Summary

The increase in the number and value of family trusts in the United States has been accompanied by an evolution, even revolution, in the ways in which families participate in trust decision-making.  In the past, a single family member might participate as trustee or hold a power of appointment to change the trust disposition, but collective decision-making was rare, even for larger trusts.  A family member might also serve as an “advisor” on investments or distributions, but trust law did not allow a true division of the trustee’s legal authority.  The list of choices was short; other alternatives for family participation were either unavailable or unknown.

In contrast, modern trust law and practice have spawned a wide variety of formats and methods for family participation in trust decisions.  Recognizing the reality that not everyone can or should serve alone as an individual trustee, families have utilized these alternatives in their trusts.  Advisors from various disciplines encourage this trend on the ground that it facilitates responsible use and management of wealth. 

But now there are signs that the Internal Revenue Service may undermine this progress by expanding the restrictions it applies to trust decisions it characterizes as tax-sensitive.  Concerned that vote-trading within the family could potentially be used to evade these restrictions, the IRS is considering rules that would effectively ban all family participation in most key trust decisions.  The IRS would apparently justify this ban by combining an expansive reading of the reciprocal trust doctrine with a broader application of its restrictions on powers to change trustees.  The family would then face the threat that its continued involvement would trigger a severe penalty–an estate, gift, or generation-skipping tax on all the assets in all the trusts in question, whether or not there is any evidence of reciprocal voting or even any exercise of the tax-sensitive powers.  Choices for family participation would once again be limited, undermining years of progress in modernizing the role of families in family trusts.

Options abound for opening up decision-making to the family under modern trust law.  The family can take responsibility for its own wealth.  But the efforts of the IRS to combat presumed tax abuse may take away that choice.

Source of the Threat

Under the trust laws of most states today, options abound for opening up the trust structure to the family, so it can collectively participate in the control and management of its wealth.  Trust companies organized under state law but privately owned or controlled by the family or other family trusts—so called “limited purpose,” “private,” or “family” trust companies—were relatively rare 15 years ago.  Now this option is promoted, or accommodated, by the regulatory law and banking commissions in at least a dozen jurisdictions.  Moreover, for smaller concentrations of wealth, the family can opt for less expensive methods by using multiple family co-trustees, trust committees or specialized fiduciary roles. 

All of this collective family involvement in family trust affairs—understandably considered a positive development—is now threatened by an unduly restrictive application of the tax law.  The Internal Revenue Service Priority Guidance Plan for 2006-2007 (and the prior year) includes this project:  “Guidance regarding the consequences under various estate, gift, and generation-skipping transfer tax provisions of using a family-owned company as the trustee of a trust.”  The IRS is reviewing how decision-making powers held by board members and executives of a family trust company can run afoul of the income-tax grantor trust rules and, more importantly, the estate, gift and generation-skipping rules when a family trust company holds powers that the IRS considers tax-sensitive.

In the simple context of a single trust with an individual trustee who is also a beneficiary, this is a garden variety estate tax issue, e.g., a power to control distributions under a non-ascertainable standard cannot be held by beneficiaries for their personal benefit, even in a trustee capacity, without triggering taxation as a general power of appointment.  The IRS project addresses such questions in the more rarified context of a family-owned trust company.  When a family forms its own trust company, can beneficiaries sit on the distribution committee that would make the same discretionary decisions to distribute to them?  When does that result in transfer tax liability?  Is there any provision for recusal or other prophylactic language that can be used in the trust or trust company documents to avoid such a bad result?

If limited to family trust companies, with no impact on other choices for family participation, the answers to these questions would warrant scant attention by the broader estate planning community.  Unfortunately, death and taxes are not that simple.  Indeed, it appears the IRS analysis is moving in a direction that threatens not only such trust companies, but almost all forms of family participation.

The IRS appears ready to expand the reach of existing precedents and effectively ban family members from exercising tax-sensitive powers, such as distribution powers and powers to change trustees, even when the family is not acting through an elaborate structure and the trust document prevents the affected individual family member from voting on the tax-sensitive question.  For example, in a case where three family co-trustees, A, B, and C, serve together as co-trustees on each of three trusts, and each trust allows for “best interests” discretionary distributions to its respective primary beneficiary (A, B, or C), it would no longer be sufficient to preclude individual A from voting as trustee on a distribution to A, with parallel restrictions on B and C for their trusts.  All of the family trustees would have to be disqualified from voting on “best interests” distributions to any one of them.