The Transition Game Getting It Right


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The Transition Game Getting It Right
By: Chad R. baker

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The Transition Game Getting It Right

  1. 1. The Transition Game: Getting it Right. "Life is pleasant. Death is peaceful. Its the transition thats troublesome." -Isaac AsimovLike it or not, eventually every family business faces hold long grudges that tear apart families (andtransitions. Transitions of the founders into businesses).retirement; transitions of the family; transitions of themanagement; market transitions; and transition of the Understanding the intricate and interwovenultimate ownership of the business, to name a few. legal obligations among these roles can be a trickyHow will the founders or senior generations estate business. It is imperative that the trust agreement isplan ensure that these important transitions properly drafted to effectively manage this added complexityoccur? against the backdrop of an already existing relationship dynamic among the family and others Often, their estate plan uses one or more trusts involved in the business. To help, this article is aas a mechanism to address these transitions. This can brief summary of some of the more common legalbe an excellent solution for managing both succession considerations to help you evaluate and effectivelyand tax issues. But trusts can also be bombs waiting use trusts as part of your transition explode. This is because trust and businessarrangements often place family members in multiple Management of Trust Assets: Trustee Must be aroles of trustee, business manager and beneficiary, "Prudent Investor." Generally, trustees are requiredeach with its own set of rules, obligations and to prudently invest the assets of a trust afterprivileges. This complexity demands careful thought considering the purposes, terms, distributionand attention. Without it, the best intentions may fail requirements to all of the beneficiaries (present andin execution unless the trust is carefully drafted to be future) and other circumstances of the trust. This isas unique as the family, the business and the called the "Prudent Investor Rule." It typicallytransitions each will encounter. requires a trustee to diversify trust assets to minimize risk. Thats fine if the only assets are publicly traded Many people dont know that trusts are and relatively liquid investments such as stocks, bondsincredibly flexible devices. If you can think of it, and cash. It doesnt work well if the assets includechances are good that a trust can be drafted to closely held, non-publicly traded business interests.implement your idea. Management of trust assets and Under the Prudent Investor Rule closely held businessdistributions to beneficiaries can be tightly controlled assets are considered to have more risk than aor largely left to the discretion and judgment of the diversified portfolio of marketable securities. In fact,trustee. Despite this flexibility, trustees cant just do under the Prudent Investor Rule, the trustee can bewhatever they want - there are rules. In fact, the held responsible for losses incurred in connection withrelationship of "trust" between a trustee and the trust holding closely held business assets. This can createbeneficiaries is based on obligations of a trustee to incredible tension among family members when somemeticulously manage trust assets. These obligations work in the business and are also trustees andare derived from a combination of the provisions of beneficiaries and those family members who are notthe trust agreement, statutory rules, and case-law active in the business but are also beneficiaries.forged over seven centuries of English and American Ultimately it puts the control of the business in thelitigation (“trusts” first appear in the English system hands of the non-active family member-beneficiaries.late in the thirteenth century). These obligations arecalled "fiduciary" obligations, or duties, and are the Fortunately, the Prudent Investor Rule of mosthighest level of responsibility the law provides. states, including Ohio and Michigan, allows theTrustees who breach these fiduciary duties can be creator of a trust (often referred to as the "settlor,"personally responsible for any resulting losses. And "grantor" or "donor") to "override" the default Prudentyes, family members do sue each other, or at least Investor Rule. With proper drafting, a trust grantor 1
  2. 2. can authorize the retention of certain privately held however, most states allow for the grantor to waivebusiness assets or override the Prudent Investor Rule some or all of these notice requirements throughaltogether. But is this appropriate in all express language in the trust agreement. Before youcircumstances? Is it appropriate for all trust assets? Is run to amend your trusts, however, consider this -it appropriate for all trustees? without information and the right to demand it, beneficiaries may have a difficult time determiningImpartiality and Loyalty. A trustees fiduciary whether or not the trustee is doing a good job.obligations also require the trustee to act impartially Another matter to carefully consider.when investing and managing trust assets, taking intoaccount the differing interests of the beneficiaries. Distribution Standards-Who Gets What andThis is obligation is called the duty of impartiality. When. Often overlooked are what trust lawyers callThis duty prevents a trustee from favoring one “distribution standards.” These are the directions tobeneficiary over another. Like the Prudent Investor the trustee on how much to distribute, who gets it, andRule, it may work well in a managed portfolio of when. Despite the fact that these few provisions of amarketable securities but what happens if a family long trust agreement are what ultimately controls themember who is not active in the business needs (or distribution of trust assets, it is often overlooked aswants) cash but the manager-trustee-beneficiary needs “boiler plate.”(wants) to retain cash reserves? Trustees make distributions according to the This duty of impartiality goes along with terms of a trust agreement and their obligations toanother important fiduciary obligation to invest and make distributions affect the way the trustee mustmange the trust assets solely in the interests of the manage the assets of the trust (see the “Prudenttrust beneficiaries. This is known as the duty of Investor Rule” above). These distribution standardsloyalty. Under this duty, a trustee cannot consider the direct the trustee regarding when a distribution shouldbenefit to the trustee – who may also be a manager of be made and how much. But, the standards may alsothe business held by the trust – but only to the give the beneficiaries the legal right to compel abeneficiaries. distribution from a trustee as well. It all depends. The twin duties of impartiality and loyalty can Basically, you can describe distributioncreate a significant legal dilemma for a trustee- standards for a trust as a spectrum from “mandatory”manager. Here again, a properly drafted trust to “pure discretion.” A mandatory distributionagreement can help. By adding carefully considered eliminates flexibility and the chance for a trustee toprovisions addressing the inherent conflict of interest, adapt to changed circumstances after the creation ofthe grantor can alleviate the trustee’s duties and favor the trust but it ensures that a beneficiary will get thethe management of the business. Without these distribution. Examples of a mandatory distributionsprovisions, however, the trustee risks breaching his or are directions that the trustee should distribute “allher fiduciary duties to the beneficiaries of the trust. income to the beneficiary, at least quarterly,” or “trustee shall distribute 1/3 of the trust assets to theI Have to Do What? Im not Giving Them the beneficiary when the beneficiary reaches age 35.”Financial Reports of the Business! Managers offamily businesses often dont like to share financial At the other end of the distribution spectrum isinformation with family members not active in the “pure discretion.” This is often referred to as abusiness. At least not all the time, and on demand. “wholly discretionary trust.” A common example isHowever, those managers are controlled by majority that distributions to the beneficiaries may be madeowners and if those majority owners are trustees, “for any purpose as the trustee determines in its solethose trustees have a duty to inform and report to trust and absolute discretion.” Under this standard, thebeneficiaries. Depending on the status of the beneficiary isn’t entitled to anything except as thebeneficiary under the trust, providing this information trustee sees fit. In this case, the only limitationmay be mandatory. Even if not mandatory, the laws imposed on the trustee is the vague legal notion thatof most states require a trustee to provide information the trustee may not “abuse its discretion.” Not veryto any beneficiary who requests it. Fortunately, comforting to a beneficiary in need of money when 2
  3. 3. the trustee-business manager wants to plow the cash general administrative matters, but designate aback into the business. separate trust advisor, or committee of advisors, to manage and direct the closely held assets. In fact, the Most grantors prefer to be somewhere in the trust advisor(s) can be given almost any power, suchmiddle – providing distributions for certain things as a power to make distributions to the beneficiariessuch as health care, education and general support, or or to remove and appoint the trustee. In many ways,for the down payment on a new house – but also give the trust advisor or advisory committee acts like athe trustee the flexibility to distribute for any “board of directors” of the trust, which is moreadditional purposes at it determines. These are familiar territory to family businesses.“hybrid” or “support” trusts. Of course, there are many rules governing the Finally, if the trustee is also a beneficiary of rights and responsibilities among the trustee, thethe trust, the beneficiary-trustee can only have advisors and the beneficiaries, but a well crafted trustdiscretion to distribute for “health, education, will adequately deal with these to achieve themaintenance and support” otherwise the tax law treats grantor’s objectives, minimize the inherent conflict ofthe beneficiary-trustee as having too much control and multiple roles and go a long way to maintaining thewill include the assets of the trust in the trustee- family peace.beneficiary’s estate at death or may impose a gift taxon distributions to other beneficiaries. Protection from Creditors of Beneficiary. A big fear among family business owners is that ownership Instead of treating these distribution standards of the business can wind up in the hands of a creditoras simple “boiler plate,” careful drafting of these or some other person that isn’t a family member.standards helps the grantor design a plan that gets the Family businesses often use shareholder or “buy-sell”right amounts, to the right people at the right times agreements to help protect against this risk. However,after considering the needs of the business and the under a buy-sell agreement the other owners or thefamily. business generally have to actually purchase the at- risk ownership to protect it from involuntarilyChoice of Trustee(s). With all of this responsibility changing hands. Trusts on the other hand, can preventand potentially conflicting obligations, selecting the this. As long as assets are held in a well drafted trustproper trustee(s) is critical when creating trusts for set up by the senior generation, creditors (includingfamily business planning. It may not be best to have former spouses) of the next generation beneficiariesthe beneficiary-business manager also serve as the typically can’t reach the trust assets. These trusts aretrustee. Of course, the manager might prefer this often referred to as “spendthrift” trusts. Againbecause of the perception of control over the business, though, this requires careful coordination because thebut with all the potential conflicting legal obligations, power of a spendthrift trust is inextricably tied to thethere may not actually be the perceived level of distribution standards discussed above. Once acontrol and there will definitely be exposure to legal distribution is made from the trust to a beneficiary,risk. On the other hand, professional trustees, such as creditors of the beneficiary can attach the trust departments, don’t really want to manage This often causes a “mandatory” distribution standardclosely held business assets – and the family probably to defeat the benefit of any spendthrift provision.doesn’t want them to either. So trustee selectionbecomes difficult, yet critical. Business Tax Planning meet Fiduciary Tax Rules. Most business owners have a good working Remember though, that trusts are very flexible understanding of the tax treatment of their businessinstruments. For example, one possible solution is to and how it interacts with their personal income taxdraft the trust as a “directed” trust. This means that planning. After all, they’ve paid the income tax eachthe grantor can designate one trustee – a bank, for year. They may not understand the intricacies of C-example – as the custodian of assets with the corporations vs. S-corporations, or partnership tax, orresponsibility for tax compliance, record keeping, LLCs taxed as partnerships, C-corps or S-corps, buthandling distributions to beneficiaries, management of generally, owners have a working understanding andthe portfolio of marketable securities and other good CPA to help. Once you add a trust as the owner, 3
  4. 4. you now enter the world of “fiduciary tax,” which hasit’s own rules affecting taxation, it’s own set of tax Conclusion. Business can be tough. Transitions canbrackets and rates, and it’s own nuances of fiduciary be “troublesome.” Using trusts can seem complex.accounting income, distributable net income, But in reality, using trusts for business transitions mayallocations of expenses and treatment of income and be the single most powerful and effective way todistributions from business entities. Though owners address the various roles and interests of the family –and beneficiaries don’t need to have a detailed as long as those trusts are carefully considered andunderstanding of the rules, it’s important that their tax well thought out.advisors do. ***** Chad R. Baker, Esq. is a partner with SHUMAKER, LOOP & KENDRICK, LLP focusing on personal wealth and family business planning. He is a Board Certified Specialist in Estate Planning, Probate and Trust Law in the state of Ohio and is also licensed in Michigan and Florida. He is an adjunct professor of law at the University of Toledo College of Law teaching courses on Trusts & Estates and the Law of Nonprofits, Tax Exempt Organizations and Charitable Gifts. You can email him at or follow him on Twitter @chad_baker_law. 4