71 minute read
The Tacoma Bridge…and Other Planning Disasters
By Scott Johns
Scott Johns is the sole member of Johns Law Firm PLLC with offices in Juno Beach and Stuart, Florida.
The Tacoma Narrows Bridge was a suspension bridge in Tacoma, Washington, that opened in the summer of 1940 and connected the city of Tacoma to the Kitsap peninsula. Barely four months after being opened to vehicle traffic, the bridge started “fluttering” violently during a sustained wind event and ultimately collapsed into Puget Sound. From the moment the bridge was placed into service, people noticed that the bridge would move and warp vertically during windy conditions, which is not something you want from a bridge. Without getting deep into the physics, the problem was that the manner in which the bridge was constructed caused the windward side of the bridge to experience torsion, and the pattern of air flow under the bridge exacerbated the problem, generating “lift” underneath the bridge. (Think what would happen to an airplane if the end of the wing away from the plane were welded to a wall: the wing would try to lift and ultimately rip off of the wall.) In short, although the bridge may have “looked fine” when viewed in splendid isolation, the design of the bridge didn’t account for how aeroelastics (more basically, physics) would stress and eventually destroy the bridge once a sustained gust of wind came along. This article is meant to address a similar concept in estate plans: Things that may look or sound good conceptually on paper may collapse the moment you start stress-testing them with real-world applications.
Family Members Serving as Trustee, or “How to Ruin Thanksgiving Dinner”
We’ve all heard some iteration of the phrase “don’t mix business with pleasure” sometime in our lives. A more specific application of that sentiment, directed towards trusteeships, is this: Don’t select a trustee who risks damaging a positive personal relationship with a beneficiary by simply doing the trustee’s job. When discussing naming family members to serve as trustee of trusts for the benefit of other family members, we’re necessarily discussing the imposition of a business-type relationship upon people who until now may have had a purely familial relationship. We must be cognizant of the possibility that imposing this dynamic, even if temporary, can permanently affect the relationship in question, turning it from a positive or cordial relationship into something hostile and bellicose. What follows are some of the significant stress points to consider when naming a family member to serve as trustee. For purposes of this discussion, I shall designate “Uncle Joe” as the archetypical family member trustee.
My Framework for Individual Trustees, Generally
Though beyond the scope of this article, in my experience clients who want to name family members to serve as trustee do so because they either operate under a framework in which “professional trustees are too expensive” or believe a professional trustee adds unwanted “complexity” (which is facially nonsensical because the job is what it is regardless of who holds it). Although the value proposition of professional trustees is beyond the scope of this article, I will assert that most clients who have this view are operating within a framework in which they view trusteeships less as actual jobs and more akin to the task of performing carpool duty for shuttling neighborhood kids to baseball practice. If clients don’t think that trustee duties are a big task, they aren’t going to spend significant time contemplating the selection of a trustee. Further, and somewhat amusingly to me, the trustee’s identity ipso facto communicates the settlor’s mindset regarding trustee selection to all other parties involved.
Consider this: Suppose a client names Uncle Joe to serve as trustee. Uncle Joe has a lot going on in his life. He has a family and a job, along with all the responsibilities that come with them, and presumably spends his time on recreational activities or hobbies. When Uncle Joe learns that he’s been named as trustee, is he going to think that he needs to completely rearrange his life to handle his new responsibilities as trustee? No, he isn’t, and practice bears this out. He’s going to think something to the effect of “I have a family, a job, and hobbies. The settlor knew all of this when I was named to serve as trustee, so the settlor must think this is something inconsequential enough that I can work it into my life without jeopardizing my job or interfering too much with my family and my hobbies.”
Thus, I believe the best-case scenario for an individual trusteeship is that the trustee will treat the job as a not-too-important hobby. Consider this arrangement from the perspective of a beneficiary: Somebody left you money and selected a custodian for that money who will get around to caring about it once they’ve seen to their own workplace and family responsibilities, and probably also several of their own hobbies whenever free time is found. Is it surprising that a beneficiary would feel anything other than anxiety towards a trustee whom they think will act in a cavalier manner with “their” money?
Let’s suppose that Uncle Joe (rightfully) believes he has a positive relationship with all the trust beneficiaries. After all, he talks to them a few times a year and sees them at family events or around the holidays, and everyone seems to get along with one another quite well. That’s pretty good, isn’t it? Therein lies the rub; Uncle Joe’s relationship may be positive when viewed through the family prism, but that relationship is very different from that of a trustee-beneficiary relationship. The responsibility of determining when, why, and how much to distribute to beneficiaries can be succinctly stated (I just did it), but it can be very time-intensive and quite personal in practice. It may require acquiring information about beneficiaries and their relationships vis-à-vis one another that never comes up over Thanksgiving dinner (are the topics discussed at your own family holiday dinners more or less intense than your most serious conversations with your parents or children?). Will Uncle Joe really put in the time, reviewing the terms of trust agreements and consulting with a trust attorney to discuss what is and is not within the parameters of any distribution standards, to do the job properly? Will Uncle Joe spend significant time becoming intimately aware of the financial needs and family circumstances of other family members? Do those family members want Uncle Joe in their most personal affairs? Will they be completely forthright about their financial and family matters with Uncle Joe to allow him to properly do his job? If the answer to any of those questions is “no,” I believe we’ve failed from the start.
Within that framework, let’s move on to some specific problems that may arise, while keeping these questions just posed in mind. Note that in my opinion, once any of these problems arise, the damage has already been done, such that there isn’t much difference in result if beneficiaries have an easy path to removing and replacing Uncle Joe as trustee (in case you were thinking that removing Uncle Joe solves all problems).
Uncle Joe Steals the Money
This is obscene, but it happens. Remember that Uncle Joe has a job and family obligations. Maybe Uncle Joe has never earned more than $80,000 in salary in any given year. Suddenly, Uncle Joe has custody over several million dollars. That money could go a long way towards improving Joe’s own lot in life. Consider the myriad circumstances (and very easily made justifications) that could tempt Uncle Joe to stick his hand in this particular cookie jar:
1. Improving Joe’s lifestyle. “Man, wouldn’t my life be so much better with an extra forty grand? . . . Surely my sister knew of my circumstances and would understand me taking a few extra bucks for serving as trustee. . . . I think she knew this is an inconvenience and I’m doing her a favor. . . .”
2. The unforeseen expenditure. Maybe Uncle Joe’s roof popped a leak and needs to get replaced. Maybe Uncle Joe’s wife had a bad hospitalization and the costs aren’t fully covered by her health insurance. “It’s not like I’m going to make a habit of reaching into this money. I’m sure everyone would understand these are extreme circumstances.”
3. The “it’s really a family reserve.” Uncle Steve (you know, the brother of Uncle Joe and the deceased) just found out his daughter was admitted to Random Prestigious University, there’s no way Steve can afford to pay tuition on his salary, and he doesn’t want his daughter taking on mountains of student loan debt. “I’m sure my sister understands that this is a lot of money for her own kids. They don’t need it all. I’d be ok if I had died first and my sister did the same with my money.
All of these iterations of Uncle Joe taking money that doesn’t belong to him always seem to play out in the same way. If the amount Uncle Joe wants to take doesn’t look “too high” (in Joe’s completely-made-up-without-the-foggiest-idea-of-what-comparable-fiduciaryfee-schedules-look-like estimation), he’ll sneak that money out of trust funds under the rubric of taking a “standard trustee’s fee.” If the number is higher than Joe feels comfortable straight-face claiming as a trustee’s fee, “special or unique services” may be manufactured as a line item on an annual accounting (without any explanation of those special or unique services, naturally, and assuming an accounting is given). If the number is even higher than that, Uncle Joe may well dispense with providing accountings altogether or rely on the beneficiaries not wanting to be perceived as a “bad guy” by instituting a lawsuit. In any event, we’ve opened the door to the worst-case scenario: deliberate theft by the trustee and a burden on trust beneficiaries to institute a lawsuit against Uncle Joe to remove and surcharge him, and the speculative prospects of collection that come with such a lawsuit. (Uncle Joe may not be made of money; the money he stole may be spent and gone forever.) Regardless of the outcome of such a lawsuit, it’s unlikely that Uncle Joe will be welcomed at the dinner table next Thanksgiving..
Uncle Joe “Sets and Forgets” the Investments
I’m deliberately burying the lede on this one so that I can paint the picture and set the stage for the problem, all the while redundantly mixing metaphors. Suppose Uncle Joe, to his credit, engages with a financial advisor to handle the investments and portfolio mix, recognizing that his selection was probably geared more towards deciding when and why to make distributions and how much to distribute. Once Uncle Joe places the money with an investment firm, how much time (if any) is Joe going to spend conducting follow-up? In my experience, the answer is “none” or “close to none.” To the extent individual trustees have enough conscientiousness to engage a financial advisor, what often follows is a complete abdication of any further responsibility for investment performance (as in, they don’t really bother to see what the performance looks like at all). As with anything else, there are good and bad money managers. Though few individual trustees seem to recognize it, the onus for investment performance ultimately remains with the trustee. In the short term, reliance on a professional money manager may shield the trustee from any personal liability if issues are raised. But if review of investment performance would reveal poor performance, the trustee may not be able to hide behind the presence of a professional money manager beyond that point in time.
The problem in this scenario is that the practical responsibility for investment performance review falls upon the beneficiaries, the same as it would if a professional trustee were serving. If a professional trustee is serving, however, replacing the money manager is often relatively easy (if the trustee is also the money manager, consult provisions for trustee removal; if the trust is a directed trust, the beneficiaries often possess hiring and firing powers over the money manager). With an individual trustee, the beneficiaries must typically convince the trustee to fire and replace the investment manager, adding an extra step to the process, or they may need to seek removal of the trustee to then daisy-chain removal of the investment manager. Note that if the basis for their complaint is that the investments are being managed poorly, that poor performance is likely to continue during the pendency of litigation, further exacerbating their problem. Thus, we’ve created a problem that poor investment performance may not be rectified as quickly as it might be otherwise.
Worse Yet: Uncle Joe Ignores the Investments
This scenario happens a lot: The settlor did her own investing on a platform and had some heavily concentrated positions. Uncle Joe was nominated as trustee when the settlor died. Uncle Joe thinks his only job is dealing with the distributions and dismisses any responsibility for redeploying or diversifying asset holdings (“this is obviously what she wanted to invest in”).
Who cares what Mom wanted to invest in while she was alive? She was free to invest in whatever manner she chose when “what she wanted” related only to herself. Now that Uncle Joe is handling the money, he has responsibilities to beneficiaries regarding the investments whether he wants them or not. It is here that I will state the rules of risky portfolio allocation in an overly simplified manner: If the trustee beats the market, the beneficiaries win. If the market beats the trustee, the trustee is liable for breach of fiduciary duties (sounding in violation of the prudent investor rules).
Consider the following “hypothetical” (read: actual scenario): Lady dies and leaves her assets in trust for the benefit of her children. All of her assets are included in her gross estate for federal estate tax purposes so that we could sell off positions and redeploy at no or minimal tax “cost.” For simplicity, let’s say that the entire value of those assets is encapsulated in an investment portfolio. Approximately 70 percent of the value of that portfolio is concentrated in the stock of a company that builds, among other things, airplanes. For sake of the hypothetical, let’s call this company something nonobvious . . . like BA. The trustee assumes the trusteeship and does absolutely nothing regarding redeployment of capital within the portfolio (recall that all the BA stock could have been sold shortly after the settlor’s death and redeployed in a more diversified manner to safeguard against volatility). A couple of years go by and, by George, if BA doesn’t have a couple of its airplanes fall out of the sky. Over the next three months, BA stock drops in value by approximately 20 percent. Rudimentary mathematics tells us that a 20 percent loss multiplied by 0.70 (the value of BA stock relative to the whole of the portfolio) equals a 14 percent loss for the portfolio as a whole. Over the same period of time, the S&P 500 grew by approximately five percent. Congratulations! Your selection of a lazy individual trustee led to the beneficiaries experiencing a 20 percent loss when compared to the market as a whole. Is that really what we believe the settlor wanted? Decreased purchasing power for her family members? Unfortunately, this scenario plays out far too often when family members serve as trustee, and beneficiaries are left with an asset mix that more closely resembles a pile of lottery tickets than a sound investment strategy. Again, Uncle Joe may not be made of money, so there may not be any way to make up for that loss in portfolio value if he is sued. If Uncle Joe’s slacking off causes trust assets to tank, he’s almost assuredly not welcome around next Thanksgiving.
Wild Card: Uncle Joe Greases the Squeaky Wheel
It’s also possible that Uncle Joe may be inclined to take the path of least resistance when dealing with family member trust beneficiaries in an effort to avoid doing anything to cause detriment to a familial relationship. In this scenario, Uncle Joe administers the trust as a de facto pot trust (regardless of what the trust agreement actually says) and doles out money when and in the amount necessary to keep people from causing him anxiety and making any problems for him (remember, he has a job, family, and hobbies; the last thing he wants is headaches in his free time over other people’s money). Suppose his nieces Sally and Susan have competing beneficial interests in the trust. In the absence of Sally making a fuss about anything, isn’t it possible that the amount of money Joe distributes to Susan will be directly correlated with how often Susan bugs him for money? Once Sally finds out about this, she has a conundrum on her hands. If she complains, she risks looking like “the bad guy” for accusing Uncle Joe of bad action, and also invites a fight from Susan for daring to question when and why she needs money. Or she could become just as nagging as Susan to increase the frequency with which she gets money from Uncle Joe. This invites a “Thunderdome” situation to see who can badger the most money out of Uncle Joe before the money runs out. Now there’s potential for a three-way fight: Sally and Susan attack each other for their spending habits and also attack Uncle Joe for allowing all the money to be spent, and it’s anybody’s guess as to what the ultimate resolution is (there’s a strong chance that Uncle Joe made a bunch of impermissible distributions, but neither Joe, Sally, nor Susan has the ability to put money back into the trust if demanded, so the practical result is that nothing happens, possibly beyond Uncle Joe getting removed as trustee).
As a short aside, this presents a good guide for crafting distribution standards: If you insist on selecting a family member as trustee, the trustee will always have better “cover” from beneficiaries the less discretion the trustee is given. For all the myriad ways Uncle Joe might be tempted to disregard trust agreement terms for the sake of convenience, rigid distribution standards give Joe something to point to when, not if, a beneficiary complains about the amount of money he or she is receiving. This is perhaps the only time I’ll ever say this, but this is exactly the way you want Uncle Joe to be able to hide behind the statement “this is what your mom wanted” as a means of deflecting complaints about him not loosening the purse strings. Otherwise, this time it’s Uncle Joe who doesn’t want to be around at Thanksgiving, lest he be badgered with requests for money.
Uncle Joe Doesn’t Do Anything Obviously Objectionable, Yet We Have Problems Anyway
Suppose Uncle Joe does everything as bythe-book as can be expected: He secures sound asset management, engages an attorney to help review the trust agreement and discharge his duties, properly contemplates distribution standards anytime he makes a distribution, and sees that accounting and tax returns are timely delivered and filed. What happens the first time he denies a beneficiary’s request for funds? In my experience, beneficiaries assume the whole trust arrangement is a cockamamie game in which Uncle Joe rubberstamps requests for money whenever they want and they can hide behind the existence of the trust should they need to do so. (I can’t recall it verbatim, but I once heard a beneficiary say something to the effect of “this isn’t a ‘real’ trust; ‘real’ trusts have ‘real’ trustees,” which gave me a good chuckle.) Should Uncle Joe not rubberstamp distributions, beneficiaries get angry, and I mean “I’ve been betrayed!” Game of Thrones dynasty-style indignation. Sometimes, beneficiaries deploy dirty, war-of-attrition-style tactics to wear Uncle Joe down and nag him into resigning if he won’t give them money as they desire. Sometimes, they’re willing to scorch the ground and salt the earth of their relationship with Uncle Joe if that means getting some more walking-around money. While this is not true 100 percent of the time, I believe the notion that beneficiaries will get pugnacious at a family member trustee who doesn’t act as their personal patsy is close enough to being absolute that you can rely on it the same as the theory of general relativity and the Pythagorean theorem. Thus, even in the ideal situation, the intrafamilial relationship can get strained unless Uncle Joe acts like the beneficiaries are his boss. As with the previous scenario, Uncle Joe may want to avoid Thanksgiving get-togethers for the sake of his stress levels and sanity.
Penultimate Thoughts: How Much Cost Is an Individual Trustee Saving?
Overlaying all of these scenarios, the question arises: How much is the trustee to be paid for serving as such? Perhaps more aptly: How much is Uncle Joe insisting on being paid to make it worth his while? Consider a scenario in which the aggregate value of trust assets is $5 million. Consider a (very real-world) scenario in which a professional fiduciary who also provides investment advisory services might charge one percent for the money management only and 1.25 percent to serve as trustee and do money management. The difference between those two figures is $12,500, meaning cost savings are achieved only if Uncle Joe takes less than that amount. If Uncle Joe is in the 22 percent income tax bracket, savings are achieved with Uncle Joe’s trusteeship only by his walking away with $9,750 or less. What’s the likelihood Uncle Joe agrees to take such a small fee? Even if Uncle Joe takes a small fee, are we getting any actual value from Uncle Joe’s service, or are we sacrificing competent job performance so that we can shift some money from a professional trustee’s coffers into Uncle Joe’s wallet? Even if Uncle Joe waived fees for his service, do we want to burden Uncle Joe with the responsibility of service, and inject all the potentialities just discussed, just to save a few thousand dollars on professional trustee fees? When a client says, “it’s too expensive,” what they’re really saying is, “I haven’t thought about it and don’t want to be bothered with thinking about it.” Make them think about it because it’s usually worth it to the beneficiaries.
Final Thoughts: Perverting a Relationship
Ultimately, I believe there are only three ways a family member trusteeship plays out: One, a party (be it the trustee or beneficiary) is afraid, embarrassed, or reticent to ask about distributions because that’s more personal than one of the parties is prepared to get, and trust administration functions akin to setting a car in neutral and pushing it down a hill because somebody prevents serious information from being collected that would allow administration to function in a useful manner. Two, emotions rule the day and Uncle Joe and the beneficiaries engage in a longgame fight about who has the power. (Uncle Joe doesn’t want to be told how to do things by beneficiaries, and beneficiaries don’t like Uncle Joe functioning as a de facto parent from whom they need to request money, and all the legalities get thrown by the wayside.) Three, Uncle Joe does rubberstamp distribution requests, which gives divorcing spouses and other creditors of a beneficiary an opportunity to take a poke at trust assets, via routes such as the emerging and re-emerging doctrines of “de-facto trustee” or “sham trust,” or alternative theories of recovery that perform end-runs around statutory prohibitions on attachment of beneficial interests in trust such as writs of garnishment. (See, for example, Berlinger v. Casselberry, 133 So. 3d 961 (Fla. Ct. App. 2013), a case from Florida’s Second District Court of Appeals.) All of these scenarios strike me as bad options, so I recommend none of them.
Few people ever seem to consider that their children and their uncles or aunts have precisely the relationship that they have for a reason: at least one of the parties didn’t consent to it being anything more than what it is. Putting one of them in charge of money for the other fundamentally and permanently alters their relationship. Consider something as banal as asking the trustee for money to go on vacation. Might Uncle Joe inquire about, and then pass judgment on, the vacation activities themselves? Do the beneficiaries worry about Uncle Joe getting personal with them and blathering about frivolous or reckless spending? Might Uncle Joe think the beneficiaries are spoiled jerks if the nature of the request is expensive? Might the beneficiaries find themselves haggling with the trustee over the minutia of the trip (you get a three-star hotel, not a five-star hotel; you can go for four nights, not seven; etc.) Might a beneficiary feel guilty for asking for money at all, as if asking for the money constitutes “flaunting” it to Uncle Joe? Might a beneficiary refrain from asking solely to avoid awkwardness with their uncle? Might the existence of all these questions suggest there are too many opportunities for fights to happen over answering these questions such that you shouldn’t pervert a relationship between the family members at issue by naming one of them to serve as trustee?
How many of you, reading this article, have ever had an in-depth conversation with a family member (other than a parent or child) about how much money you were making, or wanted to spend on something and why you wanted to spend it, or how you were allocating your disposable income among yourself and your family and their wants and desires? I don’t think it happens very much, and for good reason, so let’s try and keep it that way. For your client’s benefit and the benefit of their intended beneficiaries, I encourage you to dissuade your clients from nominating family members to serve as trustee; that way when everybody gets together at Thanksgiving, the only reason anybody fights is because they got to talking about movies and somebody made the imbecilic assertion that Die Hard 2 was the best John McClane film. (With apologies to the late Alan Rickman, who absolutely crushed it as Hans Gruber, the answer is Die Hard with a Vengeance; all other answers are wrong.)
Tarnishing a Relationship to the 74th and a Half Power—Naming a Spouse or Child of a Second(or Third, or Seventh) Marriage to Serve as Trustee
The above-cited phrase is a common predicate in marriage vows and is intended to convey the message that the death of one of the parties to a marriage ought to be the only thing that terminates the vows made between spouses. There are two things about this framework that are critically important to note. First, nobody is making any promises to somebody else’s kids. Second, they openly state that the internal logic acknowledges that any promises made to anybody go out the window as soon as one of the spouses dies. If you’ve ever attended a wedding at which you recall one of the participants making a vow to the effect of “if you die first, I promise not to spend all of your money so that your kids can have some of it once I’m gone,” please write to me. To the extent hostilities between stepparents or stepchildren can hide themselves when everyone is alive, those hostilities come out to play once the topic of “who’s going to get the inheritance money?” is broached. With that framework in mind, very serious attention needs to be given to fiduciary appointments in second marriage situations in which an estate plan calls for children to receive some or all of a parent’s money only after the surviving spouse (who is not their parent) dies. Most commonly, this dynamic appears in the form of a marital deductiontype trust for the benefit of the settlor’s spouse, of which such trust the settlor’s children are the remaindermen, so that is the scenario to which I shall apply the following themes. (If any of you grant the surviving spouse beneficial interest in a bypass trust, consider the following themes equally applicable.)
Perhaps the strongest “rule” I can offer regarding trustee selection is this: You should never select a person to serve as trustee who has incentive to disregard or pervert the trustee’s directives. In this case, all the beneficiaries who might serve as trustee have double incentives to pervert the trustee’s directives (more money for them AND spiting somebody they don’t like). Consider a typical 2056(b)(7) QTIP trust in which discretionary invasion of principal subject to an ascertainable standard is also permitted. In this scenario, there is strong incentive for perverting fiduciary directives.
If the surviving spouse is sole trustee, there’s a seemingly sensible rationale for that individual to think, “if I were really supposed to be restricted in accessing the money, why is it that I’m the only person who can access it?” Thus, self-serving financial interest and lack of interest in trust law particulars can lead the trustee-spouse to disregard the terms of the trust agreement entirely and simply take money whenever and for whatever reason the surviving spouse desires. If the surviving spouse surrenders to this temptation, further abdication of other fiduciary responsibilities (such as failure to render accountings) is sure to follow. Why would we expect the trusteespouse to inform the beneficiaries of how much money is being spent if the trusteespouse has already rationalized away any trust formalities? By this point, “accounting and information reporting” has been reinterpreted as “it’s none of their business how I spend the money” in the mind of the trustee-spouse.
In practice, this fiduciary selection encourages a scenario in which principal is spent impermissibly for the benefit of the surviving spouse and the remaindermen’s only recourse is to sue their stepparent trustee to produce accountings and, if the accountings reveal malfeasance, put the money impermissibly taken back into trust (known as a “surcharge” action). There are a myriad of problems in this scenario: (1) the stepparent may not have the money if the principal impermissibly taken was spent on current expenditures and (2) if principal distributions were permitted but limited by an ascertainable standard, the burden is on the remaindermen to show that distributions were made in excess of the standard, meaning any litigation will revolve around the fact-intensive inquiry of what the outer bounds of the ascertainable standard is and whether the surviving spouse exceeded those bounds in taking money from the trust. Add to this that the remaindermen will have to fund their own lawsuit unless they win AND get an award for attorney fees, but even then, they may not be able to collect. Think about it: If the trustee-spouse was taking funds for current expenditures, that individual may not have had other resources, and that money is likely gone. Thus, there’s a good chance that the trustee-spouse’s only source of assets with which to satisfy an order to pay the opposing party’s litigation costs are the assets impermissibly taken from the trust. All in all, my candid assessment of an “all to marital deduction trust with surviving spouse as sole trustee” plan is really a “my surviving spouse can run rampant with trust assets and it’s on the remaindermen to spend their own time, money, and intellectual and emotional capital to ensure the surviving spouse complies with the settlor’s wishes” plan. That doesn’t sound like a good plan to me.
Alternatively, if we appoint the remaindermen, we’re appointing the people who stand to gain by seeing that as little as possible is distributed to the surviving spouse. In this scenario, the myriad problems that present themselves are (1) negligent or deliberate failure to distribute income on the annual (or more frequent) basis required by the trust agreement; (2) bad faith refusal to exercise discretion over principal distributions; (3) improper invasion of principal for the benefit of the remaindermen, who are not themselves current permissible distributees, which has the compounding deleterious effect of reducing the value of principal from which income can be generated; and (4) greatly increasing the cost of securing enforcement by the surviving spouse (think: if the surviving spouse doesn’t receive distributions, that individual has less available money with which to fund a lawsuit over not receiving distributions . . . a bit of a downward spiral, isn’t it?). My assessment of the “all to marital deduction trust with remaindermen as trustee” plan is that we have the same fundamental problems, simply with the roles reversed: The remaindermen have incentive to shut off the money valve whenever they want and the surviving spouse has to spend time, money, and intellectual and emotional capital to ensure compliance with terms of the trust agreement. This doesn’t sound like a good plan either. To recap: If you give fiduciary duties to the economically inferior party, the upshot of taking money for themselves may outweigh any perceived costs of noncompliance with terms of a trust agreement. If you give fiduciary duties to the economically superior party, they may perceive that the economically inferior party can’t afford to bring a lawsuit to force compliance, thus giving them some upshot to ignore the terms of the trust agreement anyway.
This spouse/remaindermen discussion to this point has admittedly presumed a bad relationship between current distributees and remaindermen and bad faith action by the trustee-beneficiary. But I submit that even if the relationship is positive or neutral and the trustee isn’t acting in bad faith, things that the trustee would do in the ordinary course of action can be interpreted as bad faith because the existence of the trustee having a beneficial interest means that actions taken that benefit that interest necessarily look like self-serving actions. Consider the following scenarios, in which the action taken would probably be considered prudent by a trustee who didn’t hold a beneficial interest:
1. “I’m not getting enough income.”
You’ll be hard pressed to find a surviving spouse receiving a mandatory income interest who doesn’t simultaneously think that no amount of income is too high and the amount of income being generated currently isn’t enough. This is due to some curious elements of the human condition in which people (1) like free money and (2) prefer not needing to ask somebody for money over needing to ask somebody for money. As a consequence, income beneficiaries tend to not only believe that the value of their income interest at the time of trust inception is a hard “floor” below which their interest may never fall, but that they are also entitled to growth of that interest with time (in my experience, this is usually because nobody ever spent time with the settlor or beneficiaries discussing the specifics of distribution standards, failing to articulate the difference between income and principal, and failing to discuss growth drivers for assets under administration). If a trustee-beneficiary sells off a stock with an otherwise high-yielding dividend because the market value of the stock is about to crater, the income beneficiary can’t help but conclude this was an “excuse” to take money away from the income beneficiary and give it to the remaindermen. If principal value jumps up 15 percent, but the income interest doesn’t experience a commensurate increase, the income beneficiary can’t help but conclude there’s some “shady investing” going on that disproportionately benefits the remaindermen. If the income beneficiary’s cost of living (inflation, anyone?) goes up but the income interest doesn’t pace inflation, the income beneficiary will feel like his present ability to pay for things is being sacrificed for the benefit of the remaindermen.
2. “Principal isn’t keeping up with the market.”
On the flipside of things, you could have a portfolio that isn’t growing with the market, such that time-value-of-money considerations are causing the remaindermen’s interest to suffer. The two ways in which this scenario most frequently arises are when the settlor held positions geared towards income generation and the trustee never bothers to examine whether portfolio allocation ought to be changed (similar to “Uncle Joe ignores the investments,” discussed earlier) and when a trustee-beneficiary holding an income interest deliberately seeks out investments that lock in a high-income yield and doesn’t care much what happens to principal (I’ll be dead when that money’s spent, so what do I care?). Both scenarios look like the trustee is sacrificing principal value to secure current income (which is true). It doesn’t help very much what the trust agreement says once beneficiaries get angry because a trust agreement can at best give you guidance as to how the interests should be balanced. The raw numbers of rates of return are always subject to being viewed through the lens of trust agreement guidance and attacked as “not following the guidance,” so having a trustee with “skin in the game” making the decisions necessarily invites charges that the guidance isn’t being followed.
Family Member Trustee Wrap-up
Any personal or legal battles over whether a trustee’s actions are prudent are going to involve claims that the trustee’s identity is ipso facto proof that the actions taken weren’t prudent. By naming an independent trustee in office, you can take these types of “unclean hands” arguments off the table; have we never seen a trial court decision in which the fact-finder decided that somebody was a “bad guy” and reached the decision they wanted regardless of whether the factual circumstances supported that decision?
Naming BOTH the surviving spouse and kids to serve as co-trustees isn’t a great solution either. To the extent you have more than three trustees who can act by majority, there’s no point naming the surviving spouse because the surviving spouse is getting outvoted every time, and if you name a spouse and remaindermen as co-trustees and require unanimity for action, you’re likely rendering the office of trustee as incompetent to act as the US Congress after most midterm elections, as the surviving spouse and kids will be diametrically opposed to one another on most actions (though, at least in this latter scenario, you can probably minimize the risk of the mandatory income interest not being distributed in a timely manner).
Friends don’t let friends serve as trustee for one another. Get a professional trustee when you can, and if the settlor refuses to go that route, at least find somebody who isn’t going to have his judgment clouded by having a personal stake in what happens to trust assets.
Lifestyle Restrictions on Beneficiaries
The problems in this section all arise because the settlor is demanding directives that are informed by emotion. Emotions are, by definition, disassociated from reasoning or knowledge, so allowing clients to dictate trust agreement provisions driven by emotion is often tantamount to drafting trust agreement provisions that don’t make any sense. As will be shown, because these concepts are driven by emotion, little thought is often put into them. Once we think about them for a bit, we find they’re either very difficult—or impossible—to practically implement.
The “I Don’t Want My Wife Seeing Other Men” Restriction
The first situation I want to address is one I’ve seen and heard more often than I’d like, and it arises when a client develops anticipatory enmity, directed through the time-space continuum, towards the client’s not-yet surviving spouse’s “replacement” spouse or paramour. In an effort to keep that rapacious and duplicitous scoundrel, who shall not become known until an indeterminate future time and place, from insidiously worming his way into the client’s money via romantic interludes with the client’s spouse, the client has already concocted a plan: “My spouse can use the assets . . . UNLESS. . . .”
That “unless” is invariably aimed at making the surviving spouse take the Benedictine monastic vows: unless my spouse starts “dating” somebody or “cohabitates” with somebody, coupled with a directive that no money be spent on any activity in which our hypothetical conspiring philanderer might indirectly benefit (no flights, no lodging accommodations on vacations, etc.). Invariably, the client’s idea for how to go about implementing these restrictions is as well-constructed as a Wile E. Coyote roadrunner-catching contraption.
There are myriad problems with attempting to impose such conditions on gifts to a surviving spouse. First, as with any condition, it is imperative to define the condition in an objective and unambiguous manner. If your condition is couched in subjective terminology, or if reasonable people can disagree over the meaning of your seemingly objectively worded condition, there’s a strong chance you will wind up with a judge saying that your “condition” is unenforceable. Second, it is equally important to create a framework by which the satisfaction or failure of the imposed condition may be pragmatically measured or observed. Erwin Schrödinger would tell you himself that observing a cat inside of a box proves difficult if the box is opaque.
To illustrate the problem with trying to condition gifts to a spouse based upon that spouse’s subsequent romantic endeavors, let us examine the condition that the surviving spouse will have access to money unless she “cohabitates” with another man. How in the name of the gods of the Uniform Trust Code is anyone to define what “cohabitates” means to determine if the wife’s beneficial interest fails? What if she’s spotted with somebody on the street acting a bit too giggly? What if she’s spotted at dinner with somebody? Are we to count the number of hours she spends on a daily basis with another person and where that time is spent? Are we hiring a private investigator to stalk this person 24/7 so we can log these hours? Once questions such as these are raised in an effort to illustrate the impossibility of crafting bright-line rules, client pushback invariably devolves into an appeal to draft some vague, ethereal, Potter-Stewartian “I know it when I see it” standard, leaving the planner in the unenviable position of trying to explain why drafting “make it up as you go along” rules are a bad idea.
Clients who are quick on their feet have occasionally attempted to throw my objections out the window by modifying their request to the indisputably objective measurement of “remarriage.” Although this condition satisfies our requirement of objectivity (some iteration of requiring documentation from a governmental body recognizing marriage between two people), this condition cannot be pragmatically measured or observed unless that information is volunteered. Who is to be responsible for determining whether this condition has been satisfied? Let us immediately dispense with the notion that the spouse should be responsible for proving that she isn’t married, as such a framework invokes the hallmark logical fallacy of demanding that somebody prove a negative. (What’s she supposed to do . . . annually acquire letters from every recognized governmental body on the planet stating they can’t locate a marriage certificate?) The best I’ve thought of is requiring the spouse to produce an income tax return, which may indirectly serve as evidence of remarriage if a joint 1040 is filed, and that game is foiled if the surviving spouse does the married-filingseparately angle. Moreover, there are a lot of additional problems involved in requiring the surviving spouse to produce an income tax return as a precondition to eligibility for distributions.
This leaves either the trustee, other beneficiary, or third party with the responsibility of proving that a marriage exists at any point in time. How is the trustee supposed to prove that? Spend time scouring public records, hoping to discover a marriage certificate? This says nothing of the fact that marriage licenses are confidential in several states and countries; what if the spouse chose to have an exotic, “destination” wedding halfway around the globe? Is our trustee to enlist the services of Remington Steele to fly around the world hunting for marriage certificates? (I get Pierce Brosnan may need the work, but this feels unrealistic.) This concept is entirely impractical as it lacks any realistic means of enforcement.
Oh, and I almost forgot . . . imposing such conditions also renders the gift ineligible for the federal estate tax marital deduction, if you care about such trivialities. If the client really loves his spouse, the client should drop the pettiness of caring what the spouse does after the client’s death. If finding a new romantic interest makes the surviving spouse happy, why would you want to make the surviving spouse choose between money and new love? That amounts to emotional extortion. You shouldn’t do it, and you cannot practically do it . . . so don’t do it.
Drug Testing or Substance Abuse Restrictions
I personally find the desires of clients who endeavor to prevent beneficiaries from taking inherited money and putting it up their nose to be well-intentioned. But things get confounded in a hurry when trying to incorporate those concerns into trust provisions. Further, I submit that whether a client has a well-articulated concern (“Jimmy does cocaine”) or is merely chasing ghosts of prospective addictions, it makes no difference from a drafting perspective.
I hope the following series of hypotheticals will reveal that attempting to condition a beneficiary’s eligibility for trust distributions upon determinations of a beneficiary’s use, or abuse, of drugs requires a lot of parts that are difficult to move from the realms of the subjective to the objective when framing the parameters or are otherwise impractical in terms of identifying the existence or nonexistence of the condition so imposed. Importantly, note that any condition is only as strong as its weakest component, so if any one of these fails, the whole condition fails.
Defining the Concern
To begin, I have never had a client who was able to articulate concerns about drugs with precision. In every event, the initial analysis seems to be little more than:
1. “Drugs” = “bad”
2. I don’t want my money spent on “bad” stuff.
3. Don’t let the beneficiary have money for drugs.
Fundamentally, the issue is that filling the first gap in logic, namely, “what is a drug,” always proves very difficult because any objective standard either deliberately excludes things that we would want to count as a “drug” (which defeats the client’s end-game) or includes within its ambit things that at this point are deemed socially acceptable (which leads us into the realms of trust law dealing with public policy overrides on restrictions desired by the settlor).
When pressed on this topic, clients frequently respond with some level of indignation that I don’t immediately recognize what they want (“isn’t it obvious?”). It is not obvious because colloquial word use doesn’t play well in trust agreements. We need something hardlined and absolute, and defining “bad things” is a fool’s errand. The rub lies in
determining not only what those bad things are, but also when “bad” is “bad enough” and how to measure “enough” such that we should be prohibiting trust distributions once we’ve reached “enough.” With that, let’s take a trip down the rabbit hole where I take clients who want to include substance abuse provisions in trust agreements, shall we?
First Stumble: What Are “Drugs”?
The first problem arises is attempting to define what constitutes “drugs.” “You know . . . drugs!” No, I do not know . . . and neither does the trustee. This is of fundamental importance because conditioning eligibility to receive funds on using “drugs” suggests that money may be directed to one person instead of another based upon a determination of whether drug use is present (and we know that if the trustee makes an incorrect call, another beneficiary may be waiting to institute a breach lawsuit). Before we can start telling beneficiaries they’ll be punished for using drugs, we need to know what items make the list of “drugs” and to what degree their use will affect distribution standards. Invariably, this segment of the conversation either winds its way into clients constructing a nonexhaustive list of drugs they can identify—if we’re doomed to argue about whether something is “like” items on a list, we may as well not have a list—or takes turns down culture alley (what is or is not acceptable today), which is as fluid and changing to me as the image perceived with every incremental turn of a kaleidoscope.
Second Stumble: “Illegal” Drugs
How about marijuana usage . . . is that acceptable? Marijuana was, and allegedly still is, illegal at the federal level, but a lot of states have “decriminalized” it. As of this writing, 38 states permit use in some manner. If legality is a moving target even for the people charged with enforcing laws, how useful a metric can it be for the rest of us? If a beneficiary uses marijuana in a state such as Colorado, where consumption is “legal,” do we ignore usage? What if the beneficiary crosses state lines into Wyoming, where consumption is illegal? Should we do something about the beneficiary’s usage now? Already we see that trying to use legality as our metric allows the whims of various legislatures to overlay some arbitrariness on our trust agreement.
Further, why should legality of the substance matter at all? I thought we were concerned about beneficiaries doing “bad things” to themselves. There are all sorts of legal things that work deleterious effects on people’s minds and bodies. Don’t we hear or read about drunk-driving-related deaths all the time? Is it not conceptually possible that somebody who regularly consumes alcohol is doing worse things to his body than somebody who occasionally snorts cocaine? Nobody’s sought to outlaw beer and liquor to counter these problems, to my knowledge. Further, what if one day heroin becomes legal? Does that now become something our beneficiary can acceptably consume in large quantities? These questions demonstrate that trying to define our parameters around the legality of substances at any given time produces an epic failure, in that our metric will achieve the client’s goals only occasionally and, even then, by dumb luck.
Third Stumble: Lifestyle Impairment
After having attempts to blow past the issue without needing to devote any intellectual capital with the “illegal” patch job, clients attempt to get around my “illegality” hang-up by expanding the panoply of substances with which we concern ourselves by redefining drugs as “things that impair a beneficiary’s ability to function in society.” Holy subjectivity, Batman! Now we need to figure out what “impairment” and “function” mean within this framework. What constitutes impairment? How are we measuring how well a beneficiary is “functioning” in society, and even if we determine that a beneficiary isn’t “functioning” optimally, how do we know with certainty if it’s due to substance use?
Consider the hypothetical of a beneficiary who consumes a handle of vodka every night but is otherwise able to hold a steady job without repercussion. Does this constitute “substance abuse”? One could argue the beneficiary in this hypothetical is “abusing” alcohol, in that said beneficiary’s liver is being stressed harder than Atlas’s shoulders, but this argument shifts the goalposts from our framework of evaluating the beneficiary’s functionality in society (that is, vis-à-vis other people). If we’re sticking to a “function in society” type of metric, and if there are no observable consequences of substance use that we would interpret as evidencing adverse effects on the beneficiary’s lifestyle, do we really want to be shifting or infringing upon beneficial interests? If we do, then what we’re really saying is that a third party gets to make a value judgment on a beneficiary’s consumption. This leads to inquiries about how much consumption is too much consumption. I don’t have a good answer to that question, so I don’t bother trying to answer the question at all. It’s not like the trustee can acquire all the world’s supply and ration it to the beneficiary consistent with the trustee’s liking, or be around the beneficiary 24/7 to determine how much is in the beneficiary’s system at any given time.
Fourth Stumble: “Abusing” Drugs or Substances
By now, clients are focused on attacking the strawman I’ve just created, namely, the heavy-substance-consuming-yet-otherwise-high-functioning beneficiary. “But he’s abusing drugs!” Great . . . what does “abuse” mean? Abuse is a very nondescript word that functions better as a colloquial descriptor rather than something signaling objective measurement (another iteration of the Potter-Stewartian “know it when I see it” concept). The primary definition of “abuse” in noun form is “the improper use of something.” Considering that the explicit purpose of many drugs is to alter your state of mind, a wordsmith might cheekily argue it’s impossible to abuse drugs because they’re being used precisely for their intended purposes. At the other extreme, it could be argued that the usage of something that’s designed to screw you up is always improper (what, pray tell, is a “proper” use for heroin?). Look at that; I’ve created a conundrum where substance use can simultaneously always and never meet the definition of abuse. So . . . if this definition of “abuse” doesn’t work, what definition should we use?
What if we try defining abuse as usage that is “detrimental to one’s health,” or some iteration thereof? Doesn’t this lead to a similar semantic or linguistic argument? Lots of stuff is detrimental to one’s health. Ask yourself if there is a meaningful distinction, within this framework of substance abuse, between a person who develops liver failure from alcohol consumption and a person who becomes obese from chocolate bar and soda consumption and ultimately develops type 2 diabetes. Has anyone ever heard of somebody being sent to a detox center to be weaned off Skittles and Kit-Kats? Have you ever seen a trust agreement that forbade eating candy? Where do we draw lines of demarcation between any number of things that might ultimately be detrimental to one’s health? Using this type of framework is a bit like searching for leaves in a forest: You can find them everywhere.
Lastly, the concept of abuse speaks to the state of mind of the user, yet typically the client is focused on the consequences of the use and couldn’t care less about the intentions of the user. (We’ve moved past the client’s disingenuous “I don’t want the beneficiary hurting himself with drugs” framing into the more honest “I don’t want him using my money on drugs and that’s the end of it” portion of the proceedings by now.) Now this starts to look like we’re exactly wandering into the realms of passing moral judgments on our beneficiaries and trying to police their conduct with a trust-agreement-specific moral code. (Again, consult the “void as against public policy” jurisprudence in your jurisdiction.)
Fifth Stumble: Have the Doctor Test Them! (Addiction Determination)
Finally, we arrive at “send them to the doctor and the doctor will decide.” If the client doesn’t arrive at this concept on her own, I make it a point to direct the client’s attention to this. Deferring to the determination of a medical professional seems appealing, as if by farming the determination out to a third party, we’ve rid ourselves of the problem of trying to define it inside a trust agreement. But we’ve merely substituted one problem for another. When, why, and how often are we sending a beneficiary to the doctor’s office?
When and why are we testing the beneficiary? If the trustee doesn’t have a cognizable basis for believing drug use is an issue, incorporating such provisions into an agreement is just a nuisance play, as it literally becomes instituting a solution in search of a problem. Either a trust agreement is going to provide, in some form, that submission to drug testing is a prerequisite to being eligible to receiving distributions, which means people are being punished in advance for things they may not have done, or testing will be a discretionary call made by a trustee or third party. Who wants to be the person who decides whether to accuse somebody else of being on drugs? If you’re wrong, you’re the person who falsely accused the beneficiary of being on drugs. That’ll do wonders for your relationship going forward. I definitely don’t think the beneficiary will spend time trying to find ways to screw with the trustee as a retaliatory measure; no chance of that happening at all.
Who is paying for the visit? Don’t assume outsider-forced drug testing is paid for by insurance. Who picks the doctor? How much time does the beneficiary have to schedule an appointment to see this doctor? How is the trustee getting access to the doctor’s notes and records? That’s right; you’ll need the beneficiary to sign a HIPAA authorization so that the trustee can see those records. Beneficiaries LOVE giving people their medical records all because somebody is paranoid about drug use that isn’t happening, in my experience. Oh wait . . . no, no they don’t.
Let’s also consider an issue beyond our control: What if the doctor, or the doctor’s employer, doesn’t want any part of this? Physicians are probably glad to examine people who come seeking treatment for themselves. But what if the person comes saying, “I’m not on drugs or abusing them; I just need somebody else to say so.” Does the doctor want to jeopardize getting sued over making a judgment call that didn’t actually relate to treating a patient? More pointedly, now that a lot of physicians are leaving private practice and becoming hospitalists . . . do you think the owners or board members of the hospital system are going to allow the employees to meet with people to make determinations that are wholly unrelated to the hospital making money by treating people, and only serve to expose the hospital to being dragged into somebody’s private trust-related lawsuit? I suspect that the notion of seeking physicians to opine in this area have gone the way of the dodo; it simply isn’t obvious yet.
Sixth Stumble: Testing Frequency
How often is a beneficiary to be tested? By engaging in the exercise of asking the question, we’re necessarily thinking past the sale of creating a dynamic between our trustee and beneficiary akin to that of an ex-convict and parole officer. I can’t think of anything more condescending and humiliating than forcing somebody to get drug tested before they’re allowed to get a check. What if the beneficiary tests negative? Does the trustee get to keep sending him off to get tested every so often just because? If we suspend the ability to force testing after a negative test or two, doesn’t that inform the beneficiary he has a green light to start using drugs if he wants to do so? What if a beneficiary tests positive? Are we shutting off the money valve completely, or might we want to spend some of that money on treatment to get the beneficiary off drugs? How many questions do I have to ask for which there aren’t good answers before it sinks in that this is a very, very, very, very, very stupid idea?
Final Thoughts on Drug Testing
The whole exercise of trying to address drug use inside a trust agreement ultimately boils down to two scenarios: (1) the client worries that a beneficiary will develop problems with drugs or (2) the client has advance knowledge that a beneficiary has problems with drugs. The crux of my position is that there isn’t a meaningful difference from a trustee’s perspective between either of these scenarios, so who cares? Things that have happened in the past are irrelevant for the specific purpose of distributing funds currently or in the future (unless we believe that nobody in human history has ever ceased with drug use). Nobody ever knows when and if somebody will develop a dependency problem, and the state of things at the time of distribution is all that matters. Whether a beneficiary has a known substance abuse problem gives the trustee more reason to look for a problem, but it doesn’t change the difficulty associated with finding the markers that signal that a problem exists right now, when we’re thinking about distributing money.
Clients miss the mark on this because they think about it through the prism of what they do with their money. They can be as arbitrary with their money as they want, so they can absolutely tell somebody who is asking them for money, “go get drug tested first,” and then deal with the ramifications of that demand on the fly. Clients are never bound by rules when giving out their own money, so they don’t appreciate the situation into which they’re attempting to place others. Clients always focus on the problem (“I don’t want my money spent on drugs”) but also summarily discharge themselves from spending any time considering how to solve the problem (“that’s why I’m paying you”). If the concept of punishing a beneficiary for drug use is to be given any teeth (reduced or eliminated benefits), then a trustee who fails to identify drug use runs the risk of being liable to whomever would stand to benefit if a drug-using beneficiary’s beneficial interest is reduced or eliminated. However, trustees can’t spend their days following beneficiaries around “life policing” them. Thus, we invariably create a scenario where a trustee is heavily incentivized to safeguard the office of trustee by acting paranoid and making our beneficiary submit to testing even absent subjective suspicion of drug use.
If drug testing is a concern, address it indirectly. Make distributions purely discretionary (this gives the trustee a lot of flexibility and avoids the imposition of rigid rules about how testing does and doesn’t work to determine eligibility for distributions) and authorize the expenditure of trust funds for treatment so that IF you find a beneficiary who is using drugs, we can seek help. Ultimately, recidivism is a common problem with drug users, so the uncomfortable reality for many a settlor is that we need to decide whether we’re cutting a beneficiary’s eligibility for money, cold turkey style, if drug usage persists, or if we’re going to live with the fact that drug usage is a part of a beneficiary’s lifestyle.
Attempting to Effectuate Corporate Actions Within Trusts and Wills by Disregarding Corporate Formalities
Though beyond the scope of this article, the liability theory of recovery known as “piercing the corporate veil” warrants mention as a lead-in to this topic. This theory asserts that when (1) corporate formalities have been so disregarded by shareholders such that the facts and circumstances evidence that the shareholders treat corporate assets in the same manner as their personal assets and (2) shareholders would be unjustly enriched vis-à-vis creditors if recognition were given to the corporate structure, then the corporate entity may be ignored and a corporation’s duties, obligations, and liabilities may be imputed to its shareholders. (This concept similarly applies to other entities such as partnerships and LLCs, notwithstanding that the idiomatic phrase describing the concept is phrased in terms of a corporate entity. “Reverse veil piercing” is when a creditor of an individual can attach assets held by an entity if the debtor is “hiding” personal use assets inside of that entity. For the duration of this topic, I will speak of limited liability companies (LLC or company, hereafter), notwithstanding the subheading, because they seem more commonplace than corporations among clients who are playing monkey business with entities. (After all, corporations require a separate tax return, whereas single-member LLCs can be disregarded for tax purposes.) But these issues apply with as much weight to corporations.
I want to discuss this topic because the reality is that people abuse entity formalities ALL THE TIME. I have seen people inquire about forming LLCs because they want to stash away some cash and use the LLC as a creditor exemption tool. (I wish this didn’t need to be said, but LLCs don’t exist for clients to manufacture “creditor exempt checking accounts” for themselves and their kids.) I have seen clients talk about selling or making a gift of real estate, only to subsequently discover that the client doesn’t own the real estate (it’s owned by an LLC). I could go on, but all these scenarios arise from the same problem: clients acting as if LLC assets are indistinguishable from personal assets. This problem usually manifests itself in the estate planning arena when clients want to effectuate company directives in one of two manners:
1. Devise or bequeath companyowned assets as part of an estate plan. Even if clients own 100 percent of the company, they seldom understand that company property isn’t theirs to give because it belongs to a separate legal “person” under state law.
2. Vote to replace the manager of the company or to direct company action after the client’s death. Clients always seem to think they can either vote from the grave or mandate that their PR or trustee vote membership interest on their behalf, from the grave, in a certain way.
For purposes of the remainder of this topic, let us consider a hypothetical client who owns membership interests in an LLC and that the LLC actually operates some kind of business, i.e., the client is explicitly mixing business with pleasure. What follows is a discussion of specific problems raised by clients’ desires to take action as if company’s assets were their own assets.
Attempting to Bequeath Company Cash
Something I’ve seen too many times is a client wanting one of his kids to receive a large bequest of cash upon the client’s death and pointing to money sitting in a company bank account. Why is all this cash sitting in the company’s account? Because that’s where the client keeps his personal use cash, of course! My favorite answer ever, received when asking a client why money is being stockpiled in a company account, is that the client’s wife would spend it all if he moved it to
their joint account. (There’s so much to unpack there that I’d need to hire a moving company for a few days.) Ultimately, to get to where the client wants to be, either (1) the company needs to distribute cash commensurate with the client’s membership interest, now or to the PR or trustee upon the client’s death, or (2) we satisfy the bequest with membership interests (which, if we’re playing it straight, requires “more” ownership interests than would otherwise be expected after taking into account discount factors on membership interest). These options raise issues of fiduciary obligations for the company, the company’s manager, or both.
Is there any on-hand cash being retained by the corporation for a legitimate corporate purpose (debt servicing, holding cash to acquire property plant or equipment so that they don’t have to finance that purchase with debt, awaiting deployment to acquire inventory, serving as a “rainy day” fund to protect against volatile cash flows or funding short-tointermediate cash flow needs for a cyclical business in a downturn, etc.), or is it all representative of shareholder earnings that ought have been distributed already (i.e., members or managers have allowed for the stashing of personal use cash inside the corporation by deliberately not making distributions)?
If the answer is that the corporation is both properly holding cash for its own uses and improperly holding stores of shareholder cash, we have a commingling problem that needs to be sorted out. Note that if the corporation is holding stores of cash for shareholder use, not only is there a “reverse veil piercing” problem if the shareholder runs into creditor problems, but also company creditors might be able to argue that those cash reserves should be available for their benefit and attempt to void any subsequent company distribution to members. (Although beyond the scope of this article, take a look at your state’s version of section 405 of the Uniform LLC Act, and also what is colloquially called a “clawback” action at bankruptcy.) If, instead, the answer is that all the on-hand cash is shareholder cash masquerading as company money, not only should we get that cash out ASAP, but also we should dig a bit deeper into company operations, as there are likely other iterations of “disregard of entity formalities” happening.
In either instance, we also need to recognize a potential conflict of interest scenario for the manager. I pick on the manager because managers usually hold authority over amount and timing of distributions; consult your LLC operating agreement or default state law provisions. The manager of the LLC should have her own representation to assess fiduciary duties as manager, separate and apart from whoever is representing the client or successor-in-interest to the client. As we said at the top, we’re assuming this company has an operating business. There are chances of creating problems for the company and other members, particularly if there are members unrelated to the testator’s family or estate plan beneficiaries. We cannot let the estate planning tail wag the company dog, and other members may have valid reasons to object to company actions that are going to facilitate another member’s personal estate planning concerns, so it’s best to have somebody counsel the manager in the first instance, and then determine if the client-member’s desires can be accommodated without making a mockery of the manager’s fiduciary obligations.
Attempting to Devise Company Real Property
This one has the potential to induce level10 migraines: The client wants to give Amaranthacre to an estate plan beneficiary and Amaranthacre is owned by the company. (I hate dealing with Whiteacre or Blackacre; they’ve both been conveyed so many times that it seems inescapable that there are clouds upon their titles.) Things become even more problematic if there’s an S corporation election on the company and we have to deal with entity level gain when distributing appreciated real property. (Federal income taxes are beyond the scope of this article, but I direct your attention to Internal Revenue Code §§ 1371(a) and 311(b)(1) if you want to examine this issue further.) The fundamental problem is that there are almost always actual and immediately-due costs associated with transferring title to real property.
As one example, I’ve seen a US corporation, involved in commercial real property development, that was owned by a foreign national and taxed as a C corporation (a “blocker” corporation, in colloquial language), that was the owner of a single-member LLC that was holding single-family residential real property that one of the shareholders of the C corporation intended to use as a vacation home for the interim and potentially use as a primary residence in the event the shareholder immigrated to the United States, thereby creating possibility of tax at both the corporation and shareholder levels, along with implicating tax attribution problems for other shareholders, when trying to clean this all up. This example is meant to illustrate the fundamental difference between dealing with cash held inside the company vs. real property or noncash assets. Removing cash from an entity is less likely to generate “costs” than removing noncash assets. (Please note, this is a generalization, not an absolute rule upon which you should rely.) In this example, we have potential for corporate-level tax (which indirectly affects all shareholders), dividend treatment to the shareholder receiving the property (more tax), and state law costs incidental to the transfer of the real property itself or the entity that owns the real property. The following is a list of some of the costs that are typically borne when trying to clean up the “personal use assets held by a company” problem:
1. Realization of taxable gain (by the entity or owner) upon distribution.
2. Deed preparation and recording fees (you may also have tangible or intangible taxes, documentary stamp taxes, and other associated costs in your jurisdiction).
3. Revaluations of, or changes to, the value of that property for state ad valorem taxes.
4. Due-on-sale or transfer provisions of any lending agreement if the property is mortgaged.
5. Changing insurance policies on the property (a new owner needs a new insurance policy).
Further, because many of these problems happen at the entity level, the entity has the state-law obligation to pay these costs. If somebody other than the ultimate beneficial owner of the real property in question has ownership in the entity, do you think he’ll be happy to learn that a pro-rata portion of money that would otherwise be distributable to him is going out the door to clean up somebody else’s mess of an estate plan? I’ve seen an instance in which a family-owned business admitted a longtime employee as a membership interest holder, and once that person got clued in to all the nonsense happening with disregard of corporate formalities, stuff hits the proverbial fan.
Considering that these issues exist in addition to all the issues discussed above regarding cash, this is one of the messiest possible estate planning disasters, so be smart: Identify ownership of real property immediately after a client starts talking about devising it, and if anything seems out of whack, get on the problem immediately; kicking the can down the road brings the mess to a head after the client dies, and beneficiaries are going to (perhaps properly) deduce that you’re responsible for the problem.
Trying to Vote Membership Interest or Force Company Action from the Grave
This one is straightforward, so I shall be brief: Dead people cannot legally vote membership interests. If a client controls 100 percent of a company and wants to pick his own successor manager, then to the extent you’re going to find a person who will agree to take a job at an unknown time in the future when the client dies, the way to do it is via a contract between the company and that person. For example, you might name a successor manager in the operating agreement, see if you can secure soft agreement to terms of a would-be employment contract in advance, and have the operating agreement state that the nomination or acceptance of the successor manager is dependent on the signing of an employment contract. DO NOT name a successor manager in a will or revocable trust agreement. That does nothing, and the persons who carry the vote of the entity are the ones who will select the next manager. Similarly, you can’t vote membership interest in a will or revocable trust. The people who receive the membership interest will vote it as they see fit, not necessarily as the now-dead client wanted.
I’ve seen this problem rear its head when a client directed something to happen with the company that would have benefited person X; persons Y and Z were managers or membership interest holders who prevented the client’s stock from carrying the vote, and they said “no.” Person X gets very grumpy with the dead client’s attorney and persons Y and Z, believing that, just because the client’s testamentary documents said so, they should supersede everything. Now we have hostilities on part of person X directed at a bunch of people who didn’t do anything, much less anything wrong, because somebody else put something very dumb in a testamentary document.
Just as you’d separate your reds from your whites when doing your laundry, separate what’s inside and what’s outside a company when a company owner starts talking about doing things in an estate plan.
Failing to Address Issues Surrounding the Vote or Governance in a Business When Some Family Members Are Active in the Business
This one can derail an estate plan worse than that time James Bond fired a tank missile at a Soviet stealth train. (If you know that movie and are suddenly inclined to re-watch it, don’t; I saw it this past Christmas time, and it does not hold up as well as other Bond movies.) It goes like this: Frank Jr. is self-made and owns his own refrigerator repair company. That company constitutes a substantial bulk of Frank Jr.’s wealth. Frank Jr. has three children, Leslie, Chandler, and Frank Jr. Jr. (Yes, that’s two Jr.’s, and shame on you if you don’t get the reference by now.) Leslie works at the company full time and is expected to take over running the business when Frank retires or dies. Chandler has her own job and her own life on the other side of the country and is neither involved in, nor cares about, the company. Frank Jr. Jr. is as doofy as his name sounds and is an absolute deadbeat. Nevertheless, Frank Jr. wants to benefit all three of his children equally in his estate plan. In order for each child to receive one-third of aggregate asset value, Chandler and Frank Jr. Jr. are going to wind up owning the majority of the company. Consider the following issues and determine for yourself whether this is a sound plan:
From Leslie’s Perspective:
1. How smart is it to let two people who collectively have zero knowhow, and devote zero time to understanding the business, carry the vote of the business?
2. How is Leslie supposed to run the company efficiently if she needs to persuade (read: tell) her know-nothing siblings how to vote their shares every time shareholder action is needed?
3. What if Leslie’s siblings allow the human condition to creep in (admitting you’re holding a huge value asset about which you know nothing is tough for some people) and start pretending they know how the business should be run and casting their vote “as they see fit”?
4. If item 3 comes to fruition, doesn’t this “plan” leave Leslie’s livelihood (recall, she works full time at the company) at the mercy of people who have a higher-than-desired likelihood of running the company into the metaphorical ground?
5. Even in the best-case scenario, how much time does Leslie want to spend explaining herself or teaching the business to her siblingowners, who have questions about company performance and want to review whether Leslie is doing a good job?
From Chandler and Frank Jr. Jr.’s perspective:
1. Isn’t the entire value of their inheritance dependent on how well Leslie runs the company? How well does she run this company? They have no way to assess her job performance. (Think: teaming up and
outvoting Leslie or trying to install a new manager, à la items 3 and 4 from Leslie’s perspective.)
2. Can they sell their interests? (Probably not.)
3. Might they rather not be in business with their sister?
4. Might they rather have cash to invest somewhere else?
5. Might they want or need to sell off principal so that they’re not stuck receiving only distributions from current earnings? (Recognize that they’re in a situation similar to an income-interest-only QTIP beneficiary . . . if the dividends aren’t large enough to meet your spending needs, you have a problem.)
6. Does ownership of company equity carry any obligations? (Think about capital calls. It’s bad enough in their mind they inherited something they might not be able to sell. Being asked to contribute their own money to preserve their inheritance makes it look more like they inherited a money pit.)
There’s nothing quite like forcing people who don’t want to own a business to own a business, and further compounding the problem is forcing siblings who might not want to be in business with each other to be in business with each other. Solving this planning disaster often can involve a lot of leg work up front, whether it be obtaining life insurance on the current owner or key man, bringing in additional equity members, working out a deferred sale to one or more family members, or finding a third-party purchaser. Much as that might seem like a bother, any of those options is a lot better than looking at a business that risks bleeding money or collapsing because of inefficient management, with a bunch of kids looking around, seeing that none of them has done anything particularly wrong, and concluding this may be the attorney’s fault through shoddy planning.
Assigning Ownership in a Closely- Held Business Sight-Unseen
This one is unlike any of the others because this one is directed at you, attorney-reader. If problems arise here, it’s 100 percent on you. It goes like this: The client tells you he owns membership interests in XYZ, LLC, but “just can’t find the operating agreement,” so in the interest of facilitating probate avoidance, you transfer “all his membership interests in and to XYZ, LLC,” to the trustee of his revocable trust. Then sometime later somebody gets their hands on the operating agreement and discovers there is a whole host of restrictions on transferability coupled with penalties that can be invoked by other members on account of the purported transfer.
A disaster scenario looks like this: A client is a minority interest holder in an LLC but holds enough membership interest that he can “swing” the company vote, such that his voting power can be colloquially labeled “important.” The client’s attorney assigns the client’s membership interests to the trustee of a revocable trust as part of his estate planning and then an operating agreement is found that contains some troublesome provisions. The first of these provisions says that any transfer of membership interests made without first securing the written consent of all other members holding membership interests subjects those membership interests to a buy-sell/put-call option. The second of these provisions says that even if the buy-sell/put-call option isn’t exercised, the recipient of the membership interest is only a “mere assignee,” entitled to receive distributions if and when made, but isn’t admitted as a member and can’t vote the membership interest unless agreed to and admitted by all other members.
Now the client is at the double-mercyveto powers of the other members. If the buy-sell option is exercised, the attorney will want to call the malpractice carrier because the client is losing the benefit of his bargain on a “gotcha.” If the buy-sell provision is enacted AND has a formula for determining the purchase price that allows the other members to buy out the client for pennies on the dollar, your client is losing aggregate asset value on that “gotcha” as well . . . and the attorney should probably go into hiding in addition to calling the malpractice carrier. If the buy-sell provision makes exercising the buy-sell too expensive for the other members, one bullet is dodged, but the client may catch a bullet on the second provision, i.e., the “mere assignee” provision. In this scenario, the client no longer has a vote at all, much less swing vote power, and is reduced to being along for the ride.
If you think this hypothetical sounds a bit too fantastic, unrealistic, and contrived, ask yourself this: If you invested in a closely-held business and somebody entirely unrelated to you (perhaps you don’t even know this person) did something that gave you the opportunity to buy a larger interest in the company at a steep discount, or garner more voting power for free, wouldn’t you take that opportunity? What makes you think a typical person who is a private equity investor wouldn’t do the same, all day, every day?
In a fashion, this might be the biggest no-no in this article. In many of the other scenarios, while you might wind up in a suboptimal position, there might be enough gray area where the only “costs” associated with implementing a bad plan are headaches, anger, and resentment. In this scenario, you subject a client to the savage reality of private equity investment. (I use “savage” not to cast aspersions, but to draw attention to the economic dynamics at play.)
Be smart. Whenever a client tells you he owns membership interests, make him prove it first. (Clients frequently don’t really know what they own; they might be holding debt rather than equity, for all you know.) Then, get a copy of an operating agreement and confirm with other members and the manager that you have the most recent one before you start looking at assigning membership interests.
Treating a Business Entity as a Substitute for a Trust, Without Giving Any Thought to Anything
Finally, let’s ponder a scenario in which ALL the problems discussed thus far appear: the client who puts all his assets in a single-member LLC and wants you to draft a quickie will leaving the LLC to Uncle Joe . . . because, you know, he’s “talked to” Joe and Joe “knows what’s supposed to happen.” Whenever this scenario comes up, just as with this article, I conclude the conversation and go do literally anything else with my time.
Published in Probate & Property, Volume 36, No 4 © 2022 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.
