Business Succession Planning Through Trusts

Business Succession Planning Through Trusts

Many of my clients elect to hold ownership of their business until death, and then provide for a disposition of ownership at that point. There are various issues involved with this approach, mainly depending on factors such as whether or not their children work for the company or if there is a disposition of the business to employees or some other third party. 

Children in Business 

If children are involved in the business and the owner does not intend to sell the business before his/or death, the first question to ask the owner is whether treating his/her children equally is critical. If it is, equality will be based on the value of the business on the owner's date of death or perhaps on the date of distribution, depending on how the trust is drafted. The owner's trust agreement may direct the trustee on how to value the business for distribution purposes (e.g., formula approach, limits on valuation discounts, selection of appraiser, estate tax value). The IRS requires that the trustee or executor value the business for estate tax purposes at its fair market value, which is the price at which it would change hands between a willing buyer and a willing seller, neither under a compulsion to buy or sell and both having a reasonable understanding of the facts. The trustee's duties generally require the same approach under state law. However, the owner may direct otherwise in the trust agreement for distribution purposes. For example, the owner may instruct that the business be sold or transferred at a discount to one or more children. 

In some cases, an owner may have enough assets outside of the business to permit the children involved in the business to receive the business and the other children to receive non-business assets, with all of the children receiving equal shares. If this is not possible, it is common for an owner to purchase life insurance as a means for providing sufficient non-business assets to result in an equality of distribution among the owner's children. In such a case, the owner should consider an Irrevocable Life Insurance Trust (ILIT) if there is any chance that federal estate tax will be due at the owner's death. 

Properly Identifying the Scope of Business Is Important 

Perhaps some of the assets owned by the operating entity are not critical to the business or are passive in nature. For instance, real estate subject to a long-term lease could be owned by children who are not involved in the business. Planning may be required to set up such real estate for distribution after the owner's death. Removing real estate or other non-operating assets from an ongoing business can be challenging. However, it is important for an owner to evaluate the actual assets that are included in the operating business, as opposed to those that are ancillary but still may be of value and produce an ongoing income string. An owner may want to be careful to make sure that there is a long-term agreement between the business, and let's say, a separate Limited Liability Company that may own the real estate for purposes of leasing the real estate to the operating business, to protect against some of the children who are not involved in the business voting to dramatically increase rent or impose other terms on leasing the property to the business that may be detrimental to the children who are involved in the business. 

Active Children/Non-Active Children 

A sale by the non-active children to the active children of their inherited interest in the business may be a tax-efficient solution, and the trust agreement may grant an option to purchase to the active children. The option should describe how the purchase price will be determined and the payment terms. If the trust is a party to the transaction and the trustee has a personal interest in the transaction, there is a potential conflict of interest. An owner should be careful to include provisions such as perhaps a third-party trustee appointed for purposes of handling the sale. Such an option may instead be added to a buy-sell agreement or other entity document, separate from the trust agreement, so long as all of the children will be bound by its terms after the business owner's death. 

Frequently, there is also a question of how to handle the increase in a business' value with respect to the purchase price. For instance, when the owner of a business exits a number of years before his or her death and then the business is to be distributed at death to a child that has worked in the business, oftentimes a change in value of the business could be attributed to the efforts of the child who has worked there subsequent to the owner's exit. The question then becomes how to handle the increased equity or value of the business for purposes of disposing of the business from an owner's trust. There are no simple solutions in this context, and every case is different. Oftentimes, the most effective approach is to draft terms into the trust reflecting certain agreed-upon values as of certain dates and freezing a buy-in or buy-out value for purposes of the disposition of the business. 

Distribution Options 

Creating voting and non-voting interests in a business may allow for control to be transferred to children in the business, while treating all children equally from a point of view of value. Because the voting interests represent a small portion of the overall equity in the business, the trust agreement could include a specific distribution of the voting interest to the children in the business and a pecuniary distribution to the other children of an amount equal to the value of the voting interests. The residue of the trust can then be distributed equally. A buy-sell agreement can play an important role for creating an exit mechanism for the passive children to eventually sell their interests. 

Similarly, the separate, equal shares of the children may be funded with disproportionate interests in other assets held by the trust. Absent specific instructions in the trust agreement or an agreement among all of the beneficiaries, the trustee's duty of loyalty to all beneficiaries requires that the trustee treat the beneficiaries identical in the funding of their shares. A business owner, prior to his/her death, may authorize the trustee to fund the equal share of one or more of the children with interests of the business before funding the shares with other assets. 

In some cases, the business owner may choose to make unequal distributions to the children. In other words, the business may be transferred to one or more children involved in the business following the owner's death, and remaining assets will be transferred to other children. 

Compensation of children in the business can be a difficult topic. Are the children being paid for performance or are they being paid simply because they are offspring of the business owner? In either case, the trust agreement may instruct the trustee on that subject. In the long run, compensation should be based on performance, and the trustee's role will be made easier if the matter is resolved in the planning process before the business owner's death. 

Sale to Key Employees 

If a business owner identifies one or more key employees, rather than children involved in the business, as critical to the continued success of the business, both before and after the owner has died, the succession plan may focus on transferring management, and perhaps ownership, of the business to the key employee or employees. If this is true, a non-compete agreement with the employees may be vital, especially if the barriers to entry into the business are not significant. In addition, economic consent of such a stock option plan may help retain key employees. 

In addition, an opportunity to acquire the business may help retain key employees regardless of other agreements and benefits in place. Usually, the biggest challenge in this situation is the employee's ability to pay the purchase price, or even come up with a reasonable down payment. Rarely will the business generate sufficient cash flow to pay the purchase price as quickly as the trustee or the beneficiaries of the trust would like. Delaying the payment of the purchase price adds to the risk of default. Still, granting an option for rights of first refusal to key employees may be the best approach for selling the business after the business owner's death. Smaller businesses are generally difficult to sell after a business owner dies, frequently because the owner is so important to the success of the business. As a result, a transition of the management to the key employees during the owner's lifetime could be an important step to ensure success of the estate plan. 


There are many strategies available to accommodate the goals of business owners to dispose of their business interests either before or after death. The key to maximizing the value of a small business and ensuring a smooth transition of business ownership is to actually plan for that event, as opposed to leave it to chance. 

Remember, planning to plan is not a plan.