Trusts are usually associated with estate planning, but trusts can also apply to business operations. As a small business owner, you can hold the business in a trust instead of using a business entity such as a limited liability company (LLC) or corporation.
How a Business Trust Works
A trust is an agreement that allows one party, known as a trustee, to hold, manage, and direct assets or property on behalf of another party, called the beneficiary.
In a business trust, a trustee manages a business and conducts transactions for the benefit of its beneficiaries. The trustee, which can be a company or an individual (including the business's owner), can be authorized to distribute business income and transfer property to beneficiaries.
A business owner can be the sole trustee of the trust that holds the business and be a trust beneficiary, as long as the business owner is not the sole beneficiary. Commonly, the beneficiaries of a business trust are investors or shareholders. If it is a family business, the beneficiaries might be the owner's heirs.
The Different Types of Business Trusts
Entrepreneurs can choose from the following types of trusts, as classified by the Internal Revenue Service (IRS):
- Grantor trust: A grantor is the individual who creates a trust, transfers business interests into it, and controls beneficiary distributions from it. With this type of trust, the grantor maintains control and authority over the trust. In addition, the grantor and the grantor trust are not treated as separate tax entities. The grantor must pay taxes on the trust's income.
- Simple trust: Simple trusts must distribute all earnings from trust assets to the beneficiaries, but the principal amount placed in the trust cannot be distributed. Simple trusts are also prohibited from making charitable donations. Beneficiaries are required to pay taxes on any income they receive from the trust. A simple trust can deduct certain expenses and must file a tax return. A simple trust that does not meet the IRS definition may be reclassified as a complex trust.
- Complex trust: Unlike simple trusts, complex trusts are legally permitted to accumulate income, make distributions other than income, make charitable donations, and take charitable Like simple trusts, complex trusts must file tax returns and can deduct certain expenses.
Note that a business trust can be a revocable trust or an irrevocable trust. With a revocable trust (i.e., a living trust), the grantor can change the terms of the trust or revoke the trust entirely and take control of the assets it contains. An irrevocable trust, by definition, cannot be easily changed or revoked.
The Pros and Cons of a Business Trust
Depending on the type of trust formed, business trusts may offer the following advantages over some traditional business structures:
- Avoidance of probate upon the death of the business owner
- Reduction or elimination of estate taxes
- Business continuity when the owner dies or become incapacitated
- Separation of business assets from personal assets (similar to an LLC)
- Greater privacy than an LLC, since public filings are not required for a business trust
- Protection of assets from creditors
- Simpler formation process than some traditional business structures
Business trusts can also involve the following complications:
- Ongoing costs to maintain the trust (e.g., paying a third party to manage it)
- Challenging legal regulations (e.g., the IRS does not recognize a business trust as a type of business organization)
- Fiduciary relationship between the trustee and the beneficiaries requires the former to act in the best interests of the latter and may be different than the duties required in a typical business structure
Because each business is unique and the various types of business trusts are subject to different regulations, the pros and cons of a specific trust arrangement should be evaluated individually with the help of a knowledgeable attorney. If you have questions about business trusts and whether one can be used to your advantage, we encourage you to reach out to our Westchester County business attorneys to discuss specific trust strategies. Give us a call today at 914-530-3070.