George F. Bearup, J.D. Senior Legal Trust Advisor

Trust Situs: Michigan Compared to Delaware

Take-Away: Greenleaf Trust recently obtained trust powers in Delaware, leading many to ask the question ‘Why?’ A recent survey of all 50 states that focused on the ‘best place’ to situs an irrevocable trust named Delaware as one of four states in its ‘top tier’ for a trust. These ‘winning’ states are: South Dakota, Alaska, Nevada, and Delaware, in that order. Apparently there are several reasons Delaware is a top choice to locate an irrevocable trust. Some of the reasons why Delaware is often the jurisdiction of choice in which to establish an irrevocable trust are because its laws are viewed as highly favorable (compared to other states) with regard to: directed trust liability protection for trustees, avoidance of state income tax on accumulated trust income, restricted beneficiary access to trust information (aka silent trusts,) the ‘Delaware Tax Trap’ which can create an income tax basis step-up on the death of a power of appointment holder, strong asset protection statutes, broad investment selection flexibility for trustees, confidentiality if the trust becomes involved in litigation proceedings, and a pre-death trust validation procedure that can be used to eliminate or forestall anticipated future trust contests.

Survey Results: In a recent survey of the state trust laws published in the January 2018 Trusts & Estates magazine, authors Dan Worthington and Mark Merric list the pros and cons of each state’s trust laws. That survey uses multiple factors upon which the authors ‘rank’ a state’s trust statutes and other laws that impact the administration and taxation of an irrevocable trust. Delaware ranked 4th in that survey. Michigan’s trust laws and its legal environment to administer an irrevocable trust ranked further down the list of a states, in 27^th place.

Factors: What is summarized below are some of the factors that went into the authors’ survey, and where appropriate a couple of comments or explanation with regard to the factor that was used, but only comparing only Michigan and Delaware’s trust laws. These factors provide helpful insight into the decision where a trust should be located when it is administered; some factors are fairly obvious while other factors are admittedly ‘deep into the weeds.’

Caveats: I am not license to practice law in Delaware. As such what follows is simply a short summary of the authors’ observations and weight that they placed on multiple factors that go into the complex decision where to situs an irrevocable trust. This summary is intended solely to provide a context to support Greenleaf Trust’s decision to obtain trust powers in Delaware and it may help to explain why many of Greenleaf Trust’s clients may now wish to consider using Delaware as the situs for their trust.

Rule Against Perpetuities: The rule against perpetuities (the Rule) is a product of state law, not federal law. At common law the Rule required that a beneficiary’s interest in a trust must vest, if at all, within the period of a living person, plus 21 years. Later a uniform statute was created [the Uniform Statutory Rule Against Perpetuities] which set the maximum duration of a trust to the greater of the common law Rule or 90 years. The purpose of the Rule is to prevent trusts holding property, especially real estate, in trust for extended periods of time tying up wealth in one family while avoiding estate taxes on that wealth. This issue became more important when Congress created the generation skipping transfer tax (GST) in 1986 which is designed to tax transfers to more remote beneficiaries from a long-term trust, transfers that would otherwise avoid federal estate tax because the trust beneficiary did not ‘own’ the assets held in the long-term trust. Simply stated, if there is no required transfer of assets out of a trust [which the Rule otherwise requires], there can be no GST tax imposed. Thus, since 1986many states have rushed to either eliminate or extend their Rule to enable assets to be held in trust for extended periods, i.e. centuries, thus avoiding the imposition of a federal estate or GST tax on the trust’s assets, all the while sheltering those assets from the beneficiaries’ creditors. Hence the arrival of the estate planning device often called the dynasty trust. The longer assets can be held in a dynasty trust the better the state trust law, so the authors conclude.

Delaware: Delaware abolished its rule against perpetuities enabling dynasty trusts to continue for multiple generations [thus protecting trust assets from creditor claims while avoiding estate and GST taxation when later generation beneficiaries die.] Delaware’s state constitution is silent as to the rule against perpetuities, in contrast to some states which by constitution prohibit long-term restraints against alienation or perpetual restrictions on the transfer of real estate. In addition, the Delaware law with regard to the Rule follows an important (favorable) Tax Court decision in Murphy which means that Delaware’s law that pretty much dispenses with the Rule.
Michigan: Michigan has an opt-out form of statute that implements the Rule. The authors of the survey view this approach as the ‘least favorable’ approach to the Rule, since the common law Rule or the Uniform Statutory Rule, both of which are adopted in Michigan, is maintained as part of state law. Consequently, the underlying Rule period remains unchanged in Michigan, or it is more likely to inadvertently be triggered. Thus, depending on the facts and trust language, a dynasty trust in Michigan could possibly face a 90 year duration. Michigan’s state constitution does not address the rule against perpetuities, apparently a good thing. Nor does Michigan’s statute adopt the favorable provisions that were featured in the Murphy Tax Court decision.
Explanation of Murphy: This Tax Court case affirmed Wisconsin’s method to completely repeal the rule against perpetuities, substituting a more flexible, alternate vesting statute for trust beneficiaries. This approach, followed by other states, including Delaware, addresses both the Rule’s time or duration and vesting elements for GST tax exemption purposes.

Taxation: With the Tax Cut and Jobs Act, far more emphasis is now placed on saving income taxes than estate taxes, including the income taxation of irrevocable trusts. Trusts that accumulate income, often a dynasty trust, are subject to both federal and state income taxes. Some irrevocable trusts are designed to accumulate income. But if that accumulated trust income is subject to state income taxation, that wealth can be substantially eroded over time through taxation. Some states, e.g. Texas, Florida, South Dakota, Wyoming, do not impose a state income tax. Other states continue to impose a state income tax on a trust’s accumulated income. How a state’s income tax statute is phrased can permit the income that is accumulated in the irrevocable trust to nonetheless avoid state taxation.

Delaware: Delaware’s state income tax is imposed on a trust’s accumulated income only if Delaware residents are the trust beneficiaries. Restated, if there are no Delaware resident beneficiaries of the trust, then the trustee can accumulate income inside the trust and avoid paying Delaware income taxes on that accumulated income. Additionally, as a small matter, Delaware generally imposes a very small state premium tax on life insurance held in a Delaware situs trust, i.e. 100 bps on the first $100,000 only. This premium tax is particularly important if the trust intends to hold a private-placement life insurance policy (the earnings on the policy investments ‘inside’ the policy are deferred from income taxation, resulting in something of a tax-shelter for that trust asset.). [Note, though, that Delaware will impose a premium tax of 200 bps if the life insurance policy is held by an LLC.]

Michigan: Michigan’s statute with regard to the imposition of state income taxes on accumulated trust income is far more likely to cause the trust to incur and thus have to pay the state’s income tax, as it ties taxation to more than just the domicile of the trust beneficiaries. Restated, he Michigan income tax statute provides far more nexus points upon which to justify the imposition of its state income tax on accumulated trust income. Michigan also imposes a premium tax on life insurance of 125 bps.

Trust Protectors: More and more trusts are created with trust protectors to provide the ability to change the trust’s terms, or to remove a trustee, without having to go to court and obtain judicial approval. Going to court always means spending money on legal fees, publicity, and worst of all, unpredictable judges, all of which can be avoided if a trust protector is given broad enough powers over the trust. State laws differ if the trust protector, if one is named, must act as a fiduciary with all the attendant fiduciaries duties in carrying out its function, e.g. the duty to act impartially with regard to all trust beneficiaries.

Delaware: Delaware has a specific statute that describes the powers of a trust protector. Delaware’s laws permit the trust settlor to decide in the trust instrument if the trust protector is to act as a fiduciary or merely as an agent (without fiduciary duties) with respect to the trust. Delaware also appears to permit formal trust protector entities to serve in that role over multiple trusts, i.e. a trust protector business.
Michigan: Michigan’s Trust Code acknowledges the role of a trust protector. MCL 700.7103. But the powers of a trust protector are not defined by statute (which may be a good thing or a bad thing depending upon what the problem is that is to be addressed.) What does distinguish Michigan’s role of trust protector is that the trust protector will always act in a fiduciary capacity with regard to the trust beneficiaries, and that fiduciary role held by the trust protector cannot be eliminated by the trust settlor in the trust instrument. MCL 700.7809(1) and (2) and MCL 700.7105(2)(h). So a trust protector in Michigan always serves in a fiduciary capacity.

Directed Trustees: Yet another trend is to permit third parties to direct the actions of the trustee. This may be limited to directing the trustee to make investments, or it could extend to a person or committee that directs the trustee to make trust distributions (to whom, when, and in what amount.) This is important on occasions when a closely held business is held in an irrevocable trust, and the settlor wants someone more familiar with the business to provide directions to the trustee. That then raises the question of what the trustee’s liability will be if the actions that it took were at the direction of a third party. If the trustee is not ‘calling the shots’ it wants assurances that it will not be sued if the directions that it followed do not work out as planned. This is a hot topic in the estate planning world, as indicated by the recent adoption of the Uniform Directed Trustee Act, which is now being considered in Michigan.

Delaware: Delaware has a specific statute that addresses the liability (or more accurately the absence of liability) of a trustee that is directed to act by another individual or committee. Few instances exist where a directed Delaware trustee will be held liable for following the directions of a third party, and far more will be required than negligence before a directed trustee will be held liable.
Michigan: Michigan contemplates that a trustee may be directed by a trust protector. MCL 700.7809. A directed trustee in Michigan is generally not liable for following the directions of the trust protector unless the trustee’s compliance with the direction with regard to the attempted exercise would be contrary to the terms of the trust ( an objective standard since the trustee can read the trust instrument) or would constitute a breach of any fiduciary duty that the trust protector owes to the beneficiaries of the trust (a much more subjective standard, as it implies that the trustee knows, or can somehow can ascertain, if the trust protector has a conflict of interest, has acted disloyally, or has acted with partiality in some manner towards some of the trust beneficiaries or trust assets.)

Ease of Trust Modification: In an age when trust laws keep changing along with tax and property laws, it is important, especially for dynasty trusts, to be as flexible as possible to change the trust instrument to adapt to those external changes, including the ability to change the express terms, and sometimes the beneficiaries, of an irrevocable trust. A common example is a trust beneficiary who through disability later becomes eligible to receive governmental benefits, which eligibility can be jeopardized if the beneficiary possesses the right to receive trust income or principal; eliminating those ‘rights’ would preserve the beneficiary’s eligibility for governmental benefits.

Delaware: Delaware has specific statutes that permit a court to reform a trust and a trustee to decant the trust to a new trust. Delaware also has modern virtual representation laws which can be exploited to facilitate and expedite changes to trust instruments in court proceedings without having to appoint a guardian ad litem for unborn or unascertainable future trust beneficiaries. Added to these enabling statutes is the Delaware Chancery Court which controls trusts and which is highly sophisticated in understanding how trusts function and the roles and responsibilities of trustees. Correct or not, the thinking is that a court in Delaware will be more receptive to trust reformations, modifications, or the enforcement of Delaware laws that provide more protection to the trustee that carries out its fiduciary duties.
Michigan: Like Delaware, Michigan has adopted many of the provisions of the Uniform Trust Code including many virtual representation For example the Michigan Trust Code has provisions that permit the modification or termination of a trust [MCL 700.7410 and MCL 700.7411] and judicial reformations to correct mistakes in the terms of the trust [MCL 700.7415]. Michigan also has, in effect, two trust decanting statutes [MCL 700.7820a (administrative provision changes); and MCL 556.115a (dispositional changes for the beneficiaries.) Frankly I did not see where Delaware’s laws were all that more favorable or liberal than Michigan’s statutes that permit future trust modifications. I do strongly suspect, however, that the Delaware Chancery Court is far more adept at dealing with requests to modify, reform, or decant an irrevocable trust than are Michigan probate judges (referring to sophistication more so than competence and integrity.)

Special Purpose Trust: Special purpose trusts are normally trusts that are created without individual beneficiaries (whose presence is normally required to enforce the terms of the trust), such as a ‘pet-trust’ or a trust that holds an art collection or a legacy cottage. Another recent example of a purpose trust is a gun trust that is designed to hold title to the registered guns, in order to avoid many of the registration and fee requirements of the federal government.

Delaware: Delaware law permits a special purpose trust to exist and be enforced even when there is no individual beneficiary of the trust.
Michigan: Michigan has a very limited purpose trust statute, primarily for pets. Specifically, the Michigan statute provides that the trust must have a definite beneficiary or it is either a charitable trust or it is a non-charitable trust for the care of an animal. MCL 700.7402(c) and MCL 700.2722. A special purpose trust to hold an art collection or a wine collection or to hold real property, without an individual beneficiary, would not be permissible under the Michigan Trust Code.

Privacy and Confidentiality: Settlors who adopt irrevocable trusts usually like their privacy and want that same level of privacy for the trusts that they create. Often they settlor does not want the trust beneficiary to know the amount of wealth held in the trust out of a fear that the wealth might lead the beneficiary to a life of indolence. Then there are occasions where the trust beneficiaries who have outstanding creditor claims against them do not want the existence of the trust, or their interest in the trust, to become available to the general public.

Delaware: The Delaware statute permits a trust settlor to direct the trustee to not communicate the existence of the trust to trust beneficiaries. Thus it permits a level of silent trust to exist for a specific number of years in Delaware. However, Delaware’s laws do not expressly allow for the trust protector to modify the notice to beneficiaries. Along the same lines, if the trust is involved in court proceedings, e.g. annual accountings, beneficiary litigation against the trustee, Delaware law permits the court to seal the court record with regard to the trust and its assets for up to 3 years.
Michigan: Michigan does not permit a trust settlor to relieve the trustee of the duty to inform and report to trust beneficiaries with regard to their trust. [MCL 700.7814 and MCL 700.7105(2)(j).] Moreover, while Michigan Court Rules can permit a court to seal a file, it is only in extraordinary circumstances that a public court file will be sealed in Michigan.

Change of Situs: The ability to change the situs of a trust is important when families look for the most favorable laws under which their trust is administered as their circumstances change over the years. An obvious example is if they wish to change the situs of the trust to a jurisdiction that does not impose an income tax on accumulated trust income. But changing the situs of an irrevocable trust can also threaten the GST ‘grandfathered exempt status’ of an irrevocable trust, so changing situs has to be carefully considered. The concern is that a desired change in situs might expose the trust to a new legal regime and laws that could inadvertently change the rights of beneficiaries or jeopardize a GST exemption (which often goes along with establishing a GST exempt trust.)

Delaware: Recent court decisions in Delaware make it clear that Delaware law will govern the administration of any trust that allows for the appointment of a successor trustee without geographic limitation, once a Delaware trustee is appointed and the trust is administered in Delaware, unless the choice-of-law provision of the trust instrument expressly provides that another jurisdiction’s laws will always govern the administration of the trust. These favorable court decisions assume that the settlor’s decision to appoint a Delaware trustee reflects the settlor’s implied intent that Delaware law will always govern the administration of the trust, even if there is a subsequent change in situs.
Michigan: Michigan does not have a statute like Delaware’s that clearly centers trust administration in Michigan to always be subject to Michigan’s laws, even if there is a change in situs of the trust.

Limited Powers of Appointment: Effective flexible trust planning and administration can be achieved by giving trust beneficiaries a limited power of appointment to redirect assets different from what the trust instrument prescribes. Thus, a limited power of appointment is a tool often included in a dynasty trust to allow the power holder to appoint trust assets to or among a group of beneficiaries, altering the trust’s prescribed distribution formula. But then there is IRC 2041(a)(3) which prevents a perceived tax abuse, commonly known as the Delaware Tax Trap, so as to avoid an inadvertent federal estate tax upon the power holder’s death. The use of limited powers of appointment are most often reserved for beneficiaries and decedents who are ascertainable on the creation of the trust to prevent the inadvertent violation of IRC 2041(a)(3) which can cause estate tax problems. Additionally, the exercise of the limited power of appointment could be considered a constructive addition to, or material alteration of, the beneficial interests of the trust, thus endangering its grandfathered GST status. As such, some states have adopted statutes that curtail the scope of the limited power of appointment to avoid the estate tax or GST tax problems that the power might otherwise cause.

Delaware: Delaware’s laws with regard to powers of appointment are designed to avoid the inadvertent exercise of a limited power of appointment that could jeopardized a GST exempt irrevocable trust.
Michigan: Michigan’s law is drafted much like Delaware’s law with regard to a limited power of appointment and the protection against an inadvertent modification to a grandfathered GST trust.
Explanation of the ‘Tax Trap’: The Delaware Tax Trap refers to the exercise of successive limited powers of appointment over successive generations that allows for a virtual perpetual trust without exposing assets to either the federal estate or GST taxes. IRC 2514(d) was added to the Tax Code to prevent this abuse/result from occurring. The successive exercise of the limited powers of appointment will cause estate taxation of the assets subject to the limited power of appointment in the power holder’s taxable estate, or will treat it as a taxable gift, and might also impact the ‘grandfathered’ GST exemption of an older irrevocable trust.

Discretionary Trusts: Many settlors are concerned about the beneficiaries of their trust losing trust assets to creditors or to former spouses in a divorce. As such, they look for state laws that strive to protect the assets held in the irrevocable trust from those creditors of the beneficiary. In this regard, state laws are not consistent, e.g. Massachusetts and Connecticut trust assets inherited during the marriage, including beneficial interests in trusts, as part of the beneficiary’s marital estate in the event of a divorce. Michigan normally treats inherited and gifted assets during the marriage as not part of the marital estate in a divorce.

Delaware: Delaware has adopted the Uniform Trust Code, so many of that uniform statute’s features are a part of Delaware’s laws. Delaware has a strong statute that specifies that a beneficiary’s creditor cannot reach the assets held in a discretionary trust. The authors do offer something of a criticism of Delaware’s laws in this regard. According to the authors, the best type of discretionary trust legislation is a statute that protects the beneficiary’s interest in that trust from creditors (or divorce courts) which: (i) provides a clear definition of what a discretionary trust is; (ii) spells out that the beneficiary has no enforceable right to force a distribution from the trust; and (iii) asserts that the interest that the beneficiary holds in the trust is not a property interest. Apparently Delaware’s statute does not include item (ii) [no enforceable right] which they view as a weakness. Nor is there a particularly ‘helpful’ definition of what is a discretionary trust.
Michigan: This may be one of the few areas where Michigan’s laws may be better than Delaware’s. Michigan’s Trust Code provides a clear and expansive definition of a discretionary trust. MCL 700.7103(d). This definition gives to the trustee considerable latitude in the exercise of its discretion [MCL 700.7815], while confirming that the trust beneficiary has no property right in a trust interest that is subject to a discretionary trust provision. Finally, the Michigan Trust Code spells out clearly what and when a creditor of the discretionary trust has access to the assets in the trust: The creditor of the beneficiary of a discretionary trust does not have a right to any amount of trust income or principal that may be distributed only in the exercise of the trustee’s discretion, and trust property is not subject to enforcement of a judgment until income or principal, or both, is distributed directly to the trust beneficiary. MCL 700.7505. The Michigan definition of a discretionary trust does not, as the authors would like, contain a statement that the trust beneficiary possess no enforceable legal right to force a distribution from the trust. Still, I think Michigan’s protection to a trust beneficiary may be a bit better than Delaware’s laws.
Explanation of Property Interest: If a trust beneficiary does not possess an enforceable right to a distribution from the trustee because the trustee has sole discretion to make any distribution and there are no ‘standards’ imposed to confine the trustee’s discretion, no creditor can ‘stand in the shoes of the beneficiary’ to access the assets held in the trust. Thus, the beneficiary’s interest in the trust is not a property It is nothing more than expectancy that cannot be attached by any creditor, nor can the interest be viewed as an asset acquired during the marriage, all of which go a long way to keep creditors and former spouses out of the discretionary trust.

Self-Settled Trusts: At common law a person could not create and fund a trust with assets, become the beneficiary of that trust, and then prevent their creditors from accessing their self-settled trust. Many states now adopt statutes that permit these irrevocable trusts, which are designed to protect trust assets from future (not current) creditor claims.

Delaware: According to the survey authors, Delaware has the ‘best self-settled legislation’ in the country. Unfortunately the author’s do not explain why that reached that conclusion, other than a passing observation that a creditor has a very short period of time in which to challenge the transfer of assets by the settlor to a Delaware self-settled trust.
Michigan: Michigan’s 2017 Qualified Dispositions In Trust Act is its answer to the legalization of self-settled trusts. Much of Michigan’s statute was based on Ohio’s version of self-settled trusts, and Ohio’s version fared favorably in the author’s comments. Perhaps Michigan’s statute was so new the author’s did not feel comfortable passing judgment on its merits.

Charging Order Remedy: Many family businesses and investment entities are set up as limited partnerships or limited liability companies. The laws of each state differ, often dramatically, on whether a limited partner or LLC member’s interest in the partnership or LLC can be seized under a judicial order and liquidated to satisfy the creditor claims of the limited partner or member. Some states limit the judicial remedy of a creditor against an LLC member or a limited partner to a charging order. This is important to a trust that might hold the partnership or LLC units.

Delaware: Delaware’s statutes provide that the sole remedy to a creditor of a limited partner or LLC member is a charging order, which is a limited judicial remedy that does not cause the disruption of the operations of the partnership or LLC or impact the interests of other partners or members of the same legal entity.
Michigan: Michigan’s law is much like Delaware’s in that it provides that a charging order is the exclusive remedy for a judgment creditor’s claim against a member of an LLC. Not as clear is if a charging order is the sole remedy for a judgment creditor’s claim against a limited partner’s interest in the partnership. The LLC statute’s use of the term exclusive remedy is intended to communicate to a judge that other equitable remedies that judges often construct in order to do ‘justice’, e.g. the imposition of a constructive trust, are not available to access assets held in the LLC.
Explanation of Charging Order: As a generalization, a charging order imposed on a partner or member’s interest in the entity entitles the judgment creditor to receive whatever distributions that the partner/member would have otherwise received. The charging order does not give the judgment creditor the right to vote the limited partner or member’s interest in the entity. Thus, without a vote, generally the judgment creditor cannot force the liquidation of the LLC nor can the judgment creditor force the LLC manager to make a cash distribution from the LLC.

Dominion and Control Remedy: Some states permit the use of innovative theories to enable a judge to exploit its equitable remedies to permit a creditor to ‘pierce’ a trust in order to access the trust’s assets. For example, some courts will find that the trust beneficiary retains so much control over the trust assets that the court finds that the beneficiary indirectly controls the trustee and thus the assets held in the trust, thus permitting the judgment creditor access to the trust assets to satisfy a judgment against the beneficiary. Another legal theory that courts will use to fashion equitable remedies is that the trust is the alter ego of the trust beneficiary. These theories often surface when there is a close family relationship between the trustee and the trust beneficiary. These legal theories present yet one more threat to self-settled asset protection and dynasty-type trusts.

Delaware: To prevent the imposition of these legal theories to attack a trust, Delaware adopted a statute that provides that a creditor has no more rights than provided by the trust document itself. The authors seem to think that this type of statute can preclude an alter ego finding by a court, but they question whether the statute would prevent a Delaware court from using an equitable dominion and control remedy to expose the assets of a trust to satisfy the creditors of the trust beneficiary.
Michigan: Michigan has no similar statute that attempts to remove from a court its equitable remedies of alter ego or dominion and control.

Trust ‘Migration:’ This term is a bit misleading. It deals with a trust instrument that is silent on whether a trustee should look at the beneficiary’s resources before making a distribution from the trust to that beneficiary. As a generalization, at common law, and the first two Restatements of Trust, if the trust instrument is silent, then the trustee does not have any obligation to look to a beneficiary’s resources to determine the amount of a distribution to th