Your family business is more than a mere investment asset. It is your life’s work a legacy to pass on to your spouse and children. It involves not only passing wealth, but often passing tradition, pride and responsibility to your employees and the community.

When passing a family business to the next generation, there are some important questions to ask: 

• Who will manage the business? 
• How will profits be divided between those who work in the business and those who do not? 
• How should conflicts among share­holders be handled? 

Answering these questions about your chil­dren’s generation is difficult enough, but for future generations, it may prove impossible. Placing the business into a trust is often a good starting point when a family business is part of the estate. Here’s how a trust can work for you.

Why a Trust

Let’s assume you have one child in the busi­ness and two children who have no desire to work there. If the business is worth less than one-third of your total estate after federal estate taxes, one answer may be to:

• Leave the business to the child who works there,
• Equalize amounts to the other two; and
• Divide the balance of your estate three ways.

Assuming the child in the business does not mind having all of his or her eggs in one bas­ket, this solution may be satisfactory without
a trust.

Most of us, however, are not that lucky. Closely held businesses are frequently a large part of their owners’ estates, in particular after federal estate taxes are paid. What should you con­sider if the business is worth more than the working child’s share?

A carefully structured trust may accomplish your objectives. In setting one up, you should try to anticipate problems and provide the trustee with specific instructions and the pow­ers to address them. 

The trustee must have among other powers the power to retain the closely held busi­ness in its current or successor form, regard­less of what percentage of the trust that may be. Ordinarily, a trustee has a duty to diversify investments to minimize risk. You may even want to compel the trustee to retain the busi­ness unless the child in the business consents to the sale or unless some objective guidelines of financial performance are not achieved.

However, be aware of potential conflicts among your children. The children outside the business will frequently want to sell the busi­ness while the child in the business may want to keep it at all costs because it pays his or
her salary. 

Allocating Profits

Should you leave it up to your children to divide the profits or should the issue be addressed in your estate plan?  The child in the business is entitled to a salary and some addi­tional reward for making the business grow. The children outside the business, however, are bearing a significant amount of risk for which they should be rewarded.

For example, imagine that the closely held business is a farm. There is a measurable reward for return on capital (cash rents) that clearly belongs to shareholders. The balance of the profit belongs to return on labor (which should go to the child in the business) and return on bearing risk (which belongs to all of the children).

In addition, the method of payment is impor­tant. Dividends from a normal corporation (what the Internal Revenue Code calls a C corporation) are very inefficient because they are taxed twice, once at the corporate level and once at the shareholder level. For that reason, you may want to consider another form of organization, such as a partnership, a limited liability company (LLC) or an S corporation. 

Partnerships, LLCs and S corporations have the advantage of being taxed only once, at the ownership level. The disadvantage of a part­nership is that the partners have unlimited liability, unless they are limited partners in a limited partnership. The disadvantage of an S corporation is that the types of shareholders are limited.

If your family business is currently incorpo­rated and you want it to be a partnership after your death, you will have to instruct your executor to liquidate the corporation before distribution of the estate. If the business has other shareholders, they may oppose liquida­tion because of the significant tax liability it would create. 

Choosing a Trustee

Your choice of a trustee is important because the trustee has ultimate control of your share of the business. Choosing the child in the business or the child outside of it creates an inherent conflict of interest that which helps the other children may hurt the child-trustee or vice versa.

For example, the child in the business may want to retain a major part of the year’s earn­ings for expansion or for a reserve, while the children outside the business may want divi­dends or distributions. Furthermore, the child in the business may be the only one who knows enough about the business to be a trustee. If you believe this child can be fair to his or her siblings, choosing a child
in the business as trustee may be the
best answer. 

A professional trustee may tend to push for eventual sale of the family business because he or she is likely to have a natural inclination to reduce risk. If you want the family business retained and have chosen a professional trus­tee, provide specific instructions about the circumstances under which you will permit the business to be sold. 

Minor Children

What if your children are minors or have not yet settled into careers? What if there is no indication which child may go into the busi­ness, if any? You may want to give a dispro­portionate amount of stock maybe even voting control to the child in the business, but you don’t know which of your children it will be.

Once again, a trust may be the answer. The trustee can exercise discretion or follow trust directives in allocating and distributing stock among the children who are active and inactive in the business.

Trust as Transfer Tool