James runs a rapidly growing family business. Things are going great now, but he worries about the future. If he should suddenly become incapacitated, who will run the enterprise for the benefit of his wife and children, none of whom has yet mastered the skills required to manage a commercial operation?
After consulting with his attorney, James comes up with a solution: a revocable trust which designates a skilled trustee to take the reins of the business in the event James can no longer perform his duties. By helping to assure the long-term survival of the enterprise, the trust gives the family considerable peace of mind.
“A revocable trust is created while a business owner is still alive,” explains Michael P. Sampson, partner in the Minneapolis law firm of Maslon LLP (www.maslon.com). “It allows the owner to retain control of business assets while arranging for a trustee to step in and manage things in case the owner becomes incapacitated.” The revocable nature of the trust is important for anyone who, like James, wants to retain ownership and control of the business assets. And—as we will see next—a revocable trust will also help the family avoid costly probate if James should die.
Family businesses everywhere establish trusts to solve a host of critical problems. Upon the death of the business owner, for example, a trust can protect against costly probate, secure sensitive business information from prying eyes, guard family assets from crippling lawsuits and creditor claims, and even obviate turf wars by surviving children. (The traditional use of trusts to avoid estate taxes has become less important, since federal tax law recently increased the estate tax exemption to $11.2 million for individuals and $22.4 million for married couples.)
The good news is that trusts can be created by all sizes of organizations. “Even smaller family businesses can utilize trusts,” says John J. Scroggin, partner in Atlanta-based Scroggin & Company, a law firm active in business and estate planning (www.scrogginlaw.com). “The issue is driven not by size, in terms of revenues or assets, but by a desire for long term protection of a business.”
How can you use trusts to help your own family business? For starters, consider using one to efficiently allocate assets to the younger generation. Although a will can do the same thing, a trust is more difficult to challenge and has the advantage of avoiding probate. “Probate can be expensive and time consuming,” says Sampson. “This is especially true in states such as California, Florida, Illinois, and New York, where probate is very complicated, or for businesses operating in more than one state.” In the latter case, survivors may have to deal with the complications required to satisfy more than one set of probate laws.
In addition to saving you money, avoiding probate can also protect your business secrets. “You might not want your competitors looking up your will at the courthouse to see how much money or debt your family has,” says Sampson. Public records are also sometimes accessed by predators who try to victimize people who have inherited money. “Having your property passed along under the terms of a trust avoids the creation of public records that result from court involvement.”
Can a trust which allocates family business assets to the next generation be revocable? Yes, but that has inherent risks. Consider Sarah, who wants to do just that. Sarah’s attorney tells her that if she makes the trust revocable, all of the business assets will remain under the ownership of the family. As a result, they will be at the risk of being attacked by creditors or lost in lawsuits. The assets might also be seized to satisfy any nursing home bills incurred by the person who establishes the trust.
For these reasons, Sarah decides to set up an irrevocable trust. Because the trust will own the business assets, they will not be subject to above risks of loss, either before or after Sarah dies.
The terms of an irrevocable trust can navigate complex family dynamics. Here are a few examples:
To Protect the Income of a Young Child
Adam and Sylvia, who own all of the stock of ABC Company, have a nine-year-old child named Jane. They establish an irrevocable trust that designates Adam’s brother Jason as the trustee. In the event of the death of the parents, Jason will run the enterprise. Jane, the trust’s beneficiary, will receive stock dividends and distributions from any assets.
To Avoid Sibling Disputes
Andrew and Beth are concerned that when they die their children might squabble about the family business assets, putting the organization’s survival at risk. Daughter Suzanne has already said she wants to run the business, while her brother John feels the business should be sold and the assets distributed.
“A trust can designate that Suzanne will run the business, and that John will not be involved but will receive a certain amount of money monthly from the trust,” says Nicole N. Middendorf, CEO of Prosperwell Financial, Plymouth, Minnesota (www.prosperwell.com). “And the trustee will make sure the provisions of the trust are carried out.”
In a case like this one, says Middendorf, a trust is especially valuable because it can mandate the disposition of assets at a time when emotions might run high. “Money often brings out greed,” she says. “People can be tempted to make decisions based on their own interests rather than on what makes sense for the future of the company and the family.”
To Protect a Victim of Addiction
Bart and Susan want to avoid leaving a sudden windfall to their son Chet, who is struggling with a drug addiction. How can they make sure Chet is taken care of in the event of their deaths, while avoiding a waste of inherited assets?
“A trust can designate that Chet receive a certain amount of money every month,” says Middendorf. “Or, to avoid funding the addiction a trust can pay his rent so he always has a roof over his head. The trust could even mandate that he pass a drug test to receive his monthly payment.” A similar arrangement can also help out if the beneficiary has a mental disability.
To Control a Spendthrift
Some people are just bad with money. Henry and Ida are afraid that their daughter Beverly will spend her inheritance on fancy cars and travel. That’s why they decide to set up a “spendthrift trust” that will release funds only for expenses related to health, education, maintenance, and support.
“A spendthrift trust can be a valuable way to protect beneficiaries from spending all of their inheritance,” says Arlene Cogen, a certified financial planner and philanthropic leadership consultant based in Portland, Oregon (www.arlenecogen.com). But she warns that it’s not a foolproof mechanism: “Bear in mind beneficiaries can be very creative when it comes to petitioning trustees for health, education, maintenance, and support. This can create an adversary relationship between the beneficiary and the trustee. One way around that is to create a trust which provides the individual with a set income stream, so they cannot keep knocking on a trustee’s door for money.”
To Obviate Claims From an Estranged Spouse
While Amy and Clark feel their son Andy is skilled enough to run the family business, they are concerned about his marriage to an estranged spouse. In the event of a divorce, will the spouse sue to obtain business assets?
Scroggin offers this solution: Amy and Clark establish a trust that calls for Andy to be paid a salary for his work, while the equity of the business, along with any profits, remains in the trust for protection from lawsuits. In the same way, a trust can protect business assets from the claims of creditors if the inheriting person is in debt.
To Avoid Claims Arising From Multiple Marriages
Multiple marriages can create their own problems. James wants to make sure that if he dies his wife Mary receives income for life from the company dividends and asset distributions, so that she can take care of their children Betty and Jack. However, if Mary should remarry and then later die, James wants to make sure the money from the business then goes directly to Betty and Jack, and not to Mary’s new spouse or to that individual’s own children.
Again, a trust can mandate this more complex asset distribution pattern. “The division between ownership and benefits can be helpful when people get married more than once and have children from multiple spouses,” says Sampson.
To Avoid Claims Arising From a Childless Marriage
Harris and Marge have three children named Deborah, Francine and Bart. Deborah is married to a man named Frank but has no children and is not expected to. Harris and Marge are concerned that if Deborah is given some of the equity and then dies, the equity will pass on to Frank, a non-family person who may try to dictate business decisions, and make unreasonable demands, such as the hiring of his friends.
Furthermore, if Frank remarries and then dies, his new spouse, a stranger to the family, might end up owning a third of the business. And that person might demand an exorbitant buyout to avoid a lawsuit. “In this example, when Deborah dies without any descendants, a trust can call for her interest to pass on to her siblings or their descendants,” says Scroggin. “Trusts often are used to assure that business interests are retained for the benefit of family members rather than passing to outsiders.”
The above scenarios illustrate the flexibility of irrevocable trusts. They can do all kinds of things for people who are too young to run a business, have no interest in doing so, are incapacitated, or need to be protected from their own damaging decision-making habits. Trusts solve business problems by separating legal ownership and control of a business from the enjoyment of the business assets by beneficiaries.
Flexibility, though, runs both ways. Attorneys advise against micromanaging the family business transition. “Sometimes people take control too far by not including enough flexibility for the beneficiaries,” says Sampson. “As a result, what seems like a reasonable provision in a trust today might make no sense some years down the road.”
Sampson gives this example: Mark heard that “incentive trusts” could be established to obviate the problem of a child becoming a “trust baby” and slacking off instead of working. So to inspire a work ethic in his son Jerry, Mark established a trust that would provide distributions to match his son’s earned income each year. However, Mark’s attorney encouraged the inclusion of a provision allowing additional distributions in the trustee’s discretion, just to provide flexibility.
One day Jerry was driving home on a motorcycle when a serious accident left him unable to ever work again. If it were not for the provision allowing discretionary distributions beyond the amount of Jerry’s earned income, the trust assets would not have been available to provide the money required for his medical attendant.
That story carries a moral. “Don’t try to design for a scenario that is too specific,” advises Sampson. “It’s a good idea to include a provision that the trustee can make distributions of income and principal in the trustee’s discretion just in case something unanticipated happens.”
Sampson also suggests another point of flexibility: the ability to change a trustee who is uncommunicative or too tight with distributions. “There should be a way to replace the trustee,” he says. “You can even give that power to beneficiaries as long as the new trustee is truly independent. The replacement should not be an employee of one of the beneficiaries, for example, or a relative. The flip side is that the trustee must be strong enough to sometimes say ‘no’ to the beneficiaries. The balancing act is to provide enough flexibility without giving so much freedom that the trust becomes a sham.”
As the above comments suggest, trusts need to recognize the possibility of future surprises. That’s why the trend today is toward the use of “Discretionary Trusts,” irrevocable trusts which do not specify a set amount of income for beneficiaries but allow for trustee discretion.
Sampson says that many business owners tell the trustees something like this: “I want my kids to be educated, and I don’t want them living in a van because they encounter a health problem. But I do not want the money used for lifestyle enhancement.” Such terms may be included in the trust itself or in a side letter addressed to the trustee.
Discretionary trusts offer considerable protection from creditors and lawsuits. That’s because the law says a creditor can only access the assets of an irrevocable trust to the same extent as the beneficiary. So if the beneficiary cannot get at the money in the trust to pay a business expense without the permission of the trustee, neither can a creditor.
Discretionary trusts also free the trustee to invest for the highest total return without needing to worry about meeting arbitrary mandated payouts. So, for example, the trustee may decide to invest more money in a broad basket of stocks and bonds rather than only in lower-yielding bonds which would provide guaranteed but limited income.
Starting the trust planning process early will help protect your family business assets from a sudden loss through an unexpected lawsuit or death. “Planning should start as soon as your business has assets worth protecting,” says Bill Babb, Senior Consultant at the Family Business Institute, Raleigh, North Carolina (www.familybusinessinstitute.com). “You want a smooth and safe transition program in place before the death of someone in an ownership position.”
When seeking outside help to plan your trust, toss a wide net. A family business transition has implications for income and estate taxes, the protection of assets, and the outstanding agreements of banks and creditors. Because so many areas are involved, experts suggest assembling an advisory team that consists of an attorney, an accountant, a management consultant, and a banker.
Having bank lenders represented is especially important. “It often happens that when a key person dies the banks get squirrelly and call outstanding notes,” says Babb. “To avoid that, take the initiative long before the actual transition takes place by helping your bankers develop working relationships with whoever will be taking over the reins of the business.”
If designing a trust takes resources away from management duties, the result is worth it. “Protecting family business assets requires a commitment of time, effort, and money,” says Babb. “It’s easy to procrastinate and allow the decision-making process to get bogged down. But no one has the promise of tomorrow. The risk of delay is that your business assets will go to creditors and the IRS rather than to the people you want to receive them.” RB