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.”

The percent return selected by the trust owners correlates to tax benefits received in a formula set by the IRS. To qualify for a unitrust, the owners must take a minimum 5 percent annual distribution. Stone recommends that clients not set a rate so high that the principal inside the trust is depleted over time because the payout exceeds the growth rate of the principal. He usually recommends no more than 6 percent to 7 percent.

These trusts are irrevocable, so the payout rate cannot be changed once it is established for the entire life of the trust. When the business owner dies (or both joint owners die) after receiving a stream of income over years, the amount remaining as principal inside the trust goes to the named remainder beneficiary charity. The trust dissolves.

Irrevocable life insurance trust

For larger businesses that have valuations above $11 million, succession planning through trusts can help with avoiding estate taxes. Under current law, $10.86 million is the joint exclusion for estate tax filing in 2015; estates smaller than $10.86 million are not subject to estate taxes.

Some business owners have what Stone called a “dynasty strategy,” where they want business assets to be available to multiple generations of the family. For such a strategy, sometimes an irrevocable life insurance trust works well. The trust buys a permanent life insurance policy to cover both (joint) owners of a corporation.

Term life insurance might not work under these conditions. “If you happen to be blessed with great longevity in your family,” Stone said, “and both spouses live to be 100 years old,” then term life insurance might expire before the people. “Permanent life insurance would be there for the purpose of covering future estate taxes to maintain the original value ... in perpetuity for beneficiaries,” he said.

The life insurance is used to enhance the value of assets in the trust. If a $10 million business inside a trust grows to be worth $20 million at the time of the second of joint owners’ death, the amount over $10.86 million (2015 amount, adjusts each year) would be subject to estate tax at up to 40 percent, Stone said. Life insurance could be set up to cover the nearly $4 million tax liability.

“It’s a way to make sure the full $20 million passes to your heirs,” Stone said. Premiums on the life insurance would come out of the trust’s assets, reducing the size of the estate and eventual taxes due.

Stone looks at the entire financial picture of business owners when they seek help with succession planning, starting with profitability.

In the early days of business ownership until a few years prior to the point at which the business is to be sold, founders tend to minimize profits as a way of reducing taxes. They count every possible expense, may draw hefty salaries, and may invest in equipment or other assets along the way, even before the assets are essential. But in preparation for exit, the owners ought to reverse their thinking almost 180 degrees to maximize corporate profits. The long-term benefit is that profitability is used in business valuation and in calculating multiples when the business is put up for sale. Higher profits result in higher multiples.

“Is the entity maximizing its profit potential,” Stone said. “That’s the ultimate goal of the owner, to be able to extract that value. What you’re concerned about is maximizing the value of the stock,” through the firm’s profits.

“It’s the reverse of the accumulation phase” of business ownership, he said. “For many business owners, it’s hard to grasp. You actually want to minimize income and maximize the share value. The whole paradigm shifts in the last few years.”

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