate taxation?
PFTC’s and the underlying LLCs are generally owned by the family thus presenting possible estate tax issues, if not properly structured. The IRS is no longer issuing private letter rulings regarding the transfer tax consequences of family owned PFTC’s. They have been collecting comments for a forthcoming revenue ruling and/or procedure on the topic, which has not yet been issued. Families are currently relying on previously issued Private Letter Rulings (PLRs) in the structuring of their PTC’s. Most experts claim that the future revenue ruling should also be based upon these PLRs.
The IRS issued three PLRs in 2005 approving certain carefully structured PFTC arrangements in which a PFTC serves as trustee of certain family trusts. These three 2005 PLRs as well as prior PLRs with similar results have up to this point provided non-binding guidance regarding the proper structure and operation of a family PFTC. In these PLRs the IRS ruled that:
· The value of the trusts for which the PFTC served as trustee were not included in the grantor’s or the beneficiaries’ estate for federal estate tax purposes.
· The PFTC could distribute, apportion or accumulate principal and income from the trusts for which the PFTC was serving as trustee to the grantor’s beneficiaries without causing the grantor or the beneficiaries to be treated as the owner of such trusts.
· Subject to certain restrictions regarding discretionary distributions, the grantor and the beneficiaries served as shareholders of the PFTC and participated in the daily activities of the PFTC without causing the value of the trusts to be included in their estates for federal estate tax purposes; and
· For generation-skipping transfer tax purposes, naming a PFTC as trustee did not adversely impact a trust’s exempt status.
These three 2005 PLRs included the following key features:
· The board of directors had at least one board member that was not a family member, or a grantor of, a donor to, or a current or contingent beneficiary of a trust (i) of which any family member was a grantor, donor, or current or contingent beneficiary and (ii) for which the trustee had any discretionary power (other that an investment power) that was not limited by an ascertainable standard. (See PLR 200546055 and 200548035). PLR 200523003 provided that no more than half of the direction could be related or subordinate to the grantor.
· In PLR 20053003, the board of directors appointed a Distribution Committee (a/k/a Discretionary Decisions Review Committee in PLRs 200546055 and 200548035) to make discretionary distributions of trust principal and income.
· In all three 2005 PLRs, the Distribution Committee was subject to restrictions with regard to discretionary distributions of trust principal and income. The restrictions were critical in protecting the grantor and beneficiaries from causing the value of the trusts to be included in their estates for federal estate tax purposes.
PLR 200523003 provided strict rules regarding the composition of the Distribution Committee. Trust grantors (and their spouses) as well as current and contingent beneficiaries (and their spouses) were prohibited from serving on the Distribution Committee. Any person considered related or subordinate to the grantor or current or contingent beneficiary was also prohibited from serving on the Distribution Committee. No member of the Distribution Committee could participate in any discretionary decision with respect to any trust beneficiary to whom he or she owed a legal obligation of support. And the majority of the Distribution Committee members could not be employees or directors of the PFTC.
In contrast, PLRs 200546055 and 200548035 provided more flexibility with respect to discretionary distributions.
As previously discussed, the IRS is due to issue a public ruling or revenue procedure concerning private family trust companies based upon guidance it has been collecting on the subject as well as previously issued private letter rulings. This ruling and/or procedure should provide new guidance dealing with the possible attribution of trustee powers to grantors or beneficiaries by reason of their participation in distribution decisions as part of their office or position in the governance of a family-controlled trust company that serves as trustee of the family trusts. This attribution would be relevant for purposes of applying the grantor trust rules of Internal Revenue Code section 671-678 and estate and gift tax provisions such as code sections 2036, 2038, 2041 and 2514.
Most advisors feel this revenue ruling and/or procedure will be in line with prior private letter rulings and there will hopefully be no surprises.
7. Alternatives to the PFTC?
Two popular alternatives to the PFTC are the "directed trust" and the "Special Purpose LLC" to serve as trust protector, investment and distribution committee. Frequently, these two alternatives are used in tandem with each other.
Alternative #1: A “directed” trust is generally drafted so that a Trustees’ duties and discretion as to distributions and/or investments are removed by a provision in the trust agreement and/or by state statute and given to an investment committee/trustee, distribution committee/trustee, a trust advisor and/or trust protector. The general structure of a modern trust using a directed trustee is as follows:
1. An Administrative trustee (i.e. SDTC) who is typically based in a “directed” trust statute state (i.e. South Dakota) and/or is drafted into such a role in the trust document and exonerated from acting in a “directed” capacity. The administrative trustee is not responsible for the trust’s investment management, but instead takes direction from the Investment Committee. The administrative trustee’s typical duties are to title and take ownership of the trust assets, establish and maintain a trust bank account, prepare and/or sign the trust tax returns, prepare and send trust statements, make distributions and receive contributions, etc… Additionally, the administrative trustee ensures that the trust document is followed (i.e. if the investment managers are investing in hedge funds and the trust document prohibits hedge fund investing).
2. An Investment Trustee or Committee is typically comprised of the client’s family members and/or investment advisors, consultants and managers. The Investment Committee directs the administrative trustee (i.e. SDTC) regarding investment management of the trust. Generally, the grantor names a family member or members as the investment committee and they in turn hire the appropriate investment professionals. Alternatively, an investment professional may be hired directly as the investment committee. The Investment Committee may also direct and manage insurance, closely-held stock, partnerships, LLCs, real estate, art, and other illiquid assets held by the trust. Committee members may be chosen based upon their experience and expertise with a particular asset class.
3. A Distribution Trustee or Committee is also generally established to determine when discretionary trust distributions should be made. This committee is typically comprised of both family and independent members to accommodate both tax and non-tax sensitive distributions. The administrative trustee (i.e. SDTC) may also play a role on this committee as an independent committee member for tax sensitive distribution purposes.
4. Trust Protector: The Trust Protector is also being utilized more and more with domestic trusts to supplement the investment and distribution committees of many “directed trusts”. The first trust protector statute in the U.S. was in 1997 (SDCL-55-1B-6). Several states now have trust protector statutes. Advisors are drafting the trust protector function into the trust documents even in states without specific statutes.
Some of the common powers given to a trust protector are as follows:
(1). Modify or amend the trust instrument to achieve favorable tax status or respond to changes in the Internal Revenue Code, state law, or the rulings and regulations thereunder;
(2). Increase or decrease the interests of any beneficiaries to the trust;
(3). Modify the terms of any power of appointment granted by the trust. However, a modification or amendment may not grant a beneficial interest to any individual or class of individuals not specifically provided for under the trust instrument;
(4). Remove and appoint a trustee, trust advisor, investment committee member, or distribution committee member;
(5). Terminate the trust;
(6). Veto or direct trust distributions;
(7). Change situs or governing law of the trust, or both;
(8). Appoint a successor trust protector;
(9). Interpret terms of the trust instrument at the request of the trustee;
(10). Advise the trustee on matters concerning a beneficiary; and
(11). Amend or modify the trust instrument to take advantage of laws governing restraints on alienation, distribution of trust property, or the administration of the trust.
Alternative #2 - Unregulated Entities: The unregulated entity alternative is generally used in combination with the "directed trust" structure discussed above. A recent trend is to establish unregulated entities such as a limited liability company to place a liability umbrella over the heads of the individuals filling the roles of Trust Protector, Investment Committee and/or Distribution Committee. It is very difficult, if not impossible, to acquire individual liability insurance coverage to serve as committee members and/or trust protector. However, some insurance companies will provide coverage to an entity established specifically for these purposes, thus protecting the trust protector and committee members. Such an entity would also provide legal continuity of its corporate existence by continuing without regard to any single individual’s death, disability or resignation. The entity typically has by-laws that allow for additional members to be added or removed so that the entity can continue along with the trust. These entities have to be properly structured so as to avoid estate tax inclusion issues.
There are not any specific state statutes for these special purpose unregulated entities, however, South Dakota generally allows families to establish such unregulated companies on a case by case basis. These entities must generally be exempt from regulated Private Trust Company status and are typically special purpose type entities with limited defined duties, as previously discussed.