The Beauty of Irrevocable Trusts
For ultrawealthy clients in the property business, an adviser’s starting point should be an irrevocable trust. But you can’t stop there.
For ultrawealthy clients who invest in real estate, an adviser’s starting point should be an irrevocable trust. But you can’t stop there.
A STARTING POINT FOR HIGH-NET-WORTH CLIENTS — especially those exploring real estate investments — is to emphasize that irrevocable trusts are an essential part of estate planning.
This is not affected by the recent discussion of the possible elimination of all federal estate taxes. Even if irrevocable trusts are no longer created for tax reasons, they should still be created.
Having appreciating real estate owned by flexible irrevocable trusts gives clients more tax planning options, whatever the tax laws happen to be. The more flexible buckets in which clients’ assets are stored, the more opportunities to plan.
Regardless of the potential tax benefits, building wealth in irrevocable trusts provides assets with protection benefits from lawsuits and claims.
Nothing Washington does is likely to reduce the litigious nature of our society. Just one example of the possible benefits of irrevocable trusts is that they can insulate assets from the divorce claims of heirs.
Below are some other details of estate planning that are worth considering for clients with significant real estate holdings:
It has become common in modern estate planning to have trusts administered within states that have tax and legal environments that are favorable.
Four states — Alaska, Delaware, Nevada and South Dakota — have been the leaders in the trust game for years, but other states continue to join the fray by enacting more favorable rules.
There is much at stake. The general concept of “irrevocable” in an irrevocable trust is that it cannot be changed. In recent years, however, the notion of merging — or, in estate planning parlance, decanting — an existing trust into a new trust has become more widely accepted.
This can provide a great deal of flexibility to modernize administrative provisions in an old irrevocable trust. But not all states permit decanting.
An even newer construct is nonjudicial modification. This occurs when a living grantor, all fiduciaries and all beneficiaries agree to change an irrevocable trust. Delaware enacted a law permitting this move last year.
This is an incredibly robust provision, but only one example of the kind of favorable laws that Delaware and other
trust-friendly jurisdictions can provide.
Another favorable option that might have considerable importance for some real estate investors is the ability to have a quiet trust. The general rule in many states is that most adult beneficiaries (sometimes referred to as qualified beneficiaries) must receive information about the trust. This would typically include a copy of the trust document and annual reports.
If a trust is administered in a state whose laws permit the trustee to forgo such communications and the trust document provides that no communication be given, however, then the beneficiaries may not have to be informed.
For some real estate clients, this may be an important goal.
If profits are to be reinvested in the properties, the client may prefer to have a quiet trust so the heirs do not clamor for distributions when the money is needed for improvements or expansions.
MINIMIZING TAX IMPACT
Many clients use trust-friendly states to minimize state income taxes. While this may also be feasible for real estate investors, it is more difficult and limited because income generated by a property in a particular state is likely to be taxed in that state no matter where the trust owning the property is located.
Nevertheless, other types of income — such as investment earnings on cash accumulated from distributions and reinvested — may avoid state income taxation with this type of planning.
Real estate clients should consider structuring their irrevocable trusts as a directed trust. This is a trust for which the trustee function is bifurcated into at least two parts.
The first role is an investment adviser or trustee, responsible for all investment decisions. Hence, this person can determine
Many clients use trustfriendly states to minimize state income taxes.
whether the trust will hold or sell any real estate interests.
The second trustee role is as a general trustee, who holds all other trust powers. This can be a crucial component of the succession plan for an investor with significant real estate holdings. The client herself can serve as the initial investment trustee (and this should not affect the removal of the real estate interests from her estate).
If one child or heir will ultimately succeed to managing the business, but all the heirs will be beneficiaries of the trust, this structure permits passing the baton to the designated heir to manage, while leaving the trustee with the flexibility to allocate the financial assets however desired.
To take advantage of this flexible structure, the trust will have to be formed in a jurisdiction that has laws permitting directed trusts.
Otherwise, the general trustee will have liability for real estate decisions that they are not actually controlling.
The common approach to structuring real estate investments is to create separate limited liability company for each property.
If complex estate planning techniques will be used to shift some of these interests to irrevocable trusts, it will often be helpful to create a master limited liability company to own interests in the many properties and in other LLCS.
This can greatly simplify the legal documentation and financial transactions that are required.
Consider the prospect of gifting and selling interests in 20 different property LLCS to a trust, versus forming a single master LLC to own those underlying interests so that the transfer of just one LLC’S interests to the trust are necessary.
It is often helpful to create a master LLC to own interests in properties and in other LLCS.
Many institutional trustees charge an incremental fee for each limited liability company interest they have to hold because of the administrative burdens. For most clients, that is not an issue.
But for many real estate investors, given the tendency to use separate LLCS for each property, it can become a significant annual cost. Using a master LLC might be a way to avoid that.
TRUST ADVISER LLC
Real estate interests, even if held in LLC format, will create a tie to the state where they are located.
If the client creates a trust in a different state to own those interests, issues might arise as a result of the connections to the states where the properties are located.
One way to minimize those connections might be to create an limited liability company in the state where the trust is to be administered and have that LLC hold the powers of trust investment adviser and trust protector.
The people providing this service would then do so through that LLC, thus possibly reducing the trust’s connections to the state where property is actually located.
Life insurance is likely to remain an important feature of the estate plan for major real estate investors. Having permanent life insurance coverage to provide liquidity may be invaluable to avoid a forced sale of properties during a market downturn. Some type of tax is likely to be due.
Using insurance to defray some portion of that tax (whether capital gains or estate tax) can be vital to the succession of the real estate business.
When planning that insurance, advisers should consider using irrevocable trusts that are flexible enough to hold real estate LLC interests and life insurance.
Having both real estate and insurance in the same trust can enable distributions from real estate properties to be used to fund insurance premiums, avoiding the need to deal with annual gifts and the requisite notices (Crummey powers) traditionally used with such gifts.
Taking this action might require the appointment of a separate trustee for insurance matters.
Succession planning is a vital issue to address for clients with extensive real estate holdings. Advisers should make sure that the attorneys involved are coordinating both the provisions and planning in the governing entity documents and the trust and estate planning. In many cases, this work is handled by different lawyers, and if it is not coordinated, costly problems can result.
The document used to file a professional LLC in Nevada.
Having permanent life insurance coverage to provide liquidity may be invaluable.
Martin M. Shenkman, CPA, PFS, JD, is a Financial Planning contributing writer and an estate planner in Fort Lee, New Jersey. He runs laweasy. com, a free legal website.