A large part of business sucession planning is structuring the transfer of business ownership. While outright transfers can be less complex, transferring ownership in trust can provide practical benefits that are worth navigating the complexity of tax laws and state trust codes. There are significant tax implications of placing S-Corp shares into a grantor trust, and there are further tax benefits that come with holding those shares in either an Electing Small Business Trust or a Qualified Subchapter S Trust. While it is
easy to focus on these options and their respective tax considerations, anyone
considering restructuring S-Corp holdings should understand the practical
considerations associated with placing shares of a small business into a trust for purposes of keeping a business in the family or transfering it to another small, defined group.
Reasons to Consider Placing S-Corp Shares into a Trust
One of the key reasons why a business owner may decide to place shares of a family business, or other closely-held business, into trust is to maintain control. Through the use of a trust, the owner can have greater control over what happens to those shares down the line, whether that is after the owner’s retirement or after the owner’s death.
- A trust can restrict whether, how, and when shares may be sold, distributed, or otherwise transferred.
- Trusts can ensure predictability regarding the pool of individuals who have interests in the business in the future, particularly when compared to scenarios where shares are freely transferrable by shareholders.
- Likewise, trusts may restrict transfer of shares by limiting potential transferees to a particular group, without the need to arrange for and negotiate shareholder agreements. This can be particularly handy in situations where reaching agreement with some existing shareholders is unlikely.
- Trusts can provide a particular inheritance schedule beyond the primary beneficiary or beneficiaries, allowing for more certainty regarding the stake held by future descendants or contingent beneficiaries.
- Trust provisions may also provide additional protection from a beneficiary’s creditors, which is often not available if the shares were held outright by the beneficiary.
- Appointing a sophisticated trustee with specialized knowledge of the business can help ensure that the shares will be voted in a responsible manner, rather than allowing the beneficiaries without specialized knowledge to vote. This is particularly advantageous in situations where a grantor wishes to have a spouse and/or descendants benefit from holding an interest in a family business, but the desired beneficiaries are not as sophisticated, do not intend to be actively involved in the business, or are not as personally interested in the business as the grantor.
These can be quite compelling reasons for a grantor to contribute their shares to a trust.
Reasons to Reconsider Placing S-Corp Shares into a Trust
Although the above advantages may seem compelling, many of them can be a double- edged sword. In addition, the power to maintain control over a business through trust provisions which control the company’s shares may fit the stereotype of the much maligned “deadhand control”, i.e. burdensome control of assets by a long-deceased grantor which restricts their optimal productive use by beneficiaries.
- Different types of trusts may require particular distributions or come with other conditions which restrict how beneficiaries may benefit from the trust and its assets. Likewise, restrictions on trustee authority may restrict actions that could otherwise, from a corporate standpoint, be approved by shareholders of the business.
- Contributing assets to a trust will limit the ability of beneficiaries to access liquidity. In particular, provisions which restrict the sale, pledge or other transfer of trust assets may further narrow a beneficiary’s options for accessing capital or reinvesting and diversifying their investment portfolio. If the market changes, or a company’s leadership declines, this could be a major disadvantage.
- Often, passing on a family business to children, siblings, or an even larger family group may seem idyllic, but often forcing family members to continue to work together, or at least interface with one another in a business context, may make for a difficult business environment or may even damage family relationships.
- Giving interests in a family business or other closely-held company, such as beneficial interests in a shareholder trust, may create tension between passive beneficiaries and those who may also be employed at the company and taking a more active role. Indeed, this may create a feeling on the part of the more directly involved beneficiaries or shareholders that they are contributing more to the continued health and success of the business than those who are seen as merely collecting a check. Although unlikely to be as much of a concern in very large businesses, this can be devastating to smaller businesses with smaller profits to spread around. Indeed, depending on the size and complexity of the business, and particularly the ownership pool, the cost of hiring skilled officers and managers to operate the business may make investment in the family business impractical, unless family members are both interested in continuing to operate the business themselves and are sophisticated and skilled enough to do so.
- Skilled, independent trustees can be expensive, as can the other costs of trust administration. This may be even more concerning if family members are actively involved with the business. In such situations, those family members may find such costs particularly irksome if they believe that they could administer the trust (or vote the shares) with better subject matter knowledge and without the added cost.
- Locking up significant assets in a trust can impair the beneficiaries’ ability to diversify their investments. As much as the desire to keep a business in the family may seem desirable, the risk of keeping a disproportionate share of assets in the stock of a single company may outweigh the other perceived advantages. Thus, many trusts include provisions which allow the trustee to determine when to sell the underlying shares or distribute the shares outright.
Although not as complex as some tax law considerations, these issues are extremely commonplace and have killed more than a few small businesses and driven apart even more families. Striking a balance amongst these pros and cons requires a great deal of forethought and wisdom on the part of the grantor, and artful drafting and counsel by a knowledgeable attorney.
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