As a business owner, you've poured your heart, soul, and countless hours into building your company. But have you taken the time to consider what will happen to your business if you become incapacitated or pass away? While it's not the most comfortable topic to think about, properly planning future business ownership can help protect both your company's future and your family's financial security.
Whether you're running a startup, managing a family business or hold equity in a private company, trusts can protect and transfer business interests that could be vital for their long-term success. Here’s how they work and what you need to know.
Why consider trust ownership for your business?
Many business owners default to keeping their business interests in their personal name, assuming they'll deal with succession planning "later."
But think about this scenario: You get sick, or have an accident, and are unable to continue to run your company. Who would make business decisions? While you might think a power of attorney would be enough, many financial institutions and business partners can reject or delay accepting power of attorney documents, especially if they don't meet specific requirements.
A properly structured trust can create a more seamless transition of control, allowing your chosen trustee to step in and manage business affairs without disruption. This can be especially important if you are the sole owner or a key decision-maker.
Other reasons to consider a trust include:
- Avoiding probate: When you pass away, assets held in your individual name typically must go through the probate process. This means your business details become public record, operations may face delays waiting for court approval and your estate could incur additional costs and administrative burdens. By transferring your business interests to a trust, you can bypass probate and ensure a smoother transition for your successors.
- Succession planning: A trust allows you to specify exactly how you want your business to be managed and distributed upon your incapacity or death. You can name a successor trustee to oversee operations and provide detailed instructions for the eventual transfer of ownership to your chosen beneficiaries.
- Asset protection: Depending on the type of trust and how it's structured, placing your business in one may offer some degree of protection from creditors and lawsuits. This can be especially valuable if your company operates in a high-risk industry.
- Estate tax planning: If your estate is likely to be subject to estate taxes, certain types of irrevocable trusts can be used to remove business assets from your taxable estate, potentially saving your heirs a significant tax bill.
Trusts can offer control and flexibility over your assets
One common misconception is that putting business interests in a trust means giving up control. In reality, trusts offer a way to maintain control while protecting assets and planning for succession.
For example, you might want your spouse to benefit financially from your business but prefer that operational decisions stay with your business partner. A trust can separate these economic and control rights, ensuring both goals are met.
Revocable vs. Irrevocable Trusts: What's the difference?
When it comes to trust ownership of your business, you have two main options: Revocable Trusts and Irrevocable Trusts. Understanding the key differences can help you decide which type best serves your needs.
Revocable trusts
Also known as living trusts, revocable trusts can be modified or terminated by the grantor (the person who creates the trust) at any time. Here are the main features:
- Flexibility: With a revocable trust, you maintain complete control over the assets and can change the trust terms, beneficiaries, or trustees whenever you wish. This can be ideal if your business is still in the early stages or you anticipate needing to adjust your plan over time.
- Incapacity protection: If you become unable to manage your business due to illness or injury, your chosen successor trustee can seamlessly step in to handle day-to-day operations and major decisions per your instructions.
- Probate avoidance: Assets held in a revocable trust bypass the probate process, allowing for a faster, private transfer of your business to your beneficiaries.
However, revocable trusts have some limitations. Because you retain control over the assets, a revocable trust does not provide any meaningful protection from creditors or lawsuits. Plus, assets in a revocable trust are still part of your taxable estate, so there are no estate tax advantages.
Irrevocable trusts
As the name suggests, an irrevocable trust is one that generally cannot be modified or revoked once it's established. The grantor essentially relinquishes control of the assets to the trust. Key features include:
- Asset protection: Since the assets are no longer under your ownership or control, an irrevocable trust can provide a barrier against creditors and litigation (assuming it's properly structured and funded in advance of any claims).
- Potential estate tax savings: Business interests placed in an irrevocable trust are generally removed from your taxable estate, which can be a powerful tool for reducing your estate tax liability.
- Succession planning: Like a revocable trust, an irrevocable trust allows you to specify how your business should be managed and distributed to beneficiaries. The trustee is legally bound to follow these instructions.
The main drawbacks of irrevocable trusts are their inflexibility and loss of control. Once an irrevocable trust is set up and funded, you typically can't modify the terms or take back control of the assets without beneficiary approval (and sometimes court approval). Additionally, placing a business in an irrevocable trust can result in the potential loss of a step-up basis at your death, which could result in higher capital gains taxes for your beneficiaries if, and when, they sell the business.
Transferring your business to an irrevocable trust also means giving up direct ownership and control, which can be a psychological hurdle for many entrepreneurs.
Key trust provisions business owners should consider
Regardless of whether you opt for a revocable or irrevocable trust, there are several key aspects your trust document should include if you're a business owner:
Specific powers for managing the business
Your trust should explicitly authorize your trustee to continue operating the business, making investment decisions, hiring and firing employees, and taking other necessary actions to manage the company effectively. This helps ensure a smooth transition and continuity of operations.
Trustee succession plan
Name not only your initial successor trustee but also alternates in case your first choice is unable or unwilling to serve. Better yet, discuss the decision with your preferred trustee first to ensure they’re already willing and able to serve. You can also cConsider naming a professional fiduciary, such as a bank or trust company, if you’re not comfortable naming someone you know. Or you can name them as a backup to ensure there's always someone qualified to manage the trust.
Beneficiary distribution instructions
Clearly outline how and when your business interests should be distributed to your beneficiaries. You might include provisions for the trustee to maintain ownership until certain milestones are reached, such as beneficiaries reaching a certain age or the business achieving specific goals.
Asset protection language
If creditor protection is a goal, your trust should include strong spendthrift provisions that restrict beneficiaries from pledging or encumbering their trust interests. This can help shield the business from beneficiaries' personal liabilities.
Overriding the prudent investor rule
One often overlooked issue is the "prudent investor rule" that applies to trustees. This rule typically requires trustees to diversify investments and avoid concentrated positions. This could directly conflict with holding a controlling interest in a private business.
To address this, you may want to consider explicitly overriding the prudent investor rule in your trust document and grant the trustee power to maintain business interests. Without this provision, your trustee could actually be legally obligated to sell or diversify business holdings.
Dispute resolution procedures
Consider including mediation or arbitration clauses to resolve any disputes between trustees and beneficiaries outside of court, which can be costly and time-consuming.
One common challenge is balancing business operations with family financial needs, especially when family members aren't involved in the business. One solution to this could be bifurcating trustee roles. Appoint one trustee (perhaps a business partner) to handle business operations and another (often a family member) to manage family financial matters.
Coordination with buy-sell agreement
If your business has multiple owners, ensure that your trust provisions align with any existing buy-sell agreements. Your trust should direct the trustee to carry out the terms of the buy-sell if triggered by your incapacity or death.
Considerations for specific business structures
The type of entity your business operates as can impact trust planning:
- Corporations: If you own shares in a C-corporation or S-corporation, you'll need to review the company's bylaws and any shareholder agreements to ensure they permit trust ownership. S-corporation stock can only be held by certain types of trusts, so it’s a good idea to work with an attorney to structure your trust the right way.
- Partnerships and LLCs: Review your partnership agreement or LLC operating agreement to see if it allows for trust ownership of shares. You may need to amend the agreement to accommodate your trust. Also, consider any restrictions on transfers of ownership and how they might impact your succession plan.
- Sole proprietorships: While a sole proprietorship is not a separate legal entity, you can still use a trust to hold and transfer business assets like real estate, equipment, and intellectual property.
The advisor's role in trust planning
If you're considering trust ownership for your business, your financial advisor can be a valuable resource throughout the planning process. They can help you clarify your objectives for the business, both during your lifetime and after you're gone. They can also guide you in prioritizing competing goals like maintaining control, minimizing taxes, and protecting assets.
With a deep understanding of your financial situation and estate planning needs, your advisor can help you weigh the pros and cons of different trust structures and determine whether a revocable or irrevocable trust (or a combination) is best suited for your circumstances.
Your advisor is often just one tool to have in your financial toolbox. They can serve as a point person to coordinate the work of your estate planning attorney, CPA, and other professionals involved in the planning process.
As your business and personal circumstances change over time, your advisor can help you review your trust plan to ensure it remains aligned with your goals.
Is a business trust right for you?
Placing your business interests in a trust can protect your company's future, streamline your estate plan, and potentially minimize taxes. But it's not a one-size-fits-all solution. The right approach depends on your specific goals, family situation, and business structure.
If you're considering trust ownership for your business, start by meeting with your financial advisor. They can help you review your options and develop a plan that safeguards your legacy and ensures a smooth transition for your company when you're no longer at the helm.
