By Maurie Cashman
How can you be fair to all children when transitioning business ownership to your children? In â€œLimiting Ownership to One Childâ€ we discussed the benefits of transferring your business to one child who is active in the business. The first step is to implement the planning process we described in Steps to a Successful Family Business Transfer and the second is to allow only one child succeed in business ownership. The third is to design a transition that is fair to all children.
â€œMost of our obstacles would melt away if, instead of cowering before them, we should make up our minds to walk boldly through them.”
–Orison Swett Marden
A Business Transition That Is Fair To All Children
Most parents have a natural instinct to distribute every asset equally between all children. The thought of giving one asset, probably the most valuable asset, to one child is considered unequal and, therefore, unfair to the other children.
However, leaving the business entirely to the business-active child and making an equitable distribution of the balance of family assets to the inactive children, and perhaps to the business-active child as well, may be the fairest plan.
Fairness is usually a judgment parents make about what they think is fair to the children. It overlooks is what the children consider 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.
Perspective of Business Active Child
Why might the business-active child resent having a sibling who is inactive in the business as a co-owner?
- You had no co-owners in the business because you wanted to operate the business independently. Remember, the apple doesnâ€™t fall far from the tree and your child likely doesnâ€™t want to share ownership any more than you did.
- It is the efforts of the business-active child to increase the value of the business that should be rewarded. You probably offered all of your children an equal opportunity to participate in the business and become owners. Yet, only one child snatched that opportunity. Why force youâ€™re the child who chose to succeed you to share the rewards with children who chose different career paths?
- When there are co-owners, the business-active child has a fiduciary duty of due care and loyalty to all other shareholders. That means that the business-active childâ€™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. The controlling vote is not enough. Would you subject your compensation and perks to this level of scrutiny?
The Inactive Childâ€™s Perspective
What about the inactive childâ€™s viewpoint? Inactive children are unlikely to want ownership in the business, if other choices are available.
- 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 owner of an illiquid security that generates no immediate income or benefits. The inactive child can only sell his interest to the business-active child. Thatâ€™s a big problem since the active child likely wonâ€™t have the money to purchase it and, if he does, his idea of fair market value is likely to differ dramatically from that of the inactive child. Save yourself the grief and just purchase a Family Feud board game.
- Inactive children usually prefer to receive assets that are more liquid and less risk-oriented than ownership in the business. This is generally true even if they have to wait until both parents die to receive their inheritance.
- While common sense says that the inactive childâ€™s interest is less, the IRS begs to disagree. While a non-controlling ownership interest can be discounted in value, it will 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.
- If the business is a pass-through entity from a tax perspective, the inactive child may be forced to pay taxes on her share of the earnings of the company, even if there is no policy for distributing dividends to pay those taxes. This can put the inactive child in jeopardy of either having to pay those taxes from their own pocket, possible forcing them to sell personal assets, or to sell to the business-active child to eliminate the tax consequences. Be careful who carves that turkey at Thanksgiving!
- Finally, the inactive child will be un-able to make any decisions regarding the future course of the business.
If only one child should own the business, how do you be fair to all children when transferring the business to the business-active child and other assets to the inactive children? Obstacles include:
- It makes good business as well as income and estate tax sense to transfer a significant amount of the business during your lifetime to the business-active child. However, the inactive children will not likely receive their share of the family wealth until after you and your spouse die. The non-business assets are usually retained by you to provide income and financial security to you and to your spouse after you die. The timing difference is offset by the liquidity difference in the assets the children receive. The business-active child may receive assets now but his assets are highly illiquid and subject to business risk. The inactive children may have to wait but the assets they receive will be highly liquid and relatively risk-free.
- If the business-active child contributed to building the value of the business up to the point of transfer of ownership, isnâ€™t it fair to consider that part of the business to be that childâ€™s interest now? How do you determine the active childâ€™s contribution to existing business value?
- The business value may be significantly greater than the combined value of the other family
Present vs. Future Value
In addition to the present difficulty of distributing business and non-business assets equally, there is an 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 inactive child.
To understand the present vs. future value problem consider this:
- Is the business-active child adding to the businessâ€™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.
- Is the business active child paying for part or all of the business?
- Is the business-active child, in effect, paying for the business now through sweaty-equity (lowered compensation, more working hours, and greater risk)? If so, the current transfer is really compensation of that childâ€™s efforts.
- Has the active child become a critical element in your retirement plan by ensuring that the business can pay you any deferred compensation and purchase your stock? If so, you may have implemented a golden handcuffs strategy to tie the business-active child to the company by transferring stock to them over time. Acquiring stock because it benefits you should not penalize the business-active child when it comes to sharing in the estate.
For most families, a discussion of fairness vs. equality is the answer. Because of the difference in contribution to the business and differences between assets being transferred it is imperative to be 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 to hold a family meeting using advisors to facilitate the discussion.
Finally, be certain to make appropriate adjustments in your will, trusts and buy-sell agreements to apportion assets in the event that you die before the assets have been transferred. As part of those documents, the business-active child should have the right to have her share of your estate consist of business assets while the remaining children have the right to have their portion of the estate satisfied with other assets.
Â© 2016 Aspen Grove Investments, Inc.