Trusts can be useful tool in business succession planning
Trusts can be used for a variety of purposes in addition to succession planning, but they serve well in that capacity, according to Richard Stone, founder and chairman of Private Ocean wealth-management firm in San Rafael. The company has 26 employees, many of them former business owners. In 2009, the company merged with another firm that had roots going back nearly 40 years. Stone founded a predecessor company in 1983. PrivateOcean’s clients come largely from the North Bay, including Marin, Sonoma and Napa counties, then from San Francisco and the Peninsula.
Revocable living trust
The most basic trust, and one that is highly useful in protecting business assets, is a revocable living trust, Stone said. As the name implies, this trust can be revoked, and it exists during the lifetime of the business owner. When the business owner dies, the assets in the trust transfer to his or her beneficiaries.
Most business owners name themselves as trustees of their revocable living trusts so they can control the assets in the trust and use them to their advantage during their lifetimes. “The ownership of a corporation should be held in a living trust,” Stone said. “That avoids probate,” and provides a confidential record so the public is not aware of the details of financial transactions inside the trust.
A revocable trust can be revoked for any reason, Stone said, and at any time, providing great flexibility and a broad range of application. He routinely places any business entity - corporation (both C-corp. and S-corp.), limited-liability company or sole proprietorship - into a revocable living trust.
Private Ocean itself has a three-level nesting of business ownership: an S-corporation holds shares of the limited-liability company that comprises Private Ocean. “My S-corp. owns my LLC shares,” he said, “which are in turn owned by my living trust. From a standpoint of liability protection, it’s very good. Also it’s a good way of separation of assets, keeping a clear, distinct demarcation of what expenses and income relate to each entity.”
Legitimate business expenses - such as overseas travel for a business conference where a partner brings his or her spouse along - may be appropriately allocated to different business entities in such a nesting, according to Stone. Certain expenses, “you may not want to run through the LLC,” he said, but instead run through the S-corporation, “which is totally legal. It makes it very clear, and it flows through on your personal tax return.” In this instance, if the spouse has an interest in the S-corp. but not the LLC, the expense would pertain only to one business entity.
“There is not a situation in which it is not a good idea” to hold business ownership in a revocable living trust, Stone said, and ideally the trust ownership is established prior to any business operations.
Most Private Ocean clients, who tend to have businesses with valuation from $5 million to $40 million, already have created revocable living trusts. “We put that trust in place on day one,” he said.
Charitable-remainder trusts
A business owner usually has legacy interests that also guide how trusts can be used to achieve succession-planning goals. “If there is any charitable component of your legacy, then there are some wonderful tax strategies in using a charitable remainder unitrust,” transferring shares of the business into the trust prior to its sale.
There are two types of charitable-remainder trust: unitrusts and annuity trusts.
In an annuity trust, the trust makes an agreement in advance with the income beneficiary to pay a fixed amount of income. “It might be a 4 percent” trust that holds principal of $10 million, and pays $400,000 a year to the business owner.
“We much prefer a unitrust,” Stone said, where the payout - say 5 percent - can vary according to the year-end value of the assets inside the trust. If the assets grow in 20 years, for example, from $10 million to $20 million, the payout will be 5 percent of $20 million, or $1 million for that year. “It’s more flexible,” he said, noting that the unitrust is also tax-exempt.
When corporate assets are transferred to the trust and then sold, no capital gains tax applies to the transaction. The capital gain ends up being paid out to the trust’s income beneficiary over time, much like an installment sale, but not all at once. “You have the vast majority of that corpus (capital) working for you” over many years, he said.
Many high-income-tax earners find themselves in a 30 percent tax rate for capitals gains, especially with the alternative minimum tax. “In that $10 million example,” he said, “$3 million could come right off the top to taxes. You are left with a net $7 million.” The unitrust sidesteps that tax loss and preserves the $10 million as capital inside the charitable-remainder trust. “It’s going to be spread out over a much longer time,” he said. “You are paying the tax as you receive the income.”