When a trust owns an interest in a closely held business, a substantial distribution from that business can create an important question: Who is entitled to the money?

The answer may be particularly significant when the trust provides income to one beneficiary during that person's lifetime and ultimately leaves the trust principal to other beneficiaries.

Consider a trust that owns a majority interest in an LLC. The LLC sells valuable real estate or another significant business asset and distributes some or all of the proceeds to its owners. The trust receives its share of that distribution.

The lifetime beneficiary may believe that because the trust received a cash distribution from the LLC, the money is trust income that should be distributed to him or her. The remainder beneficiaries may take a different view: the money resulted from the sale of a substantial business asset and should remain part of the trust principal.

Under New York law, neither conclusion necessarily follows simply from the fact that the LLC distributed cash.

The trustee must determine whether the distribution constitutes income or principal under the trust instrument and New York's principal-and-income rules. And when the trust owns an LLC interest, rather than owning the LLC's underlying assets directly, that analysis can become more nuanced.

Why the Difference Between Income and Principal Matters

Many trusts divide the economic benefits of the trust among different beneficiaries.

A lifetime beneficiary may be entitled to receive the trust's income, while children, grandchildren or other remainder beneficiaries ultimately receive the principal after the lifetime interest ends.

New York law recognizes this fundamental distinction. Income generally represents the current return generated by principal. Principal is the property held in trust for the beneficiaries ultimately entitled to receive it.

The distinction can have important economic consequences.

If a $1 million business distribution is classified as income, it may be payable to the lifetime beneficiary. If it is classified as principal, it may instead remain in the trust for the remainder beneficiaries.

The trustee is therefore not merely making an accounting decision. The classification can determine which beneficiaries ultimately receive those funds, whether today or in the future.

The First Step is the Trust Instrument

A trustee should not begin with the assumption that every distribution from a business is income. The analysis begins with the governing trust instrument.

New York's principal-and-income rules recognize that a trust must be administered with regard for the respective interests of income beneficiaries and remaindermen. The trust instrument's provisions concerning the allocation of receipts between income and principal generally come first. In the absence of controlling provisions in the trust instrument, the statutory rules govern.

That means the language of the particular trust are important.

But where the trust language does not resolve the issue, New York law provides rules for determining how a trustee should characterize distributions received from an LLC, corporation, partnership, or other entity.

When a Trust Owns an LLC, There Are Two Different Levels to Consider

One of the most important aspects of the analysis is distinguishing between the LLC's finances and the trust's finances.

Suppose a trust owns 60% of an LLC, and the LLC owns commercial real estate.

The LLC—not the trust—owns the real estate. If the LLC sells the property, the LLC receives the purchase price. The LLC may then distribute some, none, or all of that money to its members, including the trust. Thus, receiving the purchase price and any possible LLC distributions are separate transactions.

At the first level, the LLC must determine what money is available for distribution to its members under its operating agreement and applicable law.

At the second level, the trustee must determine how the distribution the trust actually receives from the LLC should be treated for trust-accounting purposes.

That distinction matters because it can be incorrect simply to treat the trust as though it directly owned and sold 60% of the LLC's real estate. The trust owns an interest in the entity; the entity owns its assets.

The General Rule for Distributions From an Entity

New York's Uniform Principal and Income Act specifically addresses money received by a trustee from an entity. EPTL § 11-A-4.1 provides the central framework.

As a general rule, money received by a trustee from an entity is allocated to income. But there is an important exception: Money received in a total or partial liquidation of the entity is allocated to principal.

That exception can change the result when a closely held business sells substantial assets or makes an unusually large distribution.

When Does a Distribution Become a “Partial Liquidation”?

The term “liquidation” can be misleading.

Business owners may associate liquidation with shutting down a company, filing dissolution documents, and ceasing to exist. But for purposes of allocating a business distribution between trust income and principal, the analysis does not necessarily turn on whether the LLC has formally dissolved.

Under EPTL § 11-A-4.1, a distribution can be treated as a partial liquidation if the entity characterizes the distribution that way.

There is also an important mathematical test. A distribution—or a series of related distributions—is deemed to be a partial liquidation if it exceeds 20% of the entity's gross assets as shown on its immediately preceding year-end financial statements. That rule can have serious consequences.

Imagine an LLC with $4 million in gross assets at the end of the preceding year. During the following year, the LLC sells a major asset and makes a $1 million distribution to its owners.

The amount distributed exceeds 20% of the LLC's prior year-end gross assets.

That potentially changes the trust characterization analysis. Rather than treating the trust's share as ordinary income merely because the LLC issued a distribution, the partial-liquidation provisions may require the trustee to treat the receipt as principal.

The Source of the LLC's Money Does Not Necessarily End the Analysis

This is another area where disputes can arise.

Suppose the LLC sells real estate using seller financing. The buyer makes:

a down payment;
monthly interest payments for several years; and
a final balloon payment of the purchase price.

At first glance, the characterization may appear straightforward.

New York's traditional principal-and-income rules recognize interest on money lent as income, while consideration received from the sale or repayment of principal is generally principal.

But there can be an additional analytical step when an LLC is involved.

If the LLC, rather than the trust, owns the note and receives the payments, the trustee ultimately receives a distribution from the LLC. The trustee therefore must analyze the character of that entity’s distribution under the rules governing receipts from entities.

The distinction illustrates why tracing the economic origin of the money may not, standing alone, answer the trust-accounting question.

The Entity's Characterization of the Distribution Can Matter

Documentation can also become important.

New York's statutory framework permits a trustee to rely on an authorized statement by an entity concerning the source or character of a distribution.

Accordingly, when a closely held company makes a significant distribution to a trust, the trustee may need to examine more than the check or wire transfer.

Relevant documents may include the LLC's operating agreement, financial statements, resolutions authorizing the distribution, transaction documents relating to an asset sale, and documentation concerning the source and characterization of the distribution.

The immediately preceding year-end financial statements may be especially important when the statutory 20% partial-liquidation test is implicated.

Trustees Can Find Themselves Between Competing Beneficiaries

These issues become challenging because the trustee may owe duties to beneficiaries whose financial interests point in opposite directions.

The lifetime income beneficiary may benefit from treating a receipt as income.

The remainder beneficiaries may benefit from treating the same receipt as principal.

The trustee must administer the trust with due regard for both interests.

For that reason, a substantial business distribution should not necessarily be distributed immediately to an income beneficiary simply because it arrived in the trust's bank account as cash.

The trustee may first need to determine:

what the trust instrument requires;
what the LLC actually distributed;
whether the distribution arose from ordinary operations or an extraordinary transaction;
how the LLC characterized the distribution;
whether the distribution or related distributions trigger the partial-liquidation rules; and
how the receipt should ultimately be allocated between trust income and principal.

Business Ownership Inside a Trust Can Create Complex Fiduciary Disputes

Closely held businesses frequently represent a substantial portion of a family's wealth. When an LLC interest passes into a trust, business law and trust law can intersect in ways that were not obvious when the estate plan was created.

A distribution that looks like ordinary business income may raise significant questions under New York's trust-accounting rules. A sale of company assets can create competing claims between lifetime and remainder beneficiaries. And a trustee's decision about how to characterize and distribute substantial funds can itself become the subject of a fiduciary dispute.

For trustees and beneficiaries alike, the important point is straightforward:

The fact that a trust receives cash from an LLC does not, by itself, determine who is entitled to that money.

The trust instrument, the nature and documentation of the business transaction, the entity's characterization of the distribution, and New York's rules governing income, principal, and partial liquidations all may matter.

Where substantial business interests or distributions are involved, those distinctions can determine the allocation of significant assets—and can become the source of substantial trust and estate litigation.

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The Glennon Law Firm, P.C. represents fiduciaries, beneficiaries, business owners, and other parties in complex trust and estate and business disputes throughout New York. This article is for general informational purposes and is not legal advice.