FAMILY FEUDS IN TRUSTS: HOW TO ANTICIPATE & AVOID

First Run Broadcast: March 7, 2018

1:00 p.m. E.T./12:00 p.m. C.T./11:00 a.m. M.T./10:00 a.m. P.T. (60 minutes)

Family feuds are the most destructive force in trust and estate planning. When a senior

generation of a family dies or decides to pull back from leading a family company, long

suppressed rivalries, disputes and inter-personal conflicts rise to the surface and have an adverse

impact on the company’s operations and value. These disputes often place planners in the

extremely difficult spot of having gain the trust of warring factions, understand their grievances,

and use the tools of planning to help them and company find a value-preserving resolution of

their conflicts. This program will provide you with a real-world guide to identifying and

resolving family feuds in trusts.

• Sources of family feuds in trusts and techniques to resolve short of litigation

• Disputes involving distributions, control of assets/family business, personal rivalries, lack

of communication

• Techniques for resolution – outside consultants, ongoing family meetings, lifetime

gifting, distribution standards

• How choosing trustees can provoke or dampen family disputes

• Practical problems when an operating business is held in a family trust

• How to work with warring family factions while protecting yourself as lawyer

Speaker:

Daniel L. Daniels is a partner in the Greenwich, Connecticut office of Wiggin and Dana, LLP,

where his practice focuses on representing business owners, corporate executives and other

wealthy individuals and their families. A Fellow of the American College of Trust and Estate

Counsel, he is listed in “The Best Lawyers in America,” and has been named by “Worth”

magazine as one of the Top 100 Lawyers in the United States representing affluent individuals.

Mr. Daniels is co-author of a monthly column in “Trusts and Estates” magazine. Mr. Daniels

received his A.B., summa cum laude, from Dartmouth College and received his J.D., with

honors, from Harvard Law School.

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Family Feuds in Trusts: How to Anticipate & Avoid Teleseminar

March 7, 2018 1:00PM – 2:00PM

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Please note: This form is for your records in the event you are audited Sponsor: Vermont Bar Association Date: March 7, 2018 Seminar Title: Family Feuds in Trusts: How to Anticipate & Avoid Location: Teleseminar - LIVE Credits: 1.0 MCLE General Credit Program Minutes: 60 General Luncheon addresses, business meetings, receptions are not to be included in the computation of credit. This form denotes full attendance. If you arrive late or leave prior to the program ending time, it is your responsibility to adjust CLE hours accordingly.

ESTATE PLANNING FOR FAMILY BUSINESSES – FAMILY FEUDS IN TRUSTSAND TECHNIQUES TO RESOLVE THEM

Jennifer A. PrattVenable, LLP – Baltimore

(o) (410) 528-2883japratt@Venable.com

© Jennifer A. Pratt

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PERSPECTIVES ON CLOSELY-HELD BUSINESS: OPTIONS, GOALS, KEY ELEMENTS, AND MAJOR COMPONENTS

Let’s look at “different slices” or perspectives of Business Succession Planning:Options, Goals, Key Elements, and Major Components.

A. Options Regarding “Passing on” the closely-held business. Three basic options for the business owner are:

(1) Liquidate (either before or after death of the business owner). This is the decision not to continue the business, and it is the correct decision in some circumstances.

(2) Outside Sale: Sell to outsiders (either before or after death of the business owner). “Outsiders” means non-family members and individuals who are not existing Key Employees. This option is hard to achieve for most companies due to marketplace conditions, but in some circumstances it can be achieved.

(3) Continue the business as a going concern to family members, or Key Employees, or a combination of both. Some form of this third basic option is most often chosen. “Continuation” can take the form of an “internal sale,” or the form of a gift, or a combination. An “internal sale” is often the best way to maximize the value back to the business owner. “Internal sales” usually involve to a significant extent the phenomenon of: “B Y O W Y O $.”

B. Goals, To Be Achieved. The point of the business succession plan is to achieve the business owner’s particular goals. The business owner states his or her goals; and the business succession team advises regarding the techniques that achieve those goals.

(1) Transfer to Children.

(a) By gift techniques, or sale techniques, or both.

(b) Easiest when all children are involved in business. “Equality” between children in the business, and children not involved in the business, can sometimes be a difficult issue to resolve (see C (4) below).

(2) Transfer to Key Employees.

(a) Choose from the techniques involving stock ownership devices for Key Employees.

(b) Everything from a (simple) Combination (cash/stock) Bonus Plan, to a (complicated) ESOP (an Employee Stock Ownership Plan).

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(c) The perennial problem in this context is where the Key Employees get the money with which to buy the business. Future earnings of the business, and life insurance on the life of the business owner, are two of the most commonly used sources.

C. Ten Key Elements.

(1) Key Element #1: Retirement Planning.

(a) Providing adequate support for the lifestyle needs of the business owner during retirement is an essential component of business succession planning. The business owner did not work hard all of his or her life just for the privilege of continuing the business to family members or Key Employees.

(b) Qualified plans are one source of retirement dollars. The tax aspects of the design and administration of qualified plans is a complex topic all by itself.

(c) There are many sources of retirement dollars: (i) Proceeds from Qualified Plans; (ii) Proceeds from non-qualified Deferred Compensation Agreements, preferably funded with appropriate financial products like fixed or variable annuities; (iii) Consulting Agreements after retirement from Company; (iv) Sales or Redemptions of Company stock; (v) Real estate leased to Company; (vi) Equipment leased to Company; (vii) Non-company related investments; (viii) Inheritance from parents of the business owner.

(d) A comprehensive analysis of retirement needs and resources must be accomplished as part of the business succession plan. The business owner will expect this topic to be covered fully.

(2) Key Element #2: Passing Control and Equity. Moving management (voting) control and equity ownership to those family members and/or Key Employees who are actively involved in the closely held business is the essential task for the closely held business owner. This is “core issue” of business succession planning.

(3) Key Element #3: Providing Income Security. Taking care of the lifestyle and security needs of the surviving spouse and dependent children who are not active in the family business requires special attention.

(4) Key Element #4: Equality Issues.

(a) Many (but not all) business owners grapple long and hard with issues related to some sense of “equality” when considering the children active in the business versus the children who are not active in the business. This complex problem area has many aspects.

(b) Even if desired, “strict equality” is not really achievable, given differences at least in the timing of gifts to children (gift during lifetime versus

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gifts at death of estate owner). “Rough equality” tends to be the business owner’s goal, but that takes many forms in accordance with specific value judgments.

(c) How much has the child who is active in the business “earned” the right to receive the business, so as to augment what would otherwise be an equal overall share? Resentment and tensions among children have to be considered. Sometimes the business is asked to support, or help support, a child who is not active in the business.

(d) There is a wide spectrum of possible value judgments by the business owner: at one extreme, the active child receives the business and an equal share of the rest and residue; at the other extreme, all children share equally in the rest and residue, and the value of the business received by the active child counts against her equal share.

(e) Possible differences of opinion between Dad (“My child that is active in the business has earned the right to receive the entire business; plus an equal share of whatever else there is.”); and Mom (“We love all our children equally, and our other children will not be penalized because they chose a different path; all our children will receive an equal share of all the wealth, including the business.”)

(5) Key Element #5: Key Employee Compensation.

(a) Often a need to retain and reward one or more Key Employees, even though the business is continued to children. The children need the help and support of those Key Employees.

(b) Choose from the numerous compensation techniques available.

(6) Key Element #6: Buy-Sell Agreement.

(a) Widely-used technique both in family situations and in Key Employee situations.

(b) Essential to prevent stock (or LLC Membership Interest)from ending up in hands of an individual who is not involved in the business (unless that is part of the design, as in providing for a family member through planned annual distributions of S corporation dividends).

(c) Never transfer equity ownership to Family Member or Key Employee unless there is in effect already (or simultaneously with that transfer) a legally enforceable, written Buy-Sell Agreement. Typically see in the Agreement at a minimuma one-way option for the Corporation or LLC to re-acquire the equity ownership on the Family Member’s or Key Employee’s death, or disability, or termination of employment, or in the event the Family Member or Key Employee receives a bona fide offer to buy the same. Usually see mandatory purchase on death, however, payable over 5, 10 or 15 years with (typically) minimum AFR as the interest rate.

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(d) Section 2703 of Chapter 14 (effective 10/8/1990) specifically addresses Buy-Sell Agreements, and its requirements must be taken into account. In general, must use “fair market value” as appraised as measure of purchase price among family members; no longer able (if you ever were) to use “formula”generating “low-ball” price. Can use lack of control and lack of marketability discounts, however, in re-purchase by operating business entity of non-voting equity ownershipowned by Key Employee or Junior Family Members who do not own at that time any (significant amount of) voting equity interest.

(7) Key Element #7: Liquidity Planning.

(a) Absolutely essential. Is the business succession plan practical and will the plan work?

(b) This “classic” estate planning problem area takes on a new urgency because high transfer taxes (chiefly, the federal estate tax) can jeopardize the ability of the closely held business to continue. The liquidity needs per se of the closely held business (for working capital; to retire debt and bank loans; to provide a strong balance sheet for bonding purposes; to replace in some cases the loss of the key man) have to be provided for, as well as the liquidity needs of the business owner’s estate.

(c) Life insurance and life insurance planning is usually a large part of the answer.

(d) ILIT: the irrevocable life insurance trust is one of the most effective business continuity techniques available today.

(e) The business owner needs expert insurance advice. To design life insurance products that respond to the business owner’s business continuity goals. To shop around and find the most cost-effective life insurance product. To advise as an expert on the credit-worthiness and safety of different life insurance companies. To give good service in the ongoing ownership of that life insurance product.

(8) Key Element #8: Minimize Taxes.

(a) A major part of business succession planning is minimizing taxes.

(b) Minimizing taxes directly impacts: the extent that existing assets achieve a high level of family security; how hard it is to achieve “equality” among children; and the size of the liquidity problem.

(c) Transfer taxes: estate tax, gift tax and GST tax (generation skipping transfer tax).

(d) Income taxes.

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(9) Key Element #9: Valuation.

(a) Valuation of the closely held business is itself a complex planning area which in many cases provides a real opportunity to minimize the total tax liabilities, and therefore greatly improves family security, helps achieve “equality” and decreases the liquidity need.

(b) Again, the business owner needs expert valuation advice.

(10) Key Element #10: Possible Bonding Issues.

(a) It is crucial for the survivorship of a closely-held construction business (for example) that bonding issues be addressed comprehensively as part of the planning process.

(b) Whose strong balance sheet will replace that of the business owner after his demise? What if the surviving spouse will not sign? What if the surviving spouse should not sign?

(c) What if some children active in the business will sign and others will not?

(d) How can we replace that portion of the net worth from the balance sheets of the senior generation husband and wife which has been used to pay federal estate taxes?

D. A Final Perspective on Business Succession Planning: the Three Major Components. (1) Ownership Transfer Plan (what is the timetable for ownership of equity to be transferred by business owner to new owners), versus (2) Management Succession Plan (what is the timetable for business owner to give up operational control of business decisions, and in what stages), versus (3) Contingency Plan (what happens to management power and equity ownership if business owner dies suddenly and prematurely).

Warding Off Analysis Paralysis*

David T. Leibell, Esq. – Wiggin and Dana LLP – dleibell@wiggin.comDaniel L. Daniels, Esq. – Wiggin and Dana LLP – ddaniels@wiggin.com

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Guest Article

We’ve all heard the family business statistics before, but they’re

worth repeating.1 Approximately 90 percent of U.S. businesses

are family firms. They range in size from small “mom-n-pop”

businesses to the likes of Walmart, Ford, Mars and Marriott.

There are more than 17 million family businesses in the United

States, representing 64 percent of gross domestic product

and employing 62 percent of the U.S. workforce. Thirty-five

percent of the businesses that make up the S&P 500 are family

controlled. Family businesses are also more successful than

non-family businesses, with an annual return on assets that’s

6.65 percent higher than the annual return on assets of

non-family firms. Unfortunately, only a little more than 30 percent

of family businesses survive into the second generation, even

though 80 percent would like to keep the business in the family.

By the third generation, only 12 percent of family businesses

will be family-controlled, shrinking to 3 percent at the fourth

generation and beyond.

The disconnect between what 80 percent of families intend and

the far bleaker reality can primarily be attributed to a failure to plan

effectively for both the family dynamics issues and the complex

estate strategies necessary for successful family business

succession. A companion piece to this article, titled “Succession

Planning,” in the March 2011 issue of Trusts & Estates2 dealt

exclusively with the role that family dynamics plays in the success

or failure of family business succession planning. This article will

focus exclusively on the technical estate planning issues involved

in family business succession.

Take it in Phases

Estate planning for a family business owner is extremely complex.

It can involve virtually all of the tools in the estate planner’s toolbox,

including straightforward testamentary planning, advanced

gift planning, insurance issues, buy-sell agreements, and

corporate recapitalizations. As estate planners, if we attempt to

address all of these issues at once, we risk overwhelming the

client, resulting in no estate planning getting done at all. Some

call this “analysis paralysis.” Our experience has shown that we

can often avoid analysis paralysis by breaking down the planning

into Phase I and Phase II.

Phase I planning involves those steps the business owner can

take that produce a relatively large benefit to the client or his

family but at a relatively low cost. In using the term “cost,” we’re

not thinking solely of professional fees. Instead, for a business

owner, the costs of implementing a planning idea can also include

such things as whether the strategy involves a loss of control

or access to cash flow, a significant investment of the owner’s

time, or even the emotional cost of addressing a particular

family issue. For a business owner, essential elements of Phase I

planning include testamentary transfer tax planning, planning for

the management of assets left to a surviving spouse or children, * This article was previously published in the June 2011 issue of Trust & Estates.1. Family Firm Institute, Inc., Global Data Points, www.ffi.org/default.asp?id=398.2. David Thayne Leibell, “Succession Planning,” Trusts & Estates (March 2011) at p. 16.

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asset protection planning, incapacity planning, liquidity planning,

including consideration of a buy-sell agreement and life insurance.

Phase II estate planning for the business owner involves those

planning ideas that may provide a significant benefit to the owner

or his family but at a greater cost in terms of a greater commitment

of the owner’s time in implementing the plan, more complexity and

professional fees, loss of control or access to cash flow, or all of

the above. Examples of Phase II planning concepts include liability

protection planning, advanced lifetime wealth transfer planning,

and testamentary planning at a level of sophistication beyond that

considered in Phase I.

Phase I

Testamentary Transfer Tax Planning

Under current law, a federal estate tax is imposed on all assets

owned by an individual at death at a rate of 35 percent. Each

individual is entitled to an exemption from the tax of $5 million.

There’s also an unlimited exemption from the tax for transfers

between spouses, known as the marital deduction, provided

that the recipient spouse is a U.S. citizen.3 If an individual

transfers assets to grandchildren, or to certain types of trusts for

children that terminate in favor of grandchildren or more remote

descendants, a separate generation-skipping transfer (GST)

tax is imposed, again at a 35 percent rate and with a $5 million

exemption. As of Jan. 1, 2013, unless Congress acts to change

the law, the top federal estate and GST tax rate will rise to 55

percent and the exemption will decrease to $1 million.4 In addition,

some states impose an independent state-level estate tax at

rates that can run as high as 16 percent or more. There are some

simple steps, however, that a business owner can take to minimize

these taxes at his death, including:

Two-share tax planning. If the owner is married, her will or revocable trust agreement should contain planning to guarantee optimal use of both spouses’ federal estate tax exemptions. Traditionally, this guarantee was accomplished by the business owner dividing her estate into two shares. The first share, sometimes called the “exemption share,” would be an amount equal to the owner’s federal estate tax exemption and the second share, sometimes called the “marital share,” would be the balance of the owner’s estate. The exemption share would pass to a trust, sometimes called a “credit shelter trust” or “bypass trust,” and the marital share would pass outright to the surviving spouse or to a qualifying marital trust for his benefit. The surviving spouse could be given generous rights over the credit shelter trust, including perhaps the right to the income, principal as needed and even a limited testamentary power of appointment,

but would not be given “enough” rights to be called the owner of the trust for estate-tax purposes. In this way, the trust would pass through the owner’s estate with no federal estate tax (because it utilizes the owner’s estate tax exemption) and through the surviving spouse’s estate with no estate tax, as well (because the surviving spouse didn’t own the trust for tax purposes). There would be no federal estate tax on the marital share at the owner’s death because of the unlimited marital deduction. At the surviving spouse’s death, the first $5 million of assets included in his estate would pass to the children, tax-free, as a result of the surviving spouse’s estate tax exemption. As a result, the couple would have succeeded in sheltering two estate tax exemptions – or $10 million under current law – to the next generation rather than only one. The Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (2010 Tax Act) provides for portability of estate tax exemptions between spouses. Thus, it shouldn’t be necessary to use the two-share structure described to shelter a full $10 million of assets from tax for the children’s generation. However, in our practice, we’ve generally recommended that clients continue to use the two-share structure rather than relying on portability for a number of reasons, including 1) The statute establishing portability is scheduled to expire at the end of 2012; 2) relying on portability fails to capture increases in the value of the exemption share between the date of the first and second spouses’ deaths; 3) there’s no portability of GST tax exemptions; and 4) relying on portability precludes use of the general benefits of a credit shelter trust, including creditor protection, the ability to sprinkle income among various trust beneficiaries, thereby potentially saving income tax for the family, and the ability to sprinkle principal among various trust beneficiaries, thereby possibly enabling greater tax-free gifting than would be available by relying on portability.

Generation skipping planning. The two-share plan described previously can be supercharged by adding generation skipping planning. Under a generation skipping plan, the wills or revocable trust agreements of the owner and spouse would provide that the $10 million that the couple would otherwise transfer outright to the children tax-free using the two-share planning would instead be transferred to generation skipping trusts for the children. The trusts would be designed so that each

3. If the recipient spouse is a non-U.S. citizen, the marital deduction is available only if the transfer is made to a qualified domestic trust for the benefit of the recipient spouse. Very generally speaking, a qualified domestic trust is a trust of which the recipient spouse is the only beneficiary and which has a United States resident trustee (which, in some cases, must be a United States bank). Internal Revenue Code Section 2056(d).

4. The generation skipping transfer (GST) tax exemption is indexed for inflation, with the result that the GST exemption in effect in 2013 will be somewhat more than $1 million. See “Dynasty Trusts,” Daniel L. Daniels and David T. Leibell, Trusts & Estates April 2007, at p. 36.

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child could receive income and principal from his trust as needed, but the child wouldn’t be treated as the owner of the trust for estate tax purposes. As a result, to the extent the trust assets weren’t consumed by the child during the child’s lifetime, they would pass to the child’s children estate and GST tax-free.4

Spousal Marital Trusts

If the business owner doesn’t want her spouse to have control

over inherited assets, or if she simply wants to ensure that the

spouse can’t leave the inherited assets to a new spouse should

he remarry after the business owner’s death, the business owner

can establish a marital trust to receive the spouse’s share of the

estate. The business owner would name some trusted individual or

institution to serve as a trustee of this trust, often with the spouse

as a co-trustee. The spouse would receive income for life, and

principal too, if needed. Upon the surviving spouse’s death, the

trust terms mandate that the trust assets pass to the owner’s

children, thereby eliminating the ability of the spouse to give those

assets to a new spouse should he remarry.

The marital trust may provide an additional benefit for certain

business owner families. Consider the following two examples. In

the first example, suppose the business owner holds 90 percent

of the stock in “Bizco,” with the remaining 10 percent owned by

outside shareholders. If the owner leaves the Bizco stock outright

to her husband (and the husband is a U.S. citizen), the husband

will inherit it tax-free. However, when the husband later dies, he

now owns a 90 percent interest in Bizco which, presumably, will

be valued in the husband’s estate with a control premium. In the

second example, suppose instead that, during their lifetimes, the

business owner and her husband were to divide the stock between

them, with the owner taking 45 percent and the husband taking 45

percent. Further suppose that instead of leaving the stock outright

to her husband, the owner were to leave the stock to a marital

trust for his benefit. At the husband’s death, instead of his estate

including one 90 percent block of stock, it includes a 45 percent

block owned by the estate and a second 45 percent block owned

by the marital trust. If the marital trust is properly designed, case

law supports the estate taking the position that the two blocks of

stock should be valued separately, with the result that a minority

interest discount should be available in the second example, as

opposed to the control premium that applied in the first example.5

In our practice, we find that, at least with business owners who

are in long, happy marriages, this technique is a simple – and for

many business owners, painless – way to reduce the value of the

business owners’ estates for tax purposes.

Asset Protection Trusts

Many business owners won’t want to pass ownership of the

business outright to a child or other descendant. Assets left

outright to a child are exposed to the claims of creditors, divorcing

spouses, and others who may influence the recipient to sell

or otherwise use the assets in a manner inconsistent with the

business owner’s intentions. If the business owner instead leaves

the assets to a properly designed asset protection trust, the assets

can receive a significant measure of protection from the claims of

the descendant’s creditors or divorcing spouse. In our practice,

we often find that business owners think that they already have

such protection in their wills or revocable trust agreements, but are

surprised to learn that if the descendant has the right to withdraw

the trust funds at a particular age, the trust may not provide much

protection at all.

Liquidity and Life Insurance

For a wealthy business owner, the tax planning described typically

won’t be sufficient to shelter the entire estate from federal and

state estate taxes. Federal and state estate taxes are typically

due no later than nine months after death. And an astonishing

93 percent of family business owners have little or no cash flow

outside the business, according to the 2007 Laird Norton Tyee

Family Business Survey.6 Accordingly, to avoid a forced sale of the

business at suboptimal prices, if there’s a transfer tax exposure at

the owner’s death, it’s critical to ensure that sufficient liquidity is

available to pay the tax. This result can be accomplished through

the use of buy-sell agreements in combination with life insurance

planning.

1. Buy-sell agreements. A buy-sell agreement is a contractual

arrangement providing for the mandatory purchase (or right of first

refusal) of a shareholder’s interest, either by 1) other shareholders

(in a cross-purchase agreement); 2) the business itself (in a

redemption agreement); or 3) some combination of the other

shareholders and the business (in the case of a hybrid agreement)

upon the occurrence of certain events described in the agreement

(the so-called “triggering events”). The most important of the

triggering events is the death of a shareholder, but others include

the disability, divorce, retirement, withdrawal, or termination of

employment or bankruptcy of a shareholder.

A buy-sell agreement’s primary objective is to provide for the

stability and continuity of the family business in a time of transition

through the use of ownership transfer restrictions. Typically, such

agreements prohibit the transfer to unwanted third parties by

setting forth how, and to whom, shares of a family business may

be transferred. The agreement also usually provides a mechanism

for determining the sale price for the shares and how the purchase

will be funded.

5. See, e.g., Mellinger v. Commissioner, 112 T.C. 4 (1999), action on decision, 1999-006 (Aug. 30, 1999).6. See “Laird Norton Tyee Family Business Survey, Family to Family, 2007,” http://familybusinesssurvey.com/2007/pdfs/LNT_familybusinesssurvey_2007.pdf.

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Other reasons for a buy-sell agreement depend on the party to

the agreement:

The founder – For someone who’s built the business from nothing and feels that no one can run it as well as she can, a buy-sell agreement allows the founder to maintain control while providing for a smooth transition to her chosen successors upon her death or disability. Structuring a buy-sell agreement can provide a non-threatening forum for the founder to begin thinking about which children should be managing the business in the future and which should not. Typically, a founder will want only those children who are active in the business to own a controlling interest in the stock, but will want to treat all children equally in terms of inheritance. A buy-sell agreement allows the founder to sell control to children who are active in the business and use some of the proceeds from the sale to provide for the children who aren’t active in the business. By specifically carrying out the founder’s intent, a properly structured buy-sell agreement avoids the inevitable disputes between the two sets of children with their competing interests.

The next generation – For those children who are active in the business, a properly structured buy-sell agreement will allow them to purchase the founder’s shares over time on terms that have been negotiated at arm’s length, won’t cripple their ability to operate the business, and may be at least partially paid by life insurance proceeds on the life of the founder. The agreement also provides a mechanism for not having to go into business with siblings (or spouses of siblings) who aren’t active in the business.

The business – A buy-sell agreement can help keep the business in the family and assure a smooth transition to the next generation. The agreement can also void transfers that would result in the termination of the entity’s S Corporation status.

The founder’s estate – A buy-sell agreement can provide: 1) a market for an illiquid asset avoiding a fire sale because the sale price is determined by the agreement; 2) liquidity to pay any estate taxes; and 3) money for a surviving spouse. But under virtually no circumstances in the family business context will a “low ball” value for selling the business be respected by the Internal Revenue Service (so don’t try it).7

2. The role of life insurance. Business owners’ estates are

inherently illiquid, with the business and the business real estate

often representing the lion’s share of the value of the estate. Family

business owners are often good candidates for life insurance,

which can provide instant liquidity at the business owner’s death

to pay estate taxes, provide for children who aren’t active in the

business, fund the buy-sell agreement, and provide for a spouse

from a second marriage.

We typically suggest that the business owner consult with

a highly qualified insurance professional in connection with

liquidity planning. We find that the type of life insurance the

insurance professional usually recommends in the family business

succession context is permanent insurance and in particular

guaranteed universal life insurance, which typically provides the

largest guaranteed death benefit for the lowest cost. Although life

insurance proceeds aren’t income taxable to the beneficiary, such

proceeds are typically taxable in the insured’s estate. That’s why

it’s so important for the insurance to be owned by an irrevocable

life insurance trust (ILIT) in which the proceeds won’t be subject to

estate tax because they aren’t considered owned by the business

owner’s estate. ILITs can be structured to own single life insurance

policies that pay out on the death of the business owner or second-

to-die life insurance policies, which pay out on the death of the

survivor of the business owner and her spouse, which is typically

when estate taxes are due. It’s important to remember that if a

business owner transfers an existing life insurance policy and

dies within three years of the transfer, the proceeds are brought

back into her taxable estate under IRC Section 2042. Whenever

possible, structure the transaction to have the insurance trust be

the initial purchaser of the policy so the insurance is out of the

business owner’s estate from day one.

Paying for the insurance depends on who owns the policy. If the

insurance is owned by the other shareholders or the corporation

in the context of a buy-sell agreement, there should be no gift

consequences on paying premiums. Sometimes the insurance

ownership is bifurcated between the business owner and the

corporation or between the business owner and certain family

trusts. This bifurcated ownership is known as split dollar, and

it’s crucial that the business owner work with an attorney and an

insurance professional who are both highly experienced in the area

of split-dollar planning, since it’s filled with tax traps. If the insured

is providing money to pay the premiums on the insurance owned

by the irrevocable insurance trust, she can often avoid paying gift

tax by qualifying the transfers as present interests gifts to the trust

following the process set forth in Crummey v. Commissioner and

its progeny.8 If available annual exclusions are insufficient to pay

premiums, the business owner can consider funding the insurance

trust with some or all of her $5 million federal gift tax exemption.

Remember, the $5 million exemption is only available, unless

extended, through Dec. 31, 2012.

7. “A Practical Guide to Buy-Sell Agreements,” David T. Leibell and Daniel L. Daniels, Trusts & Estates, March 2008 at p. 49.8. Crummey v. Commissioner, 397 F.2d 82 (9th Cir. 1968).

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Incapacity Planning

A final piece of Phase I is incapacity planning. If the owner

becomes incapacitated and no planning has been done, the family

may be forced to ask a court to appoint a guardian or conservator

to manage the owner’s financial and personal affairs. This result

can be avoided in almost all cases through the simple expedient

of a properly designed power of attorney and health care proxy

naming the appropriate individual to make financial and health

care decisions in the event of the owner’s incapacity. As a power

of attorney can sometimes be an unwieldy document to make

decisions regarding a complex business enterprise, we often

suggest that the business owner also execute a revocable living

trust agreement. The owner’s interest in the business can be

transferred to the revocable trust during the owner’s lifetime and,

while the owner has capacity, she can be the trustee. Upon the

owner’s incapacity, a new trustee would step in to make decisions

regarding the business interests held in the trust. This approach can

be preferable to a power of attorney because the trust agreement

can include detailed instructions for the trustee as to how to make

decisions relating to the business. The trust agreement can also

provide greater flexibility for appointing additional or successor

trustees; this can be more difficult to do with a power of attorney.

Phase II

Liability Protection Planning

The business activities may give rise to liability risks. A well-

constructed estate plan will address these risks and consider

methods for insulating the owner’s assets from those risks. While

it’s tempting for clients – and sometimes for their advisors – to think

that liability protection mainly involves complex trust or corporate

structures to shelter assets, we usually advise clients to first visit

with their property and casualty insurance advisor to ensure that

their liability insurance is adequate. A properly structured property

and casualty insurance program not only can protect the business

and the business owner from catastrophic losses, but also often

will provide a benefit that’s less discussed but perhaps equally

important – the payment of legal defense costs in the event of a

lawsuit against the business owner or the company. We typically

advise a thorough review of the insurance programs for both

the business and the business owner, including implementing a

healthy amount of umbrella coverage over and above the owner’s

primary insurance coverage.

For further liability protection, the business owner might

consider “insulation” strategies. One insulation strategy involves

segregating each of the business’s risky activities inside its own

liability-shielding structure such as a corporation, limited liability

company (LLC) or limited partnership. For example, suppose

that the owner’s primary business is manufacturing and that the

business is operated in a building owned by the business owner

individually. Each activity – the manufacturing business and the

operation of the real estate in which the business is housed –

should be insulated inside its own corporation or other entity. That

way, in the event of a lawsuit involving the manufacturing activities,

arguably only the assets of the manufacturing business itself, and

not the real estate owned in the separate entity or the business

owner’s other assets, are exposed to the lawsuit. Although a full

discussion of choice of entity is beyond the scope of this article,

it often will be beneficial for the chosen entity to be a partnership

or LLC, rather than a corporation, because the partnership or LLC

receives pass-through status for income tax purposes.9

Advanced Lifetime Planning

For many advisors, wealth transfer planning is the starting point

for planning for the business owner. For us, however, discussions

about transferring assets to save estate taxes or to bring the junior

generation into the business generally don’t begin until after Phase

I of the plan has been implemented. We find that this approach

produces two benefits. First, it helps ensure that the business

owner gets some plan in place instead of engaging in endless and

sometimes confusing discussions about lifetime wealth transfer

planning, all the while possibly having done nothing to ensure the

orderly passage and operation of the business in the event of the

owner’s death or incapacity. Second, time after time, we find that

the very process of going through Phase I planning can help the

business owner develop a comfort level with estate planning in

general that can make it easier to come to terms with the hard

decisions that often need to be made about asset transfers,

management succession, loss of control, or loss of access to cash

flow, in implementing Phase II of the plan.

As complex as lifetime wealth transfer can be, from the standpoint

of taxes alone, it’s actually quite simple. If an individual attempts

to transfer assets during life to avoid an estate tax, the transfer

will generally instead be subject to a federal gift tax. Since the

gift tax and the estate tax apply at the same rates and generally

have the same exemptions, there should be no incentive for an

individual to transfer wealth during life as opposed to waiting

to transfer it at death. In effect, by enacting the gift tax as a

companion to the estate tax, Congress created an “airtight”

transfer-tax system. There are, however, leaks in that system. The

three primary examples of those leaks are removing value from the

system, freezing value within the system, and discounting values

within the system.

Removing value from the system is hard to do. In most cases, if an

individual makes a gift during lifetime, that gift is brought back into

the taxable estate at death for purposes of calculating the estate

tax on the individual’s estate. However, there are two exceptions

to this general rule, which are the annual gift tax exclusion and the

“med/ed” exclusion. If an individual makes a gift using his $13,000

annual gift tax exclusion, the gifted property is entirely removed

from the taxable estate. Individuals are also permitted to make gifts

9. An S Corporation generally receives pass-through status as well, but can be less beneficial than a partnership or LLC at the death of the owner. Assets held inside a partnership or LLC can receive a stepped up cost basis if a proper election under Section 754 of the IRC is made. The Section 754 election isn’t available for assets held inside an S Corporation.

©20126

of unlimited amounts for tuition and certain medical expenses, as

long as the payment is made directly to the provider of services.

Such med/ed gifts are entirely excluded from the taxable estate.

Freezing value within the system usually connotes the individual

making a gift using some or all of his lifetime exemption from

federal gift tax. For example, a business owner might make a gift

of $5 million worth of stock in the business to a child. Upon the

owner’s death, the $5 million gift is brought back into the estate for

purposes of calculating the owner’s estate tax. However, it’s only

brought back into the estate at its value at the time the gift was

made and should be sheltered from tax at that time via the use of

the owner’s $5 million estate tax exemption.10 Accordingly, if the

value of the gifted property increases between the date of the gift

and the date of the owner’s death, the appreciation avoids transfer

tax. That is to say, the owner succeeds in “freezing” the value of

the gifted property at its date-of-gift value.

A holy grail of estate planners has been to find a way of freezing

the value of an asset at some number lower than what it is actually

“worth” to the owner’s family, also known as discounting values.

Suppose a business owner owns all of the stock in business with

an enterprise value of $5 million. If the business owner gives all

of the stock to her child, she will have made a taxable gift of $5

million. On the other hand, suppose that the business owner gives

half the stock to one child and half to the other child. An appraiser

is likely to opine that the interests received by the children are

subject to lack of control discounts, since either child could

deadlock the other in a vote involving the stock. If the appraiser

applies, say, a 20 percent lack of control discount, the value of

the gift would be reduced to $4 million. Accordingly, the business

owner succeeds in freezing values at something less than the full

value of the business in the eyes of the family as a whole.11

One of our favorite examples of a technique that can remove,

freeze, and discount values all in one fell swoop is the spousal

estate reduction trust (SERT). In a typical SERT, the owner creates

an irrevocable trust, naming her husband or some other trusted

individual or institution as trustee. During the life of the owner

and her spouse, the trustee is authorized to sprinkle income and

principal among a class consisting of the owner’s husband and

descendants. Upon the death of the husband, the remaining

trust assets are divided into shares for descendants and held in

further trust. The owner’s gifts to the SERT can qualify for the gift

tax annual exclusion because the trust would include Crummey

withdrawal powers for each of the owner’s descendants. This

removes value from the owner’s estate. If desired, the owner

could use the trust as a repository for a larger gift using her

lifetime gift tax exemption, thereby freezing values for transfer-

tax purposes. Moreover, the asset to be gifted to the trust can be

interests in the closely held business, which a qualified appraiser

may value by applying discounts for lack of control and lack of

marketability, thereby achieving a discounting of asset values for

transfer tax purposes.

Beyond being a good vehicle through which to achieve the wealth

transfer trifecta of removing, freezing, and discounting values,

the SERT provides a number of other benefits. The trust includes

the grantor’s spouse as a beneficiary. To avoid an argument that

the trust should be included in the grantor’s estate under Internal

Revenue Code Section 2036, the grantor mustn’t have any

legal right to the assets held in the SERT, nor can there be any

prearrangement or understanding between the grantor and her

spouse that the grantor might use assets in the trust. Nonetheless,

if the grantor is in a happy marriage, it can be comforting to

know that her spouse will have access to the property in the trust

even after the gift. As an additional benefit, the SERT would be

established as a grantor trust for income tax purposes. As a result,

the business owner would pay income tax on the income and gains

earned by the trust. This depletes the owner’s estate and enhances

the value of the trust, but isn’t treated as a taxable gift, in effect

providing a very powerful additional means of removing value from

the transfer tax system. Finally, the business owner could allocate

her GST tax exemption to the SERT, thereby removing the gifted

assets from the transfer tax system for multiple generations.

Additional popular wealth transfer strategies for business interests

include the grantor retained annuity trust (GRAT) and the sale to an

intentionally defective irrevocable trust (IDIT). The basic concept

behind a GRAT is to allow the business owner to give stock in the

business to a trust and retain a set annual payment (an annuity)

from that property for a set period of years. At the end of that

period of years, ownership of the property passes to the business

owner’s children or to trusts for their benefit. The value of owner’s

taxable gift is the value of the property contributed to the trust,

less the value of her right to receive the annuity for the set period

of years, which is valued using interest rate assumptions provided

by the IRS each month pursuant to IRC Section 7520. If the GRAT

is structured properly, the value of the business owner’s retained

annuity interest will be equal or nearly equal to the value of the

property contributed to the trust, with the result that her taxable gift

to the trust is zero or near zero. How does this benefit the business

owner’s children? If the stock contributed to the GRAT appreciates

and/or produces income at exactly the same rate as that assumed

by the IRS in valuing the owner’s retained annuity payment, the

children don’t benefit because the property contributed to the

trust will be just sufficient to pay the owner her annuity for the

set period of years. However, if the stock contributed to the trust

appreciates and/or produces income at a greater rate than that

assumed by the IRS, there will be property “left over” in the trust

at the end of the set period of years, and the children will receive

that property – yet the business owner would have paid no gift tax

10. In the view of some commentators, if the decedent makes a gift in a year when the gift tax exemption is $5 million but dies in a year in which the exemption is some lower amount, the estate will be taxed on the difference between the two exemptions. This is sometimes referred to as a “claw back” of the tax that “should have been” paid on the gifted asset. For a good discussion of this complex issue, see Evans, “Complications from Changes in the Exclusion,” LISI Estate Planning Newsletter #1768 (Jan. 31, 2011) at www.leimbergservices.com.

11. In Revenue Ruling 93-12, 1993-7 I.R.B. 13 (Feb. 16, 1993), revoking Rev. Rul. 81-253, 1981-1 C.B. 187. the IRS ruled that gifts of separate minority interests in stock wouldn’t be aggregated for purposes of determining whether a lack of control discount should be applied.

©2012 7

on it. The GRAT is particularly popular for gifts of hard-to-value

assets like closely held business interests because the risk of an

additional taxable gift upon an audit of the gift can be minimized. If

the value of the transferred stock is increased on audit, the GRAT

can be drafted to provide that the size of the business owner’s

retained annuity payment is correspondingly increased, with the

result that the taxable gift always stays near zero.

When we suggest a GRAT to a business owner, we nearly always

invite her to compare the GRAT with its somewhat riskier cousin,

the IDIT sale. The general IDIT sale concept is fairly simple. The

business owner makes a gift to an irrevocable trust of, say,

$100,000. Some time later, the business owner sells, say, $1 million

worth of stock to the trust in return for the trust’s promissory note.

The note provides for interest only to be paid for a period of, say, 9

years. At the end of the 9th year, a balloon payment of principal is

due. The interest rate on the note is set at the lowest rate permitted

by the IRS regulations. There’s no gift because the transaction is

a sale of assets for Fair Market Value. There’s no capital gains tax,

either, because the sale is between a grantor and her own grantor

trust, which is an ignored transaction under Revenue Ruling 85-13.

How does this benefit the business owner’s children? If the

property sold to the trust appreciates and/or produces income at

exactly the same rate as the interest rate on the note, the children

don’t benefit, because the property contributed to the trust will be

just sufficient to service the interest and principal payments on the

note. However, if the property contributed to the trust appreciates

and/or produces income at a greater rate than the interest rate on

the note, there will be property left over in the trust at the end of

the note, and the children will receive that property, gift tax-free.

Economically, the GRAT and IDIT sale are very similar techniques.

In both instances, the owner transfers assets to a trust in return for

a stream of payments, hoping that the income and/or appreciation

on the transferred property will outpace the rate of return needed

to service the payments returned to the owner. Why, then, do

some clients choose GRATs and others choose IDIT sales?

The GRAT is generally regarded as a more conservative technique

than the IDIT sale. It doesn’t present a risk of a taxable gift in the

event the property is revalued on audit. In addition, it’s a technique

that’s specifically sanctioned by IRC Section 2702. The IDIT sale,

on the other hand, has no specific statute warranting the safety

of the technique. The IDIT sale presents a risk of a taxable gift if

the property is revalued on audit and there’s even a small chance

the IRS could successfully apply Section 2702 to assert that the

taxable gift is the entire value of the property sold rather than

merely the difference between the reported value and the audited

value of the transferred stock. Moreover, if the trust to which

assets are sold in the IDIT sale doesn’t have sufficient assets

of its own, the IRS could argue that the trust assets should be

brought back into the grantor’s estate at death under IRC Section

2036. Also, with a GRAT, if the transferred assets don’t perform

well, the GRAT simply returns all of its assets to the grantor and

nothing has been lost other than the professional fees expended

on the transaction. With the IDIT sale, on the other hand, if the

transferred assets decline in value, the trust will need to use some

of its other assets to repay the note, thereby returning assets to the

grantor that she had previously gifted to the trust – a waste of gift

tax exemption.

Although the IDIT sale is generally regarded as posing more

valuation and tax risk than the GRAT, the GRAT presents more

risk in at least one area, in that the grantor must survive the term

of the GRAT for the GRAT to be successful; this isn’t true of the

IDIT sale. In addition, the IDIT sale is a far better technique for

clients interested in generation skipping planning. The IDIT trust

can be established as a dynasty trust that escapes estate and gift

tax forever. Although somewhat of an oversimplification, the GRAT

generally isn’t a good vehicle through which to do generation

skipping planning.12

As important as it may be for the business owner to understand the

risks and benefits of a GRAT versus an IDIT sale, in our practice

we’ve found that the primary driver of which technique to choose

is cash flow. With an IDIT sale, the note can be structured such

that the business owner receives only interest for a period of years,

with a balloon payment of principal and no penalty for prepayment.

This structure provides maximum flexibility for the business to

make minimal distributions to the IDIT to satisfy note repayments

when the business is having a difficult year and for the business

to make larger distributions in better years. With the GRAT, on the

other hand, the annuity payments to the owner must be structured

so that the owner’s principal is returned over the term of the

GRAT, and only minimal backloading of payments is permitted.

Accordingly, the GRAT tends to be the technique of choice where

the business produces fairly predictable cash flow while the IDIT

sale is chosen more often when cash flow is more erratic.

Additional Advanced Strategies

In addition to the estate planning strategies for family business

owners that have already been discussed, there are a number of

other estate planning strategies for family business owners that can

be extremely effective in the right circumstance but are beyond the

scope of a general overview. These include preferred partnership

freezes (private annuities and self-cancelling installment notes

(SCINs). The unique nature of particular industries, such as

commercial real estate, can also require highly tailored estate

planning strategies. While many of these advanced strategies

require separate articles of their own, we can address a few

here, including charitable planning strategies, the special issues

presented by holding closely held business interests in trust, and

postmortem planning.

12. It’s not possible to allocate GST exemption to a grantor retained annuity trust (GRAT) until the close of the estate tax inclusion period, which is the end of the GRAT term. By that time, most of the anticipated appreciation in value may have occurred, thereby preventing the leveraging of the owner’s generation skipping exemption. IRC Section 2642(f)(1).

©20128

1. Charitable planning. Although lifetime charitable strategies,

other than the charitable stock bailout, in which a charitable

remainder trust is used to redeem the senior generations’ shares in

a tax-efficient manner, are typically not common in family business

succession planning, testamentary charitable planning strategies

can be among the most effective estate planning strategies for

business owners who have done little or no lifetime planning.

Using what’s known as the testamentary note-CLAT, this kind of

planning can not only, under the right circumstances, keep the

next generation of family members in control of the business,

but also minimize or eliminate estate taxes and provide some

amount for charity, even for a private foundation controlled by the

business owner’s family.13

A second highly effective testamentary strategy is known as a

charitable lid. Although it can be structured in a variety of ways,

basically a charitable lid is a planning technique that guarantees

that if the IRS questions a valuation discount on an estate or gift

tax audit and succeeds, the difference won’t go to the IRS in the

form of estate or gift tax, but rather to one or more charities named

in the estate plan. This type of planning is thought to discourage

the IRS from questioning valuation discounts, because even if the

IRS succeeds, it won’t collect any additional amounts since such

amounts will pass to charity.14

2. Holding closely held business interests in trust. Under the

Uniform Prudent Investor Act, which has been adopted in most

jurisdictions, trustees are required to diversify trust assets unless

special circumstances or a specific direction justify not diversifying.

Diversifying many times defeats the purpose behind most trusts

holding family business interests – which is to preserve the

business in the family. How do we protect trustees of trusts that

hold concentrated positions in family businesses from surcharge

liability for failure to diversify?

One way is to indemnify the trustee for failure to diversify out

of the family business interests by specifically referencing the

business in the trust instrument and instructing the trustee

to continue to hold the stock unless certain specified events

occur. These events could include continued poor performance

of the business over a period of years or the consent of all or a

supermajority of the beneficiaries.

If the trustee is still concerned, even with the protective language,

it would be prudent to establish the trust as a directed trust in

a state like Delaware. Under a directed trust, the trustee would

serve primarily as an administrative trustee and a committee not

involving the trustee (but likely including family members) handles

investment issues regarding the family business.

3. Post-mortem planning. Sometimes, the family business owner

never gets around to doing effective liquidity planning. If that’s the

case, the tax code provides assistance by offering the ability under

certain circumstances for the estate tax to be paid over a period of

years to avoid a fire sale of the business to pay estate taxes. IRC

Section 6161 allows a one-year hardship extension (renewable

with IRS approval) for reasonable cause in the discretion of the

IRS. IRC Section 6166 allows a 14-year extension if the business

interest exceeds 35 percent of the decedent’s adjusted gross

estate. The first five years are interest only. Rigid rules accelerate

the tax if there’s a disposition of more than 50 percent of the value

of the stock. An additional means of financing estate taxes is

known as a “Graegin loan” in which the business owner’s estate

borrows funds needed to pay estate taxes on the business from

a commercial lender – or, in an aggressive form of the technique,

from a related entity – and deducts all of the interest on the loan in

a lump sum on the estate’s tax return.15

Executing the Plan

Estate and succession planning for family business owners can

be very frustrating for both the business owner and her advisors.

It’s very complicated from both a family dynamics and estate-

planning viewpoint. Unfortunately, it’s made many times more

difficult by the lack of collaboration among the advisors working

on the estate and succession plan. It’s not unusual for there to

be a long-term entrenched advisor who’s in over his head and

threatened by the involvement of outside experts. This entrenched

advisor can sometimes be more of an obstacle than a facilitator

of the estate and succession plan, with drastic results for both

the family business and the family itself. As Rousseau posited

centuries ago, and John Nash, of A Beautiful Mind, proved

mathematically, collaboration lifts all boats, including hopefully,

that of the entrenched advisor.

David T. Leibell, Esq. is a Partner in the Private Client Services

Department at Wiggin and Dana LLP. He focuses his practice on

representing wealthy individuals and families, along with business

succession and charitable planning. Mr. Leibell can be reached at

+1.203.363.7623 or dleibell@wiggin.com.

Daniel L. Daniels, Esq. is a Partner in the Private Client Services

Department at Wiggin and Dana LLP. He focuses his practice

representing business owners, private equity and hedge fund

founders, corporate executives and other wealthy individuals and

their families. Mr. Daniels can be reached at +1.203.363.7665 or

ddaniels@wiggin.com.

This article is intended for general information purposes only and is not intended to provide, and should not be used in lieu of, professional advice. The publisher assumes no liability for readers’ use of the information herein and readers are encouraged to seek professional assistance with regard to specific matters. Any conclusions or opinions are based on the individual facts and circumstances of a particular matter and therefore may not apply in other matters. All opinions expressed in these articles are those of the authors and do not necessarily reflect the views of Stout Risius Ross, Inc. or Stout Risius Ross Advisors, LLC.

13. David T. Leibell and Daniel L. Daniels, “Never Can Say Goodbye,” Trusts & Estates (October 2005) at p. 54.14. Daniel L. Daniels and David T. Leibell, “Christiansen Is a Boon for Charities,” Trusts & Estates (December 2009) at p. 14; “Charitable Lids Triumph Again,” David Thayne Leibell, Trusts &

Estates, Wealth Watch, http://trustsandestates. com/wealth_watch/charitable-lids-win-in-petter0120/.15. See Daniel L. Daniels and David T. Leibell, “Post-Mortem Planning for the Closely Held Business Owner,” ALI-ABA Audio Seminar, Oct. 29, 2008, www.ali-aba.org.

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Holding Family Business Interests In Trust

Trusts & Estates

David Thayne LeibellDaniel L. DanielsPaulina Mejia

David Thayne Leibell, Daniel L. Daniels & Paulina Mejia Thu, 2012-03-01 12:00

Does a trustee's duty to diversify override a settlor's intent?

Diversify, diversify, diversify. That's the mantra for trust investing under the Uniform Prudent Investor Act (UPIA), which has been adopted in some way, shape or form in virtually every state. It makes sense. Having all of your eggs in one basket can be dangerous. Look at Lehman Brothers and Enron. But what if the concentrated stock position in the trust is a controlling interest in a family business, and the trust's primary purpose is to perpetuate family control? In this situation, the trust's purpose would seem to override the duty to diversify. But does it? Without proper planning, the answer is unclear. But, by following certain best practices in the establishment and management of the trust, we as advisors can help our business-owner clients and their trustees minimize the duty to diversify without prohibiting the sale of the business, if that were ever necessary or desirable.

Traditional Trust Investing

Traditionally, trust investing in the United States boiled down to generating income and preserving

principal. In the seminal 1830 case, Harvard College v. Amory,1 the Massachusetts Supreme Judicial Court set forth what would become known as the “prudent man-prudent person” standard for trust investing. According to the court, a trustee “is to observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to

be invested.”2

Although this seems like a flexible standard, subsequent courts and state legal list statutes (that is, statutes that describe which investments are permissible for a trust and which aren't) interpreted the prudent man-prudent person rule narrowly to require a trustee to preserve principal or face potential surcharge. Courts analyzed the performance of each investment in the trust separately. So, even though overall trust assets increased in value, a trustee could still be surcharged if an individual asset lost value. The prudent man-prudent person standard required a trustee to invest cautiously and avoid “speculative assets.” As the stock market began its spectacular rise, first in the 1960s and then again in the 1980s, many trusts didn't participate in the upside, because they were invested primarily in bonds. In the 1990s this began to change, with trust law belatedly adopting modern portfolio theory, which had already been the standard for institutional investors for at least two decades.

Modern Portfolio Theory

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According to modern portfolio theory, which deals with the relationship between investment risk and investment return, there are two types of risk: good and bad. Good risk is known interchangeably as “market risk” or “systematic risk.” This relates to those risks applicable to all companies. For example, the recent financial recession would be considered market or systematic risk. This type of risk can't be diversified away. Bad risk, also known as “firm-specific risk” or “unsystematic risk,” however, can and should be diversified away. This includes risks associated with a particular company or industry. Think of AIG, Bear Stearns and Lehman Brothers from the recent financial downturn. If you had all of your money in any of these particular stocks, you would now be broke or close to it. If, on the other hand, you had all of your assets in an S&P 500 index fund, you would have dealt with the market or systematic risk that occurred because of the 2008 downturn, but you would still have the vast majority of your assets. A basic premise of modern portfolio theory is that investors need to have a compelling reason for not maintaining a diversified portfolio, since firm-specific or unsystematic risk can be avoided through diversification.

UPIA

The law of trust investing has gone through a massive transformation over the past two decades, beginning with the publication of the Restatement of the Law (Third) of Trusts: Prudent Investor Rule (the Restatement (Third)) in 1992, whose revised standards of trust investing based on modern portfolio theory were incorporated into the provisions of the UPIA in 1994. In general, the UPIA provides that a trustee shall invest and manage (including ongoing monitoring) trust assets as a prudent investor would, by considering the purposes, terms, distribution requirements and other circumstances of the trust. In satisfying this standard, the trustee shall exercise reasonable care, skill and caution. A trustee's investment and management decisions regarding individual assets must be evaluated not in isolation (as was the case under prior law), but in the context of the trust portfolio as a whole and as part of an overall investment strategy with risk and return objectives reasonably suited to the trust.

According to UPIA Section 3, a trustee is required to diversify the investments of the trust unless the trustee determines that, because of “special circumstances,” the trust's purposes are better served without diversifying. The diversification requirement applies not only to trust assets purchased by the trustee, but also to assets received by the trustee from the settlor. Special circumstances include the wish to retain a family business. In that situation, according to the UPIA, the purposes of the trust sometimes override the conventional duty to diversify.

It's important to note that UPIA Section 1(b) provides that the prudent investor rule is a default rule that may be expanded, restricted, eliminated or otherwise altered by the provisions of the trust. And, according to Section 1(b), a trustee isn't liable to a beneficiary to the extent that the trustee acted in reasonable reliance on the trust's provisions.

A simple reading of the UPIA alone should provide great comfort to both the settlor and trustee of a trust holding a concentrated position in a family business. The grantor's wish to retain a family business is a special circumstance that can sometimes override the duty to diversify. If the settlor is concerned about the uncertainty associated with the word “sometimes,” he needn't be, since the prudent investor rule is merely a default rule, which can be overridden by a specific waiver of the duty to diversify in the trust instrument. If only it were that simple. The Restatement (Third), case law and the Uniform Trust Code (UTC) create uncertainty that would never be apparent from the provisions of the UPIA. It's only by looking at this broader context that we come to understand that the law regarding diversification is in a continuing state of flux, and results can differ dramatically from state to state and from judge to judge.

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The Restatement

When seeking to interpret the UPIA, the best place to start is the Restatement (Third). Think of it as the legislative history. Although the Restatement (Third), like the UPIA, provides that the terms of the trust can override the diversification requirement, it does so by categorizing such provisions as “mandatory” or “permissive.” Mandatory provisions should be respected. Permissive provisions, like precatory language,

aren't binding on the trustee.3

A mandatory provision requires the trustee not to sell a specific concentrated position. Unless violative of some public policy, the Restatement (Third) provides that mandatory provisions are legally permissible and are ordinarily binding on the trustee in managing trust assets, often displacing the typical duty of prudence. A court may, however, direct noncompliance with a mandatory provision when, as a result of circumstances not known or anticipated by the settlor, technically referred to as “changed circumstances,” compliance would defeat or substantially impair the accomplishment of the trust's purposes. According to the Restatement (Third), under these circumstances, the trustee may have a duty to apply to a court for permission to deviate from the trust's terms.

Under the Restatement (Third), when the trust's terms merely authorize, but don't mandate, a particular investment, the provision is permissive rather than mandatory. A trustee isn't under a duty to make or retain investments that are made merely permissive by the trust instrument. The fact that an investment is permitted doesn't relieve the trustee of the fundamental duty to act with prudence. A trustee must still exercise care, skill and caution in making decisions to retain the investment. In addition, mere authorization regarding retention of an investment or type of investment doesn't exculpate the trustee from liability for failure to diversify.

The extent to which a specific investment authorization may affect the typical duty to diversify a trust portfolio can be a difficult question of interpretation. Because permissive provisions don't abrogate a trustee's duty to act prudently, and because diversification is fundamental to risk management, trust provisions should be strictly construed against dispensing with the diversification requirement altogether. Nevertheless, the Restatement (Third) provides that a settlor's special objectives may relax the degree of diversification required by a trustee. In this way, the Restatement (Third) appears to be consistent with the exception to diversification for “special circumstances” in the UPIA. But, in both cases, the relaxation of the diversification rules is qualified, and, therefore, a trustee may not rely on those rules with any certainty.

Case Law

In interpreting the duty to diversify under the UPIA, the courts, at first blush, appear to be all over the map. But, upon careful reflection, we can discern four distinct themes. The first three themes depend on the language in the trust regarding diversification. First, the cases seem to be least favorable to trustees when the trust instrument is silent on diversification, with no specific language overriding the UPIA diversification requirement, particularly if the trust is funded with a non-controlling interest in a public company. Second, outside of New York (and to a lesser extent, Ohio), most trustees have had good luck with “retention clauses,” even those that fall into the “permissive” category (particularly specific permissive retention clauses). Third, results for trustees have been mixed when a trust didn't include a retention clause, but did include exculpatory language relieving the trustee from certain breaches of trust. The fourth theme relates not to trust language, but rather to the special circumstances associated with family business interests being held in trust when the trust is silent on retention and the duty to diversify,

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and there's no exculpation clause. Trustees have generally been successful in situations in which the special circumstances exception to diversification has applied.

Trust Silent

There's little justification for a trustee who fails to diversify out of a concentrated stock position in a publicly traded stock when the settlor's family doesn't control the company, and the trust instrument is silent regarding diversification. In the absence of specific trust language or special circumstances, UPIA Section 3 provides that a trustee “shall” diversify the assets of the trust. This includes both assets received from the settlor, sometimes referred to as “inception assets,” and those subsequently acquired by the trustee.

Since New York is both the strictest state regarding diversification and has had the greatest number of

diversification cases, we'll begin there. The first case, In re Janes4 (which was under the former prudent person standard prior to the UPIA) involved two trusts funded at the settlor's death exclusively with shares of Kodak (which filed for Chapter 11 bankruptcy this past January, illustrating the concept of firm-specific or unsystematic risk). At the time of the decedent's death, the stock was valued at $135 per share. The trusts were silent regarding the retention of the stock. By 1978, Kodak stock was at $40 per share. The trusts were terminated in 1980, and the trustee filed a final judicial accounting. The beneficiaries requested that the trustee be surcharged for failure to diversify out of the Kodak stock. The New York Court of Appeals agreed and surcharged the bank trustee $4 million, holding that, based on the facts and circumstances, the trustee should have divested the Kodak stock no later than Aug. 9, 1973, shortly after the decedent's death.

In re Rowe5 was a case similar to Janes (also decided on the former prudent person standard), involving a New York testamentary trust funded in 1989 with 30,000 shares of IBM. Although some of the beneficiaries expressed concern to the bank trustee regarding the investment strategy, and the trust was silent regarding retention, the trustee held on to most of the IBM stock for more than five years while the value of IBM stock declined from $117 per share in 1989 to $74 per share in 1994. Needless to say, the trustee was surcharged and forced to pay $630,000, because the judge found that the IBM stock should have been sold by January 1990, shortly after the decedent's death.

Bottom line: A trustee of a trust funded with a non-controlling concentrated position in a publicly traded stock has no justification for failure to diversify, if the family doesn't control the company and there's neither retention language nor exculpatory language.

Retention Clauses

According to the Restatement (Third) Section 228, retention clauses come in two forms: (1) mandatory, and (2) permissive. A mandatory clause is typically binding on a trustee, although such clauses are extremely dangerous because the trustee can only sell the concentrated position under a mandatory provision by petitioning the court, asserting that because of changed circumstances, the stock should be sold. By that point, it may be too late and the stock could be worthless. So, business owners should avoid strict mandatory provisions.

Permissive provisions come in two types: specific and general, which can include a broadening of trustee investment discretion. In a specific permissive clause, the grantor specifies a certain security or type of security that's to be retained. Usually, such a clause relates to the particular asset or assets that funded the

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trust. In a general retention clause, the grantor doesn't mention any specific asset or assets, but instead permits the trustee to retain any assets received from the grantor.

Mandatory retention provisions

As discussed above, because of their inflexible nature, mandatory retention provisions aren't typically

used. One case involving a mandatory retention provision is In re Pulitzer's Estate,6 a New York case from the early 1930s. The case involved a trust established under the will of Joseph Pulitzer, creator of the Pulitzer Prize. The will included language prohibiting the trustees, under any circumstances, from selling

“any stock of Press Publishing Company, publisher of ‘The World’ newspaper.”7 The trustees were Pulitzer's three sons. They petitioned the court to waive the mandatory sale provision, arguing that the company had operated at a loss for five years and that if the company weren't sold, it might become worthless. The court applied the doctrine of “changed circumstances,” reading into the will an implied power to sell. In reaching its holding, the court said that it would be guided by the policy of protection of the trust funds rather than blind obedience by the trustee to the language used by the testator.

Permissive retention provisions

The New York Surrogate's Court decision in In re Charles G. Dumont8 should serve as a cautionary tale for any trustee who feels shielded from liability because of a specific permissive retention clause. Dumontinvolved a trust created under a will that was funded with Kodak stock. The will included a specific permissive provision stating that it was the testator's “desire and hope that … neither my Executors or my said Trustee shall dispose of such stock for the purpose of diversification of investment and neither they

nor it shall be liable for any diminution in the value of such stock.”9 The will went on to provide, however, that the “foregoing provisions shall not prevent my said Executors or my said Trustee from disposing of all or part of the stock of Eastman Kodak Company in case there shall be some compelling reason other

than diversification of investment for doing so.”10

Although the language in the will provided for specific retention of the Kodak stock by the trustee and included an exculpation clause relieving the trustee from liability for failure to diversify, the New York Surrogate's Court awarded $21 million in damages to the beneficiaries. The court found that although the language in the will clearly waived the duty to diversify, it didn't waive the trustee's duty to prudently manage the concentrated stock position.

The appellate court subsequently overturned the Dumont judgment based on a technicality, but it should be noted that the appellate court didn't disagree with the lower court's decision that a waiver of the duty to diversify doesn't relieve the trustee from managing the concentration prudently and, therefore, diversifying. Since the specific retention provisions in the will were permissive, rather than mandatory, they didn't relieve the trustee from the fundamental duty to act with prudence. The takeaway from Dumont is that trustees relying on specific permissible retention clauses should never become complacent. Without a mandatory provision to rely on, the trustee may find himself at the whim of a judge, particularly if that judge happens to be in New York. Having said that, courts outside of New York would typically find in favor of a trustee if faced with facts similar to those in Dumont and almost certainly in the case of a trust funded with a family business, the purpose of which was to perpetuate family control.

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A good example of a case outside of New York featuring a specific permissive provision involving a family

business is the Michigan Court of Appeals decision in In the Matter of the Jervis C. Webb Trust.11Webbinvolved two trusts funded with concentrated positions in the Jervis B. Webb Company, a closely held family business. One of the beneficiaries of both trusts, a direct descendant of the founder and the former general counsel of the company, sued the trustees for failure to diversify the assets of the two trusts and invest in stocks that paid higher dividends.

The company was the quintessential family business. Founded in 1919, it had grown significantly over the years, but remained closely held, and its leadership had passed among generations of the Webb family. In addition, almost all of the company's stock was held by family members or their trusts.

Both trust agreements included language specifically allowing the trustees to retain the stock of the company and relieving the trustees of the duty to diversify. One of the trusts also made it clear that the settlor intended that the trustees retain the company stock so that the family could maintain control of the company and continue to have employment opportunities within it. The trial court determined that both trusts relieved the trustees of any duty to diversify. The Michigan Court of Appeals agreed. The facts of Webb provide an excellent example of a trust funded to retain control of a family business. Although specific permissive language was included in each trust, and the duty to diversify was waived, the trustees weren't bound by a mandatory provision, but could sell if the trust circumstances changed — for example, if a sale were necessary because of changed economic circumstances.

What about general permissive retention clauses? A relatively recent case involving a general retention

clause is Wood v. U.S. Bank, N.A.,12 which involved a testamentary trust funded almost exclusively with the bank trustee's own stock. It's important to note that the retention clause didn't name any particular stock to be retained or waive the duty to diversify. The retention language permitted the trustee “to retain any securities in the same form as when received including shares of a corporate Trustee, even though all

of such securities are not of a class of investments a trustee may be permitted by law.”13 In ruling against the trustee, the court held that, even if the trust document allowed the trustee to retain assets that wouldn't typically be suitable, the trustee's duty to diversify remained, unless there were “special circumstances.” The court went on to note that the provisions of the Ohio Prudent Investor Act were default provisions and, therefore, could be overridden by specific trust language. According to the court, “a trustee's duty to diversify may be expanded, eliminated, or otherwise altered by the terms of the

trust.”14 But, the court continued that “this is only true if the instrument creating the trust clearly

indicates an intention to abrogate the common-law, now statutory, duty to diversify.”15

The court in Wood made some other interesting points that are helpful in drafting proper retention language. It mentioned that the trust said nothing about diversification and that the retention language smacked of boilerplate. The court stated that “to abrogate the duty to diversify, the trust must contain specific language authorizing or directing the trustee to retain in a specific investment a larger percentage

of the trust assets than would normally be prudent.”16

A second case involving a general retention clause that was favorable to the trustee is Americans for the

Arts v. Ruth Lilly Charitable Remainder Annuity Trust.17 This case involved two charitable remainder trusts funded exclusively with $286 million in Eli Lilly & Company stock. Both trusts contained the same retention language allowing the trustee:

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to retain indefinitely any property received by the trustee … and any investment made or retained by the trustee in good faith shall be proper despite any resulting risk or lack of diversification or marketability

and although not of a kind considered by law suitable for trust investments.18

The court had no issue with the language, holding that the general retention language combined with the clause explicitly lessening the trustee's duty to diversify were sufficient to except the bank trustee from

“the default duty to diversify trust assets.”19

Can we reconcile the holdings in Wood and Lilly? The trust in Lilly specifically waived the duty of the trustee to diversify, but the trust in Wood didn't. Is this enough to hang your hat on as a trustee? Although other courts have reached the same result, without the addition of a specific retention provision and, perhaps, exculpatory language, there are no guarantees of success. Even then, in a state like New York, if the trust is funded with a non-controlling interest in a public company, even these additions may not be sufficient to protect the trustee from liability for the failure to diversify.

Exculpation Clauses

Although exculpation (or exculpatory) clauses come in many shapes and sizes, in their purest form they don't act as a waiver of the duty to diversify, but, rather, relieve the trustee from liability for failure to exercise the fiduciary duties of care, diligence and prudence. The trustee is typically relieved of liability for breach of trust unless he's acting in bad faith or there's gross negligence. This standard is a dramatic reduction in the typical fiduciary standard, which is the highest standard of law. A number of states, including California and New York, prohibit certain types of exculpation clauses as against public policy. New York Estates, Powers and Trusts Law Section 11-1.7 provides that a provision in a will or testamentary trust relieving a trustee from liability for “failure to exercise reasonable care, diligence and prudence is contrary to public policy.” In states where there's no statutory prohibition against exculpation clauses, most courts don't find that exculpation clauses are against public policy. But that doesn't mean courts will respect them.

In re Trusteeship of Williams20 involved a testamentary trust funded almost exclusively with the decedent's closely held stock. Although the business was sold to a public company (Borden), the Borden stock represented 98 percent of trust assets in 1980. Even though the three trustees (two individuals and a bank trustee) eventually began to diversify, by 1990, the Borden stock still represented 40 percent of trust assets. During this time, Borden stock was on the decline. One of the three trustees wanted to continue diversifying, but the other two (including the bank trustee) voted to continue to hold the Borden stock until it recovered some of its value. It didn't. The value of the stock dropped from $36 to $14 per share by 1995. The beneficiaries sought to surcharge the bank trustee. The bank argued that it was protected from liability by an exculpation clause. The clause provided that no trustee “shall be liable for any loss by reason of any mistake or errors in judgment made by him in good faith in the execution of the

trust.”21

The appellate court in Minnesota didn't agree and remanded the case for further findings. According to the court, although exculpatory clauses aren't necessarily against public policy in Minnesota, the clause in question wasn't sufficient to protect the trustee from losses due to negligence. The court stated that exculpation clauses should be strictly construed against the trustee. Regarding the specific clause, the

court ruled that it only protected the trustee against “mere errors of judgment,”22 not negligence. The court found that if the settlor had wanted to relieve the trustee of liability for negligence, the trust would

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have said so. On remand, the trial court held that the trustee had, in fact, been negligent in failing to diversify the Borden stock and surcharged the bank trustee $4 million. This case stands for the proposition that if exculpation clauses on their own (without any additional retention language or waiver of the duty to diversify in the trust instrument) are going to be effective, they should be tailored to particular circumstances (and not boilerplate) and include a waiver of negligence. Even then, a trustee relying exclusively on an exculpation clause does so at his own peril.

Special Circumstances

As already discussed, UPIA Section 3 provides that a trustee “shall diversify the investments of the trust, unless the trustee reasonably determines that, because of special circumstances, the purposes of the trust are better served without diversifying.” According to the comment to UPIA Section 3, circumstances can overcome the duty to diversify. The comment provides two examples. First, “if a tax-sensitive trust owns an undiversified block of low basis securities, the tax costs of recognizing the gain may outweigh the advantages of diversifying the holding.” The second example involves the wish to retain a family business “in which the purposes of the trust sometimes override the conventional duty to diversify.”

In addition, the Restatement (Third) states that a settlor's special objectives may relax the degree of diversification required of the trustee. In this way, the UPIA and Restatement (Third) seem consistent.

The problem with the special circumstances exception is that there's not much case law directly on point in the context of family businesses, particularly under circumstances in which there's no retention clause

or exculpatory language. The New York appellate case In re Hyde23 falls into this category. Hyde involved contested accountings for three trusts funded with large concentrations of Finch Pruyn common stock. Finch Pruyn was a closely held family business engaged in manufacturing. Each trust granted the trustees absolute discretion in managing trust assets, but contained no directions, specific or general, regarding the disposition of the Finch Pruyn stock, and neither trust waived the duty to diversify.

The issue in question was whether the trustees' management of the trusts comported with the prudent investor rule, which became effective in New York on Jan. 1, 1995, and, specifically, whether the trustees failed to adequately diversify the investment portfolios of the trusts. Because of an ownership structure involving voting and non-voting stock, the trustees, after meeting with investment bankers, determined that a fair price for the trust's stock couldn't be obtained. Finch Pruyn also wouldn't redeem the trusts' shares, except at a heavily discounted value. In finding in favor of the trustees, the court referenced special circumstances, including the fact that a sale would result in large capital gains and the gridlock engendered by the company's capital structure, noting that it “may have been intended by Finch Pruyn's

founders in order to sustain Finch Pruyn as a family business.”24 It's important to note, however, that special circumstances weren't the only reason the court found in favor of the trustees. The court also looked at the fact that after the trustees made a great effort, they could find no buyers. The fact that it was impossible to sell the stock appeared from the decision to be just as important as the special circumstances that the trust held an interest in a family business.

UTC

No discussion of holding family business interests in trust is complete without an understanding of the role the UTC plays in the more than 20 states that have adopted it. The UTC is the first national attempt to codify the law of trusts. The UTC was drafted in cooperation with the authors of the Restatement (Third).

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The UTC is made up primarily of default provisions that the settlor can override. But, the UTC also includes certain mandatory provisions that the settlor can't override. One of these provisions is set forth in UTC Section 404, which “requires that a trust and its terms be for the benefit of the beneficiaries.” Yale Law School Professor John Langbein, who's perhaps the most respected (although at times controversial) academic regarding the law of trusts, believes that the UTC's benefit-the-beneficiaries rule may, in most circumstances, require a trustee to diversify trust investments. If, in fact, the rule mandates a trustee to diversify trust investments regardless of the settlor's intent, as expressed in the trust instrument, where does this leave trusts funded with family business interests in states that have adopted the UTC? Although Langbein says that retaining family business stock in some circumstances benefits the beneficiaries, this isn't always the case. According to Langbein:

the benefit-the beneficiaries rule requires that a prudent trustee who is directed by the trust terms to retain a troubled family enterprise should investigate whether doing so would be sufficiently inimical to

the interests of the beneficiaries of the trust that the trustee should petition the court for instruction.25

Otherwise, says Langbein, a trustee could potentially be found liable for failure to diversify. Although Langbein's position may sound extreme, it's not that different from the Restatement (Third)'s position —in the case of a mandatory provision, when there have been significant changed circumstances, a trustee may have a duty to a apply to a court to deviate from the trust's terms.

In National City Bank v. Noble,26 the plaintiffs argued that the trustee should have diversified out of J.M, Smucker, a public company controlled by the Smucker family. Although the case was decided a little more than a year before Ohio adopted the UTC, the plaintiffs used the benefit-the-beneficiaries argument to assert that the trustees should have diversified. Specifically, they claimed “that when the Trust Agreement is read as a whole, it is evident that Welker Smucker's primary concern was to create a trust to benefit his

heirs and not merely to retain Smucker stock.”27

Noble involved a trust established in 1965 by Welker Smucker, son of the founder of the J.M. Smucker Company, for the benefit of his two children. The trust was funded primarily with Smucker stock. The trust included a specific permissive provision whereby the trustees were “expressly empowered to retain as an investment, without liability for depreciation in value, any and all securities issued by The J.M. Smucker Company, however, and whenever acquired, irrespective of the portion of the trust properly

invested therein.”28 The trust also specifically waived the duty to diversify and included an exculpation clause.

Some of the beneficiaries sued the trustees for failure to diversify, because the stock had lost 52 percent of its value. However, the court disagreed. According to the court, the settlor was crystal clear in his desire to have the trustees retain the Smucker stock, without liability for any decline in value. The court found that the special circumstances exception to the duty to diversify applied, since Smucker, although public, was a family business controlled by the Smucker family.

This sounds like a definitive rebuttal of the benefit-the-beneficiaries argument in the context of family business interests held in trust. Or does it? The court went on to state that, although the trust had lost some value in the 1990s, “it is unquestionable that the value of the trust increased since inception —

providing both for the retention of Smucker stock and for the benefit of the beneficiaries.”29 Would the result have been different if the value of the Smucker stock in trust was less at the time of the suit than when the trust was funded in 1965? Unfortunately, that wasn't discussed, leaving us with less certainty

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than we would have hoped. It's interesting to note that although the 1990s may not have been great for Smucker stock, for the 10 years from 2000 to 2010, the stock's value increased 309 percent, while the S&P 500 lost 15 percent.

Best Practices

How can we as advisors sort through this sometimes conflicting body of law to advise clients who want to fund trusts that hold concentrated positions in closely held family businesses to perpetuate family control, without being forced to diversify and without having to use mandatory retention language that could be a problem if it were ever necessary or desirable to sell the stock quickly? There are best practices that, when combined, can increase a trustee's comfort level regarding holding family business stock without a mandatory provision requiring retention. They include:

1. Retention clause

A specific permissive retention clause is typically the best approach. A mandatory clause, even one that includes certain objective standards for sale, is too risky if a quick sale were ever necessary and, therefore, should be avoided. The specific permissive clause should reference the reason for permitting a trustee to retain the specifically named stock (for example, to perpetuate family control of the business), along with both an authorization to retain and a waiver of the duty to diversify, both specifically referencing the stock to be retained. The more specific and less like boilerplate a specific permissive retention clause is, the better the chances are that courts will respect it.

2. Exculpation clause

An exculpation clause on its own may not be enough to protect a trustee from the failure to diversify. However, an exculpation clause drafted to relieve a trustee from loss in value of a specific security that also includes a waiver of negligence may add incremental protection when combined with a specific retention clause.

3. Special circumstances

Relying on the special circumstances exception in UPIA Section 3 for retaining a family business should be of help in most states. Having said that, expressly referring to the special circumstance of retaining family control of a family business in a specific permissive clause that permits retention of the specific stock; waives the duty to diversify the specific stock; and provides exculpation regarding the specific stock, should provide greater protection for the trustee.

4. Delegation

Under the UPIA, trustees can delegate their fiduciary duties to invest trust assets. If done properly, and if the trustee continues to monitor, delegation typically relieves the trustee from liability for trust investments. There's no certainty, however, that diversification, which is central to the UPIA, can be waived through delegation, since the duty to monitor might be interpreted to include the duty to diversify. Having said that, delegating investment responsibility regarding the family business interests held in trust to a family member co-trustee may provide some relief to the independent co-trustee.

5. Impossibility of sale

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Another way to deal with the diversification issue is to take the decision out of the trustee's hands. This isn't done through the use of a mandatory retention provision, but rather through rigid transfer restrictions in a buy-sell agreement that all shareholders, including the trust, are party to, which make it virtually impossible for the trustee to sell without the approval of all of the other shareholders. A second approach is to recapitalize the company between voting and non-voting stock and only fund the trust with the non-voting shares. This, combined with the buy-sell, can make it virtually impossible for the trustee to sell the shares. Presumably, these restrictions would need to be in place before the stock was transferred to the trust. It's doubtful that restrictive agreements entered into by the trustee post-transfer would have any effect on the duty to diversify.

6. Beneficiary communication and consent

Just as studies have shown that doctors with good bedside manners are sued less often than doctors without them, good relations between the trustee and the beneficiaries go a long way toward reducing a trustee's liability exposure. Good relations are based on good communication, which should be regular and comprehensive. In addition, communication is a two-way street and requires not only that the trustee communicate with the beneficiaries, but also that he listen to their concerns. Sometimes trustees have beneficiaries sign retention letters. Such letters have proved of little value in court for a variety of reasons, including the lack of sophistication of the beneficiaries, the question of whether such letters are legally binding, the continuing duty of the trustee to inform the beneficiaries regarding developments in connection with the stock and the fact that retention letters typically bind only the beneficiaries who sign them. Therefore, such retention letters can prove more trouble than they're worth.

7. Decline in value

Taking the best practices referenced in points 1 through 6 above and using them in combination goes a long way to protect a trustee from failure to diversify. But, overcoming the duty to diversify with respect to family business interests held in trust isn't the whole story. There are also practical issues. What if the stock is declining in value or the stock in trust is in an industry that, because of technology, may not exist in a decade? It would be the rare settlor who would want the entire value of his business to disappear to preserve family ownership. That's why we recommend specific permissive provisions rather than mandatory ones that require a trustee to petition a court for permission to sell the stock because of changed circumstances. By the time a court approves, it may be too late. Even under a specific permissive provision, it may be very difficult for a trustee to determine when the family business should be sold. Remember the Noble case, in which the stock lost 54 percent of its value in the 1990s, but gained over 300 percent between 2000 and 2010. If the stock had been sold in the 1990s, the trust would never have participated in the tremendous upside. Knowing if and when to sell is the most difficult issue for a trustee holding a family business in trust. It requires an active trustee who works closely with the company's officers and board of directors, as well as communicates with trust beneficiaries. At the same time, he must verify the company's outlook through independent appraisals and discussions with industry experts. Even then, there are no guarantees that a trustee will make the right decision. But, with proper trust language and proper trust oversight, a trustee of a trust holding family business interests should in most cases, under current law, be protected from liability.

8. Directed trust

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There may be circumstances in which either the settlor or a trustee doesn't feel comfortable following the advice given in points 1 through 7 above and wants an alternative approach. That approach exists in the form of a directed trust. A number of states have enacted directed trust statutes protecting a trustee from liability for failure to diversify. Under these statutes, the duties of the trustee are unbundled and, typically, with respect to the trustee's investment duties, the trustee is subject to the control of a third party, known as a “trust advisor” or “investment advisor.” Through the use of a directed trust, the trust agreement can provide that the investment advisor must make all investment decisions relating to the family business, which may eliminate the trustee's liability for investment decisions, including the decision to retain the family business in

the trust.30

9. 9. Decanting. Using a directed trust probably isn't necessary in most circumstances of a trust funded with family business interests. But, given the fact that the law in this area is evolving, it would be prudent to include a decanting provision in every trust funded with interests in a family held business, which would permit the trustee, in case a particular state's law became unfavorable, to decant the trust's assets to a new directed trust in a state with a favorable statute. When decanting, it's crucial that both the trust's situs and governing law be changed to a new state.

Although some settlors will go the directed trust route from the beginning, most should feel comfortable following the best practices outlined in this article, using their home state's law, while including decanting language in the trust instrument to provide flexibility if their home state's law should become unfavorable in the future.

Endnotes

1. Harvard College v. Amory, 26 Mass. (9 Pick.) 446 (1830).2. Ibid.3. Restatement of the Law (Third) of Trusts: Prudent Investor Rule Section 228 (1992).4. In re Janes, 90 N.Y.2d 41 (1997).5. In re Rowe, 274 A.D.2d 87(N.Y. App. Div. 2000).6. In re Pulitzer's Estate, 249 N.Y.S. 87 (Surr. Ct. 1931).7. Ibid.8. In re Charles G. Dumont, 791 N.Y.S.2d 868 (Surr. Ct. 2004).9. Ibid.

10. Ibid.11. In the Matter of the Jervis C. Webb Trust, 2006 Mich. App. LEXIS 209.12. Wood v. U.S. Bank, N.A., 828 N.E.2d 1072 (Ohio Ct. App. 2005).13. Ibid.14. Ibid.15. Ibid.16. Ibid.17. Americans for the Arts v. Ruth Lilly Charitable Remainder Annuity Trust, 855 N.E.2d 592 (Ind.

Ct. App. 2006).18. Ibid.19. Ibid.20. In re Trusteeship of Williams, 591 N.W.2d 743 (Minn. Ct. App. 1999).21. Ibid.22. Ibid.

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23. In Re Hyde, 845 N.Y.S.2d 833 (App. Div. 2007).24. Ibid.25. John Langbein, “Burn the Rembrandt? Trust Law's Limits on the Settlor's Power to Direct

Investments,” Boston University Law Review, 375, 395 (2010).26. National City Bank v. Noble, No. 85696, 2005 WL 3315034 (Ohio Ct. App. Dec. 8, 2005).27. Ibid.28. Ibid.29. Ibid.30. A full discussion of directed trusts is beyond the scope of this article. For those seeking more

information, three recent articles from Trusts & Estates on this topic are (1) Al W. King, III and Pierce H. McDowell, III, “Delegated vs. Directed Trusts,” Trusts & Estates (July 2006) at p. 26; (2) David A. Diamond and Todd A. Flubacher, “The Trustee's Role in Directed Trusts,” Trusts & Estates (December 2010) at p. 24; and (3) Joseph F. McDonald, III, “Emerging Directed Trust Company Model,” Trusts & Estates (February 2012) at p. 49.

David Thayne Leibell, far left, and Daniel L. Daniels are partners in the Greenwich, Conn. and New York City offices of Wiggin and Dana LLP. Paulina Mejia is a senior wealth strategist at Atlantic Trust Private Wealth Management in New York

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Special Report: Family Businesses

L eo Tolstoy begins Anna Karenina with the line: “Happy families are all alike; every unhappy family is unhappy in its own way.” Much the

same can be said for successful multi-generational fam-ily businesses as well as family businesses that are unsuc-cessful in succession planning. Successful multi-genera-tional family businesses are all alike; they follow certain tried and true succession planning best practices, with a particular focus on family dynamics, to ensure that the business passes successfully to the next generation. Family businesses that fail to plan for proper ownership or management succession typically are unsuccessful in succession planning because they allow unique fam-ily dysfunctional behavior to replace the necessary best practices for proper succession. As a result, they not only destroy the family business, but also frequently destroy the very fabric of the family itself.

Successful family business succession planning is an evolutionary process that requires tremendous effort by the family and its advisors (including non-family man-agers) over many years. Although a deep understanding of business strategy is important to succession, it pales in comparison to the importance of family dynamics to a successful succession plan. The business owner or advisor who ignores family dynamics in a succession plan does so at his peril. The most critical issues related to a successful family business succession are family-related rather than business-related. In “Correlates of Success in Family Business Transitions,”1 the authors of the study found a consistent pattern of factors that led to breakdowns in the succession process. Sixty percent of succession plans failed because of problems in the rela-

Succession PlanningFamily dynamics play an important role in the success or failure of the family business

tionships among family members. Twenty-five percent failed because heirs weren’t sufficiently prepared to take over ownership and management of the family busi-ness. Only 10 percent failed because of inadequate estate planning or inadequate liquidity to pay estate taxes. That means that 85 percent of family businesses fail in the succession process due to inadequate planning to resolve intrafamily disputes over the business and the inability to groom successors to run the family business.

Yet families who take seriously their stewardship of the family business from one generation to the next can be surprisingly successful in effective suc-cession planning. The New York Times, Cargill and S.C. Johnson are three examples of companies that have successfully transitioned more than three gen-erations. In fact, the oldest family business operating in the United States is The Avedis Zildjian Company Inc. (a producer of cymbals), which was founded in 1623 in Constantinople and moved to the United States in 1929.

Some StatisticsApproximately 90 percent of U.S. businesses are family firms, ranging in size from small “mom-n-pop” busi-nesses to the likes of Walmart, Ford, Mars and Marriott. There are more than 17 million family businesses in the United States, representing 64 percent of gross domestic product and employing 62 percent of the U.S. work force. Thirty-five percent of the businesses that make up the S&P 500 are family controlled. Family businesses are also more successful than non-family businesses, with an annual return on assets that’s 6.65 percent higher than the annual return on assets of non-family firms. Unfortunately, only a little more than 30 percent of family businesses survive into the second generation, even though 80 percent

David Thayne Leibell is a partner in the

Stamford, Conn. and New York City offices

of Wiggin and Dana LLP

By David Thayne Leibell

16 TRUSTS & ESTATES / trustsandestates.com MARCH 2011

Special Report: Family Businesses

Generation to Generation, the model defines the family business system as three independent but overlapping subsystems: (1) family, (2) ownership, and (3) busi-ness. Each person in a family business is placed in one of seven sectors formed by the overlapping circles of the subsystems. All owners, and only owners, are placed in the top circle. All family members are somewhere in

the bottom left circle. All employees are in the bottom right circle.

A person with only one connection to the family business will be in one of the outside sectors (1, 2 or 3). For example, a family member who is neither an owner nor an employee will be in sector 1. An individual who is an owner but not a family member or employee will be in sector 2. An individual who is an employee but not an owner or family member will be in sector 3.

Those individuals with more than one connection will be in one of the overlapping sectors, resulting in that person falling within two or three of the circles at the same time. An individual who is an owner and a family member but not an employee will be in sector 4, which is within both the ownership and family circles. Someone who is an owner and an employee but isn’t a family member will be in sector 5, which is within the ownership and business circles. An individual who is in the family and works in the business but isn’t an owner will be in sector 6, which is within both the family and business circles. Finally, an individual who is an owner, family member and employee will be in the center sector 7, which is within all three circles. It’s important to

Specifying different subsytems and

roles helps to simplify the complex

interactions within the family

business system.

would like to keep the business in the family. By the third generation, only 12 percent of family businesses will still be viable, shrinking to 3 percent at the fourth generation and beyond.2

Family Dynamics The disconnect between what 80 percent of fami-lies intend and the far bleaker reality, can in part be attributed to a failure to plan effectively for the family dynamics issues involved in family business succession. Fortunately, over the past three decades, both academics and practitioners have studied and written about the family dynamics issues that are crucial to successful fam-ily business succession. We now have a large body of ref-erence material to rely upon. Family business commen-tators come at the family dynamics issues involved in succession in their own way, sometimes based on wheth-er they’re organizational psychologists, business strategy experts, historians, sociologists, economists, accountants or trusts and estates attorneys (like the always inspiring James (Jay) Hughes, Jr.). While an exhaustive discussion of the various theories is beyond the scope of this article, a discussion of the following aspects in three seminal books on family business succession planning commu-nicates certain universal themes: (1) “family businesses as systems,” as described in Generation To Generation, Life Cycles of the Family Business, by Kelin E. Gersick, John A. Davis, Marion McCollum Hampton and Ivan Lansberg3 (Generation to Generation), (2) the “Five Insights” and the “Four P’s” from Perpetuating the Family Business: 50 Lessons Learned from Long-Lasting, Successful Families in Business, by John L. Ward,4 and (3) the “three stages of succession,” from Succeeding Generations: Realizing the Dream of Families in Business, by Ivan Lansberg5 (Succeeding Generations).

Family Businesses as SystemsPerhaps the best-known family dynamics theory for family businesses is the three-circle family business systems model (see “The Circle Game,” p. 18), first developed by John A. Davis and Renato Tagiuri at Harvard University in the early 1980s. As described in

MARCH 2011 TRUSTS & ESTATES / trustsandestates.com 17

Special Report: Family Businesses

note that every person who is part of the family business system has only one location within the three circles.

The three-circle model is a highly effective tool for identifying and understanding the sources of interper-sonal conflicts as well as role and boundary issues in family businesses. Specifying different subsystems and roles helps to simplify the complex interactions within the family business system. Understanding family busi-ness succession is much easier when all three subsys-tems—family, ownership and business, with their various interactions and interdependencies—are analyzed as one system. The goal is to create an integrated system that provides mutual benefits for all system members. By iden-tifying the position of each member of the family business system within the three circles, it’s easier to understand the motivations and perspectives of the individuals as deter-mined by their place in the overall system.

The three-circle model creates an effective snapshot of a family business at any particular point in time. According to Generation to Generation, this snapshot is an important first step in understanding family dynamics in a particular family business. But as a family business enters a period of transition during business succession planning, people enter and leave as well as change their positions within the circles over time. Therefore, the authors of Generation to Generation believe that it’s important to see how the whole family business system changes as individuals move across boundaries inside the system over time. Adding the dimension of time to the three-circle model allows for a more accurate understanding of the family dynamics issues as the succession plan progresses over time.

Five InsightsAccording to Ward, there are certain overarching prin-ciples common to the world’s most successful and enduring family businesses. He refers to these as the “Five Insights” and the “Four P’s” and he considers these concepts “the framework and foundation for family business continuity.” The Five Insights represent semi-nal concepts that connect family life and the opera-tion of the business into an integrated whole.

Insight #1: Respecting the challenge. Successful business families understand that the odds are against them when it comes to passing the business to the next generation, says Ward. Because of this knowledge, they take succes-sion planning very seriously and put enormous amounts

of time and effort into it. They embrace the challenge, educate themselves and take the steps necessary to foil the adage of shirtsleeves to shirtsleeves in three generations.

Insight #2: Common issues but different perspectives. Ward believes that successful multi-generational fam-ily businesses understand the following two concepts: (1) virtually all family businesses share the same problems and issues, and (2) different people within the family business system see these same problems and issues in predictably different ways depending on their position within the family business system.

Understanding that a family business isn’t alone in the problems and issues it faces empowers a family to gain the knowledge necessary to perpetuate the business from one generation to the next. And understanding that how a family member or non-family manager perceives succession issues depends on his position within the fam-ily system requires the family to respect each and every perspective and accept that it’s healthy to disagree.

Insight #3: Communication is indispensable. Successful business families work very hard at encouraging effective communication. Lack of communication and an abundance of family secrets are significant factors in business families that are unsuccessful in

18 TRUSTS & ESTATES / trustsandestates.com MARCH 2011

The Circle GameThe family business consists of independent but overlapping subsystems

— Kelin E. Gersick, John A. Davis, Marion McCollum Hampton and Ivan Lansberg,

Generation To Generation, Life Cycles of the Family Business

1Family

2Ownership

4

7

5

6

3Business

Special Report: Family Businesses

passing the business to the next generation. Effective communication requires putting in place the forums and structures necessary to promote open dialogue. Ward finds that successful business families put in place the following structures to encourage communication: (1) formation of an independent board of directors for the business, and (2) beginning the process of having regular family meetings.

Insight #4: Planning is essential to continuity. Proper planning is crucial to the success and continuity of a family business. It’s also more complex than planning for non-family businesses. Ward uses a concept he calls the “Continuity Planning Triangle” to illustrate the challenges unique to planning in a family business. (See “The Shape of Planning,” this page.) Business-owning families have to plan simultaneously on the follow-ing four different levels: (1) business strategy plan-ning, (2) leadership and ownership succession planning, (3) estate and personal financial planning for family members, and (4) family continuity planning (in the middle of the triangle).

Business strategy planning deals with answering the question, “Where are we going as a business?” In the family business context, Ward believes that the business strategy plan is interdependent with leadership and ownership succession planning. Estate and personal financial planning is often a significant weak link in fam-ily business succession. Most family members have little cash flow outside the business and are dependent on the business for their financial security. Without significant assets outside the business, the senior generation may feel uncomfortable handing over the reins. It’s crucial that family members begin the process of wealth gen-eration outside the business as early as possible. This means contributing to retirement and profit sharing plans instead of reinvesting everything in the business. It also means thinking about where the liquidity will come from to pay any estate tax. Family continuity planning results in a family mission statement or consti-tution which sets forth the ideals and guiding principles that allow family members to act for the greater good of the family rather than in their own self-interest.

Insight #5: Commitment is required. Family busi-nesses must be committed to: (1) the family’s purpose, (2) planning for the future of the family, (3) having

effective family meetings, and (4) the business and its continuity within the family.

The Four P’sAccording to Ward, the Four P’s deal with the fundamen-tal paradox in family businesses: What the family needs to be strong and healthy frequently conflicts with what the business needs to be successful. Families resemble socialist institutions in which people are treated equally, membership is permanent and interaction is primarily emotional. Business, on the other hand, is basically capi-talistic. People are treated differently depending on their perceived contributions, and behavior is typically ratio-nal and objective. Because family and business systems have such different rules and norms, the two systems send conflicting messages over issues such as who gets hired and promoted, compensation of family members and which family members run the business. Ward believes that successful business families acknowledge the inherent conflict and contradictions between the family and the business as inevitable, and they employ the Four P’s to minimize or avert any conflict these contradictions can create.

1. Policies before the need. Successful business fami-lies don’t wait for a conflict to arise before they estab-lish policies on predictable issues. They put in place employment policies before they’re needed, setting

20 TRUSTS & ESTATES / trustsandestates.com MARCH 2011

The Shape of PlanningFamily businesses must think simultaneously on different levels

— John L. Ward, Perpetuating the Family Business: 50 Lessons Learned from

Long-Lasting, Successful Families in Business

Familycontinuityplanning

Business strategy planning

Estate and personal financial planning

Leadership and

ownership succession planning

Special Report: Family Businesses

3. Process. Even if a business has policies in place before they’re needed, a time will come when a significant unexpected issue arises. The process the family uses to resolve these unexpected issues is crucial to the contin-ued success of the family business. How the family com-municates, solves problems, collaborates and reaches consensus may vary from family to family, but one theme unites successful business families: They look for win-win solutions to the difficult problems.

4. Parenting. Although it may sound strange to discuss parenting as an important factor in successful busi-ness successions, it’s indeed a crucial factor in family business succession planning. Good parenting lays the foundation for how family members will engage each other in the family business. Parents can help children learn proper values and lessons about communication, wealth, being responsible and working as a team. Proper parenting can also help create a healthy relationship between the family and the family business.

forth the requirements for family members who want to join the business. These policies also deal with issues such as compensation and performance appraisals. By putting such policies in place at the start, the family can deal with issues as they arise and avoid emotional reactions. Such policies also help manage expectations on the part of family members. They allow the family to be more objective than they would be if they had to make the decisions in the heat of a crisis. In addition, by setting forth which behavior is appropriate, the policies help avoid conflicts.

2. Sense of purpose. Successful multi-generational busi-ness families focus a great deal of attention on defining a sense of purpose for the family, including the family business. This sense of purpose will be different for each family, but such an overarching purpose can significantly assist the family in perpetuating the family business in times of strife and conflict. A sense of purpose sustains a family business from one generation to the next.

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Special Report: Family Businesses

Stages of SuccessionMany commentators, including Ward, speak of the need to look at succession planning through the lens of the specific stage that the business is in during succession. In his book, Succeeding Generations, Lansberg does an excellent job putting the concepts of the stages of suc-cession in perspective. According to Lansberg, family businesses come in three fundamental forms: (1) the controlling owner, (2) the sibling partnership, and (3) the cousin consortium.

1. Controlling owner. Controlling owners are in charge of all aspects of the family business. They make all of the major decisions and delegate very little. Because of their economic clout and strong personalities, controlling owners cast a large shadow over their families. This is particularly the case if the controlling owner is also the founder of the business. Controlling owners typically answer to no one other than themselves. They rarely have a functioning board of directors. If there’s a board, it simply follows the controlling owner’s directions. Passing the reins to the next generation isn’t easy for most controlling owners. A controlling owner may be a hard act to follow and unwilling to step aside.

2. Sibling partnership. In this form, the ownership is divided more or less equally among a group of sib-lings, each with a fairly equivalent amount of power. Unlike the controlling owner, sibling ownership requires that the siblings be accountable to each other, and that they consider each other’s needs, perspectives and preferences. Sometimes a sibling partnership is set up in a first-among-equals form, in which one sibling is the acknowledged leader. Other times, sibling part-nerships take a shared leadership form, in which the siblings act as an equal team. The form that a sibling partnership takes (first-among-equals or shared lead-ership) can have major implications on how succes-sion unfolds in the next generation.

3. The cousin consortium. The cousin consortium is characterized by fragmented ownership, so that over a period of several generations, ownership has been dis-tributed among various branches of an extended family. Managing the dynamics of this fragmented ownership among various branches of an extended family can be

22 TRUSTS & ESTATES / trustsandestates.com MARCH 2011

very difficult, particularly when it comes to reinvesting in the business versus paying dividends. Successful cousin consortia begin to buy out those family members who aren’t interested in the business and put in place struc-tures such as family holding companies, truly indepen-dent boards and even non-family CEOs.

Transition Among Three StagesAccording to Lansberg, the three stages are fundamen-tally different in both structure and culture. Succession planning strategies that work well in one stage can be a recipe for disaster in another. From a succession planning standpoint, each stage must be viewed as unique and decisions must be made in the context of the stage that the particular family business is in, as well as the stage it will be in after the succession is complete. For example, a transition from a controlling owner form to a sibling partnership form will require a fundamental change in the leadership structure of the family business. Similarly, when a sibling partnership is transformed into a cousin consortium, there’s another complete redefinition of authority and governance structures in the family business.

As estate planners, we tend to focus on structures that ensure that a family business is passed to the intended beneficiaries in the most tax-efficient manner. We often only represent the patriarch, matriarch or both. It’s important that we don’t ignore the family dynamics issues that are so crucial to effective family business succession. If family dynamics issues cause 85 percent of succession failures and only 10 percent of estate and tax issues, perhaps we’re not spending enough time understanding how poor family relations can destroy the beautiful estate plan we put in place.

Endnotes1. “Correlates of Success in Family Business Transitions,” Journal of Business

Venturing12.285-501(1997).2. FamilyFirmInstitute,Inc.,GlobalDataPoints,www.ffi.org/default.asp?id=398.3. KelinE.Gersick,JohnA.Davis,MarionMcCollumHamptonandIvanLansberg,

GenerationToGeneration,LifeCyclesoftheFamilyBusiness,HarvardBusinessSchoolPress,1997.

4. JohnL.Ward, Perpetuating theFamilyBusiness:50LessonsLearned fromLong-Lasting,SuccessfulFamiliesinBusiness,PalgraveMacMillan,2004.

5. IvanLansberg,SucceedingGenerations:RealizingtheDreamofFamilies inBusiness,HarvardBusinessSchoolPress,1999.

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