When the documentation is done correctly, usually the family business will be owned by one’s family trust. It is then possible for the business owner to transfer his or her business at death, when the trust becomes irrevocable. For a typical two-spouse family, usually the family trust will become partly irrevocable and partly revocable after the first death. The part that becomes irrevocable is the part owned the first spouse to die, and a bequest can either be made to the children at that time, or the trust can provide that the transfer is to occur only after the second death.
Family trusts can also be irrevocable, as well, and it is possible for the business to be owned partly or entirely be it. For several reasons, it is less common for the family business to be owned by an irrevocable trust. We discuss the two basic types of trust, revocable and irrevocable, in turn.
A. REVOCABLE TRUSTS
Revocable trusts are “grantor” trusts while the testator (settlor) is living. This means that the income of the trust is taxed to the person who created the trust. IRC §676, 671. Various types of revocable trusts exist, but one of the most common is the “AB trust” or the “ABC trust.”
In a typical AB trust arrangement, a single trust containing all of the assets of a couple is split at the death of the first grantor into two (or possibly three) subtrusts. Trust A is funded with the survivor’s portion of the estate (Typically all of his or her separate property and ½ of the community property), and in a typical arrangement will have one-half of the community property estate. The other trust, Trust B, often called the bypass or exemption trust, is funded with the deceases spouses assets (His or her separate property and ½ the community property) in an amount equal to the first to die’s estate tax “exemption amount” (and thus no estate tax results); the rest, if any, is funded to the so-called marital trust (Trust C), and there is typically no tax at the first death because of the unlimited martial exemption found in IRC §2056(a), which allows spouses to transfer an unlimited amount of property between each other estate tax free, either during their lives or upon their deaths. Note: The available exemption amount available at death of either spouse must be reduced by any taxable gifts made during live which should have been reported on form 709. https://www.irs.gov/pub/irs-pdf/f709.pdf
In the typical estate plan the surviving spouse has the right to invade to corpus of trust C in specified conditions for health support and maintenance where their other assets are insufficient to meet those needs. The surviving spouse also gets to enjoy the income generated from those assets up until their death. At the surviving spouses death any remaining assets within the trust pass to the trusts beneficiaries which were chosen by the first to die.
There are variations on the marital trust (Trust C). In second marriage scenarios, where the first spouse to die wants his children from a prior marriage to benefit, rather than his/her stepchildren, a so-called Qualified Terminal Interest Property (QTIP) election is made. This allows the surviving spouse to have access to the income during her life, while allowing the first spouse to die to decide (before he dies) who will receive the property in Trust C after his spouse dies (after the second death).
B. IRREVOCABLE TRUSTS
The second type of trust is irrevocable. In general, transferring an asset to an irrevocable trust is like transferring it to a third party, such that after the transfer, the grantor cannot rescind the bequest or utilize the assets that fund the trust for his or her benefit.
When the transfer is done for no consideration, it is a gift to the trust. A transfer to an irrevocable trust removes the asset from a person’s estate, thereby reducing or eliminating any potential estate tax that would result if it were contained in his or her estate at death however if the gift exceeds the annual gift tax exemption (currently $14,000) the gift eats up the available estate tax exemption. If the available gift tax exemption is exceeds the portion that exceeds the estate exemption becomes subject to gift taxes.
When an asset is thought to appreciate greatly with time, it is more estate tax efficient to transfer the asset sooner, rather than later to an irrevocable trust. In this way, it reduces the estate taxes by transferring the asset at a lower fair market value which eats up less of the available estate tax exemption amount. Actually, to qualify the above statements, to effectively remove an asset from a person’s estate, he or she must do more than transfer the asset. It is important that he or she not retain a beneficial interest in the trust’s income or principal, or retain the power to affect the beneficial enjoyment of the trust assets. See IRC §2036(a).
Although the asset transferred to an irrevocable trust may be removed for estate tax purposes, it is possible for the grantor to remain the tax owner of the income generated from it (without actually receiving the income). Thus, the income generated by the assets in the irrevocable trust may be taxed to the grantor, the beneficiaries of the trust, or the trust itself. See IRC §641, 678.
Why would the grantor want to remain the tax owner? Well, in certain circumstances, it is actually beneficial for the grantor to continue to remain the tax owner of the income. To accomplish this, the trust document must contain certain (but not other) provisions so that it qualifies as a “Defective Grantor Trust.” In this context, the word “defect” does not refer to a deficiency. Rather, it means that the assets are excluded from the estate for transfer tax (estate, gift, and generation skipping) purposes, but the trust income is included for income tax purposes. It is from this disparity between the estate and income tax rules that results in the trust being called “defective.”
As mentioned, often it is beneficial for the trust to be defective in this way. For example, it permits the grantor to engage in sales with the trust for full and adequate consideration without having to recognize a gain or a loss. Furthermore, when the grantor pays the income tax on the transferred asset, the trust and the beneficiaries do not have to. Effectively, it allows the grantor to make additional tax-free distributions to the trust without it resulting in an additional gift tax, and the assets inside the trust grow income tax free.
There are several reasons for transferring a business interest to an irrevocable trust for the benefit of one’s family. In addition to the above-mentioned transfer tax benefits (that of removing the appreciation from one’s estate), there is, in general, also a level of creditor protection that the trust beneficiaries receive. In this context, such “creditors” include a divorcing spouse who may seek to claim part ownership of the asset. By placing it the irrevocable trust, for the benefit of one’s child, rather than in the name of the child himself or herself, the trust is the owner—and this often achieves a level of creditor protection (certain exceptions may be applicable).
