Ensuring fairness of family business transfers among childrenArticle added by John Brown on January 27, 2009
Ranked: #476 (187 pts)
Statistics widely quoted in the industry indicate that "only" one-third of all family-owned business are passed on to the second generation and "only" 10 percent of family-owned businesses are transferred to a third generation. However, personal experience indicates that those statistics are wildly optimistic and overstated. Pessimism notwithstanding, some family businesses are, indeed, successfully transferred to younger generations. For the transfer of business ownership and control from parent to child to be deemed "successful," the parents must achieve all their exit objectives, including:
We find that parents hope a child will take over a business for several reasons:
- Financial independence, meaning they are completely divorced from reliance on cash flow from the business
- Intra-family fairness regarding distribution of family wealth and businesses
- Complete transfer of business operation and ownership control to the younger generation. This usually means the parent is out of the business and is not needed in the business for any reason.
For most of your business owner clients, this all probably sounds great. And it is great, but all too often an owner's hopes and aspirations crash headlong into the brick wall of reality. This can happen for a number of reasons:
- The joy of working together (at least that's what some owners claim).
- Greater employment and financial opportunities for family members than are available elsewhere.
- Maintenance of the family's focal point -- the business. Parents see the business as the "glue" that helps the family stick together.
- Fulfillment of a childhood dream. The child(ren) has grown up in the business, knows it, and wants to stay in it by acquiring ownership.
- Gradual retirement. The owner can stay semi-active in the business by gradually turning over operations and ownership to the new generation.
- Family pride. The owner takes considerable (and often justifiable) pride in continuing a family business and tradition.
As your business owner client's trusted exit planning advisor, it's important to remind your client that all business transfers are challenging, even if family businesses tend to face significant obstacles. Despite this, it is indeed possible, given the right circumstances, to successfully exit a business by transferring it to an owner's children.
- The children, for lack of a more elegant phrase, don't get along with each other.
- The children have substantially different career goals.
- The parents want or need to achieve financial goals before feeling comfortable transferring a business to children. The children, on the other hand, desire significant ownership sooner rather than later.
- The children simply don't have the same desire, ambition or aptitude for running the business as their parents.
The key to a successful family business transfer is to guide your clients through the Seven Step Exit Planning Process(TM), the process by which all savvy owners and their trusted advisors use to plan a successful exit. In the case of a family business transfer, the exit planning process will enable you create a comprehensive exit plan that takes into account the concerns of all family members -- the owner, spouse, business-active children and non-business-active children. This process integrates all points of view into a single, unified strategy. It organizes an owner's priorities and can be easily expended to reflect additional considerations unique to family business transfers. An overview of the Seven Step Exit Planning Process(TM), as it relates to a family business transfer, includes the following:
Ensuring fairness of family business transfers for all children
- Step One: Establish parents' objectives. Financial security, receive FMV for ownership interest, wealth transfer to children, family harmony, legacy, etc.
- Step Two: Quantify personal and business financial resources. Post-ownership financial resources, value and cash flow of the business; evaluate business-active child's contribution to both.
- Step Three: Increase and protect business value. Strengthen business for child take-over, incentive planning for key employee group and/or business-active child.
- Step Four: N/A (sale to third party)
- Step Five: Transfer to insider. Design sale/gift of business interest to business-active child.
- Step Six: Business continuity. In case either parents or business-active child dies.
- Step Seven: Personal wealth and estate planning. Personal wealth building strategies for parents, and estate and gift planning to level the playing field for all children.
Any discussion of family business transfers would not be complete if it didn't include the topic of fairness versus equality. Most parents have a natural inclination to distribute every asset equally to all children. The thought of giving one asset -- and very likely the most valuable asset -- to one child is considered unequal, and therefore, unfair to the other children.
Yet, upon closer examination, leaving the business entirely to the business-active child (BAC) and making an equitable distribution of the balance of family assets to the non-business-active children (and perhaps to the BAC, as well) is the fairest plan of all. "Fairness" in this context is usually a judgment parents make about what they think is fair to the children. What it overlooked is what the children deem to be fair to each of them. This perspective is all too often missing in family transition planning. To determine what is fair, assume the point of view of the business-active child and then that of the inactive child.
Let's look at why the BAC might well resent having a co-owner sibling who is inactive in the business. Perhaps one of the following reasons applies to your clients:
And what about the non-business-active child's perspective? Inactive children are unlikely to want ownership in the business if other choices are available.
- It is the efforts of the business-active child to increase the value of the business that should be rewarded. Parents typically offer all of their children an equal opportunity to participate in the business and become owners. Yet, only one child seized that opportunity. Why should parents force the most ambitious, risk-oriented child -- the one who chose to succeed the owner -- to share the rewards with children who chose different career paths?
- The owner had no co-owners in the business because he or she wanted to operate the business independently. As an entrepreneurial "chip off the old block," the owner's child doesn't want to share ownership any more than the owner did.
- The controlling vote is not enough. When there are co-owners, the child running the business has fiduciary duties to all other shareholders. That means that the business-active child's actions, such as giving herself a bonus, or increasing her own salary, or indulging in other business "perks" must all be reasonable and comparable to what a non-shareholder performing the same duties for the company might reasonably expect. Most owners wouldn't subject their compensation and perks to the same level of scrutiny.
If only one child should own the business, how does an owner establish fairness to all children when transferring the business to the business-active child and other assets to the non-business-active children? Obstacles to a fair transfer of assets include:
- Inactive children generally prefer to own or receive assets that are more liquid and less risk-oriented than ownership in the business. This is usually true even if they have to wait until both parents die to receive their inheritance.
- If the inactive child owns part of the business, have they received anything of real value? Partial business ownership will make the inactive child the proud owner of an illiquid security that may generate no immediate income or other benefits. Further, the inactive child has no ability to sell his or her interest, except to the business-active child, and the active child won't, in all likelihood, have the money to purchase it. And if he does, the business-active child's idea of fair market value is likely to differ dramatically from that of the inactive child.
- From the above point, it would seem that the inactive child's ownership interest would have little value. However, this may not always be the case. While a non-controlling ownership interest can certainly be discounted in value, it will nevertheless rise in value as the overall business value increases (due to the efforts of the business-active child). Because it is difficult for the inactive child to get rid of the ownership, he or she has to deal with the tax consequences.
- It also is important to remind your clients that the non-business-active child will not be able to make any decisions regarding the future course of the business.
How can you help your clients find the appropriate mix that needs to be created to ensure a successful family business transfer that plans for both the business-active child and the non-business-active child?
- The business value may be significantly greater than the combined value of the remaining family assets.
- If part of the business value is attributable to the business-active child's efforts, is it not fair to consider that part of the business to be that child's interest now? How do you determine the active child's contribution to existing business value?
- And let's not forget the timing issue. It makes good business -- as well as income and estate tax -- sense to transfer a significant amount of the business during an owner's lifetime to the business-active child. The non-business-active children, however, will not likely receive their "share" of the family wealth until after the owner and spouse die. The reason for this is simple: the non-business assets are usually retained by the owner to provide income and financial security to the owner and, after the owner's demise, to the spouse. The resulting timing difference is mitigated by the liquidity difference in the assets the children receive. The business-active child may receive assets now, but his or her assets are highly illiquid and subject to business risk. The non-business-active children may have to wait, but the assets they receive will be highly liquid and relatively risk-free.
- In addition to the present difficulty of distributing business and non-business assets equally, there is the added complexity of measuring the current value of the business interest given to the business-active child against the future value of the bequest given to the non-business-active child. To understand the present versus future value conundrum, consider the following:
1. Is the business-active child, in effect, paying for the business now through "sweat-equity" (lowered compensation, more working hours and greater risk)? If so, the current gift is not really a gift, but recognition of that child's efforts.
2. Is the business-active child adding to the business's value through his or her efforts? If so, he should not have to pay for that effort by receiving a reduced share of the ultimate estate.
3. Has the active child (by continuing in the business after the owner's retirement) become a critical element in the owner's retirement plan by ensuring that the business can pay the owner any deferred compensation and purchase the owner's stock? If so, the means by which the owner ties him or her to the business -- the golden handcuffs -- may be the transfer of stock. Again, acquiring stock because it benefits the owner should not penalize the business-active child when it comes to sharing in the estate.
4. Is the business-active child paying for part or all of the business?
For most families, the decision ultimately comes down to a discussion of fairness versus equality. Because of the difference in contribution to the business and differences between assets being gifted (business versus non-business and consequent timing difference), it is imperative to be equitable or fair in treatment -- not necessarily equal. Parents must strive to be fair. They must communicate and explain this strategy to all of the children. Often, it is best for owners to hold a family meeting using you, their trusted exit planning advisor, to facilitate the discussion.
Finally, it's important to recommend that your business owner clients make appropriate adjustments in their wills, trusts and buy-sell agreements to apportion assets if their lifetime transfers of the business and other assets are not completed before their demise. As part of those documents, the business-active child should have the right to have his or her share of the owner's estate consisting of business interests, while the remaining non-business active children have the right to have their portion of the estate satisfied with other interests.
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