Many family business owners are updating their estate plans due to a heightened consciousness of mortality risk arising out of the Covid-19 pandemic. Such updates may include transfers of family business stock to a living trust to avoid probate administration of the stock at death. However, the use of a transfer-on-death (“TOD”) beneficiary designation may be a better way to avoid probate of family business stock (and other family business interests).
Why Avoid Probate?
Probate administration is a court-supervised process for settling a decedent’s financial affairs and distributing the decedent’s remaining assets to the beneficiaries identified in the decedent’s will. In cases of complex estates, with many interested parties whose interests may be adverse to one another, probate administration or other court involvement in estate matters may be beneficial, to ensure that all the rights of the decedent’s creditors and beneficiaries are fully respected. Absent such complexities, however, court involvement is not needed, and may only create delay, extra expense, and unwanted public disclosure of family financial matters.
What is the Value of a Living Trust?
A “living trust” is an excellent part of a plan to avoid probate. A living trust is a trust that a person (the “settlor”) establishes during lifetime to direct the disposition of the settlor’s property at death. It is also commonly called a “revocable trust” because the settlor can revoke or amend the trust at any time. (It becomes “irrevocable” at the settlor’s death.)
During the settlor’s lifetime, the settlor is the sole beneficiary of the living trust, and the settlor controls all decisions regarding the management, use, and distribution of trust income and principal.
Property that is held in a living trust or that passes to a living trust by beneficiary designation (such as life insurance) at the settlor’s death will not be subject to probate administration. Rather, upon the settlor’s death, a successor trustee will administer and distribute trust property to the settlor’s beneficiaries in accordance with the terms of the trust, without court supervision.
Should Family Business Stock be Held in a Living Trust?
One way that a family business owner can avoid probate of family business stock is to transfer the stock to the owner’s living trust during lifetime. This also, hypothetically, can provide a simple means to manage such stock if the business owner is rendered incapacitated by accident or illness.
Often, however, transferring family business stock to a living trust during lifetime can create complications and confusion. For example, if the family business has a buy-sell agreement with provisions that are triggered at the death, divorce, or incapacity of a stockholder, how to those provisions apply if the stockholder is a living trust, which cannot die, divorce, or become incapacitated? Similarly, does the lifetime transfer of an owner’s stock to a living trust constitute a change of control for purposes of business debt or other contracts with third parties?
At the very least, holding family business stock in a living trust will require specially drafted language in agreements involving trust ownership and will likely require disclosure of the living trust documents to key third parties, such as lenders and franchisors. For some transactions requiring owner approval, the settlor may have to provide the other parties with a copy of the trust agreement and any amendments, as well as a certification that the settlor remains empowered as trustee to exercise the rights of the stock held in the trust.
What is TOD and Why is it Better?
In 1989, the Uniform Law Commission (“ULC”) drafted and proposed the Uniform TOD Securities Registration Act (the “Uniform Act”). (For a PDF copy of the Uniform Act, with comments, go to https://www.uniformlaws.org/viewdocument/final-act-with-comments-88?CommunityKey=4138971b-da18-4a73-8bfa-86a3790c4408&tab=librarydocuments.)
According to the ULC, every state has enacted some version of the Uniform Act except Louisiana (which currently is considering enactment). (For the ULC’s list of each state’s version of the Uniform Act, go to https://www.uniformlaws.org/committees/community-home?CommunityKey=4138971b-da18-4a73-8bfa-86a3790c4408.)
Under the Uniform Act, the owner of stock in a corporation may designate a TOD beneficiary to succeed to ownership of the owner’s stock upon the owner’s death, without probate administration of the owner’s estate. (A TOD designation also can be applied to membership interest in a limited liability company, partnership interest in a limited partnership, or other interest in a business entity.) During the owner’s lifetime, the TOD designation has no effect on the owner’s rights in the stock, and the owner can revoke or change the TOD beneficiary at any time.
If the owner has a living trust, the owner can designate the living trust as the TOD beneficiary of the owner’s family business stock. Such an arrangement can offer the “best of both worlds.” The owner can avoid the complications of holding family business stock in a living trust during lifetime but can provide for the stock to pass to the owner’s beneficiaries under the terms of the trust without probate at the owner’s death. In such cases, the terms of the trust will control the disposition of the stock, even if the trust is amended after the trust is designated as the TOD beneficiary.
Although a TOD beneficiary designation does not provide for management of family business interests upon the owner’s mere incapacity, that can be addressed in the owner’s durable power of attorney for financial matters, which can appoint an agent to manage the owner’s family business stock or empower the agent to transfer the stock to the owner’s living trust to be managed by the trust fiduciaries.
How Does TOD Registration Work?
To designate a living trust as the TOD beneficiary for family business stock under the Uniform Act, the owner should direct the corporation to register the owner’s interest in the owner’s name, followed by the words, “transfer on death” (or simply, “TOD”) and then the name of the living trust. Generally, the corporation may “register” the owner’s interest with the TOD beneficiary designation by issuing a certificate showing the ownership and TOD designation or, if the corporation does not issue certificates, the corporation may “register” the change of title (i.e., the addition of the TOD designation) in the corporate records the same way it would do so to evidence a stock transfer.
Upon the death of the owner, the successor trustee of the living trust can cause the corporation to re-register the stock in the name of the living trust by providing the corporation with proof of the owner’s death, such as a death certificate. (As a practical matter, in a family business, the other owners and officers will be aware of the owner’s death and can re-register the stock to the living trust without delay.)
For family businesses with multiple owners, it can be helpful if the corporation’s governing documents, such as bylaws (or an operating agreement for an LLC), are amended to expressly describe the process for registering stock with a TOD designation and for retitling the stock to the TOD beneficiary after the owner’s death.
Family business owners who are updating their estate plans to avoid probate of family business stock should consider re-registering stock to designate their living trust as a TOD beneficiary, rather than transferring the stock to their living trust during lifetime.