When we do business succession planning, the entities we create could be a family trust, wherein the senior generation passes control of the entity, management rights, and economic benefits to the next generation. A revocable trust is a common vehicle for business succession planning, because of their irrevocability upon death or incapacity. This gives business partners confidence the surviving settlor, like a spouse, is bound by the succession plan. It binds all stake holders to the agreement.
While the business owner is still alive, as the trustee of the revocable trust, he or she retains control of the business and its economic benefits. The successor trustees will oversee the retained interest in the business. You must name a successor trustee who will not be hostile or collusive with the remaining business partners. The successor trustee must always act in the best interest of the beneficiaries.
There may be some administrative tasks to be undertaken upon the death of the first spouse, such as a transfer of the business to an irrevocable sub-trust, designed to hold the deceased business owners’ interests during the lifetime of the surviving spouse. The trust can provide an economic benefit to the surviving spouse, but not control of the business.
The trust can also provide creditor protection and divorce protection for beneficiaries. Assets are less subject to dissipation from the child’s immature judgment, their creditors, or estate taxes. These types of irrevocable trusts can take a lot of different forms, such as life insurance trusts, generation skipping transfer trusts, and intentionally defective grantor trusts. Your situation may demand a domestic asset protection trust or spousal access trust, which is an irrevocable trust where the spouse is entitled to the income generated and a portion of the principal, but they can’t change the ultimate beneficiaries of that trust, so it protects the children.
There are other third party trusts that can be created to provide creditor protection, protection from divorce, and prevent a beneficiary from retitling their ownership share together with their spouse. We have built in provisions to ensure that there’s no further estate tax to be paid and provides for income tax arbitrage. We’re distributing sufficient income to lower the income tax for the combined trust and the individual beneficiary. There’s a dynasty trust that would serve to pass the interest to future generations. As part of the business plan, we want to deal with control rights. We might create different classes of interest. We might create a real estate limited liability company that can be structured to permit ongoing management by a licensed senior generation or corporate entity that can ensure that any appreciation on the property above what’s necessary for the senior generation’s lifestyle goes to the heirs, without incurring any further transfer tax.
For non-real estate entities, we can do a recapitalization plan that can separate the economic interest and stock into voting classes and nonvoting classes. Certain beneficiaries would be entitled to receive the economic benefit but have no management or control in the business. Buy-sell agreements are a good mechanism for restricting ownership and control by limiting the persons who can own the stock or the interest, and containing provisions for voting and control of an entity. When we’re planning for specific beneficiaries or transferees, it could include a whole different host of individuals. It could be family members of the same generation or a junior generation, the employees, existing co-owners, outside buyers who will continue the business, or an outside purchaser who will liquidate the business. It could be charitable entities to transfer or it could be the public markets. Litigation can be difficult and expensive.
We may need significant liquidity for balancing the transfer tax. It may require creating a new entity or reorganizing the existing legal entity in transferring the interest to that entity. One other type of trust we could create is called a grantor retained annuity trust, which is an irrevocable trust. The grantor retains an annuity interest for a specified term and then the remainder interest passes on to the junior generations. They essentially make a gift to this trust based on the value at that time, which with the loss of control results in a reduced estate tax. We also have the intentionally defective grantor trust, which passes the assets outside the estate of the senior generation but the income still becomes an obligation for the business owners. That’s a way to keep the income tax low and provide estate tax planning and business planning at the same time.
We could do an installment sale, where the senior generation sells a percentage of the interest in the business to an irrevocable trust for the benefit of the junior generation and then they issue a promissory note which may or may not be secured. The future appreciation and the interests sold accrues to the purchasing successor generation. The value of the obligation and the promissory note remains fixed in the estate of the owner/seller. When we sell to this intentionally defective grantor trust, the sale of the trust will not be subject to income taxation to the seller. Another option is what we call a private annuity. It’s a variation of the installment note, where the business interests have changed for an unsecured promise to make the periodic payments to and over the lifetime of the seller. It is more risky. There aren’t any secured assets. Another option we have is a self counseling installment note, which is a hybrid of an installment note in a private annuity, where there’s a fixed payment term on installment note, and the cancellation on death feature of the private annuity, so there’s no continuing liability for the heirs. The consideration for the cancellation feature is a higher interest rate or mortality risk built into that principal balance.
Another thing to consider is the funding or the liquidity of these transfers. With the buy-sell agreement, we want to avoid a fire sale upon the death of the business owner. We need the liquidity to pay the purchase price. A lot of times, that can be done with a life insurance policy. We have to consider the cash flow from the business and various benefit plans inside of the business. We could do a plan where we’re passing the ownership to the employees. We’d have incentive plans such as the employee stock ownership plan also known as the ESOP, the transfer of restricted units, and stock options. Maybe there are no heirs or there are, but we’re also charitably minded. We could do a transfer to a charitable entity or trust, such as a charitable remainder trust, where the owner retains the benefits of the proceeds from sale and then it kicks off to a number of charities upon their demise. Normally, when we do that, the grantor will retain principal income of the assets and then that could be used to buy a license insurance policy to pay the beneficiaries. Then, they receive some value while the business itself is passed on to a charity.
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