The transition of a family owned or closely-held business is an important event for estate planning clients. Historically, the use of trusts has played an important role in business succession planning. Recent changes to the federal estate tax and gift tax laws as well as the income tax laws have caused planning professionals to evaluate the usefulness of trusts in succession planning. Despite these recent changes, trusts should continue to play a role in succession planning for reasons of tax avoidance, creditor protection, and centralized management of family assets. This white paper will explore the usefulness of trusts in succession planning. Trusts are not necessary for every client, but they can provide key benefits that assist in transitioning a business from one group of owners to the next in a tax-efficient manner.
TYPES OF TRUSTS
Trusts are either revocable or irrevocable and are either funded during lifetime (an “inter vivos trust”) or at death (a “testamentary trust”). Revocable trusts do not exist for income tax purposes, provide no creditor protection, and do not shelter assets from federal estate tax or Pennsylvania inheritance tax. Properly structured irrevocable trusts are creditor protected and shelter assets from death taxes.
KEY BENEFITS OF TRUSTS
Historically, trusts have been used in planning to avoid taxes – primarily the federal estate tax. Currently, the federal estate tax exemption amount is $5,340,000 per person, so fewer business owners have exposure to the tax. In addition, Pennsylvania recently enacted an exemption from inheritance tax for a “qualified family owned business interest” (QFOBI), which exempts certain business interests from the inheritance tax. Among other things, the business must have less than fifty full-time employees, have a net book value of less than $5,000,000, and must be transferred to one or more “qualified transferees.”
For many clients, funding inter vivos trusts will be advantageous even if the client does not have federal estate exposure. A properly structured inter vivos trust will provide creditor protection and remove the value of the business interest from the client’s taxable estate, thereby avoiding Pennsylvania inheritance tax. The avoidance of Pennsylvania inheritance tax (for business interests that do not satisfy the definition of QFOBI) can save valuable resources at the time of death.
If a client desires to use a trust for succession planning, funding an inter vivos trusts may be important because trusts do not qualify as “qualified transferees.” That is, a trust funded at death with a business interest is not a “qualified transferee.” If testamentary trusts are employed, then the non-tax benefits of the trust must be weighed against triggering an inheritance tax on the value of the business interests transferred at death. The exclusion of trusts as qualified transferees is an unfortunate gap in the statute and impairs the utility of common planning techniques.
Trusts provide creditor protection and the centralized management of family business assets. These benefits should not be overlooked when developing a succession plan. Trusts can be used to shield the surviving spouse and children from potential creditors, such as divorcing spouses. Another consideration is business related debt since business assets, such as real estate, are often encumbered at the time of death. The succession plan should account for business related debt.
KEY ISSUES WITH TRUSTS
The role and powers of the trustee are critical to the success of any trust in a succession plan. Whether a bank or an individual, the selection of the initial trustee and successor trustees, as well as the powers granted to the trustee, should be carefully considered. Apprehension often exists about selecting a trustee. For clients, fortunately or unfortunately, the range of choices and possibilities as to trustees and trustee powers is broad.
Corporate trustees have the benefit of continuity and professional staff, can provide efficiencies in carrying out administrative tasks, and are objective in making discretionary decisions. Individual trustees provide a personal connection to the family and can be a more effective option for managing family business assets.
Business owners often are reluctant to have an outside party control a family business interest. In recognition of this concern, the trust agreement can provide that one or more children will serve as the initial trustee (with a trust structured to avoid estate tax at the child’s death). The successor trustee can be appointed in any number of ways, including:
The current trustee (the child) has the right to appoint his or her successor
The trust beneficiary has the right to appoint the successor trustee (for example, a grandchild appointing the successor trustee upon child’s death)
The business owner identifies one or more individuals (or a bank) as the successor trustee
A trust protector (discussed below) appoints the successor trustee
The appointment of a successor trustee should be flexible enough to account for unforeseen circumstances in the future and to ensure that the successor trustee will be a bank or an individual that will respect the terms of the trust agreement. The trust agreement may provide that descendants (grandchildren, great-grandchildren, etc.) have the right to serve as the co-trustee of his or her own trust, which will allow for a greater role and level of input for the beneficiary.
In addition, the trust agreement should address whether the beneficiary has the right to remove and replace a trustee and whether this right should be absolute or conditioned in some way. If individual trustees may serve by appointment of the beneficiary, then consideration must be given to the universe of possible appointees to avoid the replacement trustee from being a “friendly” party who will ignore the terms of the trust agreement.
An important – but often overlooked – component of a trust agreement are the powers given to the trustee. The powers granted to a trustee are important to consider when the trustee is also a beneficiary since certain powers granted to the trustee/beneficiary, even if not exercised, can result in the trust being subjected to federal estate tax when the beneficiary dies. There are a variety of powers a beneficiary can have as trustee that result in the negative consequence of the estate tax applying to the trust.
The trust agreement may divide the responsibilities of the trustees. The role of one trustee, such as a corporate trustee, may be limited to “administrative” tasks and the investment of marketable assets while the other trustee, such as a family member, will have responsibility for the management of the family business assets. Consideration to these issues should be given in drafting the trust agreement. Pennsylvania law also allows for co-trustees to delegate duties to each other. The delegating trustee, however, must exercise reasonable care and skill in establishing the scope and terms of the delegation and has a duty to monitor the co-trustee. Therefore, if a division of labor is intended, then the division of labor should be laid out in the trust agreement.
The powers of the trustee should be as comprehensive as possible because the trust may ultimately own a variety of assets even though it is funded with business interests. For example, if the business interests are sold the trustee may want to purchase commercial real estate, acquire life insurance insuring the lives of beneficiaries, invest in a new business venture, or participate in natural gas exploration.
In recent years, some trusts have included a “trust protector.” In general, a trust protector is a person who has the power pursuant to the trust agreement to control the actions of the trustee or, for example, to replace the trustee. Pennsylvania, unlike some other states, imposes a fiduciary relationship on the trust protector, so the powers and identify of the trust protector should be carefully considered.
DURATION OF TRUST
The business owner should consider at what point, if ever, his or her heirs will receive their inheritance outright. Under the laws of most states trusts do not have to terminate. Therefore, the creditor protection and tax avoidance a trust offers may appeal to a business owner in such a way that the business owner does not want the trust to terminate. The upside to this arrangement is that the property funding the trusts will perpetually benefit the heirs of the business owner but in a way determined by the business owner through the trust agreement. Alternatively, some business owners prefer for their heirs to have outright control of the trust property at some point. Some business owners will provide for limited installment distributions at certain ages with the remainder of the trust held perpetually.
SPECIFIC TYPES OF TRUSTS USED IN SUCCESSION PLANNING
Intentionally Defective Grantor Trust
An Intentionally Defective Grantor Trust (IDGT) is a trust that does not exist for federal income tax purposes but does exist for estate tax and inheritance purposes. Consequently, a business owner may “sell” business assets to the IDGT in exchange for a promissory note. The “sale” is not recognized for federal income tax purposes (although is recognized for Pennsylvania income tax purposes) so no capital gain is triggered. But, since there is “sale” there is no gift for federal gift tax purposes, and the business owner’s exemption amount is preserved. The property sold to the IDGT is excluded from the business owner’s estate and appreciates in value free of federal estate tax and Pennsylvania Inheritance Tax. The IDGT, however, must be funded by the selling party with no less than 10% of the sale price.
IDGTs work particularly well with limited partnership interests. For example, a business owner with $1,000,000 of limited partnership interests can “sell” them on a valuation discounted basis for $600,000. The IDGT would be funded with $60,000 and issue a $600,000 promissory note to the seller. The note, for example, would be paid off over nine years at the rate of $73,509 annual (assuming a 2% interest rate). At the end of the nine year term, the limited partnership interests are transferred to the business owner’s heirs (either in trust or outright). The true value of the limited partnership interests would be $2,000,000 after nine years assuming an 8% annual growth rate.
Spousal Lifetime Access Trust
A Spousal Lifetime Access Trust (SLAT) is another way for a business owner to have “the best of both worlds.” A SLAT is funded by one spouse for the benefit of the other spouse for his or her lifetime. The gift is irrevocable and uses the donor’s exemption amount. The trust conceivably benefits the donor spouse because distributions to the beneficiary spouse will be used to benefit both spouses. So, the business owner can contribute property that is believed will appreciate in value to “freeze” the value for death tax purposes. The SLAT, however, cannot benefit the donor spouse if the beneficiary spouse dies, so this limitation should be considered.
Beneficiary Defective Trust
A Beneficiary Defective Trust (BDT) is a trust established by one person (typically a member of the senior generation of a family) for the benefit of another person (typically a member of the junior generation of the family). The trust is a “grantor trust” as to the beneficiary instead of the grantor. The trust, therefore, does not exist for income tax purposes as to the beneficiary, which allows the beneficiary to “sell” assets to the BDT (similar to an IDGT). The difference between an IDGT and a BDT is that the beneficiary, because he or she did not make a gift to the trust, may be a beneficiary of the trust without adverse death tax consequences.
Business assets often are owned at death even with significant lifetime planning. Trusts can be useful as part of buy-sell planning if there are multiple owners of a business. If there is a cross-purchase arrangement between or among owners, the life insurance backing the buy-sell obligations can be owned by trusts instead of by the individual owners. In the event of the death of an owner, the trust that receives the life insurance will purchase the deceased owner’s equity, and the trust will then benefit the purchasing owner’s family. The acquisition of the equity interests by the trust will keep the value of the property out of the purchaser’s estate and therefore avoid estate tax and inheritance tax. Often, the acquisition of equity by an irrevocable trust is limited to non-voting interests to continue voting ownership with surviving owner only.
Creditor protection, tax avoidance, and the centralized management of family assets are all important considerations for any succession plan. In the right situations, therefore, trusts continue to be a valuable planning tool for the family business owner and their usefulness should not be overlooked.