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| Best Practices: Matters of Trust |
Ladder Of Succession
Melissa Phipps
02/01/2005
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CREATIVE LIQUIDITY
Along with resolving questions of ownership, voting trusts can be used as building blocks to transfer the legal title and voting rights to trustees for a set duration. While beneficiaries may own the trust’s business assets, trustees vote the stock and have decision-making control. Voting trusts simply transfer legal title of shares to the trustee or trustees granted corporate voting rights, and the trust can be appended onto other types of trust vehicles, such as generation skipping trusts, for estate planning purposes. These trusts also centralize votes regarding shares, says Holly Isdale, managing director and head of strategic wealth services at Lehman Brothers in New York. “Instead of having lots of disparate family members voting,” she says, “a representative from each part of the family can have a vote.”
A lack of liquidity can lead to disaster when family members must exit a business. To solve this problem, many advisors recommend irrevocable life insurance trusts, or ILITs, which simultaneously provide substantial estate tax savings. Life insurance is often a crucial source of funding when a business does not generate enough liquidity to buy inherited stock from heirs after the death of a partner. ILIT grantors can also keep the death-benefit proceeds out of their estates (if an existing policy is transferred to a trust, grantors get the same benefit only after a period of three years), thereby avoiding any estate tax consequences. The ILIT becomes the beneficiary of the proceeds, and the terms of the trust specify that the money will be swapped out of the trust in exchange for stock. Keeping the proceeds in trust also keeps it out of the hands of company creditors.
Another tool, the intentionally defective income trust, or IDIT, is used to gift a business while also dramatically reducing estate and gift tax consequences. In this complex strategy, the grantor sells a portion of the family business stock to a trust at fair market value, meaning the owner takes a reasonable valuation discount for lack of marketability or minority interest in exchange for a promissory note for the purchase price that will last for a set duration, say 10 years. By exchanging the promissory note for the business assets, the grantor effectively freezes the value of the assets (at the discounted rate) at the time of the transfer.
The defective aspect of the trust simply means that it is not effective for income tax purposes. In other words, the trust is not required to pay them. The trust pays the grantor income distributions based on the promissory note, and the grantor pays tax on the distributions at ordinary income tax rates. In 10 years, if the value of the business has increased, the trust pays back the promissory note and distributes the rest to beneficiaries. The grantor has effectively shifted the growth of the business out of the estate and into his successor’s hands. Even if the grantor dies during the 10-year period, only the value of the promissory note remains in the estate. If the grantor prefers to keep control of the business, he can sell only nonvoting or minority shares to the trust.| TYPE OF TRUST | WHAT IT DOES | WHY IT IS USED | | Voting Trust | Transfers legal title and voting rights to trustees for a set duration. | To resolve questions of company ownership. | | Intentionally Defective Income Trust (IDIT) | The grantor sells a portion of family business stock to a trust.
| To freeze the value of assets in a trust. | | Irrevocable Life Insurance Trust (ILIT) | Provides liquidity and also substantial estate tax savings. | Generates enough liquidity to buy inherited stock from heirs upon a partner’s
death. |
The IDIT strategy of gifting future appreciation is similar to that of a grantor-retained annuity trust, or GRAT, in which the grantor puts the assets in trust and receives an annuity from the shares for a fixed number of years. Beneficiaries receive what is left in trust at the end of the term. (For more on GRATs, see “Matters of Trust,” June 2004.) Both are excellent continuation vehicles for families who expect a company’s value to increase. There exists the danger, however, that trustees with voting rights could vote to sell company stock to diversify their assets. So the grantor may build into the trust document special instructions regarding original intent, such as an authorization to hold long-term, privately held stock without being required to diversify, or instructions to liquidate the business completely after a set period of time.
For the Saslows, hammering out a succession plan has worked so far. “We recognized that there are those who are benefiting from the golden goose and those who are [caring for] it,” Ron says. “Separating the money part from the control part made everything easier.” Melissa Phipps is a senior correspondent and freelance writer specializing in wealth management and estate planning. mel_phipps@hotmail.com
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