Journal of Financial Planning: August 2024
Anne Rhodes is chief legal officer at wealth.com, the most comprehensive digital estate planning platform.
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Behind the scenes of most successful businesses lies an owner who has built the enterprise through perseverance and strategic planning. However, many overlook an essential component of business management: protecting the company against the owner’s incapacity or death. Incapacity, which refers to the physical or mental inability to handle one’s financial affairs, and death can leave business operations in disarray and lead to operational disruptions and protracted legal battles. According to the Social Security Administration, a quarter of today’s 20-year-old insured workers born in 2000 are likely to experience prolonged work absence due to disability before retirement.1 Thus, forward-thinking business owners incorporate business succession planning into their overall estate planning.
If you are a financial planner, consider how this article touches on your own business and estate planning. It is just as important for you to protect your own business as it is for you to help your clients protect their businesses. By doing your own business succession planning, you can provide a practical example and firsthand anecdotes to your clients.
This article outlines common features that business owners should incorporate into their estate plans to optimize economic benefits for beneficiaries and business continuity.
Poor Planning Horror Story
Consider Brian, a dentist with a flourishing private practice that he runs with two other business partners. Brian unexpectedly suffers a stroke and becomes incapacitated without an estate plan in place.
During his incapacity, the court appoints his spouse as his conservator. In her role, she participates in business decisions for the dental practice, but struggles to fill in for Brian. She delegates to the wrong people and causes the practice to generate less revenue. When an offer to purchase the entire practice arises, she chooses to vote Brian’s minority stake against the sale—enough to stop it—believing that Brian will regain capacity and would have been upset with a sale.
At Brian’s death, disagreements arise between the business partners and family members over the future of the practice. The family wants to sell Brian’s stake to another dentist, which the business partners vehemently oppose. They would like to offer a higher price than the other dentist is willing to pay, but struggle to come up with the liquidity to make an attractive offer to Brian’s family.
Brian could have mitigated these issues if (1) Brian had created an estate plan, preferably through a revocable trust, and (2) all three business partners had reviewed the corporate governance of their dental practice specifically with succession planning in mind.
The Role of Revocable Trusts
Business owners should consider using a revocable trust as the main legal vehicle for their estate plan, rather than a will. Trusts offer robust solutions for business continuity due to two important features: legal effectiveness before death and avoiding the oversight of a court over financial dealings.
First, unlike a will that takes legal effect only upon the testator’s death, a revocable trust has legal effect as soon as the trust creator (“trustor”) creates and places an asset in the trust (“funding”). A trustor who is a business owner can then fund their business interests into the trust so that the successor trustee named in the trust can seamlessly step into the trustee role and run the business whenever the trustor is incapacitated.2 Moreover, a trust is so flexible that you can name special trustees to act over special assets, such as the business.
By having a revocable trust, Brian could have named a business partner as his successor trustee over the business and avoided having his conservator—his spouse—handle all his financial affairs, including running the business.
Second, if someone dies with a will as the main legal vehicle for their estate plan, their estate will go through a judge-supervised process called “probate.” How much oversight the court has over the day-to-day financial affairs of the estate depends on the court, but a judge might require supervision over the business, especially if the business is a highly valuable part of the estate. A business owner may prefer to put those decisions in the hands of a private, trusted individual, such as a business partner by using a trust instead.
Revocable trusts are straightforward to establish and change, making them a popular estate planning tool for business owners.
Revocable Trust Provisions for the Business-Owning Trust
A revocable trust that could own business interests must be carefully drafted to provide a comprehensive set of business-related powers to the trustee. Three features are worth noting:
First, should multiple trustees be named and their spheres of influence bifurcated so that one trustee handles only the business affairs? Brian could have designated a business partner as “special” trustee for his business. This way, the trustee position can be specialized based on industry expertise or business acumen.
Second, does the trust override the Uniform Prudent Investor Act (or similar state law)?3 This law mandates that trustees act like “prudent investors,” emphasizing asset diversification and minimizing risk. But this law likely contradicts the trustor’s goal of maintaining a business, with the trust holding a concentrated interest in a riskier asset class without clear expected returns. This statutory requirement can be waived through the trust language.
Third, does the trust have a broad enough set of business-related powers? The trustor should concurrently review the business governing documents and understand tax elections made for the business. For example, if the business elected into “S corporation” treatment, the trust must contain provisions so that a corresponding election can be made to treat any trust created upon death as a “qualified subchapter S trust” or as “electing small business trust.”
Transferring a Business into a Revocable Trust
To ensure business continuity during incapacity, the trustor should fund the business interests (membership interests, stock, voting rights, etc.) into the revocable trust. This step is not always easy, depending on the corporate governance documents. The trust and corporate governance documents should be coordinated, and the business may need to approve the transfer.
Common hurdles to funding are:
- The business owner may not be able to transfer the shares to anyone but existing business partners under any circumstances, or only after those partners exercised a right of first refusal or other buy-out rights. In this instance, the trustor should speak to the existing partners to see if there is appetite for amending the governing documents to accomplish estate and succession planning objectives for all partners. An exception could be made for lifetime transfers to a partner’s revocable trust.
- The trustor may be allowed to transfer their interests, but only upon death, to an executor of the estate or beneficiary of a “transfer on death” designation. This type of provision is a good start but does not provide for incapacity. If the existing partners are open to amending the governing documents, they should allow for lifetime transfers to revocable trusts. If the existing partners are not open to amendments, the trustor should make sure the revocable trust (the document within their control) is responsive to these provisions and take advantage of any “transfer on death” designation by naming the revocable trust as the beneficiary, rather than an individual.
- The business owner may be allowed to transfer their interest during life to their trust, but only if the trust contains specific provisions to protect the business from interference by a trustee who is not involved in the business. In this instance, work with an attorney to ensure the business’s preferred protections are inserted into the business owner’s trust.
Business Succession Planning Tools
A good business succession plan takes into account not only the trustor’s interests, but the remaining partners’ as well. Tools exist to guarantee a smooth transition and provide liquidity for the business or their partners upon disability or death of another business owner, while doing right by the business owner’s loved ones.
First, the business may consider purchasing disability or key person life insurance. Insurance proceeds may provide the liquidity for the existing partners to purchase the deceased partner’s shares, either in the name of the business (e.g., redemption) or as individual partners (e.g., buy out).
Second, the business may consider restrictions on transfers, such as a right of first refusal for the remaining partners or drag-along rights. Usually, the right of first refusal gives the existing partners the ability to purchase the exiting partner’s interests at the same price as offered by a third party. The drag-along right allows a majority owner to force a minority owner to participate in a sale, usually so that the entire business can be sold to a potential buyer. In Brian’s case, these provisions might have protected the business partners from the recalcitrant spouse’s decisions by forcing her to sell the minority shares to someone the business partners wanted.
The business partners should do a comprehensive review of these strategies and coordinate them with their individual estate plans.
Securing Business Success with Strategic Estate Planning
Business owners must create their estate plans with business succession in mind; the two go hand in hand, and coordinating the two spheres will bring peace of mind to family members, business partners, employees, and customers. Financial planners who are business owners themselves have a unique opportunity to use their own businesses to familiarize themselves with these estate planning concepts and better guide their clients. Have you created legal documents that address your professional and personal affairs should you become incapacitated? Have you broached the topic of succession planning with your own business partners and family?
As a financial planner, you can set a powerful example for your clients by walking the walk and coming out on the other side having greater clarity about your contingency plans. Use estate planning as an opportunity to demonstrate a deeper commitment to clients’ overall well-being, fostering stronger relationships and building deeper trust and loyalty.
Endnotes
- See www.ssa.gov/oact/NOTES/ran6/an2020-6.pdf.
- See www.americanbar.org/digital-asset-abstract.html/content/dam/aba/publications/probate_property_magazine/v27/01/2013_aba_rpte_pp_v27_1_january_february_llewellyn_selecting_a_successor_trustee.pdf.
- See www.investopedia.com/terms/u/uniform-prudent-investor-act.asp.