Trust Companies as Last Line of Defense in Preventing Anonymous Criminal Activity

Believe it or not, trust companies play a vital role defending the United States financial system from anonymous criminal activity.  Financial crime in the United States generates approximately $300 billion of proceeds per year according to the Department of Treasury.  Most of the money generated from domestic crime remains onshore, but the problem is exacerbated by the fact that the U.S. has become an attractive destination for billions of dollars of illicit funds generated abroad.  The scope of money laundering is massive as only a fraction is detected each year. Indeed, investigating such activity is akin to searching for the proverbial needle in a haystack.  This is why financial institutions are required to have a robust Anti-Money Laundering (“AML”) Compliance program dedicated to the detection and prevention of suspicious criminal activity.  Suspicious Activity Reports (“SARs”) filed with FINCEN provide leads for law enforcement and invaluable evidence for successful prosecutions.   

All profit generating crime necessitates the laundering process to enable a criminal to enjoy the fruits of his or her labor.  The penultimate risk threatening the trust industry remains anonymity.  Personal trusts with a web of underlying shell corporations are ideal vehicles to disguise ownership, control, source of funds, and the true nature and purpose of the trust structure.   A hidden powerholder pulling the strings coupled with complex legal arrangements and sophisticated transactions enables successful execution of the money laundering process with relative ease.

Money laundering occurs in three distinct stages that may overlap depending upon complexity.  The first is placement where funds are deposited into bank accounts at home or abroad in a manner that avoids reporting thresholds.  Layering follows and is best described as a shell game where layers of transactions break the audit trail to separate the funds from the crime.  Lastly, the funds are integrated when money is transferred to an account(s) to purchase luxury goods or assets thereby legitimizing its source.  Dirty money is ultimately cleaned as a return on investment(s). 

Shell corporations are legal entities; such as corporations, partnerships, and LLCs, registered with the state but conduct no physical operations and hold no significant assets.  They often serve as conduits for fund transfers or as nominee owners.  Anonymity is afforded to these entities because the United States maintains no public registry of beneficial ownership information and some states even permit the use of agents serving as directors and/or shareholders.  The lack of available information often results in an investigative dead end.

The misuse of anonymous shell corporations is a top enforcement priority and served as the primary catalyst behind the Treasury Department’s new Customer Due Diligence (“CDD”) Rule requiring financial institutions to capture the natural person beneficial owner(s) and controlling persons of legal entity clients.  Interestingly, most personal trusts do not fall within its purview as it only applies to legal entities registered with the state thus creating a glaring weakness for potential abuse.  Some companies have thankfully filled this void by requiring basic powerholder information at account opening.

Financial institutions have been effectively deputized by the Treasury to report suspicious activity and now serve as a depository for beneficial ownership information sought by law enforcement.  Financial institutions, therefore, must establish the true identity of the suspicious actor along with capturing evidence of the activity.  Until uniform standards are implemented to identify beneficial owners at the time of incorporation, trust companies are among the last line of defense in preventing anonymous criminal actors from abusing our financial system. The failure to capture hidden powerholders allows completion of the laundering process absent detection.

First State Trust Company takes its regulatory obligations very seriously.  We have implemented a robust control environment which proactively identifies, monitors, and manages our AML risk.  Knowing Your Client (“KYC”) is the bedrock principle underlying AML regulations.  We accordingly KYC all powerholders associated with our personal trusts and capture the beneficial owners of all legal entity clients.  We understand our clients’ wants, needs, and how our role can best accomplish the trust’s purpose.  We recognize the importance of truly knowing our client to not only provide exceptional customer service, but to protect our clients and ourselves from anonymous criminal activity.

 

Michael McElwee, JD

Assistant Vice President, Compliance/AML Officer

 

The posts expressed are views of FSTC and are not intended as advice or recommendations. For informational purposes only.

Trustee Potential Issues When Outside Tax Preparers File Trust Tax Returns

There are occasions when a client prefers to use their CPA to file Trust tax returns rather than the Trustee. In these instances, the Trustee should ensure the CPA filing the tax returns is filing the returns correctly. The Trustee can do this by reviewing the Trust Agreement to ensure the tax return that is being filed is appropriate and review the return to ensure it been filed correctly. We have had two scenarios in 2018 where outside tax preparers filed incorrect Tax returns, as listed below;

Irrevocable Grantor Trust

When a Trust is considered a Grantor Trust for tax purposes the Grantor is responsible for the Trust tax liability. The Grantor will receive a Grantor Tax Letter annually that reports all taxable items from the Trust for that year. This information would need to be included in the Grantor’s personal income tax return.

Issue #1

  • In late 2018, FSTC was appointed Trustee of a new Trust. We were advised that an outside tax preparer was to be used. This Trust has a 30% ownership in an interest in an LLC. The LLC owned a company that was sold in December of 2018. The tax liability for the sale of the company would ultimately pass to the Trust based on its ownership of the company. The tax liability would be reported on a K-1 issued from the LLC.
  • The outside tax preparer forwarded to the Trust Officer a tax estimate payment that was to be paid from the Trust to cover the estimated income due for the sale of the company.
  • Upon reviewing the agreement, the Trust Officer noticed that the Grantor had the ability to substitute assets of equivalent from the Trust and his personal assets. This power given to the Grantor would cause inclusion of all the Trust’s tax liability within the Grantor’s personal income tax liability.
  • The Trust Officer contacted the Grantor and advised that his CPA should be forwarding him a K-1 annually which report the Trust’s annual tax liability, as the Trust is a Grantor Trust for tax purposes. The Grantor advised that he did not intend to be responsible for the Trust tax liability as there would be a significant tax liability to the Trust for the sale of the company in the LLC.
  • The Grantor contacted his attorney and rescinded his power to be substitute assets from the Trust effective to a date prior to the sale of the company in the LLC.
  • In most cases, the client’s attorney and CPA would be on the same page regarding how the Trust tax returns are to be filed. The Grantor did want to be liable for the Trust tax liability and should have been advised by his attorney how the Trust was structured, so this issue could have been avoided. All parties involved should have discussed how the Trust tax returns should be filed prior to a return being filed, if an outside tax preparer is to be used.

Irrevocable Non-Grantor Trust

Issue #2

  • FSTC had accepted a Trust in late 2016. We were notified that an outside tax preparer was to be used for the filing of the Trust 2017 tax return.
  • The outside tax preparer filed an extension for the Trust in March of 2018. In September, the tax preparer forwarded to the Trust Officer the final tax return for 2017.
  • The Trust Officer noticed that a distribution deduction has been taken on the return. The income tax liability for the Trust was reflected on the beneficiary’s K-1 in the amount of the distribution deduction reflected on the return.
  • Upon reviewing the transactions of the Trust for 2017, the Trust Officer noticed that there had been no distributions made from the Trust in 2017. An income distribution deduction should not have been taken, and there was no reportable income for the beneficiary. A K-1 for the beneficiary should have been generated.
  • The Trust Officer advised the CPA of the error, and corrections were made to the Trust tax return. The Trust tax liability was paid from the Trust.

Conclusion

It’s the Trustee’s responsibility to ensure the Trust tax returns are being filed correctly, whether if it’s an outside tax preparer or the Trustee’s tax preparer. These are two examples of issues that we have dealt with when outside tax preparers have been used to file Trust tax returns. There are potentially many more issues that could arise. It’s important for the Trustee to review the Trust Agreement and ensure the Tax returns are completed correctly prior to any tax filings. 

 

Keith Al-Chokhachy, CTFA, CFP®

 

The posts expressed are views of FSTC and are not intended as advice or recommendations. For informational purposes only.

Decanting – It’s Not Just for Wine Any Longer

In a recent article by Barbara Danberg, Esquire (see full article on our website under News) she discussed some of the beneficial reasons to decant a trust.  In short, decanting can be a powerful tool in the trustee’s arsenal.  A trustee is to work within the four corners of a trust document.  What happens though, when direction is vague or lacking completely?  As wealth transfers from generation to generation, what happens when that document just doesn’t “fit” within the beneficiaries’ estate plan?

A trust should be a source of comfort, not a source of strife.  However, as times change and tax laws and statutes are enacted, the typical “one size fits all” trust may not work for your family.  Delaware continues to be a jurisdiction that provides the mechanisms to make changes to documents that may have once been considered unchangeable.  First State Trust Company, working with your counsel, can decant into a new trust document that provides for the framework of those that it benefits. 

For more information regarding decanting and some of the ways in which it can be used, please visit our website.

For more information, please contact:

 

Jacqueline Jenkins, CTFA

Chief Fiduciary Officer / Managing Director

Phone: 561-515-6156 / Email: jjenkins@fs-trust.com 

 

The posts expressed are views of FSTC and are not intended as advice or recommendations. For informational purposes only.

Observations from the ABA Wealth Management and Trust Conf

On Feb 10-12, I attended the ABA Wealth Management and Trust Conference in San Francisco, and thought I would share some observations and key points from some of the sessions I attended:

On the regulatory front it is always interesting to hear the latest and what may be forthcoming as a focal point.  It was welcoming to hear that the regulators are realizing the ever burdensome and often confusing requirements of AML, KYC and CIP, so they may be looking to make it less onerous by better guidance and understanding.  There may be extra scrutiny on proprietary products in the future. They should be evaluated in the same manner third party products are.  (Since we don’t offer any, FSTC always thought this was an advantage for us, though we must still be diligent about what is offered by our partners.)   I think most already know this but, due diligence and ongoing oversight on vendors and partners will generate more attention going forward.  Distribution requests need authentication calls backs.  (We already do this as a standard!)  Continued emphasis on UBO’s (ultimate beneficial owners).  Here’s an interesting one: possible rollback of some of the 2017 Money Market Mutual Fund rules for stable value funds.  Not sure what but stay tuned.  Cybersecurity will continue to grow in need, effort, focus and cost.

A good point I picked up on Special Assets is the need for Occupancy Agreements on any rental properties that may be in a trust.  The agreement can be part of or in addition to the lease which covers things like not being able to use the property to rent on Airbnb and similar.

With regard to wealth transfer, if the first time your calling the family members to retain the business is after someone’s death, you’re too late.  Must make the suggestion to meet, learn and explore early and often.

Taxes:  AMT will apply to less people going forward, no more Roth IRA recharacterizations after 2018, and offshore blocker corps no longer work.

On performance: the key to change is getting over the resistance.  You must change and evolve or become irrelevant, complacency kills.  Ask yourself, what will put you out of business? Client expectations are perpetually progressive.

 

James Okamura- President FSTC

jokamura@fs-trust.com

 

The posts expressed are views of FSTC and are not intended as advice or recommendations. For informational purposes only.

2018 Global Market Recap

2018 was an interesting and volatile year for capital markets to say the least.  US Equities posted their first negative calendar year return (S&P 500 declined 4.4%) after 9 consecutive years of positive performance.  It was a bumpy ride to get there, as the S&P 500 experienced two separate 10% drawdowns, something that has happened only 1 other time in the index’s history.  According to Barron’s: In only one year — 1990 — did the market have two 10%-plus corrections, and in retrospect that marked the beginning of the great 1990s bull. (The year 1997 had a 9.6% decline and a 10.8% drop, while 2011 registered a 9.8% pullback in addition to its 19.4% correction.”

In global equities, both developed international and emerging markets (measured by the MSCI EAFE & MSCI EM indices, respectively) peaked in January, and proceeded to enter bear markets (>20%+ decline from peak) in the 4th quarter.   While the pain wasn’t felt in US equities until the 4th quarter, equities across the globe were contracting for the majority of 2018.  This bear market in global equities is best highlighted by looking at the 2018 performance of the top 20 individual countries in terms of market capitalization, which are listed in the chart below.  The US posted the 4th best return among those countries, while the average return was -11.8%, and the median return was -13.0%.  As you can see, the contraction in equities in 2018 was global and widespread. 

Blog chart 1.22.19

Taking a closer look at US equities, they peaked on September 20th and briefly entered bear market territory with a 20% drawdown through December 24th before rebounding slightly to end the year.  The 4th quarter was the worst quarterly performance in the US since 2008, which came somewhat of a surprise given the positive earnings and economic data:

  • In the 3rd quarter, S&P 500 companies posted their highest year over year earnings growth in 8 years (+32%) and profit margins reached their all-time highs of 12.1%
  • The 4th quarter is on pace to be the 5th consecutive quarter of double-digit earnings growth
  • Unemployment ended the year near its all-time low at 3.9%
  • Inflation has been hovering right near the Fed’s target of 2%

So why the sharp drop in US Equities despite all the positive economic data?  Was it a healthy correction due to valuations stretching too high after 9 years of positive performance?  Or is it an indication that a global economic slowdown could have a negative impact on the US and potentially cause a recession?  There is a case to be made for either outcome, but no way to know for sure.  The continued strong economic data gives me reason to believe that a recession in the near term is unlikely, but it will be important to watch for any slowdown in earnings or uptick in unexpected inflation.

One item of note in looking at the Q4 drawdown in US Equities, was the asset classes that historically have provided some downside protection when equities fall – Treasuries (TLT), Corporate Bonds (AGG), Gold (GLD) – ALL posted positive performance in Q4.  While these exposures didn’t insulate a portfolio from the all the damage in equities, they certainly highlight the benefits of diversification when faced with such uncertainty over where markets are going. 

Q4 2018 Performance: S&P 500, TLT, AGG, & GLD:

 Blog 1.22.19

Another important thing to keep in mind is the context of what has happened the last 10 years in the US and abroad.  Below is a chart that reflects the 10-year cumulative performance through 12/31/2018 for the S&P 500, the MSCI EAFE, and MSCI Emerging Markets indices. 

10-year Cumulative performance: S&P 500, MSCI EAFE, MSCI Emerging Markets:

Blog graph 1.22.19

The amount that US equities have advanced since 2008 as well as the outperformance in the US relative to global equities is significant.  US biased portfolios have been rewarded the last 10 years, but now more than ever there is a strong case to be diversified globally.  If you’re a believer that investment performance is mean-reverting and that a truly diversified portfolio includes international exposures, then it shouldn’t come as a surprise that many firms are overweight developed international and emerging markets entering 2019. 

So where will equities go from here?  The appropriate answer to this question should always be: “we don’t know for sure”.  At the end of 2016, many strategists and forecasts said that we were “late cycle” or in the “9th inning” of the economic expansion that began in 2008, and that equity valuations were higher than their historical averages.  The S&P 500 went on to post an annual return of 21.8% in 2017 with 12 consecutive positive monthly returns for the calendar year, something the index has never done since its inception. 

If anything the last two years highlight two things: the difficulty in forecasting market returns, and the importance of remaining invested in a diversified allocation that’s aligned with your portfolio objectives.   

 

Andrew Gibson, CFA 

Vice President / Investment Officer

 

The posts expressed are views of FSTC and are not intended as advice or recommendations. For informational purposes only.