The Arslanian Law Firm - Attorneys at Law

All My Children: Business Succession Planning That’s Fair to All

While estate taxes certainly present one concern of many family business owners, there are numerous other questions that need to be answered. When it is intended that the business continue in the family, there are many techniques that can produce significant tax savings and better assure harmony among the children.

Authored by Paul Arslanian, Attorney, C.P.A., Managing Partner, The Arslanian Law Firm PC

The 1990s were a time when many entrepreneurs went out on their own. The economy was strong, sales were booming, and many people felt they could achieve more by opening their own business – whether it be a manufacturing plant, car dealership, retail outlet or restaurant.

As the years have passed, the need for business succession planning has thus become increasingly prevalent. Succession planning – determining in advance who will assume control of a company once the principal retires or dies – is crucial to the continued viability of the business. But when should a business owner begin succession planning, and how should he or she go about it?

Ownership interests in a family business are often transferred to the owner’s children. It is commonly recommended that this transfer occur while the owner is living in order to reduce estate tax upon death.

(1) determine which children will become business owners;

(2) be "fair" to those children who will not own the business;

(3) find assets to give to the children who will not receive the business.

Let’s use the example of a widower, William, whose estate is $4 million. William has four children. His son, Robert, is the key employee of the business, having managed operations for 15 years. William’s other son, Timothy, is a clerical employee of the business. Though he has been so employed for 10 years, he has exhibited no interest in managing any part of the business. Timothy simply wishes to receive a fair wage for his services. William’s two other children, Jack and Jill, do not work in the business. William desires to leave his estate to his children upon his death, in equal shares.

DETERMINE WHICH CHILDREN WILL BECOME OWNERS
Before assuming that all four children will become owners of the business (also referred to as "stockholders" and the business interests owned as "stock"), it is crucial that William consider how each child is involved now and in the future. Consideration also must be paid to whether each child’s involvement is permanent, as a stockholder/operator, as simply a stockholder who does not work in the business, or as a stockholder who is also an employee of the business, but not in management.

After becoming educated on the pitfalls of shared business ownership, William might conclude that the business (real estate included) should be transferred only to the children who work in the business. In that event, William would exclude Jack and Jill in our example. What about the "employee" child, Timothy? Timothy also may not be a good candidate for co-ownership since he will not, or cannot, operate the business. Considering that Timothy will not take on the troubles and risks of an owner/operator, William may decide that Timothy should not become a stockholder. If only Robert becomes a stockholder, William will confront the difficulty encountered by most family business owners – "How can I be fair to all of my children?"

BEING "FAIR" TO ALL CHILDREN
"What is fair?" is the question asked more than any other during succession planning. After projected estate taxes and expenses, there may not be enough value or liquidity in the estate to give the business (and business real estate, if any) to one or some of the children while providing equal value to the others.

Assume now that William decides it is best to transfer the business to Robert only. In order to be "fair" to the other three children, a recommendation to William could be that an appraisal be performed to determine the value of the business. This appraisal can be done during William’s lifetime or upon his death as stipulated in his estate plan. While the appraisal is one factor William should consider in determining fairness among his children, reliance upon the appraised value alone may not achieve William’s idea of a fair division.

Valuations generally include significant subjective components such as discounts and premiums, and the appraiser might suggest the low end of acceptable values if the valuation is performed for estate tax purposes and the high end for sale to a third party. So what are the problems with establishing "fairness" among William’s children based upon an appraisal alone?

First, it creates disharmony among the children. Robert, who receives the business, will advocate a low value. The other three children will advocate a high value, as they will receive other assets of equal value.

Second, the fact that an appraisal will be used to determine the value of assets distributed between William’s children defeats the objective of supporting a low valuation for estate tax purposes. For example, an appraisal obtained for estate tax purposes might support that the business is worth $2 million, while an appraisal might support a value of $2.5 million if it also serves the purpose of establishing "equality" among the children. The executor of William’s estate cannot take the position that the business is worth only $2 million for tax purposes, but $2.5 million to Robert who receives it. The family may thus pay more estate taxes than necessary.

Third, advanced estate tax planning techniques, such as non-voting stock recapitalizations, voting control shifts, GRATs and the like, are often implemented in order to obtain a lower value of the business for gift and estate tax purposes. If William
implements one or more of these techniques, the children who will receive other assets of "equal value" to the business are harmed by these measures, which were adopted only for tax planning purposes.

Fourth, and most importantly, what relevance does the valuation of the IRS or an appraiser have to do with William’s idea of fairness to his children? Only William truly knows what it takes to run the business and, therefore, how much it is worth to Robert to receive it. The answer for a personal service business yielding $200,000 in wages or distributions to a child who is the primary service provider is clearly different than it is for a piece of rental real estate that yields $200,000 in annual net rental income. Although the professional appraiser will clearly take this into account, it is still William – the business owner – who truly knows what it is worth to own the business, how much effort he (and Robert as his successor) must expend to continuously realize that value, and how much (if any) Robert has "earned" during William’s lifetime by working hard to grow or otherwise better the business.

WHERE DO THE ASSETS COME FROM?
Assume William decides to distribute the business, which he believes is worth $2 million, to Robert alone in order to avoid the pitfalls that often accompany joint ownership. Projecting that there will be no assets other than the business in his estate to distribute, how does he treat the children fairly? Several solutions to this perceived obstacle exist:

1) Purchase a Life Insurance Policy - Life insurance might be obtained as a method of funding the share to be received by the children who will not receive the business. In William’s case, a $6 million insurance policy (properly implemented) would allow him to give the business to Robert and $2 million to each remaining child.

2) Robert Can Borrow – The estate plan can require that the business, or business real estate, be used as collateral for a loan from a third party. Loan proceeds can be allocated to William’s three children who will not own the business. The value of the $2 million business, burdened by the $1.5 million loan, is reduced to $500,000, which allows $500,000 to be allocated to each child with $500,000 remaining in the business for Robert.

3) Promissory Notes - The estate plan would require that the share of each child who will not receive the business be funded with a promissory note, secured by the business and/or by Robert in the amount of $500,000. This amount would be allocated to each of the remaining children. Similar to the third party scenario above, Robert receives the business, which is valued at $2 million, burdened by debt in the amount of $1.5 million. Robert therefore receives $500,000 of value on a net basis. Equal value is received by each of the other three children by way of the $500,000 promissory notes.

When the primary assets of the business owners are the business itself and the real estate upon which it operates, it is often recommended that the business be transferred to the children who work in the business, and the real estate to the other children. Presumably, this is so that those not working in the business can receive rental income from the business. Since rent paid by a business for use of real estate owned by a related party is partially determined upon tax and other factors, and not always upon economic fairness between the related parties, strong consideration should be given to the techniques discussed above. This will serve to help avoid disputes among the children regarding fair rental costs, leasing terms and the like.

SUMMARY
Shared ownership of the family business by children has inherent pitfalls, many of which cannot be recognized or addressed in advance by a legal agreement. The business owner should consider what is best for the family and the business, with reasonable contingencies for the future in mind. If the business will not be distributed to the children equally, fairness to all children should be determined by the business owner, not necessarily by appraisal alone.