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Sticks and Carrots: Liability Protection for Directed Trust Appointees Through Special Purpose Entities

Asking someone to serve as a trustee is a BIG DEAL accompanied by heavy fiduciary duties that potentially create financial liability for the trustee. 

Although many people would be happy to help their loved ones by filling this role, often they feel they are not qualified to measure up to the fiduciary standards associated with serving as a trustee.  Even the financially literate or the investment savvy relative may wish to avoid serving as a trustee because of the accounting and notice duties required of trustees.  It involves time, work, and liability.

While the sticks of time and work may be alleviated by the carrots of trustee compensation and the satisfaction of serving a loved one, the stick of liability may be the intimidating factor that causes many to shy away from serving as a trustee.  Fortunately, South Dakota has enacted several laws that serve to offer a carrot to settlors and potential trustees by limiting the liability burden or shifting it away from those the settlor needs most.

One way in which liability is shifted is through the use of a Directed Trust, which shifts certain responsibilities (and associated liability) away from a trustee and into the hands of investment committees and distribution committees.  The general benefits of Directed Trusts were addressed in my recent post, “South Dakota Directed Trusts Overview.”  While that post discusses the shift of liability away from a trustee, it places liability back in the hands of the settlor and others who the settlor places on the investment and distribution committees.  The issue then becomes how to protect those committee members from liability.

The most significant way to shield committee members and other directed trust appointees from liability is by placing them in a South Dakota Special Purpose Entity (“SPE”).  This places a liability umbrella over the individuals in the SPE.  Investment and distribution committee members, trust protectors, and family advisors may all be placed in a SPE to protect them from personal claims connected to their actions in their separate capacities.

This liability shield stems from liability protection provided for entities such as a limited liability company (“LLC”) or a corporation.  Because LLC formation and operation is simpler and more flexible than that of a corporation, LLCs are the preferred entity for use as a SPE.  LLCs also offer more privacy than a corporate structure.  Most importantly, under South Dakota law, the exclusive remedy for a judgment creditor of an LLC is the individual members’ contribution to the entity.[1]  So when the LLC is sued, the judgment creditor is limited to collecting the assets held by the LLC.  Conversely, South Dakota law also provides that when an individual member is personally sued, that individual’s interest in the LLC is off limits to a judgment creditor.  South Dakota courts have interpreted this law broadly in favor of protecting the entity and its members from creditor liability.

Other states, however, are far less forgiving when it comes to LLC member liability.  This is concerning for South Dakota SPEs because, given the nature of directed trusts in which SPEs are used, there are more people involved than under a traditional model in which the trustee fills all roles.  With more people come more jurisdictions.  For instance, a settlor from Tennessee may have a South Dakota directed trust (South Dakota situs) with investment committee members from New York and the settlor’s best friend in California serving as a distribution committee member.  If someone messes up, who is liable, and which state’s statutes and court decisions apply?

By organizing a SPE LLC in South Dakota, the LLC members (the settlor and investment/distribution committee members) are brought under one roof in South Dakota, potentially eliminating the potential for another state effectively claiming jurisdiction over the LLC or its members.  Not only does this shield the individuals from liability associated with their duties as advisors, but it also bolsters the situs of the directed trust in South Dakota, ensuring that South Dakota’s advantageous laws apply over another state.  This is important to ensure the trust yields as little tax liability as possible (South Dakota has no state income tax or inheritance tax) and to protect the trust’s assets from outside creditors of the settlor and beneficiaries (South Dakota offers favorable asset protection laws).

South Dakota offers another carrot by making it relatively easy to establish and maintain a SPE.  This SPE Tip Sheet covers the basic requirements and limitations with which a SPE must comply to serve the purposes discussed above.  For advice on whether a South Dakota Special Purpose Entity is right for you, and for assistance in organizing one as part of your directed trust, contact a South Dakota estate planning attorney.

[1] SDCL 47-34A-504.