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March 31, 2014

Family Business Succession and Estate Equalization

Most parents feel strongly about ensuring that their children are treated equally in their will. For many, this is a moral obligation, and, on the surface that would seem easy to accommodate.  Often, however, this is not the case.  Most estates are not totally liquid at the death of the testator and some assets are harder to divide than others.  This is particularly true when a family business is involved, especially when many business owners have up to 80% or more of their wealth tied up in the family enterprise.

How do we deal with the children who are not involved in the business when the children who are will receive the family company shares as their inheritance?  While the desire may be to treat the children equally, it is under these circumstances that the focus shifts to treating the children fairly.

For the children who are working in and/or managing the business it is far more beneficial to them not to have to report or answer to siblings who are not involved in that business.  For the non-business siblings other estate assets or cash could certainly be used as a substitute for company shares.  If other estate assets are used for this purpose, however, one must take into consideration the tax implications involved in this transaction and whether or not these assets are liquid enough to satisfy the needs of the beneficiary.  Often, a common method of obtaining estate equalization or fairness is through the use of life insurance, either on a single life or joint life second to die basis.

In using cash, specifically where that cash is created using the death proceeds of life insurance, the issue of the value of cash versus shares has to be dealt with.  Is there a need to provide cash to an heir who is not involved in the family business on a dollar to dollar basis?  In other words, if the value of the shares equal $500,000 should the sibling not involved in the business receive $500,000 in cash?  In my opinion, the answer is probably not.  The sibling who receives cash is free to do whatever he or she wishes and is not subject to the risk of business represented by the share ownership.  While the argument could be made that the non business sibling does not participate in growth of the business the truth is they assume none of the risk.  If all siblings were in agreement, however, the sibling who received cash and wished to take a more involved interest in the company could purchase shares from the other siblings and participate in growth – and assume risk – at a later date. I suppose one might ask what discount should there be for receiving cash in lieu of shares?  This is very subjective and a question which would require full discussion amongst all family members.

Of course, the above remarks are aimed specifically at operating businesses which have the usual management needs of most enterprises of that type.  In the situation where the family business in question is an investment company or a real estate holding company both of which generate income without the usual concerns of operational management the treatment could be different.   The investment or real estate holding company could almost be characterized as an annuity and often only the oversight of a single manager is required.  In this example it could be appropriate to divide the company shares amongst the family heirs in a manner which is consistent with the wishes of the testator without the need to substitute cash for shares for those family members not intimately involved in the running of the business.

Whichever form of family enterprise is the case, the testator should always be aware of the dangers of inequitable estate distribution, namely, family discord as well as potential estate litigation. Full communication is often the answer to all types of potential problems and risks in developing a business family estate plan.  When the family participates in full discussion directed at formulating an effective family business succession plan a lot of the potential risk dissipates.

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