Sophisticated succession planning- Private family trusts
In this blog, we are going to understand the importance of succession planning, tools used for succession planning, types of trusts and the benefits of creating a private trust.
A. Importance of succession planning in today’s world
Family-run business continue to be the norm rather than an exception in India; with most progressing fast on the path of globalization. Therefore, it has become imperative to plan the succession of the family wealth to avoid conflict among the members of the family in future and ensure prolonged legacy of the family.
A look back at the history of corporate India reveals the immense disruption due to improper or absent succession planning. Family ties have been irreparably damaged, wealth accumulated over generations has been squandered, protracted and endless litigation between the family members have resulted in draining of valuable resources that could have been put to better use and most importantly, once-leading business houses have taken a huge hit to their finances, glory and reputation.
Family businesses are different from other types of businesses. This is because on top of the business management and ownership, family and ownership dynamic come into play. This can be better understood in the following 3- circle family model crafted by Tagiuri and Davis:
TAGIURI AND DAVIS, 1982
Family, business and ownership roles overlap. Roles and relationships are complex, and crucially this system shapes the way a family business works.
The 3-circle Model helps individuals within the family business system understand what roles they play and how these interplay with others within the same system.
Because there are multiple roles or ‘hats’, coming into play when being part of a family business, it is important to be aware of them and how they might impact the business, today and in the future.
Succession planning is a process which involves strategic planning, financial planning, estate planning and HR planning. Our focus in this blog is from a financial, estate planning and tax perspective.
B. Tools used for succession planning
1. Traditionally, a Family Will has been often used as a tool of succession planning. Simply put, it is a formal declaration by the estate owner of his will to transfer his wealth to future generations.
- Cons of using a Will as a planning tool:
a. Chances of being challenged in the Court are High;
b. Leads to fragmentation of family wealth;
c. Since, transfer is triggered only on the demise of the estate owner, it might be subjected to Estate duty tax/ Inheritance tax.
2. Private Family Trust is another and most sophisticated planning tool. A trust is a legal arrangement in which a person’s property or funds are entrusted to a third party to handle that property or funds on behalf of a beneficiary.
a. The Settlor (Estate owner) can see its implementation during his life time and take corrective actions in a timely manner;
b. A Trust demonstrates family cohesiveness to the world and provides effective joint control of family wealth thru trust deed;
c. It provides united control and effective participation of all members in decision making process;
d. It is easy to operate and not heavily regulated.
Basic structure of private trust
Apart from the settlor, Trustees and beneficiaries, who are the key players in any Trust, there may also be a protector and an advisory board. The protector is essentially a person appointed under the Trust deed, who guides the Trustees in the proper exercise of their administrative and dispositive powers, while ensuring that the wishes of the settlor are fulfilled and the Trust continues to serve the purpose for which it was intended. An advisory board is a body constituted under a Trust deed to provide non- binding advice to the Trustees, often used more as a sounding board.
- Trust Deed, as a Governing instrument
A Trust Deed, as an instrument, is similar to an agreement and contains clauses similar to an agreement between two parties, in this case, the settlor and Trustee, however, which would have implications for the beneficiaries.
It is preferable that a Trust deed is in simple language and contains clear instructions, including the process and provisions for amendment thereof.
C. Different types of trusts
Usually, when property is settled into the private trust for the purpose of succession planning, it is done thru an irrevocable transfer, i.e., the Settlor does not retain or reserve the power to reassume the trust property/ income or to transfer it back to himself. Since, the settlor has no right left in the trust property, this typically provides adequate protection to the assets claimed by creditors, or in case of divorce, etc.
If the trust deed provides a list of beneficiaries specifying their beneficial interest, it would be a Specific trust. On the other hand, If the Trust deed does not specify any beneficiary’s share, but empowers someone (usually the Trustee) to determine such share, it is considered Discretionary/ Indeterminate Trust.
For general understanding and Income tax purposes, trusts can be categorized in following two broad types:
I. Revocable Trust- A trust that can be revoked (cancelled) by its settlor at any time during its life,
a. Section 63 of the Income tax act defines revocable transfer as under: A transfer shall be deemed to be revocable if -
i. It contains any provision of re-transfer directly or indirectly of the whole or any part of the income or assets to the transferor, or;
ii. It, in any way, gives the transferor a right to re-assume power directly or indirectly over the whole or any part of the income or assets;
b. Further, it also states that transfer includes trust
II. Irrevocable Trust- A trust that will not come to an end until the term/ purpose of the trust has been fulfilled;
Further, trusts can be established with a determinate of indeterminate benefits for the beneficiaries, as follows:
III. Discretionary/ Indeterminate- An arrangement where the trustee may choose, from time to time, who (in any-one) among the beneficiaries is to benefit from the trust, and to what extent; thus, the beneficiary has no more than a hope that the discretion would be exercised in his favour.
IV. Specific/ Determinate- The entitlement of the beneficiaries is fixed by the settlor at the time of settlement or by way of a formula, thus the trustees having little or no discretion.
D. How does trusts help in succession planning/ direct benefits of creating a trust:
- Inheritance tax planning- To counter the estate duty tax on inheritance which shall be leviable on the reintroduction of Estate duty/ Inheritance tax act;
- Trust reduces tax incidence;
- Protection against unforeseen action by creditors/ lender;
- Trust as an investment holding vehicle - The importance and efficacy of Trusts being used as investment holding vehicle is significant. Apart from the fact that it ensures retention of control over the business and increase in efficiency, it also provides tax efficient treatment of income upstreaming and asset upstreaming. The transfer of income by trust to its beneficiaries should not result into any additional taxation in the hands of the beneficiaries.
To conclude, Private trusts as a sophisticated tool for succession and tax planning helps achieve the varied objectives with which it is created by a family/ individual to safeguard its wealth and family reputation.
To sum up how a private family trusts sophisticatedly plans for succession in the family/ business.
Since, the financial costs associated to incorporate and run a trust is significantly high than preparing a will, it is advised to compare the non-financial factors such as maintaining family reputation, preventing future family disputes and future tax benefits, etc. with the financial costs to correctly compare the costs with the benefits achievable.
If you wish to prepare a plan for your family and business, please get in touch with us and we shall help you to take the way forward.
Please do share this blog with your friends/ colleagues to make them aware about the importance of succession planning.
BCA Journal- December 2018 edition