Future ownership structure and tax perks are among benefits
NORTH BAY – While always a top concern among planners, business succession planning has been thrust into the limelight recently, with the convergence of lower-than-typical valuations and a number of favorable tax provisions making it easier and cheaper to pass off ownership and other assets.
When that succession plan involves passing a business to the next generation, North Bay professionals in the field said that one mechanism – a trust – can allow a well-controlled ownership transition to occur earlier and open up further options for tax planning.
“Ideally, you want to start your succession planning earlier. When you’re starting it earlier, your children are usually younger, and when they’re younger, the best vehicle is often a trust,” said Joe Kitts, CPA and partner-in-charge of the Trust & Estate Tax practice of Burr Pilger Mayer in the North Bay.
While trusts can take a number of different forms, they share common threads in respect to business succession: protecting and controlling the passing of ownership and the perks to having a stake in the company.
“Often times, you have those trusts because you don’t trust the beneficiary,” Mr. Kitts said.
On the tax benefit side, one popular type of arrangement is the so-called “intentionally defective grantor trust,” he said. By “defective,” the arrangement describes a situation where the current owner gifts his or her ownership interests to their successor through a trust, yet retains control of those assets.
Since the owner is required to pay taxes on those interests, the arrangement shields the beneficiary or beneficiaries of the trust from what could be a high and untimely tax burden, increasing the scope of the gift. From an estate planning perspective, the payment of those taxes also allows the owner to remove more money from his or her estate, which is likely to be taxed at a higher rate than that of the offspring.
“The effectiveness is – you’ve passed on the value of the ownership interest to the child for gift and estate purposes, but you retain ownership from an income tax standpoint,” he said. “It leverages more of the gift and estate benefits.”
Mr. Kitts noted that earlier transferring of ownership – likely when the successor is young – can have benefits not just from the perspective of prudent planning. Those assets would have more time to grow within the trust before they were ultimately given to the beneficiary, meaning greater value at that point and less of an effect to the owner’s lifetime gift tax exemption.
“You want the business to appreciate outside of your estate,” he said.
From the perspective of future ownership, trusts offer several configurations to control the way ownership is structured in a transition while working with arrangements like limited liability companies, said Albert Handelman, an attorney specializing in trust and estate law at the Santa Rosa law firm Spaulding McCullough & Tansil, LLP.
“When I think in terms of succession planning, one of the big hurdles people often fail to clear is that, after they’ve identified and properly groomed a successor, making sure that person is in a position to take control of the business,” he said. “A trust might make the structural environment to do that.”
Mr. Handelman said that one can use a flow chart to graphically represent the structure of the proposed trust and how the current business structure – be it an S corporation, LLC or otherwise – can fit without jeopardizing the vision for future ownership seen in the family succession.
“You have this situation where the structure of the business entity and the structure of the trust has to be carefully coordinated,” he said.
A business owner may wish that multiple offspring benefit equally from the trust, though only a single child has been groomed to take over the business. One option to avoid future pitfalls in those cases includes appointing the true business successor as the trustee, which can hold voting rights for business interests away from other siblings. Those siblings can still benefit from dividends and other perks, yet it averts the possibility of a takeover.
“All of a sudden, if I make one small difference and say those ownership interests are held in trusts, they don’t get to vote on those interests,” Mr.. Handelman said. “I’ve changed the dynamic and made it a smoother operation of the business.”
Holding those interests in trusts also insulates them from future developments like the dividing of the company during a divorce and creditors, planners said.
There are many trust structures that can play a part in business succession and general estate planning. Deborah Corlett, partner at Santa Rosa’s O’Brien Watters & Davis LLP, noted that some popular structures include irrevocable life insurance trusts, generation skipping and charitable trusts.
“All of these trusts are complex in structure and implementation and, if used in the appropriate situation, can give the grantor substantial tax benefits while moving assets, including business interests, to the next generation or other beneficiaries,” she said.
Yet regardless of the purpose or structure, Mr. Handelman said that the appointing of the trustee can have major consequences for the operation of the trust. Despite the obligation to act in the interest of beneficiaries, the potential for an inflated ego on the part of the trustee can have negative consequences.
“A lot of times, when you pick somebody to be the trustee, that person thinks ‘I’ve been anointed,’” he said. “Beyond picking somebody who has business sense and the administrative skills, you’ve got one other element to consider – the psyche of that person.”
Succession professionals agree that a robust plan is best developed over a significant amount of time, taking into account that family dynamics should play a major role in the development of the plan. Offspring should be made aware of the plan early, which increases the likelihood that the transition will be smooth.
Despite that call for a controlled approach, Mr. Kitts and others noted that the favorable gift and estate tax conditions currently in place through the end of 2012 has indeed created a window of opportunity for some. Currently, a married couple can gift $10 million tax-free on top of their annual exemption, with additional gifts taxed at a 35 percent rate. That is expected to return to $1 million per individual in 2013, adjusted for inflation. Using a trust during a favorable window could allow those interests to be passed and taxed at a favorable rate.
“It’s always better to work on your tax planning earlier than later. But this is a particular window where we at least know the rules,” he said.
Using a trust for succession planning purposes is not ideal for all business owners. Many professionals will be involved in the formation and administration, and Mr. Handelman said that he typically sees it used for family succession planning in businesses valued above $20 million.
Yet for those who can benefit, including families with multi-generational wealth built into land used for agricultural purposes, the trust can help ensure the enduring success of the company, planners said.
“People want to live here. The industry is located here,” Mr. Kitts said. And for some, “it’s located in the land.”
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