22 Feb Trust Planning for Founders of Companies
co-author Ian Weinstock
As a founder of a company, you have a zillion things to think about, many of which urgently need to be addressed for your company to survive and thrive. It may therefore be somewhat stressful to add to your list of things to think about anything that isn’t strictly necessary. But in the long run, one subject that you’ll probably be happy you thought about is trust planning. In fact, thinking about trust planning relatively early in the life cycle of your company could be one of the best decisions you make for the financial well-being of your family.
How can a trust benefit you?
- A trust can facilitate a tax-efficient transfer of wealth to your family.
- The concept at work here is to transfer shares in your company at a time when their value is relatively low, so the future appreciation escapes U.S. gift or estate tax (40% in 2017 with state taxation on top of that).
- So, for example, if you give away shares in your company that are worth $100,000 at that time, you’ll only use up $100,000 of your gift/estate tax exemption ($5.49 million in 2017), and if the shares are later sold for $10 million, all of that $9.9 million of appreciation will have escaped gift and estate tax, potentially saving your family almost $4 million (or more, if state estate taxes apply as well). Clearly, then, the best time to give away shares in your company is when the value is low, and the value for gift tax purposes may, under the right circumstances, be even lower than you might think. (The valuation of assets for trust purposes is typically significantly different–and more beneficial–than what you may think of in the VC or PE context of valuation.
Some background–what is a trust?
- A trust is a legal arrangement pursuant to which one person—a grantor (a.k.a., settlor, donor, trustor)—transfers property to another person—a trustee—to administer on behalf of one or more beneficiaries according to the terms of the instrument governing the arrangement.
- Trusts can be used to achieve a wide range of goals and in a variety of contexts. For our purposes, the focus will be on the estate and tax planning benefits of an irrevocable personal trust.
- (That said, one other point is worth noting. For founders who live in states (like California) where probate of a decedent’s estate can be challenging and expensive, another type of trust might also be relevant, namely, a revocable trust. A revocable trust is a vehicle through which you can hold assets, and while you are alive, it will be pretty much exactly as though you still owned the assets directly in your own name (subject to one caveat, which we will discuss at later). But at your death, the assets will be disposed of in accordance with instructions you set out in the trust instrument, and not through a court-supervised probate process. There are no tax advantages to a revocable trust, but there is generally a saving of administrative costs and hassles for your family after you’re gone.)
Estate and tax planning.
- Every American citizen or resident is potentially subject to a 40% Federal estate tax at death on assets he or she owns or controls. However, there is a very large exemption from Federal estate tax, $5.49 million, and double that for married couples. (States may have their own separate estate taxes, with their own—generally lower—exemption amounts.)
- In addition, every American citizen or resident is subject to gift tax on assets he or she gives away during life, though with that same $5.49 million exemption. The exemption is an aggregate gift and estate tax exemption, so to the extent you use up the exemption on lifetime gifts, you won’t get the benefit of it when you die.
- The key point here is that the estate tax is based on the value of assets at death whereas the gift tax is based on the value of assets when you give them away. So, giving assets away when the value is low is tremendously advantageous in reducing the future tax burden.
- For founders who are neither American citizens nor residents, you’re only subject to estate and gift tax on your U.S. assets, but a company here qualifies as a U.S. asset for estate tax purposes. But it’s not a U.S. asset for gift tax purposes, so you can transfer shares without using up any exemption. Moreover, that generous $5.49 million exemption for American citizens or residents drops all the way down to $60,000 for non-citizen non-residents, making planning even more important.
Planning with trusts.
- To whom should you give shares? That’s where trusts come in. You can create a trust for the benefit of your family—spouse, children, parents, siblings, or any combination of them—and give shares to the trust, and then the full value of those shares in the future, with all the appreciation, can be used to provide benefits for your family for many years to come without any further hit to your gift and estate tax base.
- (Although there are certain types of trusts where in theory you can be a beneficiary alongside your family, those trusts are more complicated and expensive to set up, and in any event you cannot count on getting money out for yourself. It’s therefore generally better not to set up a trust for yourself, but rather keep enough shares of your company in your own name, out of the trust, and let the trust just benefit your family.)
- There are some up-front costs to trust planning, of course—you’ll need a lawyer to draft the trust; you’ll need an appraisal of the shares you give to the trust; and you’ll need an accountant to prepare a gift tax return—but those costs are modest in comparison to the potential tax savings. And although the trust owns the shares after the gift, and not you, as long as you choose your trustee wisely, the loss of direct control over the gifted shares need not be of concern, particularly because you can give only a portion of your shares, retaining the majority for yourself, and you can give shares to the trust at different times, not all at once, though there may need to be a new valuation each time.
- Note that the basic trust planning we’re discussing can save estate taxes, but it isn’t designed to save income or capital gains taxes. For example, when the company has a liquidity event, in general, you or the trust will still have to pay capital gains tax. There are certain more complicated types of trusts that may result in some income/capital gains tax savings, though, so if you have an appetite for complexity, it may be worth exploring more advanced planning techniques.
Look before you leap.
- In thinking about planning with trusts, please keep in mind one caveat, about capital gains taxes. If your shares in the company are qualified small business stock, certain transfers to trusts may result in a loss of favorable capital gains tax treatment.
- That may not apply to you, and for various reasons it may not be a big deal even if it does apply to you because you may be keeping more than enough stock to get the full benefit from the favorable capital gains tax treatment.
- Also, only certain types of trusts can hold S-corp. shares. Those trusts can be just as beneficial for saving taxes, but they do need to be set up more carefully.
- Therefore, before you engage in any trust planning, be sure to discuss whether your company is an S-corp. or whether your stock is small business stock with your lawyer and accountant.
When should you start thinking about trust planning?
- You should start thinking about trust planning as soon as possible, so you’ll be ready to implement a trust planning strategy at the right time.
- The harder question is when is the right time to make a gift to a trust? You could make the gift when you first set up your company, but for many people, that’s premature, particularly if you’re single without children. Generally, the best time is when you feel secure enough to part with some of the shares, and you have a spouse and/or children whose futures you want to take care of. For each founder and for each company, that time may be different. The more funding rounds occur before you make the gift, the higher the value of the shares for gift tax purposes.
- On the other hand, you don’t want to give away too much too soon, or else you might feel like you haven’t kept enough upside for yourself—being too successful at estate planning may be even worse than not doing it at all! Like Goldilocks, you want to get the planning just right.
For more information contact Ian Weinstock at iWeinstock@kflaw.com. Additional background, and a knowledge library, is also available in the knowledge section of the Oxford Valuation Partners website (https://oxfordvp.com/knowledge) .