Independent Thinking®

Delaware Direction Trusts: A Case Study

By Evercore Wealth Management
April 24, 2016

Consider a married couple in their early 60s who wish to create a trust to provide for their children and grandchildren. Like many people who have accumulated wealth, they have a large – and still growing – concentrated holding that they wish to preserve.
 
In this case, the couple wants to fund the trust with the husband’s general partner interest in a private equity fund, currently worth approximately $10 million but expected to increase significantly in value over time. The couple’s other assets are expected to generate sufficient income for their retirement, and they would therefore like to see the fund’s profits accrue to their children and grandchildren.
 
A traditional generation-skipping transfer trust, or GST Exempt Dynasty Trust, probably won’t help them accomplish their goals. The couple would need to empower the trustee with full discretionary authority over the investments in the trust, as well as over distributions – and a big part of the trustee’s responsibility is to diversify investments, in line with the Prudent Investor Rule. This would likely make the trustee very reluctant to accept the husband’s general partner interest in the private equity fund as the trust’s sole source of funding. He or she would instead propose transferring cash or other liquid assets to the trust, so that a diversified portfolio of stocks, bonds, REITS, and other customary trust investments could be created.
 
It’s a reasonable approach. But in this case, it’s not in the family’s best interest. In planning for their estate, the couple has already determined that it makes sense to transfer the husband’s general partner interest in the private equity fund now, as it has a high probability of increasing significantly in value as the fund’s investments start to mature. The unique value creation potential of this carried interest results in an effective way to leverage the couple’s gift tax exemption.
 
The trustee’s discretion over trust distributions could also prove problematic. The husband and wife would likely choose broad discretionary language to guide the trustee in making distributions to one or more of their children for their health, education, maintenance and support. No matter how carefully the language of a trust agreement is framed, future contingencies are unpredictable, and the decision over whether or not to distribute funds to the children (or grandchildren) would have been consigned exclusively to the trustee. The children could be required to jump through numerous hoops to demonstrate their need for funds, including detailed budgets and tax returns.
 
A better, more flexible solution for this family – and the many others in similar circumstances – is a Delaware Direction Trust. Delaware does not impose income or capital gains taxes on trusts administered in the state.1 Asset protection is arguably stronger in Delaware than in any other trust jurisdiction. Further, and particularly relevant to this couple, Delaware allows a trustee’s traditional duties to be spread across two or more persons. That means that a trust’s investments can be overseen by an investment advisor, and distribution decisions can be entrusted to a distribution advisor, both of whom would be empowered to direct the trustee’s actions in their respective areas of competence.
 
Delaware law allows a trust to hold almost any type of asset. The portfolio performance is based upon the entire portfolio, rather than on an asset-by-asset basis. In this case, the couple will be able to achieve their estate-planning objective of leveraging their combined GST exemptions while transferring the husband’s general partner interest in the private equity fund to the trust, in advance of its expected growth. While trusts drafted in other jurisdictions may include specific language regarding a concentrated asset (such as a family business or a large stock holding) to protect the trustee in terms of the amount of diversification required, the structure of a Delaware Direction Trust more clearly delineates the responsibilities of the trustee and investment advisor.
 
A trustor can choose a long-term financial advisor (including himself or herself) to serve as the investment advisor of the trust, to be entirely responsible for investing the trust assets. Interests in a limited liability company, limited partnership, real estate, or low basis stock are all investment options for a Delaware Direction Trust. The trustee in this situation takes on more of an administrative role, facilitating the trades, maintaining the trust account, and managing all of the tax reporting.
 
While a Delaware Direction Trust could include a traditional trustee role with regard to making discretionary distributions of trust income and principal, many trustors are opting for a more personal distribution advisor. A distribution advisor can be a longtime advisor, reliable friend or family member. This individual is entirely responsible for directing all of the distributions of income and principal not otherwise provided for in the instrument. He or she knows the family members personally and can respond to their needs appropriately.
 
The trustor may also choose to name a trust protector. This individual can also be a trusted friend, family member or longtime advisor. He or she can be granted the authority to make certain changes to the trust, to add or remove beneficiaries, to change situs or governing law, and to appoint, remove and replace the trustee. In other words, a trust protector has the power to make changes to the trust that will keep it aligned with the trustor’s wishes for many generations to come.
 
Delaware provides trustors with a different landscape for their family trusts. Families aren’t restricted to traditional trust investments, or waiting for discretionary distribution committee decisions. The ability to name investment advisors, distribution advisors and trust protectors enables them to create a trust that is custom-made to fit a family’s needs and wishes for the future.

1 Income is taxable if one or more of the trust beneficiaries reside in the state of Delaware.

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