Right To Do Or Do It Right? Trust Ownership of Family Businesses

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1 Right To Do Or Do It Right? Trust Ownership of Family Businesses Stephanie Loomis-Price I. Introduction Stephanie Loomis-Price, a partner with Winstead, PC, handles federal gift and estate tax litigation, including disputes and litigation with the Internal Revenue Service, as well as state fiduciary and probate controversy work. She has assisted clients in numerous cases in the United States Tax Court, the United States Court of Federal Claims, and the United States Court of Appeals for the Fifth, Eighth, and Eleventh Circuits, as well as County Probate Courts across Texas. She also counsels clients regarding complex estate administration. Stephanie currently serves on the Executive Committee for the Real Property, Trusts and Estates Law Section of the American Bar Association, as well as Co- Chair of its Continuing Legal Education Committee. Board Certified in Estate Planning and Probate Law, Stephanie is a Fellow of the American College of Trust and Estate Counsel. She can be reached at sloomisprice@winstead.com. The author would like to thank and acknowledge Jessica Schaefer, Esq. for her contributions to this article. Trusts are estate planning tools used to facilitate business succession plans and to allow senior family members to extend control over the management and affairs of a family s wealth through and after disability and death. Placing a business interest in trust allows the grantor the ability not only to direct how the family s wealth is administered, but also, to a great extent, how the family s business is handled. Contribution of a family business interest to a trust is not a novel concept. Increasingly over the past century, family leaders began placing their trust in trusts to care for and grow family businesses. [W]e are seeing a day in which the properties left behind by the heads of American families are less likely to be balanced portfolios of capital assets and are more likely to be going businesses. The problem with modern trusteeship... is therefore likely to be not so much one of safe conservation of assets... as it is one of alert and successful management of going businesses. 1 Even so, a business interest is different from typical trust assets (e.g., land, money, debt instruments, publicly traded equities, and bonds), and holding entity interests in trust can be problematic for trustees. For instance, an entity s governing instruments may limit a trustee s ability to sell interests in the business, making 1 Mayo A. Shattuck, The Art of Estate Planning: Its Past and An Estimate of Its Future, 87 Tr. & Est. 13 (1948). ALI CLE Estate Planning Course Materials Journal 7

2 8 ALI CLE Estate Planning Course Materials Journal February 2014 it difficult for the trustee to comply with its general duty to diversify trust assets. In addition, depending on the nature of the business interest (controlling or minority), the trustee may be faced with deciding whether to become involved in the entity s business and affairs (e.g., obtaining a position on the board, a position as a director, or no position at all). Further, if the trustee decides to take an active role in the business, are the trustee s loyalties divided between the best interests of the business on the one hand, and the best interests of the beneficiaries of the trust owning an interest in the business on the other? Could the trustee be called upon to make a business decision favoring either the trust beneficiaries or other shareholders or partners, where the decision could (or even be perceived to) harm the other? This outline focuses on the fiduciary responsibilities that may be triggered when assets of a trust include an interest in one or more closely held businesses. In particular, this outline addresses issues that may arise in the context of trustees who hold interests in general partnerships, limited partnerships, and closely held limited liability companies. 2 II. Trustee s Fiduciary Duties A. What Is a Fiduciary? 1. Defined Generally The term fiduciary is derived from civil law (the legal system originating during the Roman Empire in the Sixth Century). 3 However, while civil law has been around for centuries, the legal community in the United States has yet to devise a uniform definition for the term 4 likely because of the number of contexts in which a fiduciary relationship can arise. 5 When asked to define fiduciary, a young lawyer in my firm rattled off a portion of the late Chief Justice Benjamin Cardozo s famous quote in Meinhard v. Salmon that many of us likely read (or 2 Issues related specifically to S Corporations and C Corporations are beyond the scope of this article, although there may be significant overlap with the topics discussed here. 3 Kinzbach Tool Co. v. Corbett-Wallace Corp., 160 S.W.2d 509, 512 (Tex. 1942); see also Black s Law Dictionary 280 (9th ed. 2009) (defining civil law as [o]ne of the two prominent legal systems in the Western World, originally administered in the Roman Empire ). 4 See Frederick R. Franke, Jr., Resisting the Contractarian Insurgency: The Uniform Trust Code, Fiduciary Duty, and Good Faith in Contract, 36 ACTEC L.J. 517, (2010) ( Although the fiduciary relation operates in various settings, it is not identical, or as pronounced, in every situation: The scope of the transactions affected by the relation and the extent of the duties imposed are not identical in all fiduciary relations. ), quoting Restatement (Second) of Trusts 2 cmt. b (1959). 5 For example, a fiduciary relationship can arise in, among others, the following relationships: a trustee and beneficiary; executor and beneficiary; attorney and client; guardian and ward; and principal and agent.

3 Trust Ownership of Family Businesses 9 heard) in various law school classes (perhaps in Corporations; Agency and Partnership; or Wills, Trusts, and Estates): Many forms of conduct permissible in a workaday world for those acting at arm s length, are forbidden to those bound by fiduciary ties. A trustee is held to something stricter than the morals of the marketplace. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior. As to this there has developed a tradition that is unbending and inveterate. Uncompromising rigidity has been the attitude of courts of equity when petitioned to undermine the rule of undivided loyalty by the disintegrating erosion of particular exceptions.... Only thus has the level of conduct for fiduciaries been kept at a level higher than that trodden by the crowd. 6 Although a definition comprehensive enough to cover all fiduciary relationships remains elusive, a few constants remain: [A] person in a fiduciary relationship to another is under a duty to act for the benefit of the other as to matters within the scope of the relationship. 7 Generally speaking, [the term fiduciary] applies to any person who occupies a position of peculiar confidence towards another. It refers to integrity and fidelity. It contemplates fair dealing and good faith, rather than legal obligation, as the basis of the transaction. The term includes those informal relations which exist whenever one party trusts and relies upon another, as well as technical fiduciary relations. 8 In addition, because a fiduciary relationship may arise in a number of situations, the standards that apply in different situations, not surprisingly, often differ. 2. Fiduciary Standards in Trustee-Beneficiary Relationship In the context of a trustee-beneficiary relationship, the standard of conduct is set quite high. 9 Rather than merely owing a general duty of fair dealing and good faith to a trust beneficiary, a trustee is generally said to owe a beneficiary an unwavering duty of good faith, fair dealing, loyalty and fidelity over the trust s affairs and its corpus 10 and must act for the sole benefit of the beneficiary. 11 Furthermore, the duties placed on fiduciaries vary from state to state, and in some instances may be restricted, expanded, added, or eliminated by the governing trust instrument. 6 Meinhard v. Salmon, 164 N.E. 545, 546 (N.Y. 1928) (internal citation omitted) (emphasis added). 7 Restatement (Third) of Trusts 2 cmt. b (2007). 8 Kinzbach Tool, supra, 160 S.W.2d at Restatement (Third) of Trusts 2 cmt. b ( The duties of a trustee are more rigorous than those of most other fiduciaries. ). 10 Herschbach v. Corpus Christi, 883 S.W.2d 720, 735 (Tex. App. 1994) (emphasis added), citing Ames v. Ames, 757 S.W.2d 468, 476 (Tex. App. 1988), aff d and modified, 776 S.W.2d 154 (Tex. 1989), cert. denied, 494 U.S (1990). 11 Restatement (Third) of Trusts 78 (2007).

4 10 ALI CLE Estate Planning Course Materials Journal February 2014 In order to determine which duties are owed to beneficiaries (and how broad or narrow those duties are), a trustee should initially consult three cornerstone sources: (i) the governing trust instrument and any amendments; (ii) statutory law, such as the relevant state s Trust Code; and (ii) common law (or civil law if in Louisiana). With respect to the weight given to each, generally speaking, the terms of the trust instrument govern the trustee s duties, while statutory and common law duties provide default rules that apply when the trust instrument is silent on a subject. 12 However, some statutory and common law duties are mandatory, such that they cannot be waived or changed in the trust instrument (and even if the grantor attempts to do so, the attempt will be ignored). To know which duties cannot be waived or changed, the law of the applicable jurisdiction should be consulted. (A short discussion of typical statutorily mandatory provisions, with examples, may be found below in Section II.A.2.c.) a. Duties imposed by the trust instrument: In addition to the statutory and case law landscape that a trustee is likely to be familiar with, the trustee must carefully read the trust instrument to determine whether the grantor has imposed specific duties on the trustee different from those provided under statutory and common law. Typically, trust instruments contain deviations from default law in trustees duties to: diversify investments; allocate principal and income; avoid self-dealing and conflicts of interest; and make distributions on varying standards. b. Statutory and common law duties: Statutory duties are those enacted by state legislative bodies. Thus, statutory duties vary from state to state. For example, most states have adopted some statutory version (or select portions) of the Uniform Prudent Investor Act ( UPIA ). 13 Common law duties, in contrast, are those imposed by court decisions, based on specific facts in individual cases. Clearly, common law duties vary widely state-to-state and sometimes even among individual jurisdictions in a single state. Because there is no uniform body of law governing trusts, the table below describes the duties addressed in the Restatement (Third) of Trusts ( the Restatement ). In particular, we have chosen the Restatement as the reference point because it was written to provide a seamless 12 See Tex. Prop. Code Ann (requiring that the terms of a trust prevail over any provision of the [Texas Trust Code], subject to a few statutory exceptions); see also Del. Code Ann. tit. 12, 3303(a) ( Notwithstanding any other provision of [the Delaware Trust Code] or other law, the terms of a governing instrument may expand, restrict, eliminate, or otherwise vary the rights and interests of beneficiaries. ). 13 See, e.g., Uniform Prudent Investor Act and Modern Portfolio Trust Investment Statutes, available at public/documents/studies/kiziah_50_state_upia.pdf. The UPIA was drafted by the National Conference of Commissioners on Uniform State Laws in 1994, approved by the American Bar Association in 1995, and drafted for purposes of setting uniform standards for prudent trust investing. Trust Examination Manual, Federal Deposit Insurance Corporation, available at

5 Trust Ownership of Family Businesses 11 statement of the best principles of American trust law and [to offer] intellectual guidance to legislatures, judges, and especially those who counsel trustees and beneficiaries and seek to draft instruments that reflect the lawful intentions of donors. 14 In addition, we include below variations of those duties found in Texas (the state with whose laws we are most familiar) that may be implicated when a trustee holds a business interest in trust, where applicable. (Please refer to the table that begins on the following page. Please note that the references numbered 1-16 immediately below are internal to the table only.) 1 Restatement (Third) of Trusts Foreword 76 (2003). 2 Id Id InterFirst Bank Dallas, N.A. v. Risser, 739 S.W.2d 882, (Tex. App. Texarkana 1987, no writ) (discussing obligation to obtain fair market value). 5 Restatement (Third) of Trusts 78 cmt. a. See also section III.B.2 3 of this outline. 6 Restatement (Third) of Trusts Id Id Id Tex. Prop. Code Ann Restatement (Third) of Trusts Tex. Prop. Code Ann Barrientos v. Nava, 94 S.W.3d 270, 285 (Tex. App. Houston [14th Dist.] 2002, no pet.). 14 See section II.A.2.c of this outline. 15 Tex. Prop. Code Ann Restatement (Third) of Trusts Restatement (Third) of Trusts: Foreword (2003)