Monday, May 24, 2010

Fiduciary roles: should you serve as a trustee?

Your father asks you to serve as trustee for the trust he’s creating to hold the shares of the family business. Most of us are honored to be invited to serve in a fiduciary role, to be asked to take on an important position of responsibility. But particularly in a family situation, consider the potential downsides of a fiduciary role. Before you sign the documents, think about the responsibilities you’re taking on, and whether you’ve got the time, energy and expertise necessary to do the job right.

Serving as a trustee is a fiduciary role, which requires you to act in the best interests of another – in the case of the trust, in the best interests of the beneficiaries. At great risk of oversimplification, the core notion of fiduciary duty is: never can you put your own interests first, or act for your own personal gain.

Under the common law, a fiduciary owes three primary duties to the beneficiaries: the duty of care, the duty of loyalty, and the duty of impartiality. The trustee must carry out the express terms of the trust, must act prudently, must treat the current and future beneficiaries impartially. The trustee must protect and secure the trust property, ensuring that it is not commingled with other assets. He or she must invest the trust property to produce a reasonable income. Fiduciary duty is the highest legal standard under US law, a particularly daunting hurdle if you are someday sued for negligence.

If you’re asked to serve as trustee of a family trust, find out who the beneficiaries will be. Will you be asked to exercise discretion over distributions? What will it do to your relationship with your siblings if you turn down a request for a distribution? Your fiduciary duty to act in the best interests of the beneficiaries may conflict with the desires of your father, the grantor of the trust – for example, your father may envision that all profits will be reinvested in the company, while a sibling beneficiary may have a compelling need for distribution, and your fiduciary duty obligates you to invest the trust property to achieve a reasonable income. How will you resolve those conflicts within the scope of the law and the scope of the family relationship? Are you also in the senior management team of the company? You may agree that the company desperately needs to retain cash – but remember, your duty as trustee is to the beneficiaries, not to the business.

Adding further fuel to the fire, what about the duty to diversify trust property, a fiduciary obligation recognized under the law of some states? Are you at risk for being sued by a beneficiary who believes that the capital would be more productive if invested in a diversified portfolio rather than a single, privately-held stock? Does the trust instrument direct you to retain the company stock? Permit you to retain it? Does your state law permit the grantor’s intent to trump the duty to diversify?

If these questions make you feel a bit queasy, good. Serving as a trustee can be a tough job, at times requiring you to resolve layers of familial and legal conflicts. Don't undertake the role without giving it considerable thought. Talk with experienced legal counsel and at least one other person who has taken on a similar role.

Next post, we’ll talk about strategies for reducing trustee liability.

Sunday, May 9, 2010

More on structuring business-owning trusts

How can business-owning families use trusts to transfer ownership between generations, without demotivating and disengaging the next generation?

Last week I attended the annual conference of Attorneys for Family Held Enterprises (“AFHE”). Friday morning brought an excellent presentation by Marion McCollom Hampton and Andrew Hier of OMBI Consulting on “The Impact on Beneficiaries When Family Business Ownership is Held in Trust”. The speakers pointed out that trusts can undermine effective and healthy ownership of family businesses by removing the decision-making authority of family members and weakening initiatives for shareholder education, and by reducing or eliminating the incentive for the family to create governance structures and decision-making processes.

At Fisher Renkert LLC, we recognize that transferring ownership of a family business in trust rather than outright can have a substantial negative impact on the business. Improperly drafted trusts can demotivate and disenfranchise next generation family members, who find themselves passive beneficiaries rather than active shareholders. Inserting a third party – the trustee – into the system can disrupt both the family and the business. However, given the potential upside to be gained from transferring ownership in trust – significant tax savings over generations, protection from creditors (including divorcing spouses), ensuring stable ownership even when the beneficiary is legally incompetent – our goal is to design trust structures for business-owning families that engage the family, promote effective family and business governance, and support business continuity.

As the OMBI team pointed out, and as I’ve emphasized in prior posts, choosing the right trustee for a family business trust is critical. But even more important than choosing the right trustee in the first instance is ensuring ongoing oversight of the trustee by granting a trusted individual the power to remove the trustee, and to replace a trustee who has resigned or been removed. The holder of this “remove/replace” power has substantial indirect power over the trustee, and through that power, the ability to influence trustee decision-making. While a family member often can’t serve as trustee for tax reasons, a family member can hold and exercise the remove/replace power without running the risk of estate or gift tax inclusion so long as the successor trustee is not “related or subordinate to” the grantor or the beneficiaries (as that phrase is defined in Section 672(c) of the Internal Revenue Code). By granting the remove/replace power to a beneficiary or other family member, power can be shifted from the trustee back to the family.

Typically, the holder of the remove/replace power is called the Protector. Traditionally, the Protector of a trust has been an individual. At Fisher Renkert LLC, we suggest that families consider appointing a committee, or sometimes better yet, an entity, to serve as Protector, particularly for dynasty trusts or trusts holding substantial interests in an operating business. With either a committee or an entity, the remove/replace power will be exercised by a group of individuals. The group can be made up entirely of beneficiaries or other family members, but just as the quality of the decision-making of a board of directors will be strengthened by including independent directors, it can be helpful to include non-family members on the protector group, selected for their knowledge of the family, skills and experience. While the primary charge of the Protector group is oversight of the trustee, ongoing education of family members regarding the purposes, structure and investments of the trust can be an important secondary charge.

The group should meet regularly – at least quarterly – with the trustee and the family, and should receive copies of all information provided to the trustee, as well as the trust’s accountings, tax filings and other formal records of trustee decision-making. The group may also liaise with the family council and the board of directors of the operating business. The issue of protector succession is also simplified by use of a group – when a member of the group ceases to act for any reason, the group itself can be charged with the task of appointing a successor in accordance with specified criteria.

Thursday, April 22, 2010

The Myth of "THE FAMILY"

So, what is “the family”, anyway? Just about everyone in private wealth management circles refers to a group of related clients as “the family”. THE FAMILY - a monolith – a group whose members have interests, objectives, concerns, and assets that can be managed in common.

The problem with “THE FAMILY” is that there is no such thing, at least not when it comes to wealth management. The individuals, trusts, foundations, corporations, LLCs and other entities that make up “THE FAMILY” are all unique, and to throw them together and treat them as a homogeneous unit serves no good end (except perhaps to maximize the assets under management).

Families themselves make this same mistake sometimes, particularly when wealth is new, children are young, and the ink has barely dried on the documents creating all the wealth holding structures – trusts, partnerships, foundations. At this point, the patriarch or matriarch may be excused for thinking that the assets belong to THE FAMILY, and making investment decisions based on the notion of a single pot of wealth, but for such a family the process by which the single pot is divided into separate pots, each with its own distinct purpose, constraints and time horizon, has already begun. It is critical for the family’s advisors and for family members themselves to understand each pot, and to consider it as a separate investor.

A specific example may help highlight the risk of investing on behalf of THE FAMILY. Let’s say that the Smith family has multiple accounts with MetroBank, including Dad’s investment account, a trust account for a GST-exempt trust intended to benefit the Smith children and grandchildren, and an account for the family’s foundation. Let’s say, further, that the MetroBank investment advisor recommends that the Smith family invest a portion of their assets in MetroBank’s Alternative Fund, a fund-of-funds designed to give individual private investors access to a broader array of investments and managers. (This suggestion might have raised fewer eyebrows before the market chaos of 2008.) The Smith FAMILY account – all the accounts viewed as a single pool – is large enough to warrant considering the investment, and it fits within the family’s broad investment guidelines and asset allocation. Particularly if family decision-makers are enthusiastic about Alternative Fund, there may be a temptation to make the investment for THE FAMILY and figure out later from which accounts the cash for the investment should be pulled.

But a quick look at the separate accounts raises a host of questions:
• Even if Dad’s account has the cash, does the investment suit his time horizon? If he is retired, what are his cash needs? If the Alternative Fund, like many fund of funds, won’t make distributions, then will Dad’s cash flow be constrained? If Dad should die while holding the investment, it might generate a discount for estate tax purposes, but a lockup provision could create a liquidity problem for his estate. Even if there is no lockup provision, the liquidity constraints experienced by many funds in 2008 and beyond are evidence that liquidity may be unavailable just when it’s needed most. Other questions arise: What are the track records of the individual funds held by Alternative Fund? Does MetroBank conduct any regular due diligence in connection with the fund? What is its long term mandate? Is the fund’s style subject to creep over time?
• The GST-exempt trust is intended for the benefit of Smith children and grandchildren. It potentially has the longest investment time horizon, so it may be a good candidate to make the investment in Alternative Fund. However, its trustees – not the investment advisor, not Dad, not the beneficiaries – are responsible for making the decision whether or not to invest, and they should keep in mind that they have a fiduciary duty to invest to meet the needs of the trust’s beneficiaries. What are the beneficiaries’ projected needs? If the beneficiaries have other sources of income and principal, then perhaps the trust account might benefit from a long-term investment horizon. But if a grandchild is born with a catastrophic medical condition, will the trustees be able to liquidate all or a portion of the investment quickly if necessary to pay for medical treatment not covered by insurance, or ongoing care? Another concern: will the Alternative Fund generate substantial phantom income – say, lots of short term gain – but not throw off cash, thereby creating a tax liability will need to be paid from other assets? And who will bear that tax liability – the trust itself, or is the trust a “grantor” trust, so that the trust’s income, gains, losses will flow to an individual (perhaps Dad) who will be responsible for the taxes? If Dad will bear the taxes, does he have the cash to handle the liability (a question which likewise needs to be answered before Dad’s account invests in Alternative Fund…)
• Considering whether an investment in Alternative Fund makes sense for the foundation account raises the same issues of liquidity, asset allocation, due diligence and long term cash needs as the other two accounts, along with a new question: will the fund throw off UBTI and thereby create a tax liability for the foundation? Even if the fund doesn’t throw off UBTI now, is its investment mandate broad enough that it might in the future? If the investment otherwise makes sense for the foundation, there a separate sister fund for non-taxable investors?

The point of bringing up all these questions is not to put in doubt the validity of this specific investment for the Smith family accounts – this is in no way a cautionary tale about alternative investments. Rather, the point is that any investment needs to be considered investor by investor – viewing each account separately. Taking the easy way out and treating the Smith family accounts as THE FAMILY - failing to recognize the very different investment profile, risk tolerance, cash flow, time horizon, liquidity needs, tax circumstances of each account – can put family wealth at risk.

Monday, April 5, 2010

Thoughts on multi-generational planning - Part 5: Do Inheritances Infantilize?

Warren Buffett’s widely-publicized decision to transfer most of his wealth to charitable foundations rather than to his children and grandchildren has sparked discussion about whether inheriting wealth might be a curse rather than a blessing. Inheriting wealth cripples motivation, saps the will to work, and leads inheritors to live a life of unhappy indolence, or so this story goes. Rather than becoming independent contributors, inheritors regress until, like infants, they become completely dependent upon their inheritance.

But is it true that wealth invariably cripples motivation? Clearly not – just as there are wealthy inheritors who have lost their way, there are inheritors around the globe for whom wealth has been a tool in building a rewarding life and creating value for themselves and others. So, are there steps that families can take to reduce the risk that their kids and grandkids will become trust fund babies?

Perhaps the best way to inoculate the next generation is to set a good example. If parents do meaningful work and manage money wisely, if the family expectation is that all children will study hard, obtain the best possible educations, get good jobs and live well within their means, then kids are more likely to gain confidence and a sense of self-worth from work rather than spending. Kids also need to understand the denominator problem – unless they too commit to sustaining and building the family’s wealth, the inexorable increase in beneficiaries at each generation will quickly dissipate even the biggest fortune.

How wealth is transferred also makes a difference. Trying to protect wealth at all costs – by keeping the next generation in the dark about family wealth, failing to educate them in the basics of stewardship and wealth management, creating trusts with elaborate control provisions – generally backfires. Beneficiaries who sense that they aren’t trusted are much more likely to display the very behavior the grantor feared most. Beneficiaries who understand the uses and purposes of family wealth, who see themselves as responsible stewards with an important role to play in preserving and growing wealth, are more likely to carry on the family’s legacy.

Buffett’s charitable transfers illustrate another important and growing trend in family wealth transfer – the value of philanthropy. Buffett funded substantial gifts to foundations run by each of children, thereby giving them a considerable degree of power, independence and responsibility – a lasting confirmation of his respect for them, their charitable goals and their decision-making ability. Buffett and his first wife undertook major philanthropic efforts individually, jointly, and in partnership with others (including the Gates Foundation) thereby setting a precedent and providing an important education for his children.

Monday, March 22, 2010

Thoughts on multi-generational planning – Part 4: Strategies for protecting key family assets

How do you protect a unique family asset – say, a family vacation home, or an extensive art collection – if your goal is to ensure that it remains in the family over generations?

Before you do anything else, ask yourself: does it really make sense to own this asset collectively going forward? The denominator problem is inexorable: as families grow, so does the number of owners and the complexity of managing and governing.

Consider a family vacation cottage at the beach: dividing 13 weeks of summer among 3 children may work, but dividing that same amount of time up among 10 grandchildren – with attendant scheduling problems (“He got Labor Day last year so I should get 4th of July!” and management issues, such as divvying up the annual opening and closing chores, painting, plumbing repair and weeding – probably will make owning a share of the cottage seem more like a burden than a benefit to at least some of the group. If having 10 grandchildren co-owning a cottage doesn’t faze you, how about 35 grandchildren?

Instead of leaving the cottage to your descendants in your will, wouldn’t it be better first to talk with the next generation about the responsibilities and costs of ownership, and then encourage each of them to assess their long-term interest realistically? If you’re one of those senior generation members who figure “the next generation will work it out after I’m gone”, shame on you. Assuming that your family will come up with a decision-making system on the fly in the power vacuum that will follow your death is a fool’s gamble. If the asset is important to you and the family, then you owe it to your descendants to help them put in place a workable plan now, while you’re alive and able to contribute to the process.

How is the asset owned currently? You probably own the cottage in your own name. Rather than change the deed to transfer undivided interests to each of your descendants, with the result that they own it as tenants-in-common, you should contribute the cottage to a partnership or limited liability company (LLC) first, then transfer interests to your descendants. With a partnership or LLC, the long-term administration will be simpler because future transfers won’t need to be recorded on the land records. Ownership will be more private because the names of the individual owners won’t be on the town land records. The family will benefit from enhanced creditor protection in the event a guest or passer-by is seriously injured (or worse) on the property, because the claimant’s recovery will in almost all cases be limited to the assets of the LLC.

Putting the cottage into a partnership or LLC will also give you the opportunity to create a more formal decision-making process to guide the family’s use and maintenance of the property, in the form of a partnership agreement or operating agreement. Don’t just accept the default provisions in your lawyer’s model agreement – they were developed for commercial deals and aren’t designed to handle intra-family issues. Your family should jointly develop and agree upon the rules and procedures, particularly those that will govern decision-making in the event of a serious disagreement amongst the members of the group. You might appoint a family member with great interpersonal skills to lead the process, but better still might be to appoint a third-party facilitator with experience working with family groups, to ensure that the process is both smooth and comprehensive.

Wednesday, February 24, 2010

Thoughts on multi-generational planning - Part 3: Avoiding unnecessary complexity

Over the years, I have seen clients become almost mesmerized by the intricate features of complex planning structures – multiple trusts, holding companies, interlocking entities, tiered partnerships, freeze or preferred return structures. They focus on the detail but lose sight of the big picture, which is transferring family wealth in ways that will maximize the family’s long-term benefit. For families, I think that complexity can be a bit like Novocain, at least at the outset – focusing on high-tech techniques numbs nerves that are twinged by the prospect of transferring wealth, power and control. The family leader thinks, “Since I’ve hired the best minds and put in place the most sophisticated planning, then how can my plan possibly fail?”

In families’ defense, it is easy to get swept up in the benefits of complex techniques, and hard to envision exactly how the structure will operate – and what resources will be required to maintain it – in the future. Complexity brings with it potential cost in many forms:
• First, the more complex the structure, the more moving parts it will have, and the more moving parts, the more opportunities for unforeseen glitches, conflicts and issues that will require attention (at a price) in the future. For example, just moving cash through an investment holding structure to fund a new investment or make a distribution for taxes can create tax and legal issues, particularly if the cash is needed quickly and is in the “wrong” entity.
• Second, a complex structure is more expensive to administer, and will require greater and more sophisticated resources on an ongoing basis. Administrative staff, accountants, investment advisors, bookkeepers, other legal counsel, insurance advisors – all will need to understand the structure and its purpose, and work cooperatively to keep it operating smoothly. Families are often distressed when they see bills arising from conversations among advisors (sometimes without any family participation), yet such conversations are often essential to running a complex structure.
• Third, even if all parties understand the structure and its purposes at inception, memories fade, advisors come and go, circumstances and laws change, and the structure that once was a perfect example of form following function can come to seem more like a Rube Goldberg creation. Family members who don’t understand the purpose and operation of a planning structure are more likely to challenge its validity in the future.

So, is the answer to throw out complex, sophisticated planning? No. The answer is to recognize that the extra return derived from the complexity – in terms of increased financial return, additional control, greater flexibility, tax savings, etc. – needs to be great enough to overcome the drag of increased administrative cost and time, and the risk of future obsolescence. Families need to think carefully about their wealth transfer goals – and the resources they are willing to commit to achieve those goals – long before they instruct lawyers to draw up documents. They should talk with families who have implemented similar planning about their experiences, and to their team of trusted advisors about the long-term ramifications of the planning. The point is to utilize complexity when it adds value, but with eyes wide open.

Next week: Part 4: Strategies for protecting key family assets

Wednesday, February 17, 2010

Thoughts on multi-generational planning - Part 2: Choosing the right fiduciaries

Who owns the assets in a trust? Most families who create a trust assume that “the family” or perhaps “the beneficiaries” own the assets, but in fact the trustee is the legal owner under common law. A trust can be an extremely effective planning tool, offering tax savings, asset protection benefits, and professional management of complex assets. But choosing the wrong trustee – putting the wrong person or group in charge of the assets - can put all those benefits at risk.

First, what does a trustee do? A trustee is responsible for investing trust property, administering the trust, and making distributions, all in accordance with the terms of the trust. A good trustee understands the scope and responsibilities of the role and takes those responsibilities seriously. A good trustee
• understands the grantor’s intent in creating the trust,
• knows the beneficiaries and monitors their needs, their other assets and sources of income,
• if not an investment expert, has the knowledge and experience to monitor investment professionals (and/or, in the case of business-owning trusts, business managers) effectively
• has the administrative capability (whether in-house or outsourced) to manage trust accounting, reporting and compliance.

Trustee candidates come in many forms – from individual family members to corporate trust companies formed by major international money-center banks, to private trust companies formed by families to serve as trustees of their trusts.
• Individuals often provide more personalized service than corporate trustees. A knowledgeable family friend or advisor often can bring a better understanding of the grantor’s intent and the beneficiaries’ needs, but may lack comprehensive investment knowledge or have limited access to investment and administrative resources. Individual trustees may charge lower fees than corporate trustees, but families should keep in mind that an individual trustee will need to engage investment and administrative service providers, and so the total cost for an individual trustee may be similar to (or even greater than) the cost for a corporate trustee.
• Corporate trustees typically offer a full package of services; many have served wealthy families for multiple generations and have developed strong teams. However, corporate reshuffling, promotions and career transitions often mean that team members may change frequently. Families should be aware that some corporate trustees will not serve as trustee of a trust holding interests in an operating business or other non-liquid assets.
• Private trust companies offer a family the opportunity to create their own custom-designed corporate trustee, which may be of significant value when trust assets include a substantial operating business or other unusual and nonliquid assets, but families should be forewarned that a PTC requires a substantial and ongoing investment in legal, accounting and administrative structures and systems and so should not be undertaken without substantial due diligence and planning.

Separate trustees can be appointed to handle certain specified trustee responsibilities, thereby enabling the grantor to custom-design the fiduciary team (at least on paper). Conceivably, a trust might have a directed trustee in Delaware, an independent trustee to handle distributions, a family trustee to share investment decision-making, provide oversight and ensure that the beneficiaries’ interests and needs are met, an investment trustee to oversee management of the trust’s portfolio, and a special trustee to manage particular assets (such as an interest in a startup venture). When dividing fiduciary responsibilities among a group of the trustees, the potential to achieve a custom-tailored structure needs to be weighed against the risk of creating an overlap between trustee roles, or worse, a gap.

Families often invest large amounts of time choosing a trustee, without giving much thought to successor trustees. Often, the issue of successors arises many years after the trust’s creation. How can a family ensure that the successor will be qualified and capable? And what provisions can be included to protect against an incompetent, ineffective or downright dishonest trustee? Probably the least effective option is to name successor trustees in the document, because the successor may not be alive or capable of serving effectively when the time comes. Almost as ineffective is to give the trustee the right to name his, her or its successor, a practice which can perpetuate poor trustees. Giving the beneficiaries of the trust the power to name the trustee can work in the case of capable, adult beneficiaries, but will not be so effective if the beneficiary(ies) are young (or otherwise legally incompetent), disinterested or otherwise incapable of exercising the power effectively.

A better option for solving the problem of trustee succession may be to name a protector for the trust. A protector may be granted a number of powers under the trust, but the most common is the power to remove and replace the trustee. With this power, the protector serves as monitor and overseer of the trustee, providing an important check-and-balance to the trustee’s power. The protector is typically a knowledgeable individual who knows the family well and brings applicable professional expertise to the role. For larger trusts, or trusts holding complex assets such as interests in one or more closely-held businesses, appointing a committee or an entity to the role of protector can be especially powerful; while an individual protector might become incapacitated or otherwise inattentive, a committee or entity, properly constituted, should be able to exercise its responsibilities seamlessly for the duration of the trust. The committee or entity serving as protector would have its own set of rules and procedures specifying its composition, responsibilities, decision-making procedures, and succession provisions.



Next week’s post: Thoughts on multi-generational planning – avoiding unnecessary complexity