Understanding the pitfalls and risks of irrevocable trusts
CPAs need to understand the drawbacks of irrevocable trusts if they’re providing personal financial planning services to wealthy individuals.
December 9, 2013
Clients who own real estate for commercial purposes often take title to the property in an irrevocable trust. This approach has its benefits: The trust can help protect the property from creditors, yet the client can stay in control and be the trustee.
But irrevocable trusts also have drawbacks that accountants need to understand, especially if they’re providing personal financial planning services to wealthy individuals who have several such properties. Planning for the disposition of all that real estate—whether it is apartment or office buildings, rental units, or the family business headquarters—can be particularly troublesome. Let’s look at some of the issues involved.
How is the title held?
How the title to the property is held—in an irrevocable trust, corporation, limited partnership, or limited liability company (LLC)—is an issue that should be reviewed from the viewpoint of income taxes, estate taxes, succession planning, and liability concerns.
When property is held in an irrevocable trust funded by the donor, and the donor retains its benefits (receiving income and/or principal distributions) and/or retains control over the property, the property will probably be included, in full, in the donor’s taxable estate. The trust will also be treated as a grantor trust for income tax purposes, and all income and deductions will flow to the donor’s individual income tax return.
When that donor dies, what was a grantor trust becomes a separate taxpaying entity. The trust probably contained a spendthrift provision, protecting the trust’s assets from creditors. In many states, however, spendthrift provisions do not necessarily mean the trust property is protected from creditors while the donor is alive and a trust beneficiary.
Holding title to the real estate in an irrevocable trust presents another issue: Trustees have a fiduciary duty not just to the donor, but to all beneficiaries, including any other permissible beneficiaries during the donor’s lifetime—as well as the beneficiaries who would take over at the donor’s death. The trustee is obligated to prudently invest and manage the trust assets. That prudent man risk obligation is quite different from the business judgment rule, also known as the businessman’s risk.
In many states, the prudent man rule applies, and the trustee owes the beneficiary the fiduciary duties of skill, loyalty, diligence, and caution. When managing investments, trustees must consider several factors, including:
1. Marketability of the trust property;
2. Length of the investment, if a term is set;
3. Trust duration;
4. Probable condition of the market at trust termination;
5. Probable market conditions for reinvestment of the proceeds if the investment is sold;
6. Total value of all of the trust property and the nature of any other investments;
7. The needs of the beneficiaries;
8. Other assets of the beneficiaries; and
9. The effect of any investment on the trust.
Under the businessman’s risk standard, trustees may choose investments that have a moderately high risk of losing value, but that also offer growth potential and capital gains, or sometimes tax advantages, rather than for the purpose of growing current income. Individuals can make riskier choices when they are dealing with their own investments rather than holding them in trust for the benefit of others.
When the business is owned by a trust, the prudent man rule for investments made by the trustees may conflict with the business judgment rule that would control if the property were owned by a business entity. For example, when deciding whether to retain, mortgage, or sell a property, the trustee must consider his or her fiduciary duty, rather than the lower standard that would apply to a businessman facing the same choices.
Holding real estate in an irrevocable trust also presents issues pertaining to income. Consider all the questions in an arrangement in which the trust document requires all income to be distributed to the beneficiary (during the donor’s lifetime or after death). How is income defined? And what does the trustee have a duty to distribute? Is it income for trust accounting, income tax, or cash purposes? If the trustee is to distribute all income annually, how can he or she hold an operating reserve? What happens with depreciation? What about reinvestment for repairs? How will the accounting be prepared?
From an estate tax viewpoint, if the value of the trust is fully included in the donor’s estate and he or she is married, does the trust say that the spouse is the lifetime beneficiary after the donor’s death? Does the trust qualify for the estate tax marital deduction so that there is the option to defer estate taxes until both spouses die?
When an irrevocable trust no longer fits
If a client owns commercial real estate in an irrevocable trust that no longer makes sense, there are remedial options. The court could be asked to reform the trust, as it does not accomplish the donor’s intent. Trust reformations are permissible in many states. Trusts have been reformed to ensure the marital deduction option, to add improved language for managing the property, and to handle the question of how income is defined.
Another option is to transfer title to an LLC that the trust owns. An LLC could more easily obtain financing, because few institutions that sell their mortgages in the secondary market will issue mortgages to trust-owned real estate. It is also cleaner from a liability perspective in that the liability should be limited solely to the LLC assets. The LLC would be subject to businessman’s risk, and all the business decisions would be made at that level by the managers of the LLC and the terms of the operating agreement. The trustee of the trust would be dealing with the trust assets and not be in charge of, or responsible for, the business decisions.
The term irrevocable does not always mean that the plans set in place decades ago are set in stone—rather, mechanisms are available that provide flexibility to update those plans.
Patricia M. Annino, J.D., LL.M., a nationally recognized authority on estate planning and taxation, received the Boston Estate Planning Council’s “Estate Planner of the Year” Award in 2007, and chairs the Estate Planning practice at Prince Lobel Tye LLP. She has been voted by her peers as one of the Best Lawyers in America (trust and estates), a Super Lawyer, and a Top 50 Massachusetts Super Lawyer. She is a Fellow of the American College of Trust and Estates Counsel (ACTEC).