Often misunderstood, the trust is a versatile vehicle that's well-suited for a variety of situations
The United States is on the threshold of a major demographic shift. The post-war “baby boom” generation — a group of some 78 million Americans — has arrived at, or is nearing retirement age. This generation now faces the very real necessity of planning for retirement, the end of life and a smooth transition to succeeding generations. In the context of a family-owned business, this planning will take the form of anticipating a transition in the ownership and control of the business, whether to family members or to an outside purchaser.
Succession planning for the family business presents a unique set of challenges. Particularly when ownership is to be transferred to family members (most commonly children or more remote descendants), seemingly insurmountable challenges may present themselves: The successors may lack the skills and experience to assume control, at least in the near term; differences in aptitude and interest among the members of the next generation may make equal treatment seem impossible; or the next generation's own financial or personal difficulties can weigh heavily against any transfer at all. These and other challenges may lead to the disastrous decision to forgo planning entirely.
One of the most useful structures an estate planner can suggest is to employ one of the oldest solutions: the trust. Although a commonly used vehicle for gratuitous transfers, the trust is an underused, and very often misunderstood, form of ownership for an operating business.1 In the context of both business and personal planning, it's exceptionally versatile and well-suited to a variety of situations for which other forms of ownership may not be appropriate.
How a Trust Can Help
Several aspects of the trust make it particularly useful for ownership and control of a closely held business. The most important of these are the trust's defining characteristics of bifurcated ownership and shared benefit. With regard to the first: reduced to its simplest form, the trust is a mechanism to split the ownership of an asset or group of assets into legal ownership (held by the trustee) and beneficial ownership (held by the beneficiaries). Each of these may be further divided; for example, legal ownership may be held by several co-trustees, and a trust may have multiple current beneficiaries and segmented temporal interests (for example, income and remainder beneficiaries).
With regard to the second: a trust enables multiple persons to benefit from the same asset or group of assets. For example, if the trustee is authorized to make distributions to or for the benefit of multiple beneficiaries, each of them may receive a benefit from the return produced by the trust property, whether equally, according to need or by some other guideline or set of guidelines contained within the trust document.
The combination of these two characteristics makes the trust ideal for use in the context of the family business, particularly when ownership and control of the business may otherwise be passed to a group of recipients of varying abilities, interests and personalities — that is to say, most families. By combining the characteristics of bifurcated ownership and shared benefit, ownership in trust can help achieve the following results:
- Enable continued focus in the control and management of the business;
- Resolve the very difficult problem of treating beneficiaries equitably despite varying degrees of participation;
- Forestall conflict and resulting deadlock;
- Protect against abuse and mismanagement;
- Compel compromise and cooperation among the beneficiaries; and
- Preserve family assets against the personal liabilities of individual family members.
Of course, no legal structure, however versatile or well-suited to the demands of the situation, is a panacea. Application of any particular strategy requires careful consideration of the particulars of the case, and a great deal of thought about the terms of the documents and the identity of those charged with carrying out those terms. That said, the following examples provide an overview of the potential benefits of using a trust for family business ownership.
Treating Children Fairly
Example 1: Mother is the founder, sole shareholder and CEO of a successful food service business. Between shareholder distributions and executive compensation, the business produces sufficient cash flow to support Mother's current lifestyle. On a fair market value, going-concern basis, the business is valued somewhere around $20 million. Mother has three children, only one of whom is active in the business.
Planners will recognize this as a common situation, and one that can be very difficult to resolve. Mother wishes to treat her children equitably, but she also wants to incentivize and reward the child who is active in the business. If she gives the lion's share of the business to that child, the other two likely will feel they've been treated unfairly, particularly if there aren't sufficient other assets to equalize the three. It may be possible to give each a roughly equal economic interest in the company but give the active child voting control — for example, by recapitalizing the stock into voting and non-voting shares and giving or devising the voting stock to the active child. However, this may create more problems than it solves. The disenfranchised children may grow resentful of their sibling, particularly if they view him as taking advantage of the situation (for example, by taking excessive compensation). On the other hand, dividing the vote equally among the three children may create chaos or deadlock.
Consider the utility of a trust in these circumstances. Suppose, for example, that Mother creates a trust for the benefit of the three children. At some point, whether during her life or at death, she transfers the stock into the trust, which is divided into three separate shares, one for the benefit of each child. Mother names all three children as trustees, and gives each of them the power to appoint his own successor. As a result, each child is bound by a fiduciary duty to exercise ownership and control of the stock for the benefit of the other two. The trust instrument might require unanimous consent of the trustees for action (or a majority vote except for major actions such as selling the stock), perhaps with the ability to appoint an outside tie-breaker voter if the trustees are unable to reach a consensus. In this way, the trust serves as a mechanism, backed by a fiduciary duty, to achieve shared control of the company at the shareholder level for the collective benefit of the children.
This example highlights numerous issues that a planner should consider carefully and discuss thoroughly with the client. For example, we assumed above that the trust would be divided into three shares. While there's much to recommend in this arrangement — perhaps chiefly, the separation of the beneficiaries' interests — there may be compelling reasons to maintain the trust as a single “pot,” with perhaps the trustee being authorized (but not required) to divide some or all of the trust among the three children and their family lines at some future time.
Also, naming all three children as trustees may be inadvisable in a particular family context. The dynamic among them may make it impossible to attain a consensus under virtually any circumstances. While most planners would counsel against naming one child as trustee for all three, consider naming a third party, whether alone or as co-fiduciary with one or more of the siblings.
The larger point is that the planner can structure the trust to accomplish Mother's objectives, while keeping the primary source of the family's wealth intact and functioning. The trust can be drafted flexibly enough to anticipate and respond to changing circumstances. For example, as noted above, the trust may give the authority to divide some or all of the trust into separate shares among the beneficiaries, as and when appropriate. The trust could (or should) provide for oversight by one or more protectors, who might also be given the power to change the trust's administrative or dispositive provisions to achieve desired results — for example, the power to change the succession of trustees, or the power to bestow a general power of appointment on a beneficiary to achieve a better tax result.
Ownership and Control
Example 2: Father died two years ago, leaving ownership and control of his construction company equally between his two children, Brother and Sister. Sister, who is actively involved in the management of the company, wishes to buy Brother's shares (who isn't involved in the business). She offers to have the company redeem Brother's shares by giving a cash down payment and paying the balance over five years, evidencing the unpaid balance by an unsecured promissory note bearing a market rate of interest.
Consider, first, the likely concerns of Sister in this transaction. As a manager of the company, she's concerned with its cash flow, which will be affected much more, at least in the short term, by a large cash payout than it will by a relatively small payout combined with an installment obligation. From her standpoint, the installment sale is preferable, particularly if she can get a higher return on the company's cash flows than the company will pay to Brother on the deferred obligation.
From Brother's standpoint, this proposed transaction involves substantial risk. First, the company's creditworthiness is of great concern. If the company fails before the note is completely paid, Brother loses some or all of the value of his shares. Compounding this concern is his inability to exercise much (or any) influence over the direction of the company, at least absent some provision in the redemption agreement to the contrary. Second, Brother has forgone appreciation in the company above his rate of return on the note. If, for example, Sister sells the company to a third-party buyer, the sale proceeds inure to Sister's benefit, because Brother's financial benefit has been fixed by the terms of the redemption, again, absent an agreement to the contrary. For example, there could be a “tag-along” clause that entitles Brother to a share of the additional value created by the sale. Even absent a sale of the company or its stock, he may have traded a greater return (in the form of distributions from the company, if they are made) for the relative certainty of whatever interest rate is specified in the note.
What if Father had devised the company stock to a trust for his children's benefit, rather than leaving it outright? On the one hand, this likely would make the above transaction much more difficult to achieve. If Sister is a trustee, the transaction would likely be an act of self-dealing and therefore voidable by Brother (although presumably he would have given his consent to the sale in advance). If there's an independent trustee, that trustee may be unable or unwilling to enter into the transaction. Moreover, depending on how the trust is structured (that is, as separate trusts or as a single “pot” trust, with or without authority in the trustee to divide), it may be difficult or impossible to identify and segregate Brother's interest in the company.
On the other hand, ownership of the company in trust may address some of the underlying dynamics motivating the transaction in the first place. For Sister, control of the company at the shareholder level almost certainly is a basis, if not the principal basis, of her desire to liquidate Brother's interest in the company. If that control is vested in a trustee or trustees, then a redemption of Brother's interest in the company likely becomes irrelevant and meaningless. Unless the shares are held in separate trusts, with different trustees, a redemption of Brother's half of the company won't change the shareholder control of the company — and even then may not affect Sister's ability to exercise that control, depending on the identity of the trustee of her trust. If the trust is a single trust, then a redemption of half the stock changes nothing, either in terms of voting control of the company or of each sibling's beneficial interest.
This example emphasizes the importance, and the sensitivity to context, of the structure of the trust and of the choice of fiduciary. The structure of the trust — that is, how the beneficiaries' interests are held, for example separately or collectively — can impact, not only the way in which the trustee manages and distributes the assets of the trust, but also the ease (or lack thereof) with which the beneficiaries' interests may be segregated and diversified. The identity of the trustee or trustees can profoundly impact the dynamics and outcome of the trust's administration. In this example, if Sister and Brother are co-trustees of the trust (or of each trust), then each of them is under a fiduciary duty to administer the trust in the interests of all of the beneficiaries. This might force compromise — or at least maintain a situation of “mutually assured destruction,” wherein each of them is constrained, if not by the bonds of familial devotion, then at least by the specter of familial litigation. At the very least, it assures a level of mutual accountability for the prudent ownership and management of the company.
Suppose, on the other hand, that an unrelated party is a co-trustee, or even the sole trustee. Suddenly, the entire dynamic changes. No longer is the tension between Brother and Sister; rather, their focus is directed toward a common enemy, the outsider who exercises a veto power, if not outright control, over the family business. The outsider can protect both the company and the beneficiaries, but in so doing runs the risk of incurring the wrath of all concerned. (I say it's for reasons like this that professional fiduciaries earn their fees.)
Consider, also, the perspective of the beneficiaries vis-a-vis their individual liabilities. Suppose that Brother is in an unhappy marriage, or that he has creditor problems. If he owns the company stock individually, that stock is subject to all of his individual liabilities, and a judgment creditor could obtain ownership of half of the company, compromising the family's collective wealth and compounding Sister's difficulties immeasurably. If the stock is held for Brother's benefit in a discretionary trust with spendthrift provisions, this forecloses many of these potentially serious possibilities; most (although certainly not all) creditors will be unable to reach Brother's interest in the stock or gain any measure of control over the company shares.2 This by itself, even without the considerations relating to the control and management of the company and the reconciliation (or at least balancing) of the siblings' differing interests, can be a compelling reason to use a trust.
The example illustrates some of the ways in which the trust can be used to address some of the fundamental tensions and sources of potential conflict in the rather simple fact pattern outlined above. Of course, no solution exists in a vacuum, and the suitability of any given planning strategy must be considered in the context of the actual situation. However, the trust can provide significantly more protection for the interests of the beneficiaries, as well as both flexibility and accountability in the continued management of the family business.
Example 3: Father, who died two years ago, was the founder of a retail chain that operated more than 100 locations in the Southeast. At the time of Father's death, ownership of the company had been divided among several different entities that were in turn owned by a series of trusts for the benefit of his children, none of whom has the experience or the inclination to become involved in the active management of the company. As part of Father's planning, which was implemented over a course of years under evolving circumstances, the stock of the company was recapitalized into voting and non-voting shares. A limited liability company (LLC) owns the voting shares, and the LLC's members are the owner trusts. The managers of those trusts are Father's widow (who was Father's fourth wife and isn't the mother of any of the children) and his closest friend, who is an executive at the company. Both of them are also the trustees of the owner trusts and are on the board of directors of the company. They have significant concerns about the continued management and direction of the company, which employs hundreds of people and the continuation of which was Father's chief preoccupation.
This third example illustrates two separate, but related concerns: the complete separation of control from economic benefit, and the challenge of continuation of a family enterprise when the family no longer has direct (or any) involvement. Let's consider the second of these concerns first. Certainly, the ownership of the voting stock of the company through an LLC provides some measure of continuity and stability. The LLC operating agreement can, and typically does, provide some mechanism whereby managers can be replaced, whether by the member trusts or (perhaps) by the managers themselves. However, the LLC's utility may diminish over time. Suppose, for example, that the LLC operating agreements provide for the election of successor managers by the members. Suppose, too, that the trust agreements were drafted over a period of years, and that many of them appoint successor trustees who are either no longer available or no longer suited for the role. (Most planners will appreciate the difficulty and necessity of forecasting through the years and appointing, or even better, providing a mechanism for appointing, suitable successor trustees.) As events develop, management of the LLC, and by extension, shareholder control and leadership of the business, may devolve to trustees unsuited or ill-prepared for the challenge.
The managers are faced with a set of priorities that are, to some extent, contradictory. As officers and directors of the company, they're charged with acting in the best interests of the company and its shareholders. Moreover, they share Father's commitment to maintaining the company as a closely held business that offers employment opportunities to the members of the communities in which it operates. This commitment is “hard-coded” into the documents of the owner trusts as precatory language. At the same time, they're under a fiduciary duty to manage the assets of the owner trusts in the best interests of the beneficiaries, whose interest in the company is primarily, if not exclusively, financial (and the assets of the trust are, therefore, largely fungible). In that role, their task is to maximize the economic result for the benefit of the beneficiaries. (Of course, this obligation is consistent with their corporate duty to maximize value to the shareholders.)
Consider whether a statutory trust (that is, a trust created under an enabling statute such as the Delaware Statutory Trust Act (DST Act), sometimes called a “business trust”) would be a superior form of ownership for the voting shares in this case. For purposes of the discussion, we'll assume that the jurisdiction of choice for establishing the trust is Delaware, although this is one of several possibilities. The DST Act3 permits the creation of a statutory trust upon filing a certificate of trust with the Delaware Secretary of State. It imposes very few mandatory requirements beyond having at least one Delaware trustee (whose duties can be limited to essentially serving as an agent for service of process) and requiring that the trustees be subject at a minimum to a standard of good faith and fair dealing. Its primary attraction for planning is its flexibility: nearly all aspects of the trust's operation can be defined by its governing instrument, which doesn't need to be executed by the beneficiaries (the beneficial owners) to be binding on them.
Without disturbing the rights of the LLC members (for example, the right to distributions),4 the managers could establish an entity that preserves the integrity of the existing structure (and Father's intent and vision) while ensuring a more orderly, rational continuation of shareholder-level control. For example, the trust's governing instrument could provide for:
- Appointment by the trustees of their own successors, subject (if appropriate) to the approval of the other trustees — and perhaps of the beneficial owners as well;
- Clearly defined fiduciary standards (and protection against baseless claims) for the trustees;
- Perpetual existence, with provisions for termination upon stated events (for example, sale of the company — which in turn could require super-majority or even unanimous approval of the trustees);
- A waiver of any requirement of diversification, absent the circumstances described above (that is, a favorable transaction), and a recognition of Father's intent to maintain the company as a closely held business; and
- Subject to the duty of good faith and fair dealing, the ability to enter into transactions with the company or with the trustees (self-dealing).
The last item may be particularly important if there's an agreed-upon strategy to monetize the beneficiaries' interest in the company, for example in a management buy-out or a sale to an employee stock ownership program.
In addition to its structural adaptability, the statutory trust offers flexibility for income tax purposes unrivaled by any other entity. Depending on the terms and the desired result, the trust may be treated as a trust, grantor trust, partnership or even corporation for federal income tax purposes. If (as is likely) the LLC is treated as a partnership for income tax purposes, the trust can obtain similar treatment, again so as not to disturb the positions of the beneficial owners. On the other hand, the managers' options aren't limited to this if another treatment is more favorable. For example, there may be state income tax savings if the trust is taxed as a non-grantor trust.5
Moreover, it's an ideal vehicle for holding an asset long-term. The leading case in this regard is Estate of Schutt v. Commissioner,6 in which the decedent employed two DSTs to ensure that his “buy and hold” investment strategy would survive him. The estate successfully argued that perpetual maintenance of a single undiversified asset in accordance with the settlor's intent was a legitimate, non-tax reason for each trust's existence. In the age of the modern portfolio theory, few would argue that a trustee is well-advised simply to hold an asset or group of assets unthinkingly (at least, absent clear direction in the trust document to do so), but if circumstances such as those outlined in the example call for a vehicle that can serve as a long-term, even perpetual ownership vehicle, the statutory trust is a satisfactory solution.7
The statutory trust is a form of ownership that's well-suited for a variety of business contexts and can be tailored for the particular circumstances. As noted above, it's extraordinarily flexible, in terms both its operative provisions and its income tax aspects.
The statutory trust can also be used to facilitate the buy/sell agreement of an operating company. Entity buy/sell agreements often are structured as “cross-purchase” agreements, whereby the owners agree to buy each other's interests upon defined events such as disability or death. These arrangements often are funded through the purchase of insurance on the life of each owner. Suppose that each owner transfers his interest to the trust, which issues a certificate of beneficial ownership to each contributing owner. The trust also owns the insurance policies on the owners. The terms of the trust provide that, upon the death of a beneficial owner, the owner's estate receives payment for the owner's beneficial interest (which may be represented by a certificate) at the agreed-upon price or as determined by the agreed-upon formula. By agreement, this is treated as a distribution to the surviving beneficial owners and a purchase by them of the decedent's interest, which is allocated pro rata among the survivors. The entire transaction is effected by the trustee, who is under a fiduciary duty (as defined by the document) to carry out the terms of the trust.
- See John H. Langbein, “The Secret Life of the Trust: The Trust as an Instrument of Commerce,” 107 Yale L.J. 165 (1997).
- The thorough planner might also think about the optimal structure of the business itself in the unlikely event Brother's creditors might successfully attach his interest in the trust. For example, a limited liability company interest typically is less attractive to a creditor than corporate stock, as most state statutes drastically limit the rights of a creditor who attaches such an interest.
- Tit. 12 Del. Code Section 3801 et seq.
- This is true even if the rights of the members differ, as the statutory trust easily can accommodate different classes of beneficial ownership.
- See 11 Del. Code Sections 1601, 1635, 1636 (permitting Delaware resident trusts to deduct from Delaware taxable income trust income set aside for future distribution to a non-resident beneficiary).
- Estate of Schutt v. Commissioner, 89 T.C.M. (CCH) 1353 (2005).
- On a theoretical level, Professor Steven Schwarcz, professor of law and business at Duke University, has argued cogently that the nature of the trust and the interests of its beneficial owners orient the trustees' role more toward conservation of value than toward risk-taking in the interests of profit maximization. See, e.g., Steven Schwarcz, “Commercial Trusts as Business Organizations: Unraveling the Mystery,” 58 Bus. Lawyer 1 (2003), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=319802.
James R. Robinson is a partner in the private clients, trusts and estates practice group in the Atlanta office of Schiff Hardin LLP
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