Part II: An Introduction to Lesser Known But Useful Trusts

Editor's Note: This is the second in a six-part series by Wendy Goffe of Graham & Dunn that will be published weekly through September.*




I. Commercial Trusts.

The common law commercial trust, also referred to as a business trust, has existed since the Seventeenth Century. FN1. Generally, a common law business trust is an unincorporated business organization created by an instrument that defines how property is to be held and managed by trustees for the benefit and profit of its beneficial owners.  Common law business trusts have historically been viewed as an evasion of corporate law. FN2.

The traditional trust involves a gratuitous transfer that implies that the grantor is not compensated for that transfer, and often retains no further interest in the trust corpus.  A trustee's common law fiduciary duties of care and impartiality limit the use of traditional trust assets in many circumstances, particularly with respect to adherence to the prudent investor rules.  On the other hand, the business trust is typically funded in a bargained-for exchange with a goal of managing the assets for profit, the grantor typically retains an interest in the assets as a beneficiary, and the beneficiary and the trustee share the risk of loss and the possibility of profit.  The business trust arrangement, where the trustee is permitted to make risky investments for entrepreneurial gain and share that risk with the beneficial owners, stands in total contradiction of the traditional understanding of the trustee/beneficiary/grantor fiduciary relationship.  

The common law business trust has a number of limitations, including the fact that it is not clear that it consistently confers limited liability to its investors. FN3. Because of the many limitations of the common law business trust and the common law limitations on fiduciaries, at least 30 states have enacted business trust statutes. FN4. In addition, the National Uniform Conference of Commissioners of Uniform State Laws ("NCCUSL"), which began its work in 2002, approved a Uniform Statutory Trust Entity Act on July 15, 2009, originally based on the Delaware Statutory Trust, with a number of innovations. FN5. 

     A. Statutory Business Trusts.

Statutory business trusts are more relevant to issues of income tax, and corporate and bankruptcy law, and will only be briefly described here.  Massachusetts was the first state to enact a business trust statute. FN6. Statutory business trust statutes each, to a certain extent, attempt to define the rights of the parties involved, permit limited liability and creditor protection and even statutory limitations that might result in the ability to take valuation discounts. FN7. Statutory business trusts, unlike the common law variety, are separate from their trustees and beneficial owners; they have the capacity to sue, be sued and transact business in the name of the trust not in the name of the trustees.  Some of the statutes refer to the state's more flexible corporate law where a gap in the statute exists, and others to the state's stricter trust laws, resulting in inconsistent standards of care, fiduciary duties, and limitations on liability, from state to state. FN8.

For example, under Washington law, which was enacted in 1959, a business trust is treated as an unincorporated business association created by an instrument under which property is held and managed by trustees for the benefit and profit of such persons as may be or may become the holders of transferable certificates (whether by commercial transaction or donative transfer), evidencing beneficial interests in the trust estate. FN9. 

Like a corporation, a Washington business trust must file a copy of the trust agreement and any amendments with the Secretary of State. FN10. And, it is subject to Washington's corporate law, as it relates "to the issuance of securities, filing of required statements or reports, service of process, general grants of power to act, right to sue and be sued, limitation of individual liability of shareholders, rights to acquire, mortgage, sell, lease, operate and otherwise to deal in real and personal property, and other applicable rights and duties existing under the common law and statutes of this state in a manner similar to those applicable to domestic and foreign corporations." FN11. In other words, Washington's corporate law supplements any gaps in the statute, rather than its trust law (the default under the Delaware model).

In some states, trusts are often chosen over corporations for their flexibility of management and control in the fulfillment of particular business purposes.  In certain states, this advantage of flexibility is lost because the enacted legislation subjects the business trust to substantially the same regulations as the corporate form.  Nevertheless, while largely overshadowed by corporations, partnerships, and limited liability companies, business trusts have become the preferred form of entity for certain financial transactions related to mortgages, credit cards and other debt, and many mutual funds, pension funds, REMICs (real estate management investment companies), regulated investment companies, and REITs (real estate investment trusts) are also structured as trusts, any of which could also be structured as a corporation or partnership. FN12.

The Treasury Regulations provide that "[t]he fact that any organization is technically cast in the trust form, by conveying title to property to trustees for the benefit of persons designated as beneficiaries, will not change the real character of the organization if the organization is more properly classified as a business entity under §301.7701-2." FN13. Accordingly, if a trust has associates and a profit-making objective, it will not be treated as a trust subject to Subchapter J of the Code, and will instead be treated as a corporation, partnership, limited liability company, or sole proprietorship.  If it is organized as a trust for state law purposes but does not qualify as one for federal income tax purposes, the "check-the-box" regulations allow the entity (other than a corporation) to elect treatment as either an association or a partnership for federal tax purposes. FN14.

Whether a business trust will be recognized in bankruptcy is determined by applying rules different from those under the Code. FN15. Bankruptcy courts typically consider the following factors when determining whether a trust is conducting business:  (i) whether its purpose is to generate profits; (ii) whether it has the attributes of a corporation; (iii) and--sometimes--whether the beneficial interests in the trust are transferable. FN16.

     B. Investment Trusts.

An investment trust is a trust formed by multiple individuals to pool funds for common investments, much like a limited liability company used to aggregate wealth and facilitate investing by family members jointly. FN17. Investment trusts are typically comprised of a fixed amount of outstanding shares that may be in one or more classes, and which can be bought and sold in the market. FN18. The Treasury Regulations describe an investment trust as one that facilitates direct investment in the trust assets, with interests that are "substantially equivalent to undivided interests" in the trust corpus. FN19. The Regulations distinguish statutory business trusts from investment trusts for income tax purposes, even though operationally they may be indistinguishable.  

A trust with a single class of ownership interests may be classified as a trust if there is no power under the trust agreement to vary the investment of the certificate holders.  

An investment trust with multiple classes of ownership interests ordinarily will be classified as a business entity under Treas. Reg. §301.7701-2. FN20. But, an investment trust with multiple classes of ownership may be classified as a trust if "there is no power under the trust agreement to vary the investment of the certificate holders" and "the trust is formed to facilitate direct investment in the assets of the trust and the existence of multiple classes of ownership interests is incidental to that purpose." FN21.

If an investment trust is classified as a trust (not an association or partnership), it will typically be treated as a grantor trust because the grantors are also the beneficiaries and have the power to distribute income or principal to themselves.  Nevertheless, certain investment trusts are subject to statutory provisions regarding taxation and are not taxed as grantor trusts.  These include REITs, governed by IRC §§856-859, and common investment trusts, governed by IRC §584. FN22.

     C. Environmental Remediation Trusts.

An environmental remediation trust is a type of business trust:  (i) organized as a trust pursuant to state law; (ii) formed to collect and disburse funds for environmental remediation; (iii) all contributors to which must have actual or potential liability under federal, state, or local environmental laws for environmental remediation of the waste site; and (iv) not a qualified settlement fund described in Treas. Reg. §1.468B-1(a). FN23. The remediation must be in connection an existing waste site as a result of liability or potential liability under federal, state or local law, and not to carry on a for-profit business.

Remediation costs include the expense of assessing environmental conditions, remedying and removing environmental contamination, monitoring remedial activities and the release of substances, preventing future releases of substances, and collecting amounts from persons liable or potentially liable for the costs of these activities. FN24.  

For federal tax purposes, each trust grantor is treated as the owner of the portion of the trust contributed by that grantor under rules provided in IRC §677 and Treas. Reg. §1.677(a)-1(d). FN25.  If the remedial purpose of an environmental remediation trust is changed or becomes so obscured by business or investment activities that it is no longer primary, it will lose its classification as an environmental remediation trust and will instead be treated as a business entity. FN26.

     D. Statutory Land Trusts.

There are two types of land trusts:  Charitable land trusts FN27 and statutory land trusts.  Unlike statutory land trusts, charitable land trusts are a form of purpose trust (a trust established for a specific purpose rather than for the benefit of individual beneficiaries).  Purpose trusts are discussed generally in a later installment of this article.

Statutory land trusts are private non-charitable trusts used to hold title to real property while keeping the identity of the beneficiaries confidential.  Illinois and at least 4 other states allow the creation of a trust to hold real property by statute. FN28. This type of statute is often referred to as an "Illinois Land Trust," stemming from the fact that Illinois was the first state to enact a land trust statute. FN29.  

The Statute of Uses was originally enacted in 1535 (effective 1536), during the reign of King Henry VIII. FN30.  It invalidated gifts of land in trust.  The Act was later modified by the English courts to provide that it did not apply to a trust where the trustee was actively involved in managing the property in trust. FN31.  Land trust statutes represent a departure from the Statute of Uses, which is still strictly enforced in some states.

At a minimum, a trustee of a land trust is assigned the duty to terminate the trust at the instruction of the beneficiaries, as well as convey title and perform any other act that affects title during the trust term.  The Restatement (Second) of the Law of Trusts §69 (1959) provides the majority view that these powers are sufficient to avoid violating the Statute of Uses.

Rather than acting in the name of and on behalf of the trust, the trustee of a land trust takes both equitable and legal title to the real property.  But the only duties of the trustee are to execute deeds and mortgages, and carry out acts at the instruction of the beneficiaries on all matters affecting title.  As a result of the way title is reflected, in the name of the trustee, to third parties who are not aware of the trust's existence, the trustee is not, strictly speaking, acting as an agent of the beneficiaries, but as principal.  Unless the applicable statute provides indemnification to the trustee, the prudent trustee will obtain a release and indemnification to protect itself accordingly. FN32.  

The interests of beneficiaries in the trust are considered personal property, not real property. FN33.  Hence, the beneficiaries exercise all other rights with respect to the property on their own behalf and not as agents of the trustee.  They enforce the terms of the trust, hold the exclusive right to manage, possess and control the real property, including the power to sell, lease or trade the property and to name further trustees and beneficiaries of the trust. FN34.  Among themselves, beneficiaries act as partners or joint venturers and owe a fiduciary duty to act in their mutual best interests.  Furthermore, they may not bind the trustee without its consent.

The hallmark of the land trust is that it provides limited access to information about the grantor or the beneficiaries of the trust.  Once title is vested in the trustee, the ability to pierce the veil of the trust instrument is restricted by state law.  The identity of the beneficiaries may be obtained by court order and in some cases, must be disclosed to government agencies. FN35.

A land trust is typically taxed as a grantor trust but could be taxed as a business entity.  Taxation turns on whether the purpose of the trust is to carry on a business among associates or simply to divide gain. FN36. Beneficiaries who receive an interest by way of a gratuitous transfer would not be considered associates and therefore would be subject to the grantor trust rules.

A beneficiary who transfers an interest in a land trust must file a notice pursuant to IRC §6903(b) and Treas. Reg. §301.6903-1(b), within 30 days of the transfer, so that the Service can match the beneficiary with the property. FN37. This is done using IRS Form 56.

     E. Liquidating Trusts.

Liquidating trusts relate primarily to bankruptcy and income tax matters, and so are only briefly described here.  A liquidating trust is typically used to liquidate assets of a dissolving or insolvent corporation subject to a bankruptcy plan under Chapter 11 of the Bankruptcy Code.  The trust beneficiaries are the creditors, bondholders, and shareholders of the liquidating corporation.  Outside of the bankruptcy arena, liquidating trusts are used by owners of property simply to facilitate its sale.

The Treasury Regulations recognize a liquidating trust if "it is organized for the primary purpose of liquidating and distributing the assets transferred to it, and if its activities are all reasonably necessary to, and consistent with, the accomplishment of that purpose." FN38. If the liquidation is unreasonably prolonged, or if the liquidation function becomes so obscured by business activities that the liquidation purpose is lost or abandoned, the status of the organization will no longer be that of a liquidating trust (with exceptions where continued business activities are necessary to preserve asset values). FN39.  

A liquidating trust may be taxed for federal income tax purposes in a number of different ways:  (i) as a grantor trust with the creditors as the grantors; (ii) as a grantor trust with the debtor as the grantor; (iii) as a trust subject to Subchapter J, with the creditors as the beneficiaries; (iv) as a partnership with the creditors as partners; (v) as a corporation with the creditors as shareholders; or (vi) as an entity subject to the taxation rules of IRC §468B. FN40.

Several Revenue Procedures set forth conditions for advanced rulings on whether a trust qualifies as a liquidating trust.  Rev. Proc. 82-58 FN41 discusses advance rulings for liquidating trusts in general.  If the activities of the liquidating trust are limited to those activities necessary to accomplish its original purpose, the trust will be taxed as a trust and not a business organization.  

Rev. Proc. 94-45 FN42 sets forth a safe harbor for creditor grantor trust treatment and deals specifically with advanced rulings for liquidating trusts created pursuant to a bankruptcy plan under Chapter 11. FN43. Among the many requirements for creditor grantor trust treatment, the plan, disclosure statement, and trust instrument must require that the trust beneficiaries be treated as grantors and deemed owners of the trust estate.  Furthermore, trust returns must be filed pursuant to Treas. Reg. §1.671-4(a), which specifies the return requirements of a grantor trust.

The formation and funding of a trust formed pursuant to the safe harbor rules will be treated for all federal income tax purposes as if a transfer had been made from the bankruptcy estate to the beneficiaries, followed by a deemed transfer by the beneficiaries to the liquidating trust, resulting in an immediate taxable event to the debtor and the creditor/beneficiaries.

Additional rules apply to trusts subject to Subchapter J with respect to persons who acquired interests in the trust by purchase rather than by way of a gratuitous transfer. FN44.

     F. Voting Trusts. FN45.

          1. Background.

A voting trust is an agreement among one or more shareholders of a corporation (or LLC) whereby the shareholders' shares and voting rights are legally transferred to a trustee, usually for a specific period of time or for a period contingent on a certain event.  A voting trust can be distinguished from a proxy, which can be voided in some cases and in all cases deals only with voting.  A voting trust may serve broader purposes.  A blind trust, discussed in a later installment of this article, is also by nature a voting trust, but also serves a broader purpose.

The first legislative approval of the voting trust is found in N.Y Laws 1901 ch. 355, §20. FN46. Most states have by now adopted a form of voting trust statute.  

Washington's voting trusts are governed by RCW 23B.07.300, under which one or more shareholders may create a voting trust to confer upon a trustee the right to vote or otherwise act on behalf of the shareholders.  The voting trust is created by the shareholders' signing of an agreement setting forth the provisions of the trust, (which may include anything consistent with its purpose) and by transferring legal ownership of their shares to the trustee.  Upon the signing of the voting trust agreement, RCW 23B.07.300(1) requires the trustee to prepare and deliver to the corporation's principal office a list of the names, addresses number and classes of shares of each owner of a beneficial interest transferred to the trust.

A voting trust becomes effective upon the date of registration of the first shares in the trustee's name, and, like most other voting trust statutes, is valid for 10 years following its effective date, but can be extended for additional terms of not more than 10 years each by signing an extension agreement and obtaining the voting trustee's written consent.  The voting trustee must deliver copies of the extension agreement and list of beneficial owners to the corporation's principal office.

          2. Purposes of Voting Trusts.

The objective of a voting trust may be to simply secure continuity of policy in voting for officers and corporate programs, regardless of change in ownership of stock.  Voting trusts may also be used as an aid in reorganization of the corporation, to secure the retention of control by the grantors, to restrain minority stockholders, or to aid in creating a monopoly.  

Voting trusts are also used to resolve conflicts of interest.  By putting shares in the hands of a trustee who can vote them at arm's-length from the beneficiaries of the trust, this can in some circumstances mitigate or absolve the original shareholder from what might otherwise constitute a conflict of interest.

In our present economy, voting trusts are commonly seen as a valuable tool for lenders and other professionals in workouts and other Chapter 11 cases.  By transitioning legal ownership and voting rights of a company into the hands of a mutually accepted trustee, a company may overcome problems caused by the distrust of a company's owners and management by lenders.  

          3. Voting Trusts in The Estate Planning and Dissolution Context.

A voting trust can also be a valuable tool in the context of a marital dissolution.  For example, consider an LLC or corporation owned by a divorcing couple.  A voting trust would permit the active spouse to continue to control the business, while the inactive spouse can protect his or her equity interest.  The spouse who is active in the business ("active spouse"), and other shareholders, will generally insist that the other ex-spouse ("inactive spouse") not be involved in business matters, and in particular, not have any right to vote.  Voting trusts are an excellent method to permit the active spouse to continue to control the business, while the inactive spouse can protect his or her interest in the property settlement agreement by actually owning the stock in the business.

The following are some drafting tips for voting trusts in the estate planning and matrimonial law contexts.  The length of time for which the voting trust will last should not exceed the shorter of any state law limitation on the period for which a voting trust may last, or the period for which payments (e.g. dividends) will be paid to the inactive spouse.  If all income is to be distributed by the corporation directly to the shareholder, and not retained by the trustee, this should be stated in the agreement.  The responsibilities, duties, powers, and rights of the trustee should take into consideration the terms of the separation agreement, and the restrictions on the inactive spouse.  

If the active spouse serves as trustee, and expects to be compensated, the exact arrangements should be spelled out in the agreement.  Without this additional protection there could be little money left in the corporation for distribution as dividends.  To fully protect the inactive spouse's interests, to the extent possible, he or she should also negotiate reasonable restrictions on how much the active spouse and other shareholders can withdraw as salary or benefits.  Ideally, the company's shareholder agreement would clarify the rights of the inactive spouse with respect to the stock held in a voting trust.  For example:  "Shareholder shall be entitled to receive, and shall receive, payments from the Trustee of all cash dividends or other distributions made by the Corporation with respect to the stock of the Corporation held by the Trustee hereunder.  Any and all tax benefits Shareholder shall recognize shall be the same benefits that would be recognized had Shareholder held said shares directly."


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 ENDNOTES

1. Nicholas Karambelas, Limited Liability Companies: Law, Practice and Forms §11:2 (2d ed. 2004 & Supp. 2009).
 
2. See, e.g., Tamar Frankel, The Delaware Business Trust Act Failure as the New Corporate Law, 23 Cardozo L. Rev. 325, n.4 and accompanying text (2001), at http://ssrn.com/abstract=288543 (last accessed December 30, 2009).

3. Id.
 
4. Uniform Statutory Trust Entity Act pref. note (2009 Ann. Meeting Draft), at http://www.law.upenn.edu/bll/archives/ulc/ubta/2009_amdraft.htm (last accessed December 30, 2009).
 
5. Available at http://www.law.upenn.edu/bll/archives/ulc/ubta/2009am_approved.htm (last accessed December 30, 2009).
 
6. Robert H. Sitkoff, Trust as "Uncorporation":  A Research Agenda, 2005 U. Ill. Law. Rev. 31, 35 (2005), at http://ssrn.com/abstract=724441 (last accessed December 30, 2009).
 
7. See, e.g., Del. Code ch. 12. §§3801-3862 ; Mass Gen. L. ch. 182, §§ 1-14, and RCW ch. 23.90 (entitled the "Massachusetts Trust Act of 1959").
 
8. Sitkoff, Trust as "Uncorporation," supra n. 6 at 35-39.
 
9. RCW §23.90.020.
 
10. RCW §23.90.040(1).
 
11. RCW §23.90.040(4).
 
12. See Steven L. Schwarcz, Commercial Trusts as Business Organizations:  Unraveling the Mystery, 58 Business Law. 1 (Feb. 2003), at http://ssrn.com/abstract=319802 (last accessed December 30, 2009), for a detailed discussion of the formats a business trust may take.  
 
13. Treas. Reg. §301.7701-4(b).
 
14. Treas. Reg. §301-7701-2(b)(2).
 
15. Bankr. Code §101(9)(A)(v).
 
16. See, e.g., Brady-Morris v. Schilling (In re Kenneth Allen Knight Trust), 303 F.3d 671 (6th Cir. 2002).
 
17. See Howard M. Zaritsky & Howard D. Rosen, 854-3d Tax Mgmt. Portfolio (BNA), U.S. Taxation of Foreign Estates, Trusts and Beneficiaries, A-8-10 (2008) for a discussion of investment trusts.
 
18. Treas. Reg. §301.7701-4(c)(1).
 
19. Treas. Reg. §301.7701-4(c)(2).  
 
20. Id.
 
21. Id.
 
22. See Alan S. Acker, 852-3d Tax Mgmt. Portfolio (BNA), Income Taxation of Trusts and Estates, A-20 (2007), for a discussion of the taxation of investment trusts and the various exceptions to the rules.
 
23. Treas. Reg. §301.7701-4(e)(1).
 
24. Id.  The Treasury Regulations apply to remediation trusts meeting the requirements of Treas. Reg. §301.7701-4(e)(1) on or after May 1, 1996, and certain trusts described in the Treasury Regulations formed prior to that date.  Treas. Reg. §301.7701-4(e)(5).
 
25. Treas. Reg. §301.7701-4(e)(2).  The reporting rules are set forth in Treas. Reg. §301.7701-4(e)(2), which references Treas. Reg. §1.671-4(a).
 
26. Treas. Reg. §301.7701-4(e)(1).
 
27. A charitable land trust, which may also be referred to as a land bank, is a nonprofit organization established to protect and preserve valuable open space or environmentally-sensitive land.  A land trust or land bank can take title in fee simple, or to a remainder interest, and/or it can take title to a conservation easement over property.  See Erin B. Gisler, Land Trusts in the Twenty-First Century: How Tax Abuse and Corporate Governance Threaten the Integrity of Charitable Land Preservation, 49 Santa Clara L. Rev. 1123 (2009), for a discussion about charitable land trusts.  
 
28. See, e.g., Fla. Stat. §689.071 et seq. (entitled the "Florida Land Trust Act"); Haw. Rev. Stat. §558 et seq. (entitled "Land Trust Act"); 75 Ill Comp. Stat. 505 et seq.; Ind. Code §§30-4-2-13, 14; Va. Code Ann. §55-17.1.  See also In re Tutules Estate, 204 Cal. App. 2d 481, 22 Cal. Rptr. 427 (1962) (recognizing a land trust in California).
 
29. Hart v. Seymour, 147 Ill. 598, 35 N.E. 246 (Ill. 1893), is thought to be the first case recognizing a land trust in Illinois.  See, Julius J. Zschau, Ulysses Clayborn & Andrew M. O'Malley, Using Land Trusts to Prevent Small Farmer Land Loss, 44 Real Prop. Trust & Estate L.J 521 (2009) for a comprehensive history of the land trust, along with forms and a 50 state survey of land trust legislation.  
 
30. Thomas, David A., Anglo-American Land Law: Diverging Developments from a Shared History - Part I: The Shared History 34 Real Prop. Prob. & Tr. J. 143, 181-9 (Spring 1999), at http://ssrn.com/abstract=1184122 (last accessed December 30, 2009).  
 
31. Id.
 
32. The Florida statute indemnifies the trustee unless the trustee is personally at fault.  Fla. Stat. §689.071(7).
 
33. See, e.g., 765 Ill. Comp. Stat. §405/1, Sec. 1.
 
34. Id.
 
35. Specifically, in Illinois, the trustee must disclose the identity of all trust beneficiaries under certain circumstances, including in connection with any application to the State of Illinois or its agencies for any purpose.  Id. at Sec. 2.
 
36. Acker, Income Taxation of Trusts and Estates, supra n. 22 at A-19.
 
37. See Rev. Rul. 63-16, 1963-1 C.B. 350, which discusses this requirement.
 
38. Treas. Reg. §301.7701-4(d).
 
39. Id.  See, e.g., U.S. v. Davidson, 115 F.2d 799 (6th Cir. 1940).
 
40. IRC §468B and the Treasury Regulations thereunder address the federal income taxation of Qualified Settlement Funds, Designated Settlement Funds and Disputed Ownership Funds, which are beyond the scope of this discussion.
 
41. Rev. Proc. 82-58, 1982-2 C.B. 847, as modified and amplified by Rev. Proc. 94-45, 1994-2 C.B. 684, and as amplified by Rev. Proc. 91-15, 1991-1 C.B. 484 (checklist questionnaire), as modified and amplified by Rev. Proc. 94-45, 1994-2 C.B. 684.
 
42. 1994-2 C.B. 684.
 
43. See Zaritsky & Rosen, U.S. Taxation of Foreign Estates, Trusts and Beneficiaries, supra n. 17 at A-11 for an analysis of Rev Proc. 94-45 and the requirements of a liquidating trust created under Chapter 11 of the Bankruptcy Code.
 
44. See Acker, Income Taxation of Trusts and Estates, supra n. 22, at A-21 - A-22 for a discussion of these rules.
 
45. Rochelle L. Haller, Esq., of Graham & Dunn, PC contributed to this section.
 
46. Gary D. Berger, The Voting Trust: California Erects a Barrier to a Rational Law of Corporate Control, 18, Stanford L.Rev. 1210 (May 1966).





*To read more in Wendy Goffe's series, "An Introduction to Lesser Known But Useful Trusts," please visit any one of the following links: Part I, Part III, Part IV, Part V and Part VI.