Trusts still attractive to family business owners

The resolution of the fiscal cliff drama early last year gave wealthy Americans more certainty on estate taxes than they've had in more than a decade.

The American Taxpayer Relief Act of 2012, enacted Jan. 2, 2013, also arguably made the substantial investments that many wealthy Americans had made in trusts to avoid potentially higher estate taxes a waste of money. The deal set the exemption amount at $5 million per person, with an annual inflation adjustment (the exemption is currently at $5.34 million for 2014), and made it portable for married individuals.


Living trust
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Lawyers never say die when it comes to Congress fiddling with estate-tax rules, but as those rules currently stand, only a very small percentage of the estates of high-net-worth investors and/or family business owners will face taxes.

"The $10 million to $11 million combined exemption eliminates a whole lot of small businesses from paying estate taxes," said John Wheeler, certified financial planner and a senior financial consultant at Castle Wealth Advisors.

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For family businesses, however, taxes are not the only consideration.

The estate-tax savings that many small-business owners anticipated when they transferred ownership of their business assets to a trust vehicle may never materialize, but the benefits of control and certainty about how assets will be transferred to family members, charities and other individuals continue to make trusts an attractive option.

"Trusts are not just for tax purposes but also for management purposes of a family business," claimed David Neubert, senior family wealth advisor for GenSpring Family Offices, which advises ultra-high-net-worth families. "They continue to play an important role for families," he said, adding, "Even if the tax situation wasn't what it was, wealthy families would still likely use them."

Flexibility is key

The key in setting up trusts for family businesses is flexibility, financial advisors say.

"Businesses are living, breathing organizations," Neubert said. "There's a need for flexibility."

It's not just the operating environment of a business that can change dramatically; so can the circumstances of the trust's creators and beneficiaries. (Think the 2008 financial crisis.)

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Add in the still unpredictable political environment for taxes and it makes sense to create revocable trusts that can be amended or scrapped entirely if circumstances demand. Business owners give up some of the tax advantages and liability protection of irrevocable trusts, but such trusts give people greater control of how their businesses and assets are transferred and distributed to others.

"A lot of attorneys may not agree, but when we talk to our business-owner clients, we suggest [that] having a revocable trust can be a very good idea," said Wheeler at Castle Wealth Advisors.

Trusts in the context of an operating business are not off-the-shelf products. They need to be tailored to each business and each family situation. There are four main reasons business owners use trust vehicles in regard to their businesses:

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1. Tax savings. For family business owners, the business usually represents the bulk of the family's wealth. The transfer of ownership of that asset from one generation to the next in a tax-efficient manner can very often be the difference between keeping the business in the family or being forced to sell it.

When assets are transferred from an owner to a trust benefiting others, the assets are no longer part of that person's estate—and thus not subject to estate taxes at his or her death. "Trusts along with buy/sell agreements and other business-planning documents can facilitate passing on businesses to the next generation," Wheeler said.

Trusts, however, are subject to income taxes. In fact, they are taxed at the highest marginal rate—39.6 percent—on income above $11,950. They are also subject to the 3.8 percent Obamacare taxes on income over that level.

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The high income-tax burden puts a premium on giving trustees, who oversee the trust, discretion to make distributions to beneficiaries in lower tax brackets. Balancing flexibility with tax efficiency is an ongoing effort for trust lawyers.

"There's a focus on building in mechanisms to provide flexibility while accomplishing the desired tax results," said GenSpring's Neubert.

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2. Asset protection. A key advantage of setting up a trust to own a family business is that when the patriarch or matriarch of the family dies, heirs can avoid the often long and costly probate process that accompanies the settling of a will.

"A will can be contested," said Castle Wealth Advisors' Wheeler. "A trust can be contested, too, but it's a lot more difficult."

Some trusts, though not all, can also provide protection from creditors and/or in-laws in divorces. Absent a trust that articulates the rights of family members and in-laws, a divorce can often force the sale of a business. A trust, however, won't protect assets if it was specifically created to avoid existing liabilities.

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3. Beneficiary protection. Money isn't always a good thing. In fact, numerous studies show that the children in wealthy families very often meet tragic ends when they come into financial windfalls for which they're not prepared. The issue can be drug addiction, bad habits and unsustainable lifestyles.

Trusts allow parents to distribute wealth to children in a more measured and controlled fashion.

"Many families have some form of dysfunction," said certified financial planner Bob Klosterman, CEO of White Oaks Wealth Advisors. "Protecting family members may be a compelling reason to think about using trusts."

"You have to understand the family dynamics, what you're trying to accomplish from a tax perspective, and how you want to protect beneficiaries. People should discuss these things with their advisors." -Bob Klosterman, CEO of White Oaks Wealth Advisors

4. Supervision of assets for a group. The bigger the business, the more a trust can help owners control how the business is run, by whom and for what purposes after they retire or die. In some cases, one child may be interested in running the business, while others want to sell it.

Trusts can stipulate terms by which one beneficiary retains ownership of the business, while others receive other assets or payments from the business owner over an extended period. The range of potential structures is enormous.

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Dynasty trusts can plan for generations not yet born, and charitable trusts can provide benefits to charities; a variety of other trust structures can be customized to help business owners achieve their objectives.

"There's no shortage of tools business owners can use. It's a matter of picking the right ones," Klosterman said. "You have to understand the family dynamics, what you're trying to accomplish from a tax perspective, and how you want to protect beneficiaries.

"People should discuss these things with their advisors," he added.

—By Andrew Osterland, special to CNBC.com