Understanding trusts

We have been involved with a very interesting project related to a trust.  I obviously won’t go into the project details but think the over-arching issues are worth trying to understand so hopefully others won’t run into this particular problem.

Hal and Wilma set up a living trust in 2005.  They have 2 biological children together and Hal has 2 children from a previous marriage and Wilma has one.  The kids are named Adam, Bob, Claire, Denise and Ed.  All are over the age of 21.

There are 3 primary assets in the living trust: The home worth $500,000, a joint investment account worth $500,00 and a business worth $5,000,000.  The business was started by Hal in 1984, prior to his marriage to Wilma.  The shares always remained in his name.  And, the business was treated as a Subchapter S Corporation.

Obviously H&W want to ensure that all the kids are taken care of.  To do this, Hal and Wilma set up a trust where, should Hal die first, Wilma would receive “income for life” from the business and upon her passing, the shares would be distributed to the kids.

Hal passes away in 2014.

The trouble begins almost immediately.

The two children from Hal’s first marriage immediately demand the shares be distributed to the final beneficiaries.  Their argument is that Wilma was entitled to only the income, not the actual ownership of the shares.  Naturally, Wilma didn’t agree but to ensure that the kids would feel like they in fact had “control”, Wilma had an LLC set up.  This LLC was set up with the kids owning a Class A interest and Wilma owning a Class B interest.  The Class B interest paid a Guaranteed return of 8% and did not allow for participation in any increase in value.

Sounds great right?  Wilma gets her $400,000 a year and the kids get control of the growth in value and any cash which may result from a sale of the business.

Bzzzz.  Thanks for playing.

Technically, the transfer of the shares in the business invalidated the S election since the trust was not a Qualified Subchaper S Trust (QSST).  We could probably get around that little headache but it is compounded by the subsequent transfer of the shares to an LLC.

An LLC is not a qualified owner of S Corporation interests.  So even if we could convince the IRS to ignore the QSST issue, the LLC issue killed everything.  And now we have to address 2014, 2015, 2016 and part of 2017 where the business issued distributions to Wilma but where the owner was the LLC.  Like I said, an interesting problem.

What should we take away from this?

  • Do not try to do tax and estate planning on your own.  It is easy to set up and then think you can update your documentation without talking with an expert.  Spend the money and time.  Especially if you own and operate businesses.
  • S Corporations are simple, except for their ownership structure.  Side deals with S Corporations can lead to trouble as it is easy to have nonqualified ownership or two classes of stock – all without meaning to.
  • If you are not going to gift S Corporation stock directly to your kids, then you need to plan and set up the proper trusts to protect the ownership.  To have one person receive the distributions while another gets the vote really requires the correct trust type.  This little detail gets overlooked sometimes and it can cause big problems.
  • If you own an operating business, it may be wiser to avoid titling it to a living trust.  And, if you own in jointly with a spouse, it may be better to issue a separate ownership interest to the spouse to avoid shares going in the wrong direction.
  • An LLC treated as a partnership is a great tool for planning and wealth transfer in many instances.  It can take the place of the Family Limited Partnership.  But somethings can’t be owned by an LLC.  And somethings don’t work well inside one, especially if there are guaranteed returns with insufficient cash being generated.

Thank you for the opportunity to share this little exercise.  If you have questions or thoughts, feel free to comment.  Have a great day.


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