Did you organize your business as an LLC, corporation, or other entity? If so, that’s great. These entities can provide substantial protection from personal liability. However, forming a trust for your business and its assets could provide even more robust protection. A business trust will also make it much easier for your loved one to manage your estate business in the event of your death or incapacitation. In this article, we’ll explain why every business owner should consider the potential benefits of forming a business trust.
What is a Business Trust?
A business trust is a specialized from of trust designed to encompass a business and its assets. Unlike personal trusts, these entities are used primarly by companies, investors, and shareholders, and they vary greatly in their structure, purpose, and goals.
In this guide, we’ll explain everything you need to know about business trusts, including tax consequences, how to get started, and much more. K
Business Trusts vs General Trusts: Explained
There are very important differences between estate and business trusts, but there are also many similarities.
In both estate trusts and business trusts, there is an appointed trustee that makes decisions. The trustee is responsible for holding assets, managing those assets, and distributing the assets on behalf of another party.
The party who benefits from the assets in the trust is the beneficiary. A trust can have an unlimited number of beneficiaries, and the beneficiaries do not be related.
You establish a trust when you create a declaration of trust, and someone (known as the grantor) funds the trust. You can fund a trust with cash or investments (including interest in businesses).
Despite their similarities, business and estate trusts can have very different purposes.
In a business trust, a trustee manages a business and conducts transactions for the benefit of its beneficiaries. The beneficiaries of a business trust are usually investors or shareholders. However, if it is a family business, the beneficiaries might be the owner’s heirs.
Living Trusts vs Perpetual Trusts
Deciding between a living and perpetual trust should be done after careful consideration. Having a proper trust in place can allow your heirs to avoid probate when you pass away.
Living trusts provide the most flexibility, as they can be modified throughout their lifetimes. They are designed to transfer estate assets to specific beneficiaries when one dies, ensuring taxes and other fees are taken care of. These trusts are ideal if you expect your circumstances to change in the future and want to maintain complete control of your assets.
Perpetual trusts, however, must remain as they were initially established upon creation and continue on forever without a scheduled end date. They are often used to minimize tax implications by placing larger sums of money into the trust.
A living trust offers many potential benefits, but it also comes with a few drawbacks. The accounting associated with a living trust can be complex, requiring the trustor to update and disburse funds among numerous individual accounts continually.
However, it also allows assets to quickly pass on to heirs upon death, bypassing probate court. Since living trusts are not public records, the process generally remains private.
Additionally, if someone becomes incapacitated, someone could still manage their assets through a living trust without expensive court proceedings. Ultimately, deciding whether to establish a living trust might depend on your financial circumstances and desire for privacy.
Perpetual trusts are beneficial for those with complex financial needs or large estates. They allow great flexibility in accounting and provide tax advantages and asset protection.
However, perpetual trusts must remain in motion to be valid, meaning the trust’s accounting and records must be regularly and accurately maintained, which can become costly if not thoroughly managed.
Trusts with multiple beneficiaries also need frequent communication and correspondence to ensure enduring unity of purpose throughout the trust’s lifespan.
Note that trusts can either be revocable or irrevocable. A revocable trust allows the grantor to pull the assets back out of the trust at any time, which is typical for living trusts. Irrevocable trusts are often (but not always) established on a grantor’s death. Once assets are in an irrevocable trust, the trust handles and distributes the assets.
Why Start a Business Trust?
There are several circumstances where it makes sense to establish a business trust:
Looking Out for Children
A trust makes sense if you want to set aside assets for children too young to manage the business. The trust allows the children to benefit from the business’s income while appointing someone trustworthy to manage the business assets.
Business trusts are good for succession planning. A business trust facilitates a smooth transition of ownership and management responsibilities for your business.
If you become incapacitated, a business trust can establish who is responsible as a successor trustee to make decisions on behalf of the business. You can name as many successor trustees as you need in the trust documents.
A business trust protects your assets. A business trust separates business assets from personal assets. Once there is a separation of ownership, if someone should ever sue you personally, you will not have to include the assets owned by a perpetual business trust in your assets. The assets held in a business trust can also protect the assets again creditors.
Share Profits without Control of Business
A business trust can allocate business income to your family members without ceding control of the business operations. This allows you to maintain control of the business while sharing in the profits.
Business trusts can reduce probate and court delays, and they can even help you avoid these types of red tape entirely entirely.
Types of Trusts: The Most Common Formations for Business Use
There are several types of trusts that can hold business assets.
Business Trusts as Granter Retained Annuity Trusts
A grantor retained annuity trust, or GRAT, is an estate planning tool used to transfer wealth. GRATs minimize the tax burden when moving assets from one generation to another.
A GRAT creates a trust in which the grantor chooses and pays the beneficiary an annuity each year for a set term of years. Any appreciation on the trust’s principal during that time passes tax-free to the beneficiary when the trust terminates; any excess remains in the estate.
When using a GRAT, choosing an appropriate annuity rate is important so that enough income is generated to fit within estate tax regulations while maximizing benefits for both parties.
Business Trusts as Life Insurance Trusts
A life insurance trust is an estate planning tool to pass down life insurance benefits to beneficiaries.
The life insurance policyholder and a trustee, who has the legal authority to administer the trust and distribute the proceeds according to the conditions set forth by the policyholder in their will, can form this kind of trust.
It mitigates any potential tax consequences for beneficiaries as it removes assets from one’s estate, shielding them from probate and securing new sources of liquidity for heirs.
A life insurance trust also ensures that proceeds remain private and away from creditors who may seek access if paid directly to heirs.
Business Trusts as Charitable Trusts
A charitable trust is a legal entity for the pursuit of philanthropic objectives.
This type of trust allows individuals to commit resources to benefit the public while providing various tax advantages. Charitable trusts are exempt from federal taxes and often limited state taxation.
Trustees have discretion in deciding how best to use their resources to reach their stated objective.
Business Trusts as Living Trusts
A living trust, also known as a revocable trust, is a legal tool that allows an individual to hold assets for the benefit of designated beneficiaries. Though it takes effect during a person’s life, it avoids probate after death.
Estate planning often involves the creation of a living trust document, which outlines how the assets are divided and distributed according to what the grantor wants.
To set up a living trust, you must name a trustee and specify who receives the assets. While anyone of legal age can create or modify their own living trusts, it is wise to seek professional advice to ensure that all aspects of the arrangement have been considered and your wishes are accurately represented.
How to Put a Business in a Trust
Putting a business in a trust is an important decision that requires research and planning. You’ll need to consider factors such as the tax implications of setting up a trust and how it will affect the future of your business.
To start, consult with an attorney that specializes in trusts so they can advise you on the best structure for your unique business situation. Additionally, look into what ownership and control structure you want to put in place when assigning trustees and beneficiaries.
Make sure to do your homework now so that you won’t have property transferred from irrevocable trusts in the future without careful consideration.
You also must ensure that the transfer is done according to your state’s laws.
Tax Implications of Business Trusts
Business trusts come with several tax benefits and a few drawbacks.
Business trusts can help you minimize or avoid estate taxes. You can use your annual tax-free gifts ($16,000 for 2022) to put assets in a trust. You can also use your annual lifetime tax-free limit ($12.08 million in 2022) to put additional assets in a trust. This is especially helpful if you expect the value of the business to grow over time.
Trusts require a separate tax return. Therefore, you’ll need to ensure that the trust accounting is up-to-date each year and ensure that the proper forms are filed. The accounting and tax return expenses are a concern when forming a trust. Depending on the type of trust, beneficiaries will receive a K-1 each year showing their portion of the trust’s taxable income.
One of the downsides is that trusts are subject to the highest tax rates of any entity. To minimize the trust’s taxes, you want to ensure that the majority of income is passed through to the beneficiaries and taxed at their individual income tax rates. For income to be taxed at the beneficiary’s tax rates, the income must be distributed to the beneficiary each year.
Unlike individual tax rules, trusts cannot deduct any capital losses against ordinary or investment income.
It would be best to consider your state’s tax rules for trusts. Each state has established its own rules for trust taxation.
Can I Get The Same Benefits of a Business Trust Only With an LLC or Corporation?
Though trusts share some similarities with LLCs and other business entites, they differ substantially in structure and purpose.
LLCs are better for protecting your business’s assets from creditors and legal liability.
However, trusts can cover many different types of assets, and they’re better at avoiding probate and reducing estate taxes.
In some cases, combining an LLC and a trust is the best way to manage an estate. For example, you can achieve the following benefits from a business trust coupled with an LLC or corporation.
- Protection from Creditors
- Separation of business assets from personal assets
There are benefits that you can only achieve through a business trust. Corporations and LLCs do not provide the following protection:
- LLCs and corporations do not provide privacy. LLCs and corporations are registered with your state, and some filings are public. Business trusts do not require public filings, which means there will be less public scrutiny and less scrutiny from creditors.
- A business trust acts as a living will. Your business assets are in the trust and you’ve specified how they are supposed to be handled. You’ve also already identified who can make decisions about your assets.
- A business trust avoids probates since your assets are moved into the trust upon establishing a perpetual trust or your death in the event of a living trust.
Final Thoughts on Business Trusts
A business trust can protect your assets and operations from unforeseen circumstances. It can help maintain the business operation if you are incapacitated. If you were to pass away, a business trust allows a trustee to handle the assets and avoid the assets going through probate.
Though a business trust will require a separate tax return and be subject to potentially higher tax rates, you can minimize the trust taxes by properly distributing income to the trust beneficiaries.
To properly establish a trust, you should meet with a trust attorney to discuss your long-term goals and expectations for your business.
Talk to the Experts
If you’re thinking about opening a business trust, talk to us first. Tax Hack Accounting specializes in sophisticated techniques for minimizing you business’s tax costs. Our team can explain all the tax angles you need to consider when forming a trust and much more. Connect with us now to set up a complimentary one-on-one strategy session with one of our veteran tax pros.