A Matter of Trusts
A Matter of Trusts
“A Matter of Trusts” is an in-depth assessment of how to more effectively implement family business succession planning through trusts. For an introduction to the subject of trusts in family business ownership, read, “How to Read a Trust.”
A Matter of Trusts: Creating Better Vehicles for Family Business Succession Planning
How should an owner transfer shares¹ in a family business? When the goal is keeping a first-generation business in the family for future generations, one option is for the founding owner to gift or sell the shares to the anointed successor. But what if there isn’t an anointed successor? What if other family members, fearing unequal treatment, cry foul? What if the founding owner wants to ensure that their spouse continues to receive a steady stream of income, while transitioning ownership to the next generation at the same time? To resolve these complex issues, the family’s lawyer may recommend that the founding owner transfer the shares of the business to a trust for the benefit of the surviving spouse and descendants.
Increasingly, business-owning families who want to keep the business in the family are transferring shares in trust rather than outright. A trust can offer substantial long-term tax advantages; protection for family members against potential creditors; and, when family members aren’t prepared to take over the business, the possibility of professional management of a critical family asset. By separating control from beneficial ownership, a trust offers the settlor the opportunity to tailor the degree of control granted to the beneficiaries. The trust can be structured to give capable beneficiaries effective control of the trust’s shareholdings, or can ensure that a fiduciary will make ownership decisions on behalf of those who are unable or perhaps unwilling to play an active ownership role. For a business owner seeking family ownership and continuity for multiple generations, transferring stock in trust may offer better odds for a successful succession than transferring stock outright to descendants.
Not all trusts are created equal
When it comes to transferring stock of a family business in trust, not all trusts are created equal. Consider the cluster of issues that may arise when a founding owner chooses to transfer shares of the business in trust:
- Trust models typically used by estate planners are designed to hold financial assets rather than shares in an operating business, and often don’t incorporate distribution provisions, trustee succession provisions, and administrative provisions flexible enough to adjust as the business grows, family needs evolve, and the number of beneficiaries expands over time.²
- The trustee may be unable to balance the grantor’s stated intent—to retain and grow the business—with their fiduciary duties to the trust beneficiaries, particularly if the business is not generating substantial free cash flow or the beneficiaries’ need for cash increases.
- Common law and state statutory regimes may force the trustee to re-order the family’s priorities. Common law fiduciary duties; duties imposed by the Uniform Trust Code; or the duty to diversify imposed by the Prudent Investor Act, may force the trustee to sell the business or siphon off earnings that otherwise would be reinvested in the business.
- Notwithstanding the problems created by common or statutory law, corporate fiduciaries are often unwilling to serve as trustee of a trust that holds shares in an operating business because of the depth of knowledge and involvement required to make responsible shareholder decisions. For a third party who is not involved in the business on a day-to-day basis, the learning curve can be prohibitively steep and the compensation inadequate to justify the time involvement required for good decision making.
- Business and family governance structures may be inadequate to cope with the shift from a Controlling Owner form (in which the controlling shareholder/executive owns all or a controlling interest in the business and makes all major business decisions) to an Intermediated form (in which all of the shares or a controlling interest are held in trust, and the trustee represents the family’s ownership interests in appointing a board of directors to oversee the business).³
For family members and planners considering transferring shares of a family business in trust, focusing on five key elements can significantly improve the odds that the family business will stay in the family:
- Transfer stock to an irrevocable trust during the controlling owner’s lifetime,
- Include family business-friendly provisions—including exit provisions—in the trust instrument,
- Select a capable and properly empowered trustee,
- Choose the governing law and form of the trust carefully, and
- Develop effective governance processes within the family and boardroom.
This article will refer to a trust that includes these elements as a “Family Business Trust.”
Transfer stock to an irrevocable trust during the controlling owner’s lifetime
Many controlling owners resist transferring ownership of their businesses during their lifetime. Given the central role the business plays in their lives, their reluctance is understandable, but deferring the decision can put the business at risk. Succession is a complex and time-consuming process for the family (and for management as well), and it is more likely to be successful if the controlling owner is an engaged and contributing participant. Succession that occurs in accordance with an established plan, at the initiative and with the cooperation of the controlling owner, will be more manageable than succession that occurs as a result of the unexpected death or incapacity of the controlling owner.
While specific transfer techniques are beyond the scope of this article, a variety of techniques can be used to accomplish a lifetime transfer of stock to a Family Business Trust at little or no tax cost, while offering the owner a continuing income stream on attractive terms.
Controlling owners who likely will predecease their spouses and who decide to transfer shares via will at death should consider carefully whether the typical estate plan structure will achieve their business succession goals. In the typical estate plan, property having a value equal to the remaining estate tax exclusion amount is held in a “credit shelter” trust for the benefit of the spouse and lineal descendants, with the balance passing outright or in a marital trust to the surviving spouse. This is good tax planning—the transfer will qualify for the federal estate tax marital deduction and estate tax will be deferred until the second death. Upon the surviving spouse’s death, assets held in a marital trust will pass in accordance with the terms of that trust (typically, to lineal descendants), while assets held in the surviving spouse’s name will pass in accordance with his or her will.
However, good tax planning may not necessarily be good succession planning. From the perspective of the business, transfer via the typical estate plan structure often will create two new shareholders: the credit shelter trust for the children, and either the surviving spouse or the marital trust. These new shareholders will have decidedly different interests from those of the controlling owner during his lifetime, and, quite possibly, from each other. The children may seek to sustain and grow the business, while the surviving spouse may seek to maximize dividends to ensure their financial well-being—or vice versa. If the controlling owner chooses to transfer shares at death, the planner, executor, and trustees should consider very carefully the potential personal and business ramifications of allocating business shares between the trusts created for the children and the spouse.
When there are multiple businesses and/or an entrepreneurial family culture, creating a holding company to consolidate all business interests, and then transferring shares in the holding company to the Family Business Trust, could simplify the structure and consolidate decision-making.
Whether stock is transferred in trust or otherwise, and whether the transfer occurs during the controlling owner’s lifetime or at death, it will raise complex tax and liquidity issues. The transfer is most likely to be successful when families begin planning early and work with a team of knowledgeable planners. The composition of the team will depend on the individual skill sets of its members, but at a minimum should include legal counsel with experience in corporate and estate planning and accountant(s) with an understanding of the financial positions of the business and the family. An experienced family business consultant can provide a framework and process for thinking through difficult choices, as well as extensive experience and advice gleaned from working with similarly-situated families.
Include family business-friendly provisions in the trust instrument
Beneficiary provisions: class trust for family beneficiaries vs. separate share trusts
If the Family Business Trust is intended to benefit multiple generations of family members, structuring it as a class trust—for the benefit of a group of persons—may provide greater flexibility than structuring separate share trusts for each individual child or branch.
With a class trust, the trustee will be able to vote the shares in a block on behalf of the family group collectively, taking into consideration the needs of family members and the business. Furthermore, using a class trust will minimize the impact of the denominator problem on business governance by minimizing the number of shareholders, and will reduce the likelihood that separate trusts with different trustees will vote separate minority blocks of stock.
Citing fairness, some families will prefer to transfer the stock in equal shares to separate trusts and might even welcome having different trustees serve for each trust. However, families and planners should consider carefully the impact of this decision over multiple generations. Splitting the shares into separate trusts will make shareholder decision-making more complex with each successive generation and will require a correspondingly more robust governance structure. Trying to resolve this problem by appointing the same trustee for each trust sounds appealing but may create a conundrum for the trustee, who will be forced to consider the needs of the beneficiary of each trust separately when voting the shares.
If a decanting provision is included in the trust instrument (or if decanting is permitted under local law), the trustee will be able to pour over shares from the class trust to branch trusts or separate share trusts in the future, if circumstances demand.
The Family Business Trust will be more flexible and resilient if it provides that distributions of income and/or principal may be made at the absolute discretion of the trustee, rather than mandating distributions of specified amounts (for example, “the Trustee shall pay the net income of the trust to my daughter, at least annually”) or at specified times (for example, “the Trustee shall distribute the sum of $250,000 to each grandchild when he or she attains age 30”). Mandatory distributions could force the trustee to press for dividends from the business at a time when the business is cash-poor, or could result in distribution of the shares themselves if there isn’t sufficient cash available. Furthermore, giving the trustee absolute discretion over distributions significantly enhances the asset protection features of the Family Business Trust, helping to ensure that shares of the business are not accessible to a beneficiary’s creditor (for example, a divorcing spouse).
Families may be concerned that giving the trustee absolute discretion over distributions could lead to unequal distributions or unfair treatment of some beneficiaries as compared with others. To provide guidance to the trustee in determining the amount and timing of distributions to beneficiaries, the controlling owner/settlor may wish to provide a letter of wishes to the trustees of the trust, setting forth circumstances under which the trustee should consider making relatively larger or smaller (or no) distributions. For example, the letter of wishes might recommend that distributions should be made to enable beneficiaries to obtain an excellent education, appropriate to their respective abilities and interests; that distributions should cease in the event that the trustee reasonably believes the beneficiary is abusing drugs or alcohol; or that distributions should be made with care if the beneficiary’s marriage is in peril.
Undertaking a scenario-planning exercise while developing the letter of wishes may assist the controlling owner in envisioning the circumstances that might face future generations, and thereby provide more effective guidance. Spending time envisioning what the family, the business, and the outside world will be like in 50 or 100 years, before putting planning in place can lead to more flexible documents and more successful planning.
Direction to retain
To protect the stock from forced sale, the Family Business Trust should affirmatively direct the trustee to retain the shares of the business.
The family and planner should also consider carefully under what circumstances, if any, the trustee should be directed or given the discretion to sell or transfer the shares—perhaps, in the event the board of directors foresees a major change in the business environment that will render the business unprofitable or unsustainable in its then-present form, or in the event the trustee encounters a catastrophic need within the class of beneficiaries that will require substantial liquidity that could not otherwise be raised. The direction might also include the power to sell all or part of the shares, provided that proceeds are invested in a new enterprise, or alternatively, in a family office structure to permit ongoing collective management. The trust instrument should explicitly indemnify the trustee for acting in accordance with the direction, and the indemnification should be explicitly authorized under state law.
Please note that while the settlor’s intent was at one time the focal point for courts in deciding lawsuits brought against trustees by beneficiaries, contemporary trust law is shifting to a new calculus that gives greater weight to the needs of the beneficiary and modern portfolio theory. Similarly, the Prudent Investor Act as enacted by some states requires the trustee to diversify trust assets. If possible, families may want to avoid creating a Family Business Trust under the laws of a state with unfavorable statutory provisions, as such laws could require the trustee to sell the shares of the business.
So-called “dynasty” trusts have become increasingly popular as certain states have abolished the rule against perpetuities, thereby permitting settlors to create ever-lasting trusts. Although the transfer tax benefits of dynasty trusts may be appealing, families and planners may wish to think carefully before transferring family business stock to a trust that will never terminate.
Even with collegial, well-adjusted families, circumstances may arise which threaten family unity. A number of events—a business decision to invest substantial new capital in an unproven technology, an ugly divorce, an unforeseen health or financial problem—can pit family members against each other and threaten the long-term viability of the business. The family and the planner will want to draft the trust so as to permit the trustee to take whatever actions may be necessary to effectively “buy out” shares held in trust for a family member or branch. Because of the potential liquidity issues raised, the family will also want to consider carefully and well in advance under what circumstances the trustee should honor a family member’s request to exit the trust structure, and how such an exit will be funded. Clear written guidelines setting forth the valuation mechanism and payment terms will increase the odds of a peaceful resolution to the issue.
Select a capable and properly empowered trustee
The trustee or trustees of a trust are responsible for investing trust property for the benefit of the beneficiaries, determining amount and timing of distributions, and administering the trust, all in accordance with the terms of the trust and applicable statutory and common law. Families need to keep in mind that a trustee cannot by law simply “do what the grantor would do” in given circumstances—rather, the trustee has a legal fiduciary duty to invest the trust property for the benefit of the beneficiaries.
Choice of trustee
Who should be named as trustee of the Family Business Trust? Options include a trusted individual (other than a family member or subordinate whose exercise of certain powers would create tax problems), a corporate trustee, or a private trust company. Regardless of which option is chosen, the trustee needs to understand the grantor’s intent, possess the emotional intelligence to develop rapport with the beneficiaries, and have sufficient financial and business skills to be able to review financial reports and plans, and elect board members capable of providing effective strategic oversight.
- Individual—A trusted individual may bring knowledge, skills, and a well-established relationship with the family to the role. Some families may gravitate towards appointing an individual as a cost-saving mechanism, but beware false economies: individuals will need to engage service providers, such as investment managers, accountants, and tax advisors, to administer the trust, and will need to coordinate their activities. If an individual is selected as trustee, the foremost challenge for the settlor and planner of a multi-generational Family Business Trust will be to provide a mechanism for selecting future successor trustees. Giving the trustee the power to pick his or her successor may cause a trustee to stay on long past his or her prime, and may invite cronyism. Giving the power to pick the successor trustee to a separate fiduciary known as a “protector” will ensure greater accountability and make the process more objective. The protector can be an individual, but naming a protector committee will provide better continuity of oversight. The trust should also provide for automatic removal and replacement of a trustee who is incapacitated.
- Corporate trustee—A corporate trustee may bring deep institutional knowledge and capabilities and typically offers greater administrative capabilities than an individual trustee. However, the universe of potential corporate trustees for a Family Business Trust is relatively small; while a handful of trust companies specialize in serving as trustee for trusts holding shares in private operating businesses, many trust companies will not accept the risk and potential liability involved in serving as trustee of a trust holding interests in an operating business. Furthermore, trust companies may not ultimately offer the continuity sought by business-owning families: trust companies are regularly bought and sold by their parent financial institutions, with resulting changes in staff, capabilities, procedures, and focus. If the Family Business Trust names a corporate trustee, giving a protector or protector committee the power to remove and replace the trustee will serve as a counterbalance and permit the family or its designated representatives to remove a corporate trustee if circumstances warrant.
- Private trust company—A private trust company (“PTC”) is a trust company created by the family itself to serve as fiduciary of its trusts. A PTC offers the personalized attention of a trusted individual with the perpetual life, legal personality, and limited liability of a corporation or limited liability company. A number of U.S. jurisdictions now authorize private trust companies and an increasing numbers of families are forming PTCs to serve as trustee of family trusts. Corporate trust companies that have best-in-class administrative platforms, but are reluctant to serve as trustee of a trust that holds shares in a private operating business, often will provide administrative services to PTCs on a contract basis.
Careful attention to structural and governance issues at the outset is critical to ensuring that the PTC will be respected as an entity separate from the family, and that it will serve as an effective fiduciary mechanism for the family. Compared with naming an individual as trustee, or appointing a corporate trustee, forming and operating a PTC is the most expensive and time-consuming option, but at the same time, it offers the potential for the most tailored service over the longest period of time
- Protector—A protector (whether an individual or committee) is typically given certain powers, such as the power to remove and replace the trustee, which can provide the family with substantial indirect control over fiduciary decision-making. For multi-generational Family Business Trusts, naming a committee of family members and/or trusted advisors, rather than an individual, offers greater continuity and better odds that the protector will execute its powers over the long term in the best interests of the family and the business. The trust provision creating the protector role should appoint the initial committee (whether by name or by class—for example, descendants who have attained a certain age and level of education—and spell out the procedures for appointment of successor members in the event of resignation, death, or incapacity of a member.
Trustee and protector compensation
Serving as trustee of a Family Business Trust is a major responsibility and will require significant commitment of time, effort, and intellectual, physical, and emotional energy by the trustee. The trust should provide for trustee fees commensurate with the effort required. The protector or protector committee should also be compensated, commensurate with the responsibilities borne.
Choose the governing law and form of the trust carefully
The fiduciary and trust laws of every state are different. Some are particularly hospitable to Family Business Trusts; others are more problematic. When reviewing state trust statutes, planners will want to keep the following questions in mind:
- Does state law permit the settlor to include trust provisions that eliminate or alter the duty to diversify?
- Does state law permit the settlor to include a direction to retain? Does it protect a trustee from liability for acting in reasonable reliance on the provisions of the trust?
- Does state law permit the settlor to grant a Protector the power to change the trust instrument to respond to changes in law?
- Does state law permit the formation and appointment of a Private Trust Company to serve as trustee?
- If the settlor is not a resident of the state, what specific nexus is required to ensure that the choice of governing law will be respected?
Develop effective governance processes within the family and boardroom
One of the biggest challenges in succession for family businesses is developing governance and management practices that will be workable following the transfer, and implementing them effectively. With most controlling owner structures, the controlling shareholder and the senior manager are one and the same person; ownership and management decisions are made intuitively and on the fly (and are often left undocumented); and staff does what the boss says. In contrast, when ownership of a family business is held in trust, the owner (the trustee of the trust) doesn’t run the business, and may have little day-to-day contact with management. A more formal governance structure will be essential to ensure that the business continues to be run effectively while shareholder interests are considered fully.
The trustee of the Family Business Trust, as owner of all or a block of shares of the business, will depend on an effective board of directors and management team to set strategy and operate the business. Assuming that it was the grantor’s intent that the beneficiaries of the trust also have input into the future of the business, the trustee will also need effective governance at the trust level, to understand the perspective, needs, and wishes of the beneficiaries. A Beneficiaries Council made up of the trustees and beneficiaries, can provide a forum for discussing business and financial matters and educating the beneficiaries.
The trustee and the board of directors will be able to perform their respective roles more effectively if the family has articulated its own needs and objectives clearly. Forming a Family Assembly—comprising all family members—will give them a forum to discuss and develop consensus on key issues.
Although this article has centered on ownership succession, business-owning families will also want to consider management succession carefully. Even if the controlling owner intends to stay on as head of the company after transferring ownership to a Family Business Trust, he or she should work with the board to develop a management succession plan so that a successor management team—whether composed of family members, non-family executives, or both—can be groomed to take over management of the company on an agreed-upon timeline, or in the event of an emergency.
Following ownership succession, disputes about money often arise between family members who work for the business and those who do not. The board of directors and senior management will want to work with the trustee (and, possibly the Beneficiaries Council) to develop policies that clarify how much of the cash flow generated by the business should be paid to the suppliers of capital (shareholders) in the form of dividends; how much will be paid to the suppliers of labor and intellectual capital (management) in the form of compensation; and how much will be retained by the business itself in the form of capital reinvestment. In turn, the trustee of the Family Business Trust will need to develop a policy for investing vs. distributing dividends to beneficiaries. Having the input of the Family Assembly regarding family members’ needs for cash will assist the trustee in developing an effective distribution policy, as will guidance provided by the settlor in a letter of wishes.
By transferring shares of a family business in trust, a family can provide a flexible and robust ownership structure for business for future generations. By accomplishing the transfer during the controlling owner’s lifetime, and through careful drafting of trust provisions; choice of governing law; selection (or formation) of a capable trustee; and implementation of effective family governance processes, a business-owning family can create a secure foundation for effective multi-generational ownership and control.
1. For simplicity’s sake, we have used the terms “stock” and “shares” when referring to ownership interests in a family business. These terms properly refer only to ownership interests in a corporation; however, the comments and recommendations made in this article are equally applicable to ownership in interests in a partnership, limited liability company, or other entity.
2. We refer to the constellation of issues raised by expansion of the family over generations as the “denominator problem.” Over time, the number of beneficiaries of a family trust will tend to grow; the number of generations of beneficiaries living at one time will tend to increase; and the diversity of ages, experiences, jurisdictions of residence, and financial resources of members within a generation will also tend to increase. In our experience working with business-owning families, first-generation business owners with nuclear families find it difficult to envision any management or ownership structure other than the one currently in place, and may not want to spend the time away from day-to-day operations that will be necessary to develop a governance regime suitable for third-, fourth-, or fifth-generation ownership of the business. A multi-generational trust structure that doesn’t contemplate the denominator problem and isn’t flexible enough to handle a geometric increase in beneficiaries (and, often, a corresponding exponential increase in decision-making and administrative complexity) is prone to failure.
3. We have taken the liberty of adding the Intermediated form to the three-dimensional developmental model presented by Gersick, David, Hampton, and Lansberg in Generation to Generation: Life Cycles of the Family Business (Harvard Business School Press, 1997), a model widely recognized and cited by family business scholars. The developmental model posits three ownership forms for a family business: Controlling Owner, Sibling Partnership, and Cousin Consortium. The model provides families and advisors with a framework for anticipating the consequences to the business resulting from the changing number and relationship of decision-makers in a family business following succession. It is also a very useful tool for anticipating the complexity of governance and management structures that will be necessary to run the business effectively following succession. The developmental model generally assumes that family members own shares outright; that the family therefore is the decision-making body; and that as the number of family owners increases and their relationships among each other and with respect to the business become more complex (and often more attenuated), more formal governance and management structures will be required for successful ownership and management of the business.
The developmental model does not explicitly consider as a separate form the situation in which shares of a non-public company are transferred in trust as a result of implementation of a controlling owner’s estate plan, thereby bringing a trustee into the family business dynamic. In such a case, the family’s control over the business becomes intermediated: the trustee is the legal owner of the shares and makes decisions that were formerly made by the controlling owner. Whereas the controlling owner could balance the needs of the business against the needs of the family based on his or her own personal calculus, the trustee’s decision-making is significantly constrained, not only by lack of day-to-day contact with the business, but also by the framework of the trust instrument and local, state, and federal statutory and common law.