Planning With Directed Trusts

“Planning with Directed Trusts,” that’s the subject of today’s ACTEC Trust and Estate Talk.

This is ACTEC Fellow Natalie Perry of Chicago.

Directed trusts have grown significantly in use over the past decade, but the concept itself is not new. Originating in jurisdictions like Delaware, directed trusts were developed to give trust creators greater control over how specific assets are managed, particularly in situations involving closely held businesses or unique investments. Over time, this approach has evolved into a sophisticated planning tool that allows for the separation of traditional trustee duties among multiple parties.

ACTEC Fellow Michael Gordon of Wilmington, Delaware joins us today to discuss modern directed trust design and how these structures can be used in today’s estate planning landscape. Welcome, Michael.

Introduction to Directed Trusts and Their Growing Popularity

Michael Gordon:  Thank you very much, Natalie. As mentioned, today we’re going to talk about directed trusts and, in particular, the modern directed trust design and planning with directed trusts. As Natalie mentioned, directed trusts are not new. We have statutorily recognized directed trusts in my home state of Delaware for more than 35 years. However, directed trusts have really exploded in popularity over the past 10 to 15 years, and I think that there’s two reasons for that.

First, as we’re going to discuss, directed trusts allow clients to engage in irrevocable trust planning while still including an important element of flexibility, which is incredibly attractive. Number two, with the establishment of the Uniform Directed Trust Act and its enactment in so many jurisdictions, we are seeing more and more states get comfortable with enacting and adopting directed trust legislation.

What Is a Directed Trust?

A directed trust is simply a trust that takes one or more traditional trustee powers and responsibilities and divides those powers and responsibilities among others. Whether those others are “trust advisors,” that’s the term that we use in the Delaware Directed Trust statute, whether those others are “trust directors,” that’s the term of art that’s used in the Uniform Directed Trust Act, or whether those others are co-trustees that have just been siloed with a particular task and responsibility. For instance, an “investment trustee” whose sole responsibility and authority is the investment and management of the trust assets.

The Four Key Roles in a Modern Directed Trust

In our typical Delaware Directed Trust design, we actually have four different positions within the trust.

• We have a trustee, which in our world is the Delaware trustee;
• We have an investment direction advisor;
• a distribution advisor; and
• a trust protector.

Why Use a Central Trustee and Direction Advisors?

My preferred way to structure a directed trust is to just have one trustee, which again in our world is the Delaware trustee, and then have other trust advisors or directors that direct the trustee what to do. Why do I like that? I like to have a central hub of administration in the particular jurisdiction that governs the laws of the trust, and then I like these decisions to come in from the power holders, but have the trustee facilitate. For instance, the investment direction advisor will make the investment decision, but they will direct the trustee to implement the investment decision. The investment direction advisor himself or herself does not have the direct authority to bind the trust.

The reason that I prefer that approach over bifurcating or trifurcating these traditional trustee responsibilities at the trustee level – through the use of, for instance, an investments trustee and a distributions trustee and an administrative trustee – is it further solidifies the connection to the home state, both for governing law and jurisdictional purposes and for court supervision purposes as well.

As far as the various roles, how they operate, and who are good candidates to serve in those roles, I want to spend the majority of our time talking about the role of the trust protector and what they do with respect to these, with these directed trusts, but I’ll touch on all of them.

The Role of the Investment Direction Advisor

Investment direction advisor name probably gives it away. The investment direction advisor is the fiduciary that’s responsible for directing the trustee with respect to the investment and management of the trust assets. Of the four positions that we use in these directed trusts, the investment direction advisor is the only role that we are comfortable allowing our grantor to play. We are okay with our grantor, the creator of the trust, retaining investment control over these directed trusts as long as we carve back problematic assets – so voting stock in a controlled corporation, life insurance policies insuring the grantor’s life – we wouldn’t want to see the grantor be in control of those investment decisions because of the estate tax inclusion concerns.  But otherwise, it’s a relatively tax neutral position and we are comfortable with our grantors playing that role.

The Role of the Distribution Advisor

Distribution advisor, again, name probably gives it away, but the distribution advisor holds the discretionary authority and power to direct the trustee as to how and when distributions are made to the beneficiaries based on the standards contained in the governing instrument. Who can serve in this role? Will we never allow our grantors to be the distribution advisors? Do we allow our beneficiaries to be distribution advisors? That really depends upon the language contained in the trust agreement. If we are going to limit distributions pursuant to an ascertainable standard, well in that situation we would be comfortable with our beneficiaries serving in the role of distribution advisor.

99% of the trust that I draft are structured in such a way where distributions are not limited pursuant to an ascertainable standard. We allow for distributions for any reason and, so in the vast majority of the directed trust that I draft, the distribution advisor has to be an independent party within the meaning of section 672(c) of the Internal Revenue Code.

Why the Trust Protector Holds the Keys to the Kingdom

Trust protector, this is really the most important role in my mind. What is a trust protector? What does a trust protector do? Do they protect the trust? The name doesn’t necessarily give it away. The powers a trust protector has – it really is somewhat dependent upon how the trust is drafted – what the attorney and client want to do.

In our state, in Delaware, we’ve codified the position of trust protector and we’ve specified certain powers that a trust protector can have, but it’s non-exclusive list of powers. In my trust, the trust protector really holds the keys to the kingdom. Everything runs through the trust protector. We give the trust protector the ability to hire and fire the other fiduciaries. We give the trust protector the ability to change the situs and the governing law of the trust. We give the trust protector the ability to add beneficiaries to the trust in certain situations. We give the trust protector the ability to convert the trust from a grantor trust to a non-grantor trust. Most importantly, we often give trust protectors very broad amendment powers.

Why do we do that? The way that a directed trust typically operates – and this is based on the various state statutes – is that there is a presumption that these direction advisors are serving in a fiduciary capacity; investment direction advisor, distribution advisor, trust protector, they’re all fiduciaries. But state law allows you to draft out of fiduciary status. Now, we never do that in the context of an investment direction advisor or a distribution advisor because they hold typical traditional fiduciary responsibilities.  But it is very common to provide that the trust protector is serving in a non-fiduciary capacity.

Flexibility Through Trust Protector Powers

In our trusts, we actually say the trust protector is a fiduciary, but there are a handful of powers that we give to the trust protector that can only be exercised in a non-fiduciary capacity. Most notably – the ability to convert the trust from a grantor trust to a non-grantor trust, the ability to add beneficiaries to the trust, the ability to amend the dispositive provisions of the trust. Those are all powers that we give to the trust protector in a non-fiduciary capacity. We do that for two reasons:

• Number one, those powers are really incapable of being exercised in a fiduciary capacity. It’s not in the best interests of the current beneficiaries to be able to add additional beneficiaries to the trust. It’s not in the best interests of the beneficiaries to take a trust where it’s a grantor trust and mom or dad are paying a tax liability. Now, we’re going to make it a non-grantor trust where the trust is going to pay its own tax liability. It certainly may not be in the best interest of the beneficiaries to make some of these changes to the trust that are dispositive in nature. We give those powers to the trust protector in a non-fiduciary capacity.
• The second reason we do it is just this element of flexibility that I alluded to earlier. We are constantly working on irrevocable trusts that are in existence to make changes to those irrevocable trusts. We’re relying upon state law or decanting. We’re entering into modification agreements. We’re entering into non-judicial settlement agreements.

Those things expose the fiduciaries in some cases to some risk. There’s also some potential tax risk to the beneficiaries from participating in those modifications. By having a trust protector and giving the trust protector the ability to make these broad amendments to the trust in a non-fiduciary capacity, without the participation or consent of the beneficiaries, you really minimize the potential tax risk to the beneficiaries and any fiduciary risk that would otherwise be present if you were in a situation where you were decanting or otherwise entering into a modification agreement.

So there’s many other things that we could talk about in the world of directed trusts, but that’s an overview of the modern trust design and the flexible provisions we’ve been including within these directed trusts.

Natalie Perry:  Thank you, Michael. That was a very helpful overview of the different roles involved with directed trusts.

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