Cecilia Ward is an associate at Penningtons Solicitors LLP. www.penningtons.co.uk
For many family members, ensuring the family's control of their business is kept intact for future generations is crucial and yet an astonishing number of families lose control of the family business in the third or subsequent generations. Cecilia Ward looks at the options
The family's control can be fractured in various ways. The divorce of a family member can result in an award of shares or an interest in the business to the ex-spouse. The bankruptcy of a family member can result in his shares or his interest in the business being lost to the family. Similarly, the death of a family member can result in the shares or interest in the business passing outside the family.
Control of the family business can also be lost once many family members each own a small share of the business, typically in the third or further generations. Family members who do not work in the business, or who are not interested in the business may wish to sell their share.
Shareholders' agreements or the constitution of a company can stipulate that any family member who wishes to sell must offer their shares to the other shareholders. These provisions can also be expressed to apply to events such as death, divorce and bankruptcy. Partnership agreements may have similar provisions for partnership interests. These only provide protection, however, if the other family members are inclined to purchase, and have the funds to purchase, the outgoing family member's share.
All of these issues can lead to a thriving family business passing out of a family, rather than being handed down through the generations, as the founder initially envisaged.
A solution is to place the interest in the business (whether it be shares or stock in a company or a partnership share) into a trust.
Different types of trusts
A trust formed under English law is essentially a flexible holding structure. Company shares, partnership interests, and assets used by companies, partnerships or sole traders can be placed into the trust, becoming the trust funds. The trustees hold the trust funds for the benefit of the beneficiaries, the family members. The trustees are effectively custodians of the trust funds for the family.
Trusts can be created during the family member's lifetime, or in their will, taking effect on their death. There are different types of trust, which give the beneficiaries different rights.
The first is an income trust, (called a 'life interest' trust) where one or several beneficiaries have the right to the income from the trust funds, but do not have any right to the underlying assets. On the beneficiary's death, the assets can remain in trust – either another income trust for other beneficiaries or a different type of trust, or the assets can pass directly to family members.
This type of trust may be useful where, for example, after the family member's death his or her spouse will need the income from the business, but the ownership of the business interest is to pass to the next generation on the widow/widower's death.
A discretionary trust is one where the trustees must choose who benefits from the income and underlying assets from a list of beneficiaries. This type of trust is useful, for example, in circumstances where it is unclear who from the next generation will be interested in the business. The trustees can hold the business interest in a flexible way, until it becomes clear, at which point the discretionary trust can be changed into another type of trust. This type of trust is also useful in cases where the income needs of individual family members will differ over time.
A grandchildren's trust (called an 'accumulation and maintenance' trust) can hold the trust funds for children or grandchildren, or great-grandchildren whilst they are under the age of 25. While the beneficiaries are under the age of 25, the trustees can use the income of the trust fund to 'maintain' that particular beneficiary, or accumulate the income for them. When each of them reaches 25, the trust either changes to a different type of trust, or the assets are passed to the children, grandchildren or great-grandchildren outright. It is most common for each beneficiary to be entitled to the income from his or her share on reaching 25, and for the trust assets then to pass to the next generation on that beneficiary's death.
How long can trusts last?
Each trust is capable of lasting for 80 years, and so can hold the interest in the family business for one or two generations, depending on the age of the beneficiaries when the trust is created. If the purpose for which the trust has been created no longer exists, the trustees can 'bust' the trust at any time during the 80 years. The type of trust, and the rights of the various beneficiaries to the trust funds can also change during the life of the trust, to take into account not only differing circumstances but also the ages and needs of the beneficiaries themselves through time.
Each trust must have at least two trustees, and preferably no more than four trustees. The creator of the trust may be a trustee, as may other family members, even if they are also beneficiaries. Non-family members and professionals may also be appointed.
The identity of the trustees is important. Not only are they the custodians of the family's interest in the business and therefore must be entirely trustworthy, but also, if the trust funds are shares in a family company, the trustees will vote those shares. The trustees will vote a partnership share in accordance with any partnership agreement. When deciding on the trustees, creators of trusts should consider the balance of power within the business.
The trustees' role
Their role is simply to act as custodians of the trust assets for the family. They must always act in the best interests of the beneficiaries as a whole. It is usual for the creator of a trust to write a letter of guidance for the trustees (even if he is a trustee), explaining why the trust was created, and the purpose for which the trust exists. The trustees can take this letter of guidance into account when taking decisions. The letter becomes much more important for discretionary trusts, where the trustees' decisions will affect which of the beneficiaries will then receive funds.
Conflicts of interest
If a trustee is also a beneficiary, it is important that he or she can separate their personal interests as a beneficiary, from the decisions to be taken as a trustee. This is particularly important when deciding which family members should receive funds from a discretionary trust. If the trustee also holds shares in his or her own right, it is also important for them to separate the interests of the trust from their personal interests. There may well be a situation where the interests of the trust are best served by voting for the trust one way, whilst that trustee's personal interests are best served by voting a different way.
If the trustee is also a director of the family company, there are also potential conflicts between their role as director of the company, and as trustee shareholder. It is therefore important to give careful thought to the identity of the trustees.
The creator of the trust must consider, at the outset, what powers the trustees should have. In most cases the trustees will only have the powers given to them at the outset, and therefore it is important to consider how the trust (and family business) will be run in the future, and to provide as much flexibility for the trustees as possible.
Trustees of company shares must, for example, be given powers to participate in any reconstructions or amalgamations of the business, particularly where a liquidation of the existing business is involved. Similarly, the trustees may need the power to participate in any flotation of the company or to give warranties and indemnities on any sale, if it is ultimately concluded that the family wishes to exit.
By placing the interest in the business, or business assets into a trust, those assets are then protected by the trustees, whilst the family members, the beneficiaries, can still benefit from them. Control of the business can therefore be retained by the trustees for the family for up to 80 years. The trust itself can be very flexible, to take account of the family's changing circumstances and needs at any one time.
Other uses of trusts
Trusts are also a valuable tool in planning to avoid inheritance tax and capital gains tax. They can be used for example by a founder of a family business who wishes to step back from the business, and avoid tax, but who does not wish to lose control. The founder can place the business interest in a trust, and remain trustee, voting the shares or the partnership interest for the family.
Trusts are a very flexible way of holding family assets for up to 80 years. The trust can help protect the family business assets and retain the family's control over the business for the generations to come. Family members will have the benefit of controlling the business and of the income that flows from the company shares/asset or partnership interest, but without some of the risks of outright ownership. Trusts can therefore be used to solve a variety of current and future issues for the family, including tax.