Many entrepreneurs intend to pass the family business to future generations. Unfortunately, most family businesses fail to survive into the third generation. Jeff Scroggins, a nationally known authority recent wrote an article about business succession planning. When considering the passage of a family business, there are seven important realities that need to be understood. I will only mention three of the seven realities in this article. The other realities mentioned by Jeff dealt with estate and income taxes, divorce and what happens when there is no planning at all.
Death and Disability Will Occur, but the Legacy Will Continue. We will all die. But estate planning for family businesses is not most fundamentally about death and the taxes that occur at death. It is about planning for the Legacy you will leave behind.
This perspective starts with understanding that estate planning does not start with THINGS or the taxes imposed upon them. It starts with PEOPLE: Who you were and are and who your family is and might become. In the last two decades I have observed a significant re-orientation of both clients and advisors from acting as though the preservation of family assets (e.g., minimizing taxes) is the most important goal of estate planning. Increasingly, clients and planners recognize there is often a misplaced emphasis, which focuses on assets rather than family, on structure and complex techniques over perspective, on tax savings in place of family need. When protecting and preserving the family becomes the beginning point of planning clients’ first focus on how to leave a positive impact on their family. Both the client and the planner may be forced to deal with difficult family issues (e.g., treating the children as individuals with their own personalities and problems, not as equals), which the client may have preferred to avoid – to the ultimate detriment of the client’s family.
When you deal with the inevitable reality of death and disability, you can leave a positive LEGACY for family – instead of the bitter legacy of conflict, taxes and legal expenses which so often occurs when an inadequate plan (or no plan) is in place.
There Is No Equity Value to A Family Business. When an entrepreneur wants to pass his or her business to family members, there is no true equity value to the business. Because the equity will not be reduced to cash (i.e., by a sale of the business), it provides no current benefit to the business owner. While the business owner may decide to sell the business to family members, the cumulative tax cost of such a sale normally makes it a poor planning choice.
In fact, the equity value of the business is a liability waiting to happen because of the potential state and federal transfer tax liabilities on the passage of the business and the potential need to “buy-out” family members who are not in the business.
When the issue is properly addressed, the owner is interested in control of the business and the income and benefits, which are derived from that control. Using readily available planning approaches (e.g., deferred compensation, voting rights, partnerships and trusts), the income of the business can be separated from equity, and the equity can be passed at a reduced tax cost to family members using various techniques (e.g., minority and lack of marketability adjustments, charitable lead trusts).
Essentially, federal and state transfer taxes are a voluntary confiscation tax. With proper planning the confiscation can be minimized or eliminated. The thoughtful business owner recognizes this issue and realizes that transferring current equity (and its future appreciation) can reduce the future tax burden on the business, without adversely impacting the owner’s income. Contrary to the owner’s intent, the emotional retention of all of the equity ownership or absolute control can actually destroy the business.
The Inevitable Conflict. Many business owners intend to pass their businesses to one or more designated family members who will run the business after the entrepreneur’s death or retirement. However, because the business is often the largest single asset of the estate, the owner often passes part of the business ownership to other family members who are not involved in the business. This is almost always a mistake.
During the owner’s lifetime, the owner may have been able to maintain peace in the family and serve as the “benevolent dictator” of the family business. Unfortunately, this powerful role disappears with the entrepreneur’s death or incapacity. Sibling rivalry, in-law problems and other issues often begin to come forward, particularly between those who are operate the business and those who are outside the business.
In many cases, the outsiders feel that the compensation and perks provided to the insiders are “excessive.” Outsiders question the business decisions (e.g., capital expenditures, hiring and firing of employees, expansion plans) of the insiders even when they know little about the business’s needs, operations or competition. Outsiders often believe that the income paid to them should match the compensation paid to the insiders.
Meanwhile, the insiders (who often feel they are working too hard) resent that their sweat is increasing the equity value of the outside family members who are continually asking for more and more income to which they are “not justly entitled.” The insiders may fail to see that the outsiders have a right to a return on their “investment” in the family business. Many family businesses and owners have paid huge legal fees because of these conflicts and/or have been forced to sell the family business to alleviate the problem.
This conflict is an inevitable reality as each family member attempts to direct his or her own financial destiny and feels increasingly unable to do so because of the common business ownership with other family members. This is not necessarily a matter of “good” and “bad” family members. It is a matter of increasingly different life goals – a normal part of life. Those differing life goals can create such significant conflict and stress that it damages or destroys the business.
The solution lies in setting up a structure in the estate plan that assures that those in the business own and control as much of the business as possible, while giving outsiders other assets so that they can effectively control their own financial destiny. Life insurance is often a necessary element of this “equalization planning.” This planning process is best done during the business owner’s life so the entrepreneur can dictate the terms to family members – particularly if the passage of assets is perceived to be disproportionate. Often the entrepreneur will recognize the contribution to the business of those who have had long term involvement by passing a greater part of the business to them.