Team Promotions, Inc. is a family business, founded by Ivan, its owner, in 1949, currently valued at $10,000,000. The 83-year-old patriarch, Ivan, married with three children, wants to keep the business in the “family.” Two of his children work in the successful college pennant manufacturing enterprise, and the third child is a minister. His oldest son, Lacky, has effectively been running the business for eight years; his daughter, Barbara, is a loyal hardworking employee. Both children are concerned that the demand for college pennants is on the wane.
Leaving a Business in Trust
1. Determine control. If Ivan were to leave all of the stock equally to his three children, there could well be conflicts among family members as to critical business decisions, including salaries, profit distributions, general debt obligations, capital infusions, and other tax and nontax issues. Ivan has decided to separate control from the ownership of the company by recapitalizing the company into voting and nonvoting shares. For each share of common stock issued there will be issued a small amount of nonvoting shares.
2. Equalization of Estate. After recapitalization, Ivan would own 1,000 shares of voting and 10,000 shares of nonvoting stock. He would then be in a position to devise or gift the voting shares to Lackey, thus determining control. The remaining nonvoting shares could be left in trust for the benefit of all children and their descendants.
3. Asset Protection. The nonvoting shares devised in trust could be protected from creditors of the beneficiaries, including from divorce and bankruptcy. The trust should include a “spendthrift protection” clause, prohibiting the beneficiary from assigning his interest to any potential creditor; a child could even serve as her own trustee provided distributions are limited to a standard such as “health, education, maintenance and support.”
4. Perpetuate Business. The terms of the trust could restrict the sale of the stock to certain family members, or grant them rights of refusal upon death of the beneficiary. The trust term could be as long as law allows (approximately a century in North Carolina).
5. Save Estate and Gift Taxes. While the present applicable exclusion amount (“credit”) is $5,120,000, it is due to fall to $1,000,000 on January 1, 2013. Nonvoting stock could be gifted (probably at a discount) now in trust that would care for Ivan’s wife for life, and then go to children. The stock in the trust, as well as its growth, would not be included in wife’s estate when she died, and Ivan’s full 2012 credit would have been used. Corporate distributions would benefit wife for her life. The stock thereafter could remain in trust for the lives of children.
Duty to Diversify
Extracting from efforts of scholars (Uniform Trust Code, Uniform Prudent Investor’s Act and Restatement of Trusts 3rd), North Carolina adopted a new comprehensive Trust Code in 2005. This Code provides trust assets should be diversified, and invested in a prudent, businesslike manner considering both risk and growth. But this is a default rule, and comes into play only if the trust instrument does not otherwise provide for how assets are to be invested.
A boilerplate provision often seen in trusts that are designed to hold closely held businesses state the trustee may hold one class of investment disproportionately weighted if the trustee in his discretion deems it appropriate. The trust might even include an exculpatory clause that states the trustee is not liable if he fails to diversify.
What happens if the business value drops while owned by the trust? Ivan has insisted on continuing the pennant line, despite his children warning him that college students are now texting and twitting during the games and not waving pennants.
Even with mandatory provisions to retain stock coupled with exculpatory provisions in the trust instrument, North Carolina and common law, require trusts to “benefit beneficiaries”. Court cases across the country come down on both sides of whether the trustee is liable for failing to diversify closely held business interests, even when there is mandatory language not to sell, despite the opportunity to do so.
Even if there are provisions to eliminate the need for diversification and even if there are exculpatory clauses, the trustees must be careful when dealing with a family business.
There are many good reasons to establish a trust to own your business, whether a corporation, LLC, or partnership. But unless you are committed to seeking frequent tax and legal advice regarding the administration of the trust, be ready to defend your actions as trustee to beneficiaries.