Myths About Trusts And Investment Management
From: wealthmanagement.com
Trusts have gained enormous popularity over the last 20 years. The top 1 percent of the wealthy have 38 percent of their investment assets in trusts, and the next 4 percent have 43 percent of their investment assets in trusts. This powerful trend is largely due to the fact that the modern trust can provide a family not only with powerful tax and asset protection advantages, but also with the flexibility and control of several key non-tax trust functions, including investment management. Here are some of the key investment management factors contributing to this growth.
Grantor Can be Co-Trustee
The grantor can, generally, be a co-trustee or co-fiduciary to handle investment management for the trust without an estate tax inclusion issue. However, it could result in possible asset protection and/or state income tax issues, depending on state as well as trust design. Consequently, usually a family member or family advisor, other than the grantor, will be chosen as investment management trustee and/or investment committee fiduciary of a modern directed trust.
Additionally, a limited liability company (LLC) that’s owned by the trust and the grantor may handle the investment management of a trust, and/or a member of his family can be named as the manager of the LLC.
Sophisticated Asset Allocation
Most state statutes require the proper asset allocation and diversification of a trust. These statutes emanated from the Prudent Investor Act in the early 1990s, which most states have adopted in some form. These statutes also generally allow for a trustee to delegate some or all of the investment responsibilities of a particular trust. The delegation is usually to qualified professionals, and these professionals monitor the investment management. Additionally, many wealthy families desire very sophisticated asset allocations, but trustees may lack sophistication regarding private equity, alternative investments and foreign investments and, consequently, need to delegate these investment management functions to qualified investment professionals.
But, many trustees are reluctant to delegate investment management for some of the more sophisticated asset categories due to possible liability, coupled with their lack of experience and inability to do the proper due diligence as to whom to delegate and to monitor the delegation. On the other hand, if the trust is sitused in a directed trust jurisdiction, the family can be on the investment committee and work with investment managers and advisors of their choice. The family can be protected from a liability standpoint to properly implement a Harvard or Yale Endowment asset allocation model.
No Need to Diversify
As previously mentioned, most delegated trust states require that a trust be properly diversified. Consequently, many families look to situs their trusts in directed trust states. Directed trusts can be very beneficial for families who may not want to diversify their trusts but may, instead, want the trust to hold just a few or even one asset, such as a closely held family business, large position in a public stock or family limited partnership. The directed trust structure provides a family the utmost flexibility either to diversify as broadly with as much sophistication as desired or to be as simple as desired.
State Income Tax Savings
There are two general types of irrevocable trusts: grantor and non-grantor. Grantor trusts are taxed to the grantor for income tax purposes. However, a discretionary tax reimbursement provision16 can be added so that the grantor can be reimbursed for trust income tax paid. These taxes paid by the grantor effectively are tax-free gifts to the trust. A non-grantor trust, on the other hand, is a separate taxpayer. Depending on the trust situs, there may be both federal and state income taxes. If the situs of the trust is in a no-state income tax jurisdiction for trusts, state income and capital gains taxes may be saved on trust assets, assuming the trust is properly drafted, sitused and administered in the no-state income tax trust state or that situs is effectively changed from a jurisdiction with state income taxes on a trust to one without them.
Once the trustee makes distributions to the trust beneficiaries, the distribution will, generally, be taxed to the beneficiaries in the year they receive it in their resident state, assuming they’re residents in a state with a state income tax. These distributions would also be subject to federal income taxes.
One of the few strategies to avoid both federal and state income taxes paid by either the grantor of the grantor trust or the non-grantor trust itself is life insurance. Life insurance can provide both federal and state tax-free growth within the trust, as well as federal and state tax-free distributions when distributions are made from the trust, if the trustee of an insurance policy owned by the trust makes the distributions. It’s a powerful leveraging strategy. Private placement life insurance (PPLI) is commonly used for this purpose.
