Estate planning for high-net-worth families frequently requires the use of trusts. But relinquishing investment decisions to a trustee is not a comfortable or practical choice for some families. Fortunately, Delaware trust law provides a potential solution to this problem through directed trusts.
Today, many high-net-worth families find that their wealth is concentrated in a particular investment or sector. It may be a function of having a family business, specific expertise in a single sector, such as real estate, or a relatively heavy weighting in alternative investments, such as hedge funds or private equity. While these assets may have served the family well in creating wealth, they can present difficulties in implementing effective estate planning or asset protection strategies.
A trust can be an effective vehicle to overcome these obstacles and transfer wealth to the next generation or to help protect assets from creditors. However, a concentration of assets in a particular investment or sector may present a significant obstacle to the use of trusts. The most common stumbling block is the tension between a trustee’s fiduciary duty to diversify a trust’s investments and a family’s desire to retain concentrated holdings of legacy stock, real estate, or other assets, such as a closely held business, hedge funds, or private equity, that are less transparent and can be difficult to manage and value. In addition, many families want to maintain control over the investment process or retain trusted investment advisors regardless of a trust’s investment mix.
Virtually every state’s trust law allows a trustee to delegate its investment responsibilities to an investment advisor. But delegation is not the same as direction. When a trustee delegates to an investment advisor, the trustee typically remains liable for the performance of that advisor and, therefore, monitors investment decisions. Thus, delegation of a trustee’s investment responsibilities often is not an effective planning option for these types of assets.
In Delaware, it’s different. The state’s distinctive trust law allows someone living anywhere in the United States, or the world, to create a Delaware trust funded with the types of unique assets described above. The specific feature of Delaware’s law is often referred to as a “directed trust.”
Delaware’s directed trust law provides the:
- Freedom to engage in estate planning or asset protection planning using illiquid assets, such as stock in the family business, real estate, or hedge fund/private equity investments
- Flexibility to retain control over a trustee’s discretion regarding investments or distributions so that a trusted advisor or family member can do what is best for the family/beneficiaries
- Ability to override a trustee’s traditional duty to diversify a trust’s assets in situations where the family wants to keep a concentrated position in a legacy stock, the family’s real estate holdings, or the family business
With a Delaware directed trust, a trust agreement may be drafted so that an advisor, who is appointed in the agreement, is given the authority to direct the trustee regarding discretionary investment decisions. This law relieves the trustee from virtually all liability for decisions in which it is directed by an advisor. By removing investment decisions from the trustee, the tension between a trustee’s duty to diversify assets and the family’s desire to plan using concentrated or difficult to manage assets is obviated. The result is the freedom and flexibility to implement almost any wealth planning strategy that employs a trust—asset protection trusts, dynasty trusts, marital trusts, credit shelter trusts, charitable remainder trusts, qualified personal residence trusts, intentionally defective grantor trusts, etc.—to achieve desired goals. Finally, a directed trust refers to how a trust is administered, not a specific type of trust planning vehicle. It is a feature that may be added to virtually any type of trust structure in Delaware.
Added flexibility beyond investment decisions
Beyond investments, a Delaware directed trust allows virtually every discretionary decision traditionally held by a trustee to be controlled by an advisor appointed in the trust agreement. These discretionary decisions include choices regarding when and how to make distributions to beneficiaries (the “distribution advisor”); the hiring and firing of investment managers (the “investment advisor”); the removal and appointment of trustees (the “trust protector”); and when and how to change or diversify a trust’s investment holdings. When a majority of the discretionary decisions are controlled by advisors, the trustee is referred to as an “administrative trustee,” since its role is limited to carrying out the administrative functions of a trustee—record keeping, tax return preparation, and maintaining custody of the trust’s assets.
While a Delaware’s directed trust is extremely powerful, it cannot remove every impediment to using a trust. In addition to issues related to fiduciary liability and control, execution of a trust may have estate, gift, and income tax consequences. Use of family members as the advisors who direct a trustee may cause unintended tax consequences. As a result, great care must be exercised when creating a trust that will use a family member or other non-independent individual as an advisor.
Moreover, it is important to be sure that all the parties understand their roles and responsibilities when the components of a trustee’s duties are split among the trustee and one or more advisors. It is also helpful to have a plan for dispute resolution. And if a committee of advisors is appointed for investments or distributions, it is important to think about a governance strategy.
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service. This article is not designed or intended to provide financial, tax, legal, accounting, investment, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.
Note that a few states, including Delaware, have special trust advantages that may not be available under the laws of your state of residence, including asset protection trusts and directed trusts.
Please see other important disclosures at the end of the article.