Tailoring trusts

Business owners considering
the transfer of their business
to the next generation are
likely to prefer outright transfer of
shares to chosen successors, often
because that is how they have held
the shares themselves.

It may be, however, that the preferred members of the next generation have not been identified or have not proved themselves, or there may be difficulties balancing the interests of those in the next generation who may work in the business and those who will not. The present owner may also be wary of financial or matrimonial claims against the next generation, which could put
at risk the value or the very existence
of the business.

Future flexibility

In all these situations, using a trust to hold the shares rather than transferring them outright can be beneficial and provide much-needed flexibility for the future. This is the case, even though one of the reasons frequently advanced for using trusts – minimising tax liabilities – is unlikely to apply as long as inheritance tax business property relief, capital gains tax holdover relief and entrepreneurs’ relief are available.

Putting family business shares into a trust allows control of the shares and management of the business to be separated from beneficial ownership. The settlor can decide the extent to which control can be exercised by the family beneficiaries but beyond that (or until they are deemed ready to assume further control) it can remain with the nominated trustees as owners.

However, most private trusts are designed to hold financial assets rather than shares in operating businesses, far fewer shares that give a controlling interest in those businesses.

There are a number of areas where the statutory and common law rules on trusts do not sit easily with family business shares as the principal – or only – asset. As a result, the fiduciary duties of the trustees, usually to act in the best interests of the beneficiaries, could
be at odds with the intentions of the settlor and the priorities of the business. So, how should we design family business trusts?

Key provisions

A trust intended to hold shares in
a family business should address these conflicts as far as possible by including five key provisions.

First, distribution policies: how much of its profits should the company distribute as dividend rather than retaining to fund future growth and
how much of that income should the trustees allocate of different groups
of beneficiaries?

Second, conditions on appointment, qualifications and succession of trustees. The trustees must have enough experience to act as owners of the business while avoiding the conflicts
that may arise if they are also directors of the business or potential beneficiaries. A corporate trustee is not without its difficulties in the family business context and a private trust company may be the best option for larger family businesses.

Third, directions that the trustees can retain the shares in the business that are transferred to them without requiring to diversify the trust assets. Usually, it would be the trustees’ duty to diversify the trust assets so they can consider retaining a single holding in a company that is difficult to value and sell only if they are given specific power by the trust deed; the trust should go further and direct the trustees to retain the shares long term although, like all the trust provisions, this cannot be an absolute instruction. Circumstances can change in many ways over the years and the trustees

Fourth, protection of trustees from liability. This is the converse of giving the trustees far-reaching and, in some senses, unusual powers; if they exercise them reasonably and conscientiously they should not be subject to criticism or claims.

Finally, exit provisions if a beneficiary or branch of the family no longer wishes to retain an interest in the business. This may not be part of the initial plan but it may be sensible to look forward to a day when the business can be a source of value for those family members who do not wish to be involved in it as owners or employees; on what basis would the shares be valued and on what terms would the family members be paid out?

If these special requirements are taken carefully into account, the benefits of using a trust for family business shares can be considerable (see box).

It will be obvious that the policies and structures that are put in place to govern the operation of the trust are likely to be most effective if there are similar arrangements in place for the management of the company itself and
of the wider family. Where the transfer
of the business is from the first generation of the family to the second, there will almost certainly be a need to introduce governance and management structures.

Senior management

A controlling owner is frequently the senior manager as well, so formalised structures are rare and this frequently applies in subsequent generations as well. Even if the family does have processes in place, it is essential to review them as each succession approaches to ensure that they still meet the requirements of the family and the business.

Where ownership of a business is held in trust, the trustees may not have regular contact with management and a more formal governance structure is required to ensure that the interests of the business and of the owners (the beneficiaries through the trust) are fully considered.

This is where a strong board of directors is essential and, where the trust holds a controlling interest in the business, it will of course be the trustees who control the appointment of the directors.

Even this level of involvement in the management of the business may be
more than the trustees feel they can sensibly assume, particularly if they are reconciling the interests of different groups of beneficiaries.

There are a number of structures in different jurisdictions that can provide continuity of ownership without the pressures of balancing beneficiaries’ interests as well. The VISTA trust in the BVI and the STAR trust in the Cayman Islands are two examples from offshore jurisdictions where the trustees are precluded from any management influence in the companies they own
but are similarly protected from claims
by the beneficiaries.

Evolving concept

This concept is developing in a number of jurisdictions that offer the purpose trust (a trust established for a stated purpose which could be holding the shares in the family business long term) but where the terms of the trust are supervised not by the beneficiaries, because there aren’t
any, but by an enforcer appointed by the trust deed.

Purpose trusts are not yet permitted in the UK, but high-level proposals for them have been made and their introduction may not be too far off. This innovation would require major changes of approach by practitioners and by the tax authorities who would no doubt want to make sure they did not avoid their fair share of tax.

Whether or not new types of trust are introduced, there is much that the trust world can offer to help families and family business owners preserve, transfer and develop their legacy, provided the special requirements of family businesses are taken into account in drafting the trust and choosing the people who are
to operate it.

Ian Macdonald is head of private client at Wright Johnston & Mackenzie and is deputy chair of the STEP Business Families Special Interest Group