As the population ages, the small businesses upon which the family wealth was built will pass through trusts and be managed by trustees. The responsibility for managing a decedent’s closely held business in his or her trust has some unique characteristics. A closely held business interest may have been held by the settlor’s revocable living trust prior to death as part of the estate plan, or it may have been owned by the decedent individually and became an asset of the trust through a pour-over will.
The business interest can take the form of a sole proprietorship, general partnership, limited partnership, subchapter S corporation, C corporation, or limited liability company (LLC). Each form has distinguishing characteristics. Generally, the proprietorship, partnership, subchapter S corporation, and limited liability company are pass-through entities for tax purposes. That is, the income is taxed directly to the holder of the interest. The C corporation is taxed differently; it pays a tax on its earned income. As earnings are paid out to the stockholders in the form of dividends, the stockholders again pay income tax on the dividends they receive. This double taxation of income is what distinguishes the C corporation from the other forms of business ownership.
Unless the trust document, local law, or a court order authorizes or directs the trustee to retain the business interest, the trustee, generally, has a duty to dispose of it and invest the proceeds in investments suitable for the trust. Continuing the business for any purpose other than its sale may not be considered prudent under some state statutes. Selling a closely held business takes time; a trustee must keep the business going to facilitate an orderly liquidation. The business must be managed to preserve its value as a going concern and to avoid defaulting on any loans that the business has. Contracts need to be performed in order to maintain the value of the business and avoid litigation.
Prior to death, the settlor may have entered into a buy-sell agreement, which would make the sale of the business relatively easy. A buy-sell agreement is an agreement between an individual owner and the other owners of the business that provides for the purchase of a decedent owner’s interest in the business. The agreement usually establishes the purchase price and often allows for periodic price changes as the value of the business changes. The trustee under a buy-sell agreement has no choice but to sell the business in accordance with the terms of the agreement. Often life insurance is used to provide funds for the purchase. Some buy-sell agreements only give the buyer a first right of refusal. If the right is not exercised, the trustee must then take on the responsibility of selling the business.
The trustee has a duty to use reasonable care, skill, and prudence in selling the business. If challenged, the trustee must be able to demonstrate that the price for which the business was sold was fair and reasonable. Selling a business interest is not like selling a publicly traded stock whose value is easily ascertained. There is no index or reference book that can give the trustee a value or sales price. Valuing a closely held business is complex. To establish a value, a professional appraiser needs to be retained. Competent appraisers use a variety of methods to arrive at a value, such as comparing the business with similar enterprises. Other techniques include evaluating the capitalization of income, book value versus market value, common stock of the company, liquidation value versus the going concern value, historical rates of return, price earnings ratio, and factual or intrinsic value versus market value.
The valuation of a business for estate tax purposes, which may consider minority interest and lack of marketability discounts, is not necessarily the same value that should be used to establish a sales price. The trustee should hire a specialist for this purpose and develop a marketing plan for selling the business. It is also a good idea to hire someone to assist the trustee to negotiate the terms and sell the business. As part of the selling process, the trustee should identify potential buyers, such as the decedent’s business partners, family members who may want to own the decedent’s interest in the business, owners of similar businesses, competitors, and customers of the business.
If the closely held business is a corporation and is a major estate asset, the trustee may want to take advantage of Section 303 of the Internal Revenue Code to pay taxes and expenses. Section 303 allows the trustee to redeem shares of the company stock without the proceeds being treated as a taxable dividend. When certain conditions are met, the redemption is considered a stock sale and the proceeds will be treated as long-term capital gains. This is a good way to get cash out of the business with favored tax treatment, if there is a desire to keep control of the business, by limiting the number of shares that must be redeemed to provide cash for the payment of estate taxes, funeral costs, and administration expenses. To qualify for a Section 303 redemption, the value of the stock must represent more than 35% of the decedent’s adjusted gross estate, and only those shares that are needed to cover the expenses can be redeemed.
The rationale for retaining and managing a closely held business interest should be restricted to a limited number of scenarios. A trustee typically does not have the expertise or is not equipped to manage a business, much less oversee its management by others. The decision making process will need to cover a number of basic issues.
Retention is appropriate if:
As mentioned earlier, if the trustee is to retain a closely held business interest, the trust document or local law must authorize it. Hopefully, the trust provision protects the trustee from any liability for retaining the business and not selling it. A typical provision might read as follows:
“To conduct business in partnership or in a joint venture with other persons, partnerships, or corporations; to continue and operate any business, ranch, or farm transferred to the trust by the settlor, whether during the settlor’s lifetime or by will; to do any and all things deemed appropriate by the trustee, including the incorporation of the business, ranch, or farm and the investment of additional capital for such time as the trustee shall deem advisable, without liability for any loss resulting from the continuance or operation of the business, ranch, or farm, except for the trustee’s own negligence; and to close out, liquidate, or sell the business, ranch, or farm at such time and upon such terms as the trustee deems advisable.”
Unless the trust document specifically directs the trustee to retain the business, a decision to keep it should only be made after a thorough evaluation. The following are some of the issues that need to be considered before a decision is made:
If the closely held business is a limited partnership interest, the trustee has no authority or control over the activities of the enterprise. Also, liability is limited to the amount invested in the partnership. The success or failure of the business is in the hands of the general partner. However, the trustee should review the activities of the general partner to assure that decisions to withhold or distribute cash flow coincide with the business of the partnership. The trustee must assess the general partner’s ability and the viability of the business in deciding whether to retain the limited partnership interest. On the other hand, if a trust holds a general partnership interest, the trustee will control management of the business. A general partner has unlimited liability and has a duty to manage the partnership in the best interests of the limited partners. The trustee also has a duty to manage the partnership in the best interest of the beneficiaries; he or she should make sure that these obligations are consistent with each other and not create a conflict of interest. A trustee should also consider converting the general partnership interest to a limited liability company (LLC) or an S corporation to limit the trust’s liability.
If the closely held business interest is a corporation (S corporation or C corporation), the trustee needs to determine whether the trust holds a controlling or minority interest. Control does not necessarily mean owning more than 50% of the outstanding shares of the company’s stock. Depending on who the other shareholders are, such as shareholders who are the beneficiaries of the trust, a smaller holding could give the trustee effective control over the business. The trustee needs to assess whether or not to serve as an officer or director of the company. This decision should be based on the need to maintain control over the business and have access to information versus the potential liability in being actively involved in the day-to-day running of the business. If the trustee decides to serve as a director or officer, he or she should not receive any fees or other compensation from the company. The trustee should also be sure that the company maintains adequate officers’ and directors’ liability insurance. If the trustee chooses not to serve as an officer or director, he or she should attend all stockholder meetings to facilitate informed decisions when voting on issues that affect the company.
At the very least, the trustee needs to continually monitor the activities of the business. This should include the frequent review of the company’s financial reports. The trustee should regularly evaluate the company’s profit and loss statements, balance sheet, sales reports, and other pertinent financial data. In addition, the trustee should review the minutes of the meetings of the board of directors and any committee meetings that are pertinent to the operation of the business. Periodic onsite inspections should also be made to observe the general operation of the business, working conditions, and the condition of the plant and equipment.
The subchapter S corporate (S corporation) form avoids the double taxation associated with the C corporation. There is no corporate income tax. Instead, the income is “passed through” to the stockholder and is only taxed once. This is an important income tax benefit that the trustee needs to preserve. After the death of the settlor, when a trust owns S corporation stock, it must meet certain requirements in order to maintain its status. Whether the stock is held in the marital or credit shelter trust, the terms of the trust must provide that:
The marital trust will usually meet these qualifications. However, the credit shelter trust may not. If the business will be kept and it is a growth asset, it should be put in the credit shelter trust. If the credit shelter trust, or any other type of trust, does not qualify, the IRS says that the S corporation status will not be terminated if:
The trustee may have to amend the trust to bring it into compliance if, by the terms of the trust, the trustee is given the authority to do so. If the trust does not allow the trustee to amend the trust, the trustee should consider petitioning the court for reformation of the trust to avoid losing the S corporation status.
A trademark, patent, or copyright might be among the assets included in the trust. These intellectual property rights must be managed like any other trust asset, taking into account the present and future needs of the beneficiaries, the terms of the trust, and whether or not they should be retained. A trustee should understand the basic characteristics of each type, evaluate their suitability to the particular trust he or she is managing, and, if retained, maintain the asset in accordance with the rules that apply to that particular asset.
A trademark is normally associated with a business and has an endless life as long as it is used and renewed. The trademark will have value if used in a business or product interest owned by the trust, and the trustee should make sure that it is renewed and maintained to support that asset. Copyrights owned by a trust may have significant value. The settlor may have authored a book or song that generates cash flow to the trust that may represent the majority of the trust’s income. The trustee, in addition to understanding the terms of the royalty contract, should also be aware of the expiration of the copyright. Copyrights have a long life of seventy years by statute. However, it could have only a few years left when the trustee takes over. If it represents a significant portion of a beneficiary’s income, the trustee will need to plan for replacing that income when the copyright expires.
Unlike trademarks and copyrights, patents have a shorter life span. Patents for utility and plant classes are for twenty years, while a design patent lasts for fourteen years. The trustee’s responsibilities for patent assets are basically the same as for trademarks and copyrights. If the decedent was a celebrity, these assets could have significantly more value than when the decedent was living. In this situation, a trustee would require professional assistance from someone who specializes in this area.
The trust may own gas and oil royalties. These are depleting assets, and the trustee needs to carefully review each one to determine its viability as a trust investment. An assessment should be made of its estimated duration and, like other assets that have a limited life, the trustee should have a plan for replacing this source of income. If the royalty is determined to be too risky an investment for the trust, the trustee needs to assess its marketability and make arrangements for sale through a reputable broker. Oil and gas royalties are unique investments, and the trustee should retain a qualified oil and gas professional to perform an analysis and make recommendations.
These types of assets may have been productive for the settlor prior to death, but may not necessarily serve the purpose and intent of the trust. Unless the trust specifically directs the trustee to hold the asset for distribution to beneficiaries in the future, the trustee must evaluate each one and make a determination as to whether or not it is a suitable asset for the trust.