Questions and Answers about Alaska Native Settlement Trusts
As the rest of website
indicates, a primary focus of our law firm is the use of “settlement
trusts” to hold a portion of our ANCSA clients’ assets.
From time to time, we are asked questions about the settlement
trusts, and as a service to the Alaska Native community, the following
general questions and answers are made available. The following is not
intended to be legal advice, and if you have specific questions, we
encourage you to call or email us.
1.
Exactly what is a Settlement Trust?
Answer:
A Settlement Trust is a trust organized under the provisions of the
Alaska Native Claim Settlement Act (ANCSA) and Alaska law to provide
certain benefits to the shareholders of a specific Native corporation.
2.
Have very many settlement trusts been established?
Answer:
As of December 31, 1999, just under 20 settlement trusts have been
established by Alaska Native corporations.
In the aggregate, these trusts hold over $300 million in assets.
Not every Native Corporation has established a settlement trust,
but those that have established trusts have placed substantial assets in
them.
3.
What benefits can be provided through a Settlement Trust?
Answer:
A Settlement Trust is to promote the “health, education and
welfare of its beneficiaries and preserve the heritage and culture of
Natives.”
4.
What are examples of these benefits?
Answer:
A Settlement Trust can provide educational scholarships.
It could also sponsor Native dance groups. Or it could sponsor traveling shows of native art.
The standard is very broad. At
least five Settlement Trusts of which we are aware provide straight cash
distributions to the beneficiaries on a pro rata basis.
This is being done to promote the “welfare” of the recipients.
The Internal Revenue Service (IRS) has approved all these Trusts.
At least three other Corporations have implemented settlement
trusts to provide benefits for their elders.
Two other trusts have been established to provide educational
benefits, and the IRS has ruled that distributions by these trusts will
qualify for both the Hope and Lifetime Learning Credits.
One of these trusts provides funeral benefits in addition to the
educational benefits. Still another settlement trust has been created to hold
cutover timberland in anticipation of the eventual harvest of the second
growth.
5.
Who may be the trustee(s) of the Settlement Trust?
Answer:
Section 39 of ANCSA says that the trustee(s) of the Settlement
Trust must be individuals. Thus
a bank or trust company cannot serve as trustee.
6.
Does this mean a bank or other financial institution cannot advise
the Settlement Trust?
Answer:
No. The individual
trustees would be free to hire professional advisors, including investment
advisors or managers. The
basic fiduciary responsibility for overseeing the Settlement Trust could
not, however, be delegated by the trustee(s) to some third party.
7.
Who appoints the trustees?
Answer:
ANCSA provides that the Native Corporation which establishes the
Settlement Trust has the “exclusive authority” to appoint and remove
trustees. Presumably, this
power can be exercised by the Board itself or by shareholders in the form
of elections.
8.
Is there a limit on the number of trustees?
Answer:
No.
9.
Could the Board of Directors of the Native Corporation be the
trustees of the Settlement Trust?
Answer:
Yes.
10. What
about potential conflicts of interest?
Answer:
Under Alaska law, a director must always act in good faith for the
benefit of the shareholders, exercising the same judgment a reasonable and
prudent person would exercise. Alaska
law requires a trustee to act in the same manner.
Alaska law does not necessarily prohibit a director or trustee from
serving as a fiduciary for another organization, and in fact, actually
recognizes that fiduciaries may serve on more than one board that may have
to deal with each other. In
general, what Alaska law does prohibit are transactions in which a
fiduciary will derive a material financial benefit from one or both of the
organizations of which he or she is a fiduciary.
If no such benefit is received by the fiduciary personally, the
transaction in question would usually be permissible.
In the usual situation, the Settlement Trust and the Native
Corporation will not have ongoing transactions between them; instead,
their relationship will consist of a one way flow of assets from the
Native Corporation to the Settlement Trust.
Recognize, too, that Alaska law allows the shareholders of a
corporation to ratify a transaction which presents a potential conflict of
interest. This is another
avenue by which potential conflicts can be solved.
In this regard, too, it is also relevant that the shareholders of
the Native Corporation must also be the beneficiaries of the Settlement
Trust. Thus, even if a
transaction between the Native Corporation and the Settlement Trust
benefits one entity disproportionately, usually the same people will be
benefited as are harmed. Thus,
there is really no one who will receive an unfair advantage at someone
else’s expense.
Finally, if the ANCSA corporation does have ongoing relationships
with the settlement trust (for example, a contractual relationships for
compensation to provide services to the trust), there will likely be a tax
issue whether the relationship is sufficiently “fair market value”
to the trust. If not,
the consequence could be that the arrangement could violate the grantor
trust rules discussed below, and therefore, important tax advantages could
be lost.
11.
Does this mean that you don’t have to worry about conflicts of
interest if the whole ANCSA board serves as the trustees of the Settlement
Trust?
Answer:
No, you should never ignore possible conflicts of interest.
However, it does mean that the possibility of conflicts should be
explored on a case by case basis, rather than being a reason that members
of the Native Corporation’s Board should not serve as trustees of the
Settlement Trust.
12.
Are there limitations as to the investments which a Settlement
Trust may make?
Answer:
Yes. ANCSA provides
that a Settlement Trust cannot engage in the “operation of a
business”, and prohibits the conveyance to the trust of certain assets
(primarily assets subject to the 7(i) revenue sharing obligations).
Beyond that, all assets of the Settlement Trust would need to be
invested under the “prudent person” rule discussed above.
That is, the trustees would need to invest the Settlement Trust’s
assets in the same manner as would a prudent person.
The trust agreement itself could contain other restrictions on
investments. An example of
this would be a prohibition on loans to individuals.
Often times the trustees will establish investment policies and
guidelines, which often further restrict investments.
13.
What will constitute “operation of a business” by the
Settlement Trust?
Answer:
As to what constitutes “operation of a business”, there will be
gray areas. Timber harvest
operations conducted by the Settlement Trust’s own employees, would
probably be prohibited. A
timber management arrangement (where all the Trust does is own the timber
and some third party manages the timber) would probably not be prohibited.
Similarly, leasing operations, where all the Settlement Trust does
is own the assets and collect rent (i.e., a net lease situation)
would probably not be deemed a business.
Under the Tax Code, managing one’s investment portfolio is not a
trade or business, unless one actively trades securities on a day to day
basis.
The critical questions in determining whether a business is being
operated by the Settlement Trust will probably include (i) the amount of
activity (including number of employees) in which the trust must engage to
generate the income in question, and (2) whether a recurring loss by the
trust is possible from the activity.
14.
How long may a Settlement Trust last?
Answer:
A Settlement Trust will last only as long as is specified in the
trust agreement which establishes the trust.
There is no limit on how long a Settlement Trust may last: in
theory, the Settlement Trust could last forever.
15.
Can the creditors of a Native Corporation go after the assets of
the Settlement Trust to satisfy the debts of the Native Corporation?
Answer:
The answer here is both “yes” and “no”.
The assets of a Settlement Trust are subject to the claims
of corporate creditors if the claims arose before the assets were
placed in Settlement Trust. Put
differently, a Settlement Trust cannot be used to defeat the claims
of already existing corporate creditors (including those who have
contractual relationships with the Native Corporation).
On the other hand, if a creditor’s claim against arises against
the Native Corporation after the assets are transferred to the
Settlement Trust, then the Settlement Trust is not liable for that claim.
16.
May the creditors of a shareholder sue the Settlement Trust to
recover the shareholder’s debt?
Answer:
The answer here should be no.
The Settlement Trust usually can be sued for its own debts,
not those of the shareholder-beneficiaries.
17.
Are there exceptions to this?
Answer: The answer here is “perhaps”. It is not clear whether a distribution otherwise payable to a beneficiary could be seized by a beneficiary’s creditor before that distribution is actually paid to that beneficiary. ANCSA expressly protects corporate distributions from being seized by a shareholder’s creditor before distribution, but does not specify whether the same protection applies to pending distributions from a Settlement Trust.
An open issue is whether the Child Support Enforcement Division (CSED) can reach settlement trust assets to satisfy a beneficiary’s child support obligation. The position of the state of Alaska is that it is in fact able to reach the settlement trust assets through an administrative enforcement order. This issue is in the process of being litigated, so no final answer exists.
With this in mind, it may be preferable for a Settlement Trust to
not require specified distributions (such as 100% of all income
earned by the trust in a particular year), but instead to leave
distributions in the discretion of the trustees.
This would probably limit the period during which a distribution is
payable, and thus the potential period during which a beneficiary’s
creditors could try to seize a pending trust distribution.
There may be a tax problem, though, in leaving income and principal
distributions completely at the discretion of the trustees, because this
could cause the Settlement Trust to become taxable as a “grantor
trust”. Various IRS private
rulings have approved a trustee’s discretionary power to accumulate or
distribute a portion (e.g., 25% of the annual income) without the
trust being a granter trust, but it is unclear whether a discretionary
power to distribute or accumulate 100% of the income would cause the trust
to be taxable as a “grantor trust”.
Although the grantor trust rules are discussed in more detail at
question 26 below, a grantor trust is generally a trust in which the
person or entity establishing the trust retains certain powers over the
trust that are listed as impermissible by the Tax Code.
If grantor trust status exists, it means that the trust’s
earnings will become taxable to the grantor.
Also, no provision of law automatically prohibits a creditor from trying to seize a beneficiary’s interest in the Settlement Trust. Thus, it also makes sense for the Settlement Trust Agreement to contain clauses prohibiting a beneficiary from assigning his or her interest in the trust. This is a so-called spendthrift clause; in most states (including Alaska), these clauses are enforceable.
18.
Can ANCSA land placed in a settlement trust be seized by creditors
of the Native Corporation or subjected to bankruptcy?
Answer:
In general, as noted above, the Settlement Trust only has to answer
for its own debts and the debts and obligations of the Native Corporation
at the time the Native Corporation establishes the Settlement Trust.
Corporate debts and obligations which arise after assets are
conveyed to the Settlement Trust cannot be recovered from the Settlement
Trust.
Moreover, even as to those debts and obligations for which a
Settlement Trust would be liable, ANCSA land in a settlement trust has all
the same protections that land could have if owned by the Native
Corporation itself. The automatic land bank protections provided by ANILCA
automatically apply to ANCSA land so long as the land is not developed, or
leased or sold to third parties. Additionally,
such land cannot be seized by a creditor unless the Native Corporation or
Settlement Trust gives up in writing its protection from such
seizures. One advantage to
having ANCSA land in a settlement trust is that such land cannot be sold
to third parties even voluntarily. An
ANCSA corporation, on the other hand, is free to sell its ANCSA lands.
19.
How is the transfer of assets to a Settlement Trust taxed?
Answer:
Our answer here is based on the numerous private letter rulings
which the IRS has already issued to ANCSA corporations.
First, the IRS’ view is that the transfers by the Native
Corporation to the Settlement Trust are functionally
the same as distributions by the Native Corporation directly to its
shareholders. This means that
the “present value” of the amounts transferred to the settlement trust
are taxable to the extent the Native Corporation has earnings and
profits.
Second, again according to the IRS, the Settlement Trust itself
should not have gain or loss when it receives assets from the Native
Corporation.
Third, says the IRS, the Native Corporation which establishes the
Settlement Trust will have to recognize any gain in the assets when it
transfers assets to the settlement trust.
This rule applies if the actual assets being transferred have
appreciated (that is, gone up in value).
If cash is being transferred, there would not be any gain to the
Native Corporation.
Fourth, legislation has been proposed in Congress which would
change all this, but at this writing, has not been adopted.
20.
What is the tax basis of assets transferred to the Settlement
Trust?
Answer:
The IRS has now ruled in the various private rulings that assets
transferred to the Settlement Trust have the same basis to the Settlement
Trust that those assets had in the hands of the Native Corporation,
adjusted for any gain or loss recognized by the Native corporation.
The IRS has also repeatedly ruled that for tax purposes, the period
in which the settlement trust has held its assets includes any period the
Native corporation held the same assets.
21.
How is a Settlement Trust taxed on its earnings?
Answer:
A Settlement Trust is to be taxed as are most other trusts, i.e.,
the Settlement Trust is taxable as its own entity, independently of the
Native Corporation which established it, and independently from the
beneficiaries of the Settlement Trust.
A trust normally receives a deduction for any earnings it
distributes during the year; this has the practical effect of making the
trust nontaxable to the extent of the earnings it actually distributes.
To the extent they receive taxable earnings in the form of trust
distributions, the trust’s beneficiaries are taxed at normal individual
rates.
The effect of all this is to allow a trust to eliminate what would
otherwise be a corporate level tax, i.e., to convert the two-level
corporate tax structure into only one level of tax.
This assumes the Native Corporation does not retain any forbidden
powers over the trust, which could make the trust a “grantor trust”.
Special tax rules apply to grantor trusts, as discussed in question
26 below. Assuming the
Settlement Trust is taxed as a trust, under present law the trust’s
ordinary income which is not distributed will in general be subject to a
39.6% tax rate and undistributed capital gains at a 28% rate.
These rates are generally the same as those for an individual
person, although the maximum trust tax rates start at a lower level than
for individuals.
Legislation has been proposed in Congress which would permit a
settlement trust to retain a portion of its annual income without taxation
to “inflation proof” the trust, but at this writing, has not been
adopted. This legislation was
not adopted. Other
legislation is pending which would subject ANCSA settlement trusts to a
flat 15% tax on ordinary income, with distributions being tax free to
beneficiaries.
22.
Does this mean that the Settlement Trust is not consolidated with
the Native Corporation in the same way that a subsidiary is?
Answer:
Yes, that is exactly what it means.
Thus, losses that the Native Corporation might have (such as from
depletion) would not offset the income of the Settlement Trust.
The only way the Settlement Trust could avoid taxation is first
from its own losses and expenses (if any) and second, by making taxable
distributions to its beneficiaries.
23.
Does this also mean that income from the Settlement Trust is not
taxable to the Native Corporation?
Answer:
Yes, subject to the discussion below about “grantor trusts”.
24.
Are there circumstances in which the earnings of a Settlement Trust
could be subject to more than one level of tax?
Answer:
Unfortunately, the answer is yes.
This could arise if the IRS views the Settlement Trust as either a
“grantor trust” or as an “association”, rather than a “true”
trust. It also could occur if
tax rates change so that income accumulated by the trust (and taxed once
to the trust) is then taxed again to the beneficiaries when that
accumulated income is distributed to them.
The rules under which this occurs are called the “throwback
rules” (because the income is “thrown back” to earlier tax years of
the beneficiaries and taxed at those rates.
However, as long as the income tax rates are the same (or higher)
for the trust than it is for beneficiaries, the throwback rules should not
cause a second level of tax beyond the trust’s own tax.
25.
What is a grantor trust?
Answer:
A grantor trust is a trust in which the entity which establishes
the trust retains certain prohibited powers.
In essence, the powers are the kind which would make the trust
illusory. An example of such
a power would be an unlimited power in the Native Corporation to revoke
the trust. To avoid this, the
Settlement Trust should provide that it is irrevocable.
26.
How is a grantor trust taxed?
Answer:
A grantor trust is usually ignored for tax purposes, and its assets
are treated as owned by the “grantor” (the person or entity which
established the trust in question).
27.
What is an association, and how is it taxed?
Answer:
An “association” is an entity which has characteristics
which are so similar to a corporation that the entity should be
taxable as a corporation. As
to a “Settlement Trust”, that issue could arise (according to the IRS)
because the trust has a large number of beneficiaries, who have supposedly
joined together to allow the trustees to make “profits” using the
beneficiaries’ assets, and because the assets which are being used to
generate the trust income has formerly been held in corporate ownership.
While we think this is not an issue on which the IRS should
prevail, especially given the importance of the Settlement Trust within
the 1991 Legislation, it is an issue the IRS could raise on an audit.
Because of this, most of the private rulings listed above
specifically addressed this issue.
28.
Is there any requirement that a Settlement Trust distribute a
particular percentage of its annual income?
Answer:
No. Subject to the
fact that undistributed trust earnings will be taxed to the trust,
and further subject to whatever the trust agreement requires as to annual
distributions, and further subject to any change in the law which may
result from the “inflation proofing” legislation referred to above, a
Settlement Trust would not necessarily have to distribute any of its
annual income.
29. How are the beneficiaries of the Settlement Trust taxed?
Answer:
Beneficiaries will only be taxed, in general, to the extent the
trust’s income is actually distributed to them each year.
Beneficiaries are to receive a “K-1 form” from the trustees.
The K-1 is an IRS required form and will tell the beneficiaries the
amount of taxable distributions they have received during the year, in
much the same manner as the form 1099-Div that a corporation’s
shareholders already receive. Typically,
a “substitute Form K-1” is prepared for the settlement trust which
will convey this information based upon the specific circumstances of that
ANCSA settlement Trust. Legislation
is pending that would permit Form 1099 reporting for all taxable
settlement trust distributions.
30.
Will the amount of corporate earnings affect the taxability to the
shareholders?
Answer:
No, assuming the settlement trust is actually taxable as a trust
and not a “grantor trust” (see questions 24-26 for a discussion of
“grantor trusts”). Only
the taxable income (or loss) of the trust itself affects taxation of the
beneficiaries.
31.
Do settlement trusts have to benefit all beneficiaries at the same
time in the same amount?
Answer:
No. Although this
“no” answer would seem clear from the ANCSA provisions which authorize
settlement trusts, this issue was formally litigated relative to the
Sealaska settlement trust which provides elders benefits.
In Broad v. Sealaska Corporation, 85 F.3d 422 (9th Cir.
1996), cert. denied, 117 S.Ct. 768 (1997), the federal courts
concluded that settlement trusts can be established to provide
“disproportionate benefits” such as elders benefits or educational
benefits. This is an
important advantage to settlement trusts, since present Alaska corporate
law is clear than in general such benefits could not be directly provided
by the ANCSA corporation itself. See
Hanson v. Kake Tribal Corporation, 939 P.2d 1320 (AK. 1997).
32.
Will use of a settlement trust disqualify a beneficiary from
federal needs-based eligibility programs (such as food stamps)?
Answer:
The answer again is “maybe”.
It is clear from ANCSA that the beneficiary’s interest in
the Settlement Trust is not to be counted in determining
eligibility. However, it is
not clear whether cash distributions from a Settlement Trust can be
excluded in the same way that the first $2,000 of cash distributions from
a Native Corporation are excluded. The language allowing the $2,000 exclusion refers only to
distributions by a Native Corporation.
This may be a technical clarification which Congress might be
willing to make. The Native
corporations with which we work take the position that the $2000 exclusion
includes settlement trust distributions.
33.
There still seem to be a number of uncertainties, especially
regarding the tax status of the Settlement Trust.
Is there a way these uncertainties can be resolved?
Answer:
Many of the original uncertainties regarding settlement trusts have
now been resolved by the several IRS private rulings which have now been
issued.
Other tax uncertainties (such as association status or grantor trust status of a specific proposed settlement trust) could be resolved through a private ruling by the IRS, in the same way most Native Corporations have resolved these issues as to their specific Settlement Trusts with their own private rulings.
34.
What would you say are the principal advantages we should remember
regarding settlement trusts?
Answer:
We have been involved with the substantial majority of the
settlement trusts which have been established or actively considered by
Native Corporations. Our
clients have found a variety of advantages to settlement trusts, but the
most important advantages are:
(a) Permanence
(b) Limited Risk
(c) Tax Advantages
(d) Protection from Creditors
(e) Lower Expenses than with operating companies