By Maurie Cashman
An estate freeze may involve you giving up voting control of the business if your business is incorporated. Last week we talked about the exchange of shares in your company for preferred shares. Freezes almost always involve gifting shares or selling for a nominal amount. Carefully consider the implications of this situation before moving ahead. The relationships within your family are likely very complex. I believe I once heard that all families are dysfunctional and have no information to counter that assertion. Major changes, such as would result from an estate freeze under which control of the business is given to the children, can produce unexpected changes. It is critical to consider the dynamics of your own family and assess the impact of an estate freeze.
Objective vs. Emotional Decision Making
One of the keys to ownership transition planning, which includes estate planning, is to understand the objectives of the plan and to insure that these objectives are met with the planning techniques used. When shares are gifted or sold at a significant discount to family members the mentality may shift within both the business and family. The family members receiving the gift may come to see the business in a more emotional manner than was intended and may not make business decisions in the future based on sound business principals.
In many states this is very prevalent in the agricultural industry. In Iowa we present awards for Century Farms, which are farms that have been held by the same family for over 100 years. I have the framed certificate hanging on my wall. When my dad got sick, I discussed buying the farm from him. We could have frozen the estate, incorporated the farm, and come up with a transfer mechanism. It was painful for both of us as he would have liked to sell to me and I would have liked to have bought it. However, after considerable discussion we made a decision that it simply did not make business sense for me to buy at the time and he sold to a neighbor.
I see no reason why we promote this in agriculture or any other business. Business is business. Family is family. If they work together that is great. But it can lead to disastrous decision making. There are many ways to leave a legacy, and it is not always best in the form of a farm or business.
Explosion in Asset Value
What would have happened had I bought that farm (at any value)? The land value has roughly quadrupled since I walked away from it. Dumb decision I guess. However, I am the oldest of six and I cannot imagine what the impact of that type of value increase may have had. If I had bought the farm it would now be worth far more than it was to any of my ancestors, including my parents, who had worked for over a century to simply hang on and raise a family. Suddenly I would be in a position of having fallen into a situation simply as the result of economic forces. I would not have even had to set foot on the farm to become very wealthy. And remember, my parents would have frozen their value at the date of the transfer so they would not participate in that. Now, you could set up life insurance policies for the other children but remember, there were five others and my parents had significant health issues. So how do you buy enough insurance to â€œequalizeâ€ the unforeseen and unearned increase in wealth between siblings and maintain the parentâ€™s lifestyles and healthcare needs? It is quite a puzzle and I can imagine some pain at Christmas.
Cratering Asset Value
On the opposite side of this, I watched my parents go through the Farm Crisis of the 1980â€™s. They had just bought the farm from my grandfather, under some family pressure to keep the farm in the family I am sure. Land and commodity prices suddenly dropped precipitously, making it impossible to borrow money. There was no cash-flow to support a family of six kids. I know that my dad felt tremendous fear that he was going to lose the farm that his great grandfather had settled in a sod house. He took on extra work and mom took on a job. I believe it shortened his lifespan. I think it is the closest thing to the Great Depression that our county has gone through and it will impact my attitudes for the rest of my life.
I still have emotions about that decision but we made it based on objective information we had at the time, not on emotions. However, I knew one thing: someday one of my descendants would almost surely be faced with this decision in the future, with an accumulating amount of â€œlegacy painâ€. I was not willing to let expose my son or daughter to that pressure.
Estate Freezes Breed Goats
When parents give stock in their company to their children through an estate freeze, the value that can be created by the brand, , the technology, established customer list, and so much more that resulted from a series of previous generationâ€™s risk-taking is seldom valued because the receiving generation risked nothing. So the receiving generation will either be a hero or a goat, generally a goat. If the value of the business soars they will be a goat because they did it based on the wisdom of the ancestors and not their own contribution. If the company goes down, they will be a goat for fouling up all of that same foundation that had been laid for generations, even if the company makes feather dusters.
An estate freeze magnifies family genius â€“ and incompetence, all in the name of saving tax. Families pay the highest price when they lose their mutual trust and respect for one another when gifting goes bad. And when trust is lost, family members (including their spouses who may have less emotional ties to the family) may resort to the courts and the family may be torn apart for all time. This is often the case in families with branches who have not spoken to one another in decades, all because of a few dollars in tax savings.
Undoing an Asset Freeze
It can be extremely difficult to undo an estate freeze once it is implemented. The danger arises if you carry out the freeze too early. Over the years, your cost of living may increase and you may encounter unexpected expenses for medical treatment. Life expectancies may change, creating the need for longer income streams. The estate freeze may have limited your income to an extent that it will not be sufficient to meet your needs. These types of concerns can be addressed in a properly prepared estate plan that uses an estate freeze as part of the overall plan to transfer the property to the heirs in the most tax efficient manner.
If you are seriously interested in minimizing taxes, then the best approach is to develop a preliminary plan as a first step. Next, the potential tax savings must be estimated based on reasonable assumptions that reflect your actual situation, objectives and expectations. The effect of the estate plan on the family must be discussed and carefully considered with proper legal, accounting and financial planning advice. If you decide that there is significant value to you, the plan can be implemented. More importantly, you will have to involve your children in the planning process; they must have a clear understanding of what you are considering and you must be convinced that they are absolutely in agreement with the final plan.