For families that run businesses, one of the most important uses of a trust is to ensure the smooth transfer of leadership and ownership from the current generation to the upcoming one.
A trust is most valuable as a mechanism for temporarily running the business, in the event that the current owner dies before he or she is ready to hand over the reins. Many owners. too, have good reason to postpone succession. Most often they are concerned that a leader has not yet emerged from the next generation, or that a designated successor is simply not ready to lead. By putting the business in trust, an owner conveys to potential successors that he has dealt with them on a fair and principled basis, and can maximize the chance for effective operation of the business.
A trust must be distinguished from other devices used to control a family business, including stock transfer restrictions, buy-sell agreements, and voting agreements, although these may be used in conjunction with a trust. A trust involves a grantor (the current owner) who transfers property (the business) to a second party, the trustees. The trustees hold the property, make investments, and make distributions to beneficiaries (which usually include the surviving spouse and the next generation of family members).
A trust is usually established in conjunction with an owner’s will. Once an owner’s estate taxes and other matters are settled upon his death, the business is placed in trust, and the trustees take over. They will run the business until a successor is ready, which can be anywhere from several months to many years.
The trustees have legal title to the company’s stock. They become the shareholders. They decide who sits on the board of directors (including themselves, if necessary). They invest the trust’s assets. They can hire professional managers for the company. And they can decide who finally takes over the company. The trustees also decide on distributions to family members.
The fundamental advantage of a trust is that it separates control from ownership. The trustees control the business, but the beneficiaries will, in time, receive the stock. In this way, when succession does take place, a controlling interest passes to the people who are best able to run the company, while the remaining stock passes to any number of family members.
In light of the enormous power and responsibility of the trustees, the current owner must obviously be very careful about whom he chooses for the job. An owner should not put the company in a single person’s hands, but should select a panel of trustees. Anyone can be a trustee. A senior family member may serve, but it is advisable to have at least one outside professional who is familiar with the company or the industry. Although the trust instrument can provide that the trustees act by majority vote, rather than unanimous vote, having more than three or four trustees may prove cumbersome and inefficient. Indeed, if many trustees are selected, and each views himself or herself as a representative of a specific segment of the extended family, decision-making may be impaired. Trustees are paid from the trust at a level determined by the grantor, or by local law and practice. Such compensation is considered an administrative cost, and is therefore tax deductible to the trust.
Several selection criteria should be used. The owner should consider the financial accountability of a candidate and the business and investment facilities available to the candidate, because trustees must invest trust funds on behalf of the beneficiaries. The owner should also consider the candidate’s sensitivity to the needs of the beneficiaries. Other criteria might also be important, such as the candidate’s experience with corporate governance, and familiarity with the family and the operations of the business.
Although the power of the trustees may seem unsettling, the business owner can control many of the trustees’ actions in the trust document. The owner, for example, can declare the terms and conditions under which stock can be distributed to beneficiaries. Should only those who are employed or otherwise active in the business receive stock? Should other beneficiaries receive only nonvoting stock or non-business assets? Should the trustees be authorized to make unequal distributions, to enable those who contribute the most to the business to obtain suitable reward?
The owner also can shape the role to be played by the board of directors while the company is held in trust. The owner can specify whether any one of the trustees should serve on the board, whether active or inactive family members should serve, and whether outsiders should be included. The owner should strongly consider designating, ahead of time, a qualified outsider for the board. Such a person can bring valuable experience and fresh insights, and increase the group’s credibility.
While there are many advantages to placing a family business in trust, constraints are also created, which an owner should consider when deciding whether a trust will facilitate or frustrate the family’s plans.
The very strength of a trust—the separation of ownership from control—can have adverse consequences. For example, the trustees are ordinarily required to invest trust assets according to the so-called “prudent man” rule, which requires them to proceed with diligence, care, skill, and caution. By contrast, while a board of directors may have fiduciary responsibility to company shareholders, and may also act with skill, diligence, and care, they are not required to proceed with the level of caution imposed on trustees. The differing standards can create tension between a fundamental purpose of a trust—to preserve family wealth—and a fundamental purpose of a business—to accept risk in exchange for the prospects of enhancing the value of the shareholders’ investment.
Conflict can also arise between the needs of the business and the needs of the family. Any investment of trust funds in the business will leave fewer assets for distribution to beneficiaries to satisfy their personal needs. The owner should therefore furnish guidelines indicating the circumstances under which the trustees may invest trust funds in the business.
One major concern is whether the business can be well run for a long period of time by the trustees. It is unlikely that family members in the younger generation will be interested in assuming leadership without some assurance of eventually obtaining control of the business and owning a significant portion of the company’s stock. It is difficult for even the most dedicated people to continue to work hard if they cannot see clearly when or how they will be rewarded. Trustees may run companies for 5, 10, or even 15 years, but the longer the duration of the trust, the less incentive there may be for members of the next generation to commit themselves to the business.
Such conflicts are so fundamental that it is unlikely they will resolve themselves, unless the family business owner makes clear to the trustees and beneficiaries the reasons for placing the business in trust rather than distributing stock directly to younger family members. It is also imperative that the owner create a business and estate plan that facilitates the eventual reunification of control and ownership.
The trustees determine when the trust will end. It is not advisable to dictate a timetable; too many conditions can change in the interim. Trustees are most effective when they have some latitude with which to operate. If the business owner lacks confidence in the ability of the trustees to decide when a successor is ready, the owner has chosen the wrong trustees.
Conflict can arise between management and trustees over when a trust should end. Most often it arises when a successor is truly ready to take over. He or she can reach a breaking point, saying “This is my career. If you’ll provide me with control and stock, I’ll stay. Otherwise, I’m out of here. I can get a terrific position elsewhere.”
Although a grantor should not attempt to set an arbitrary date for succession, he should provide a thoughtful and detailed memo of criteria the trustees should use to determine when a successor is ready to take over. If the rising member of the next generation can persuade the trustees he has met the grantor’s criteria, the trustees should pass on control and ownership and end the trust.
The owner also should specify the standards to be observed by the trustees in making distributions of stock to beneficiaries while the trust is in effect. And the owner should indicate to the beneficiaries that the standards for distribution are unlikely to result in equal treatment, but instead will reflect their respective contributions to the business.
The owner can take a further step, and issue both voting and nonvoting shares of stock now, while he is alive. He can then specify that the voting stock will pass to a given child or children, and nonvoting stock will pass to others.
Many business owners say they want to treat their children equally. But it is almost never feasible to distribute equal interests in the family business to all of them. A trust allows the current leader to spread ownership widely but give control to only a few, or one. By using a trust, the owner—the grantor—can provide for a suitable outcome, instead of leaving it to fate or the conflicting interests of would-be successors. And in the meantime, the trust ensures that the business will be run properly until the designated heir is ready to take the helm.
Michael L. Fay is a senior partner at the law firm of Hale and Dorr in Boston, and co-chairman of the firm’s Family Business Group.