Pitfalls and Risks When Your Client Owns Commercial Real Estate in an Irrevocable Trust

Long before he met you, your client bought his first piece of commercial real estate – that two-family house, apartment building, office building, or strip mall. At the time, he went to a real estate lawyer who advised him to take Trusts, wills, estate planningtitle to that real estate in an irrevocable trust so that it would be protected from creditors. That lawyer also told him that he could stay in control and be the trustee.

Now, decades later, the property is still in that trust, and after a visit to you and his new lawyer, the client now understands that this trust is included in his taxable estate in full.  After all, he made the down payment, he is the trustee, the primary beneficiary, and has been taking all of the income and deductions on his personal income tax returns.

For many business owners, the disposition of the real estate that houses the family-owned business, the apartment buildings, office buildings, or rental units the family has collected over the years is a troublesome issue. Planning is not as simple as it seems. In fact, planning for the future typically means going back to a hodgepodge of isolated transactions that occurred over a period of time.

How title is held and what type of vehicle it is held in – irrevocable trust, corporation, limited partnership, or limited liability company, is an issue that should be reviewed and examined from the viewpoint of income taxes, estate taxes, succession planning, and liability concerns and consequences.

When property is held in an irrevocable trust that was funded by the donor, and the donor retains the benefits of the property (the ability to receive income and/or principal distributions), and/or retains control over the property, it will probably be included in his taxable estate in full. If set up that way, it will also be treated as a grantor trust for income tax purposes and all income and deductions will flow to his individual income tax return.

When that donor dies, it will no longer be a grantor trust and will become a separate taxpaying entity. The trust probably contains what is known as a spendthrift provision, which protects the assets in the trust from creditors. However, in many states, spendthrift provisions do not necessarily mean the trust property is protected from the donor’s creditors while the donor is alive and a beneficiary of the trust.

Holding title to the real estate in an irrevocable trust presents another significant issue that may not be apparent from the document itself. The trustees of a trust have a fiduciary duty to not just the donor, but to all of the trust beneficiaries, including any other permissible beneficiaries during the donor’s lifetime and what is known as the remainder beneficiaries- those who will later take the benefical interest. The fiduciary duty of the trustees includes the duty to prudently invest and manage the trust assets. The concept of prudently investing and managing the trust assets is quite different from the concept of the business judgment rule, also known as the businessman’s risk.

In many states, the “prudent man” rule applies, and the trustee owes the beneficiary the fiduciary duties of skill, loyalty, diligence, and caution. Some fiduciary factors for the trustees to consider when managing investments include: (1) marketability of the trust property, (2) length of term of the investment, if a term is set, (3) duration of the trust, (4) probable condition of the market regarding the investment at trust termination, (5) probable market conditions for reinvestment of the proceeds if the investment is sold, (6) total value of all of the trust property and the nature of any other investments, (7) the needs of the beneficiaries, (8) other assets of the beneficiaries, and (9) the effect of any investment on the trust.

When operating under the businessman’s risk standard, trustees may choose investments that have a moderately high risk of losing value, but that also offer growth potential and capital gains, or sometimes tax advantages, rather than for the purpose of growing current income. Individuals can make riskier choices when they are dealing with their own investments rather than holding them in trust for the benefit of others.

When the business is owned by a trust, the prudent man rule for investments made by the trustees may conflict, in practice, with the business judgment rule that would control if the property were owned by a business entity, such as a corporation, limited partnership, or limited liability company. For example, when deciding whether to retain, mortgage, or sell one of its properties, the trustee must consider its fiduciary duty, rather than the lower standard that would apply to a businessman faced with those same choices.

Holding commercial real estate in an irrevocable trust also presents issues pertaining to income. For example, if the trust document requires all income to be distributed to the beneficiary (whether during the donor’s lifetime or after death), then the questions will be how to define income and what does the trustee have a duty to distribute?  Is it income for trust accounting purposes, for income tax purposes, or for cash purposes? If the trustee is to distribute all income each year, how can he hold an operating reserve? What happens with depreciation? What about reinvestment for repairs? How will the accounting be prepared?

From an estate tax point of view, if the value of the trust is fully included in the donor’s estate and he is married, does the trust say that his/her spouse is the lifetime beneficiary after the donor’s death? Does the trust qualify for the estate tax marital deduction so that there is the option to defer estate taxes until both spouses die?

When faced with the issue of a client owning commercial real estate in an irrevocable trust that no longer makes sense, there are remedial options to consider. One is to proceed to court and ask that the trust be reformed as it does not accomplish the donor’s intent. Trust reformations are permissible in many states and I have seen trusts reformed to ensure the marital deduction option, to add improved language for managing the property, and to handle the question of how income is defined.

Another option is to transfer title to a limited liability company that the trust owns. This would make it easier for the entity to obtain financing, since few institutions that sell their mortgages in the secondary market will issue mortgages to trust-owned real estate. It is also cleaner from a liability point of view in that the liability should be limited solely to the LLC assets. The LLC would be subject to businessman’s risk and all of the business decisions would be made at that level by the managers of the LLC and the terms of the operating agreement. The trustee of the trust would be dealing with the trust assets and would not be in charge of, or responsible for, the business decisions.

The term irrevocable does not always mean that the plans set in place decades ago are set in stone – rather there are mechanisms available that provide flexibility to bring those plans into current times.

 

Patricia Annino is a sought after speaker and nationally recognized authority on women and estate planning.  She educates and empowers women to value themselves and their contributions in order to ACCOMPLISH GREAT THINGS in the world – and in so doing PROTECT THEMSELVES, those they love, and the organizations they care about.  Annino recently released an updated version of her successful book, Women and Money: A Practical Guide to Estate Planning to include recent changes in the laws that govern how we protect our assets during and beyond our lifetime.  To download Annino’s FREE eBook, Estate Planning 101 visit, http://www.patriciaannino.com.

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