Purpose Trusts – Proceed with Caution

Take-Away: An estate planning trend that is gaining some traction across the country is the adoption of a purpose trust to hold a closely held business. While there may be some definite advantages to holding a family business in a purpose trust, the income tax consequences can pose a major hurdle.

Background: The necessary elements to establish a trust at common law are: (i) a trustee; (ii) a corpus; and (iii) one or more trust beneficiaries. With a purpose trust, there is no ascertainable beneficiary of the trust. Without an identifiable beneficiary, arguably no one who can enforce the terms of the trust. Common examples of a purpose trust are a pet trust or a charitable trust which has the public as the trust’s ‘beneficiary’, but no identifiable beneficiary in the terms of the trust instrument. A charitable purpose trust is permissible because the state Attorney General is given authority by statute to enforce the terms of the charitable trust. As for pet trusts, they are normally permitted, but only for the life span of a particular animal or only for a limited term of years, e.g. 21 years.

Public Policy Limitation: Also, courts are not inclined to enforce the terms of a purpose trust when there is no identifiable beneficiary. One classic example was the purpose trust of the playwright George Bernard Shaw. His trust directed his trustees to use his estate to develop a new alphabet that emphasized the use of phonetics and, once accomplished, to translate one of Shaw’s plays into that new phonetic alphabet. The trustees petitioned the court whether this trust, without beneficiaries, could be carried out, especially when the trust instrument directed the trustee to determine how many people in the world would be speaking and writing English at any given time. The court held that Shaw’s trust’s purpose did not rise to the level of a charitable trust and that it’s purposes would be virtually impossible to carry out, and thus wasteful and against public policy. The court also expressed concern that there was no one named in the trust instrument to enforce the terms of the trust.

Uniform Trust Code: Contrary to the common law’s limitations, the Uniform Trust Code (UTC) which was adopted in Michigan in 2010, formally accepted the use of a purpose trust. The UTC provides that a purpose trust is a trust that is established for a purpose (duh!) as opposed to a typical trust which is established to provide for beneficiaries. As such, a purpose trust has no beneficiaries. Prior to the UTC, the only purpose trusts permitted at common law were pet trusts and trusts used for the upkeep of graves. A purpose trust is authorized under the UTC with the missing piece that was added of the presence of a trust enforcer who possesses the authority to enforce the terms of the trust and thus hold the trustee accountable. Accordingly, under the UTC, a purpose trust may be established if there is: (i) a trustee; (ii) a trust corpus; (iii) a purpose that is reasonably possible of attainment, not wasteful, and not against public policy; and (iv) has an identified enforcer. The UTC thus uses a couple of sections to deal with a purpose trust: Section 409 deals with a non-charitable trust for a purpose so long as it provides for an enforcer, and Section 408 deals with a pet trust with year limits imposed on the pet trust’s duration.

Michigan Trust Code: When Michigan adopted its version of the UTC, it did not include Sections 408 and 409. Instead it relied on its own provision that permits a purpose trust in limited situations. MCL 700.2722 [note, not part of the Michigan Trust Code] provides, in part:

(1) Except as provided by another statute and subject to subsection (3), if a trust is for a specific lawful noncharitable purpose or for lawful noncharitable purposes selected by the trustee, and if there is no definite or definitely ascertainable beneficiary designated, the trust may be performed by the trustee for 21 years, but no longer,  whether or not the terms of the trust contemplate a longer duration.

(2) Subject to this subsection and subsection (3), a trust for the care of a designated domestic or pet animal is valid. The trust terminates when no living animal is covered by the trust. A governing instrument shall be liberally construed to bring the transfer within this subsection, to presume against the merely precatory or honorary nature of the disposition, and to carry out the general intent of the transferee. Extrinsic evidence is admissible in determining the transferor’s intent.  

(3) [a-c omitted here] (d) The intended use of the principal or income may be enforced by an individual designated individual designated for that purpose in the terms of the trust or, if none, by an individual appointed by a court upon petition to it by an individual. (f) The court may reduce the amount of the property transferred if it determines that that amount substantially exceeds the amount required for the intended use. The amount of the reduction, if any, passes as unexpended trust property under subdivision (b) [(b) describes what happens to trust assets upon the purpose trust’s termination, e.g. per the terms of the trust or to the transferor’s heirs.]

Consequently, under EPIC, a trustee of a purpose trust may select trust beneficiaries from an indefinite class, but only for a charitable trust.  In addition, a purpose trust in Michigan may only be performed for 21 years.

Purpose Trusts in Other States: As indicated above, there is a nascent trend in states other than Michigan to exploit a purpose trust for business succession planning. Some of the perceived uses of a purpose trust are to hold a family vacation property in perpetuity to allow for family use for generations ( note, without estate taxation of the property since it is owned by the trust). Of more interest of late is the possible use of a purpose trust for business succession planning using the purpose trust to hold a family business for generations, presumably protecting the business from exposure to family shareholder disputes, creditor claims against shareholders, shareholder divorces, etc. States such as New Hampshire, South Dakota, Oregon and Delaware have each adopted statutes that expressly allow for a purpose trust to hold a business in perpetuity.  The statutes in Oregon and South Dakota are express purpose trust statutes directed to hold closely held business interests. Delaware and New Hampshire statutes are not  explicitly directly to holding business assets.  In short, a purpose trust would replace normal dispositive provisions with a statement of trust purpose which would be something like: “The express purpose of this trust is the preservation, maintenance, and enhancement of the ABC corporation which is owned by the Smith Family in perpetuity.”

Perceived Benefits: The perceived benefits from using a purpose trust to hold title to shares of stock or other business interests include the following: (i)ensure retention and continuation of the business indefinitely; (ii) allow family members, descendants, and key employees to manage or participate in management of the business; (iii) provide benefits to family members both in and out of the business, and other key employees; (iv) provide for charities; (v) protect against outside disruptions or exposure to loss of business ownership through divorces, lawsuits, estate disputes; (vi) protect against the sale of the business or hostile takeovers by outside investors; and (vii) provide greater retention for employees who will not feel they are working to profit the selling shareholders.

Example: A perpetual purpose trust established in one of the limited purpose trust states could hold the controlling interest in a closely-held family corporation. The purpose trust instrument provides that the corporation is managed by carefully selected individuals, including family members and long-term employees of the corporation, or outside consultants. The purpose trust also provides for an advisory committee which includes family members, which allows them to participate in the corporation’s management and make other key decisions. The corporation continues to be run by existing managers, giving them confidence and dedication knowing that the business will not be sold out from underneath them,  but they would answer to the trustee of the purpose trust which owns the controlling shares in the corporation. The trustee, in turn, answer to the purpose trust’s enforcer, which would be a family committee, or an active advisory committee. The purpose trust’s enforcer is empowered to amend the trust’s terms, change the trust’s situs, the trust’s governing law, or the rules that are used to remove and appoint members of the other committees of the purpose trust. The purpose trust prohibits a sale of the corporation or any control by outside investors. Family members who are not employed by the corporation hold, either individually or through a trust, dividend-paying, non-voting shares of the corporation that generates a share of the corporation’s profits for them to enjoy. Those family members who are actively employed by the corporation receive salaries and bonuses commensurate with their activities and contributions to the corporation.

Tax Implications: As noted earlier, if a purpose trust is used to hold title to valuable assets, those assets will not be subject to federal estate tax on the death of an employee, or family member, or trust beneficiary. Of course, the original owners who may have transferred their interests to the purpose trust need to be careful to not retain control over the interests that they transferred to the purpose trust, as that retained control could expose their estate to federal estate taxation under either IRC 2036 or 2038.

• Income Tax: The major problem that arises from the use of a purpose trust is with regard to income taxes. There are almost no rules or tax history associated with purpose trusts in the United States. There is only one Revenue Ruling, and that dealt with a pet trust, but its implications are threatening.
• Revenue Ruling 76-486: In this Revenue Ruling the income from a trust was to be use for the maintenance of a cat. The trustee proposed to deduct distributions from the trust made for the cat’s maintenance and welfare. The IRS noted that IRC 661, which allows a trustee to deduct distributions made to a trust beneficiary, imposes a condition on that trustee tax deduction, which is that the beneficiary of the trust report the trust distribution as income by the beneficiary. Since the cat would not be reporting any trust income, the trustee could not deduct an distributions made for the cat’s benefit. In short, unless trust distributions will be reported by an individual or non-charitable entity as income, the trustee will not be entitled to an income tax deduction under IRC 6166. Consequently, even if the purpose trust distributes its profits, unless the distribution qualifies as either a charitable deduction or it is a deductible business or investment expense, the purpose trust will be taxed on its income at the much higher, compressed, trust income tax rates.

Conclusion: While a handful of states, a couple of which are ‘trust havens’ that deliberately seek trust ‘business’ [South Dakota; New Hampshire; Delaware] Michigan has opted to recognize purpose trusts in only limited situations, and with a duration limited to only 21 years, which greatly reduces the likelihood that anyone in Michigan will establish a purpose trust anytime soon, unless established for a pet. That said, it is hard to envision holding a closely-held family business in a purpose trust considering the income tax exposure faced by that trust, unless all of its profits are distributed in the form of tax deductible wages and bonuses. Still, if a business owner is interested in the perceived benefits of a purpose trust, they may want to take a close look at transferring their business to a Delaware business purpose trust.