A trust can own a valuable interest in a family business without the trustee having the right to vote, manage the company, inspect every aspect of its operations, or participate in major business decisions. That can put a trustee in a difficult position.

The trustee has fiduciary responsibilities to protect and administer the trust's assets. But what happens when one of the trust's largest assets is an interest in an LLC controlled by someone else?

Under New York law, the answer often depends on an important distinction: owning an economic interest in an LLC does not necessarily mean having the rights of a full member.

For trustees and beneficiaries, that distinction can become very important when substantial family wealth is involved.

Ownership and Control Are Not Always the Same Thing

Consider a common family-business scenario. A parent owns an interest in a closely held LLC. As part of the parent's estate plan, that interest ultimately passes to a trust. The trust is intended to receive the economic benefit of the ownership interest, perhaps providing income to one beneficiary, perhaps for a child, while preserving the underlying asset for future beneficiaries, such as grandchildren.

The trustee now holds a valuable LLC interest. But does the trustee get to vote? Can the trustee participate in management? Can the trustee object to a major transaction? Can the trustee demand that profits be distributed rather than retained? Can the trustee pursue claims on behalf of the company if those controlling it are harming its value?

The answers depend on the rights the trust actually acquired. Under New York Limited Liability law, an assignment of an LLC membership interest generally does not, by itself, entitle the assignee to participate in management or exercise the rights of a member. The assignee ordinarily receives the economic rights associated with the assigned interest, subject to the operating agreement and applicable law. Admission as a substitute member is a separate issue and may be required before the trustee obtains those additional rights.

Consequently, a trust may be entitled to substantial distributions from a family business without having corresponding authority over the decisions affecting the company's value.

The manner in which the interest passed to the trust also matters. An assignment during the owner's lifetime may raise different issues from a transfer following the owner's death.

Start With the Operating Agreement

When a trust receives an LLC interest, one of the first documents that should be examined is the company's operating agreement. The operating agreement may determine whether a transferee becomes a member, what consent is necessary for admission, and what rights a transferee possesses before becoming a member. These provisions can dramatically affect the trustee's ability to protect the trust's investment.

For example, the operating agreement may restrict transfers, require approval from other members before admitting a substitute member, or establish particular rights concerning distributions, voting, and access to company information.

A trustee should also examine the documents establishing the transfer and determine whether the trust received a full membership interest or only economic rights.

Importantly, the trustee should not assume that receiving an ownership interest automatically carries every right previously exercised by the individual who owned it.

The Trustee's Fiduciary Duties Do Not Disappear Because Someone Else Controls the Business

A lack of control does not make the LLC interest irrelevant to the trustee's responsibilities. The LLC interest remains a trust asset, and the trustee must administer that asset in accordance with the trust instrument and applicable fiduciary duties.

Depending on the circumstances, those responsibilities may include monitoring the investment's performance, understanding the rights associated with the interest, properly administering distributions, and evaluating reasonable measures to protect the trust's investment.

The trustee cannot necessarily dictate how the company operates. But the inability to control management does not mean the trustee should simply remain passive. The relevant question is what reasonable steps the trustee can and should take using the rights actually available to the trust.

Should the Trustee Seek Full Membership Rights?

One important consideration is whether the trustee should seek admission as a substitute member of the LLC. Full membership may provide voting, information, or other governance rights that could improve the trustee's ability to protect a significant trust asset.

That does not mean every trustee should become involved in managing a family business. In some circumstances, remaining an economic-interest holder may be appropriate. However, when the trust owns a substantial interest and the controlling members' interests may differ from those of the trust, the trustee should consider whether seeking additional rights is a reasonable and available course of action.

The answer depends on the operating agreement, applicable law, the circumstances of the transfer, and the interests of the beneficiaries.

When a Family Business is Worth Millions, Conflicts Can Escalate

Imagine that a trust's primary asset is a significant interest in a family company worth several million dollars. Another family member controls the business. That person influences executive compensation, determines whether profits are retained or distributed, and participates in transactions that can increase—or decrease—the value of the trust's interest.

For years, the arrangement may function without controversy. The trustee receives distributions, the business continues operating, and the beneficiaries have little reason to question its management. Then something changes:

Distributions decline.
Executive compensation increases.
A major asset is sold.
The company takes on substantial debt.
A related-party transaction occurs.
The controlling owners propose selling the business.
Or beneficiaries begin asking why a valuable ownership interest is producing relatively little income.

Suddenly, the trustee must evaluate whether the trust's investment is being adequately protected.

The situation becomes more complicated when the controlling member, trustee, and beneficiaries are relatives. Family members may have competing expectations about whether the company should produce current income, preserve capital, reinvest profits, or eventually be sold.

What begins as a disagreement over distributions can become a substantial dispute involving business governance, valuation, fiduciary duties, and the administration of the trust.

What if the Trustee Cannot Get the Information Needed to Evaluate the Investment?

A trustee cannot effectively evaluate an investment without sufficient information about its value and performance. But a trustee holding only an economic interest in an LLC may not possess the same information rights as a full member.

Under New York Limited Liability Company Law, members generally have statutory rights to obtain certain company records and information, subject to the statute and applicable provisions of the operating agreement. Those statutory rights do not necessarily extend in the same manner to someone holding only an assigned economic interest.

This creates a practical problem. The trustee may be responsible for protecting a valuable trust asset while lacking direct access to the financial records needed to evaluate its performance.

The trustee should first determine what information rights exist under the operating agreement, the transfer documents, and applicable law. Depending on those rights and the circumstances, the trustee may need to consider requesting financial information, seeking admission as a member, obtaining an independent valuation, or evaluating whether other legal remedies are available.

Importantly, the trustee's fiduciary responsibilities do not automatically create rights against the LLC that the trust does not otherwise possess.

If company management refuses to provide information, the trustee should distinguish between a legal right to obtain records and a request for information that the company may not be legally obligated to provide. That distinction may be important if the disagreement develops into litigation.

Distributions Create Another Layer of Fiduciary Responsibility

Protecting the trust's ownership interest is only one part of the trustee's responsibilities.

Once the LLC distributes money to the trust, a separate question arises: How should the trustee administer those funds?

A business distribution may constitute trust income in some circumstances and principal in others. The distinction matters because an income beneficiary may be entitled to current distributions, while principal may be preserved for other beneficiaries.

Under New York's principal-and-income rules, the treatment of LLC distributions can depend on the nature of the payment and the circumstances in which it was made.

For example, an unusually large distribution associated with the sale of a substantial company asset may raise questions concerning whether the payment represents ordinary income or proceeds associated with a total or partial liquidation.

The trustee must consider the trust instrument and applicable New York law when making that determination.

As a result, a trustee holding a substantial business interest may confront two separate fiduciary questions:

What reasonable steps should the trustee take to protect the trust’s investment in the business?
How should the trustee allocate and administer money distributed by the business?

These questions may affect different beneficiaries in different ways. A beneficiary entitled to current income may favor distributions, while a remainder beneficiary may prefer retaining capital for future growth. The trustee must navigate those competing interests while complying with the governing trust instrument and applicable fiduciary obligations.

What Should Trustees Do Before a Dispute Develops?

A trustee holding an interest in a closely held business should understand more than the percentage of the company owned by the trust.

Several questions deserve attention:

Ownership rights: Does the trust hold a full membership interest or only economic rights?
Governing documents: What do the operating agreement and transfer documents provide?
Information and control: What financial information, voting rights, and management rights are available?
Investment protection: Are transactions, compensation decisions, or distribution practices affecting the value of the trust's interest?
Available options: Should the trustee consider seeking additional rights, obtaining a valuation, or taking other reasonable steps to protect the investment?

Addressing these issues before a dispute develops may help trustees fulfill their responsibilities and reduce the likelihood of costly litigation.

When a Trust Owns a Business, the Real Issue May be Control

A trust's ownership of a closely held business can create substantial value for beneficiaries. It can also create difficult fiduciary questions when the trustee is responsible for an asset controlled by someone else.

The trustee must understand the rights the trust possesses, the limits of those rights, and the steps reasonably available to protect the investment.

When significant business equity, competing family interests, and substantial distributions are involved, disputes over that boundary can become both trust litigation and business litigation.

Understanding these issues early can help trustees, beneficiaries, and business owners protect their interests before a disagreement becomes a lawsuit.

The Glennon Law Firm, P.C. represents trustees, executors, beneficiaries, business owners, and other parties in disputes involving closely held businesses, fiduciary responsibilities, significant assets, and trust and estate matters throughout New York.

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This blog post is for informational purposes only and does not constitute legal advice. For specific legal counsel, please contact our office directly.  