A starting point with 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 tax benefits, building wealth in irrevocable trusts provides asset protection benefits from suits 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.
Here are some other details of estate planning that are worth considering:
USE TRUST-FRIENDLY STATES
It has become common in modern estate planning to have trusts administered in states that have favorable tax and legal environments. 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 non-judicial modification. This occurs when a living grantor, all fiduciaries and all beneficiaries agree to change an irrevocable trust. Delaware enacted a law permitting this 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 developers 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 will to want heirs who receive notices of trust information clamoring for distributions.
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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. Still, 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.
DIRECTED TRUSTS
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 is an investment adviser or trustee, responsible for all investment decisions. Hence, this person can determine whether the trust will hold or sell real estate interests.
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The second trustee role is a general trustee, who holds all other powers. This can be a crucial component of the succession plan for the real estate developer. The developer herself can serve as the initial investment trustee (and that should not affect the removal of the real estate interests from her estate).
If one child or heir will 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 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.
MASTER LLC
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 LLC to own interests in the many properties and other LLCs. This can greatly simplify the legal documentation and financial transactions.
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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 transfers of just one LLC’s interests to the trust are necessary. Many institutional trustees charge an incremental fee for each LLC interest they have to hold because of the administrative burdens. For most clients, that is not an issue. But for many real estate clients, given the tendency to use separate LLCs for each property, it can become a significant annual cost. Using a master LLC might 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 properties are located.
One way to minimize those connections might be to create an LLC 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 located.
LIFE INSURANCE
Life insurance is likely to remain an important feature of the estate plan for real estate developers. Having some 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. This might require appointing a separate trustee for insurance matters.
SUCCESSION PLANNING
Succession planning is a vital issue to address for real estate clients. Advisers should make sure that the attorneys involved coordinate 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.
