Real Estate Held In Trust: The Trustee’s Duty to Control and Protect

At Monday’s TRO meeting the discussion centered, in part, on holding residential real estate in trust. I thought I might add to that discussion.

Take-Aways:  (i) Lots of issues come up when real estate is held in trust, including the possibility of uncapping taxable values of the real estate, the trustee’s liability from activities or accidents that occur on the real estate premises, and access to and inspection of the real estate premises held in trust. The real property tax uncapping questions are not easily answered as there is not much logic to the Michigan Tax Commission’s interpretation of the exceptions to the taxable value uncapping rules when real estate is transferred into and out of a trust or to an LLC. (ii) With regard to the trustee that holds title to real property that it sometimes cannot access due to claims of privacy from the beneficiary-occupant, like the widow who lives in the residence held in the name of the credit shelter trust, the rights of the trustee need to be established when the trust is funded, with written terms that would be included by a landlord in a residential lease, although a lease is not required (or permitted, since the right of occupancy is conferred by the trust instrument, not a lease agreement.) (iii) The potential liabilities that arise from the trustee that holds legal title to a residence occupied by a beneficiary who is granted the use of the premises is an entirely different question that the trustee must address independently to protect itself;  the trust instrument should give the trustee some directions or confer powers on the trustee to take protective steps to minimize its exposure to liability arising from ownership of the real estate, perhaps the authority to create and use LLC’s to hold title to the real property.

Example: Husband transfers title to the residence to a revocable grantor trust. Husband dies. Husband’s trust becomes irrevocable. Title to the residence is transferred to the credit shelter trust of which GLT is named as the successor trustee. Wife is the lifetime beneficiary of the credit shelter trust. The credit shelter trust gives to Wife the right to use, rent-free, the residence for the balance of her lifetime. Upon wife’s death all credit shelter trust assets pass in equal shares to their surviving child, and the descendants of their deceased child,  two grandchildren. Wife considers the home to be her asset, notwithstanding the terms of the trust, and is not inclined to give the trustee access to her home. What duties does the trustee have with regard to the residence that is held in the credit shelter trust?

Trustee’s Duties:  

• Impartiality: We are all familiar with the trustee’s duty to administer the trust solely in the interest of the trust beneficiaries (an expansive term of art defined in the Trust Code.) Unlike the settlor and current trust beneficiaries, the trustee knows that this duty extends to all trust beneficiaries- that means the trustee must deal impartially with the interests of both the current trust beneficiaries as well as remainder beneficiaries. Few  current trust beneficiaries,  like the widow in the example, appreciate the scope of this duty of impartiality, but some day in the future the trustee will have to answer to the remainder beneficiaries if waste is permitted with regard to the residence.
• Control and Protect: The trustee has a duty to take reasonable steps to take control of and protect trust property. The reported comments to this statutory duty suggest that requiring the trustee to control trust assets carries the connotation to possess the trust assets. However, the trust instrument can override this implicit obligation imposed on the trustee to possess trust assets by permitting the trustee to use agents to whom some responsibilities are delegated. In short, the trustee can use agents to hold, or possess,  trust assets and the trustee need not physically possess all trust assets. In the example, where the trust instrument gives to the settlor’s widow the right to use the residence for her lifetime, her use implies her ability to occupy and/or physically possess the residence even though title to the residence is held in the name of the trustee. Probably an Occupant’s Agreement between the widow and the trustee [which is almost the equivalent of a residential lease] would be best to document that agency relationship along with the responsibilities that are delegated to the widow and the consequences if those responsibilities are not met.

Liability: How does the trustee protect itself when the trustee holds title to real estate?

• Appraisal and Inspection:  The obvious first step would be to have the real property appraised to confirm the value of the structure that are to be insured. Maybe a survey is needed if a large parcel is the subject. A formal residential inspection is also a good idea to disclose repairs that may be needed to preserve the dwelling’s value. That appraisal/inspection might lead to making needed repairs or improvements which, in not corrected, could lead to more liability risks faced by the trustee.
• Insurance: The real property should be insured with a casualty insurance policy issued in the name of the trustee as the named insured. This is  not the time to simply rely upon the ‘old’ homeowner’s insurance policy that the settlor had maintained, since changes might have been made to the real property after the issuance of that old policy that the casualty insurer is unaware of, which can create problems if claims are made under the ‘old’ policy and the insurer has a good reason why it does not have to pay the claim. A fresh appraisal and inspection report are needed for the trustee to obtain the correct amount of insurance coverage, and to minimize the risks posed by the real property’s condition.
• Tip: Since the widow/widower may resent the intrusion of appraisers and inspectors onto the real estate occupied by them, a dwelling that they will presume to be their own home, it would be helpful to have added to the trust instrument [if given a rare opportunity to review the trust instrument before the settlor signs it] language by which the deceased settlor clearly directs the trustee to take these appraisal and inspection steps,  as opposed to the trustee relying upon its common law fiduciary and statutory duties to inspect and protect. If the deceased settlor is the source of this perceived intrusion into the occupant’s privacy,  the beneficiary-occupant may be more receptive to giving the trustee’s agents access to the dwelling.
• Entity Wrapper: Assume that the real property held in the trust is not residential, but commercial real estate. Perhaps there is a directive in the trust to retain the commercial real property, such as a strip mall that has very favorable triple-net  leases to the landlord, that provides a strong cash flow to the trust. Obtaining casualty insurance on top of the obligation imposed on the tenants to provide proof of insurance, with the landlord-trustee named as an additional insured, is necessary to carry out the trustee’s control and protect fiduciary duty. But even with liability insurance in place, there may not be sufficient insurance protection to cover all risks. One additional step that the trustee can take is to place the title to the real estate in an entity wrapper, like a limited liability company (LLC.) The Michigan Trust Code gives to the trustee the power [a default power to the extent that the trust instrument does not address the issue] to change the form, in any manner of a business or enterprise that the settlor was engaged in at the time of his death. Arguably the trustee could wrap the commercial real estate in an LLC, of which the trustee was the sole LLC member. The significance of the LLC is that it acts as a firewall that contains liability to the assets held in the name of the LLC. For example, if a customer trips, falls, and sustains a major injury on a commercial real property held in the name of the trust, all assets held in the name of the trust may be accessed to satisfy a judgment obtained by the injured customer. In contrast, if that same commercial real property is held in the name of an LLC, and the LLC is owned by the trustee, then that same judgment can only be satisfied by the LLC’s assets, which consists solely of that one commercial real property interest, and not all of the other assets held in the name of the trust. In short, using the LLC wrapper protects the other assets held in the name of the trust. The trust instrument does not need to expressly give the trustee this power, as that is a default power under the Trust Code, but it might be helpful for the trust instrument to encourage the trustee to incur additional expenses it deems appropriate to protect the assets held in the trust. [Hopefully the real estate was already ‘wrapped’ in an LLC prior to the settlor’s death, but sometimes that is not the case]
• Caution #1: While the use of an LLC is a helpful device to limit the trustee’s liability and to protect other trust assets, any  residential real estate should not be placed in an LLC. That is because: (i) the Michigan Tax Commission has opined that an LLC is a business entity and thus holding residential real estate in an LLC deprives the residence of the homestead property tax exemption; and (ii) the same Tax Commission views any LLC with suspicion;  while a residence can be held in trust for the benefit of a surviving spouse or children or grandchildren without any uncapping of its taxable value, the same does not apply if the transfer of the residence is from the deceased owner to an LLC, which is treated as a non-close-family member, even if the trust that owns the LLC is for the sole benefit of those close family members. In short, while commercial real property can be held in the LLC, residential real estate [homes; cottages; condos] used solely for non-business purposes cannot be held in the name of the LLC without exposing the real estate to an uncapping of the taxable value. Thus, if the settlor had owned several  residential rental properties as part of his investment portfolio, they are treated as business real properties and they will not qualify for the uncapping exemption, meaning those rental residential properties can and should be placed in an LLC.
• Caution #2: Current Michigan law, unlike other states, does not permit what is known as serial LLCs. If the settlor held several residential rental units as part of his trust, and the trustee is now confronted with holding and managing those rental residential units as part of the trust estate, it is probably best, as part of the trustee’s protection duty,  to wrap each rental residential unit in a separate LLC, when the temptation is to retitle all the residential rental units into a single LLC that is owned and controlled by the trustee. This gets back to the firewall role of the LLC; a slip and fall at one residential unit could cause all the residential rental units to be exposed to satisfy the creditor claims, not just the unit where the slip and fall occurred. Some states have adopted a serial LLC statute which permits the use of one LLC to hold several different assets, yet each asset in the single LLC is protected by its own LLC type wrapper,  so there ends up being multiple LLC wrappers for liability protection, but only one master LLC entity is use. Not so in Michigan, yet. Thus, there could be a lot of paperwork associated if the trust ends up holding several parcels of commercial real estate, as each parcel should  have its own LLC Multiple LLCs translates to lots of expense and lots of paperwork which many beneficiaries do not appreciate.

Final Thought on LLCs and Trusts: In some respects an LLC functions something like a trust, if the LLC uses a manager separate from its members. The trustee manages the assets for the benefit of the LLC members. Consider a trust that directs assets to be distributed to the beneficiary upon a specified event, e.g. ‘when the beneficiary attains the age of 30 the trustee shall distribute the balance of the trust share to that beneficiary.’ But suppose the beneficiary is embroiled in litigation, facing a large judgment, when the beneficiary approaches age 30. If the assets are distributed to the beneficiary from the trust, more likely than not the judgment creditor will seize that distribution to satisfy its judgment. What if the trustee wrapped the distribution in an LLC, with the trustee retaining a 1% membership interest, and promptly distributes the 99% LLC membership interest to the beneficiary when the beneficiary attained age 30? The beneficiary then owns 99% of the LLC, the trustee remains its manager and holds the remaining 1% LLC membership interest. More to the point, if the judgment creditor moved against the beneficiary’s 99% LLC interest, all the judgment creditor receives under Michigan’s limited liability company statute is what is called an assignee’s interest. Loosely translated, an assignee’s interest means that whatever the LLC decides to distribute in the way of income to its members, the assignee is entitled to receive that member’s share of the income. But the assignee is not entitled to vote the member’s interest in the LLC. If the manager-trustee decides to NOT make a distribution from the LLC, there still must be issued to each member of the LLC a Form K-1 reporting that member’s pro rata share of the LLC’s income for the year. That means that the assignee judgment creditor receives the Form K-1 and must pay income tax on that phantom income to which the member was entitled to receive. Restated, the judgment creditor may not go after the beneficiary-member’s LLC interest if that means the creditor cannot force distributions (no voting rights pass to the creditor) yet it must pay income taxes, out of its own pocket on phantom income it might never receive. Creditors are usually smart enough to stay clear of LLC interests if there is a manager-member who is not subject to the judgment.

What if a trust instrument  included a provision that gives to the trustee the authority to wrap a mandatory trust distribution inside an LLC to protect the distribution from creditor claims that the beneficiary may face? In some respects this LLC wrapper is akin to the trustee exercising its decanting power to extend the protection of the trust beyond the normal termination date specified in the trust, but it is just an LLC  that is controlled by the trustee as opposed to creating a new trust instrument that continues to protect the beneficiary’s interest in the trust. I would not be quick to suggest to a trustee that it had the inherent power to wrap a generic trust distribution in an LLC under the Trust Code, but if the trustee possesses the power under the Trust Code to change the form of the business to another type of entity, i.e. to an LLC, and the trustee could legitimately wrap real estate in an LLC for protection of other trust assets, and that LLC  was ultimately distributed to the beneficiary, why can’t a stock portfolio be similarly wrapped by the trustee prior to its distribution?  Just something you might want to look for when you review a trust instrument.