On July 11, 2008, the Internal Revenue Service issued proposed guidance (Notice 2008-63) regarding the estate, gift, generation-skipping and income tax issues involved with trust companies that are family-owned or controlled, aka “private trust companies” (PTCs).
This guidance, pending since 2005, has been much anticipated — as wealthy families are increasingly interested in forming their own PTCs (that is to say, entities that are owned entirely by members of the same family and serve as trustee of trusts held for the benefit of that family.) For many wealthy families, a PTC is a viable alternative to a commercial corporate trustee or individual trustees. A family may form a PTC as part of a long-term fiduciary plan and use it to introduce flexibility into existing trusts, particularly those requiring a corporate trustee. A PTC allows a wealthy family in a private setting to institutionalize trustee selection and succession, as well as control investments and costs.
Even though the guidance was issued in the form of a proposed revenue ruling and cannot be relied upon at this point, the IRS clearly stated that it intends the tax consequences of using PTCs to be no harsher nor more favorable than a taxpayer could achieve by acting directly. But the fact patterns and issues addressed by the IRS are somewhat limited. Some expansion is needed to make the ruling truly helpful.
While the proposed guidance provides insight into the government's analysis, it fails to address some important questions that families thinking about PTCs must consider.
For example, the proposed guidance addresses the creation of a discretionary distribution committee (DDC) to make tax sensitive trust distribution decisions. The proposed guidance allows grantors and beneficiaries to act as members of the DDC — but they are prohibited from participating in decisions (1) regarding any trust of which they or their spouses are the grantor or beneficiary; or (2) for any trust with a beneficiary to whom that DDC member or the member's spouse owes a legal obligation of support.
Unfortunately, the proposed guidance does not address the critical questions of who may remove and who may replace DDC members. There are certain regulations that impute the powers of a trustee to a person who can remove and replace that trustee. In 1995, the IRS in Revenue Ruling 95-58 adopted a safe harbor for the removal and replacement of trustees by a grantor. The proposed guidance does not specify whether members of the DDC can be removed. If removal is possible, the guidance fails to make clear whether the limits in Rev. Rul. 95-58 apply with respect to who may do the removal or, in the event of a removal, who may appoint or be appointed as a replacement.
Answers are needed, because one of the primary reasons to form a private trust company is flexibility regarding these important decisionmakers.
Another area that needs clarification is whether the limitation on beneficiary involvement in the DDC applies only to those beneficiaries who currently are permissible recipients of payments in the trustee's discretion. Is a remainder or otherwise contingent beneficiary also barred from participating in decisions when acting as a member of the DDC? (See Treasury Regulations Section 25.2511-1(g)(2).)
In addition, final guidance should clarify that the restriction on a beneficiary participating as a DDC member in “discretionary” decisionmaking would not apply to trusts with ascertainable standards.
The proposed guidance provides that only officers and managers of the PTC may participate in personnel decisions (including the hiring, discharge, promotion and compensation of employees). Family members aren't prohibited from acting as officers and managers of the PTC. Indeed, the proposed guidance's examples only have family members acting as officers of the PTC. It's unclear why the IRS limited its analysis in this manner. Perhaps it's because officers and managers have a fiduciary obligation and thus cannot misuse this power. Further clarification would be helpful.
Overall, the IRS has, with this proposed guidance, given an encouraging first step by providing a tax-appropriate framework for PTC structures. But the Service left many key questions unanswered. So, until it releases final, comprehensive guidance, clients must carefully consider the structure and operation of their PTCs.