Family Business Quarterly
by Joseph F. Blum
How does a parent who owns a successful family business treat all his children “equally” when only some are working in the business?
In our age of career and family mobility, this question represents an increasingly common dilemma facing owners of family companies as they try to do estate planning. It raises a host of financial and emotional issues for both the older and younger generation. For example, how can children who aren’t working in the family business be granted equal portions of an estate that consists primarily of the business without alienating the children who are working in the business?
Absent resolution, these and other such questions can lead to feelings of resentment in both generations. Complete equality in such situations, as in much of life, is nearly impossible to achieve. But increasingly, those of us who work with family business estate matters are developing approaches that create feelings of equality so that everyone involved feels satisfied with the outcome.
Search for Equality
A case based on a real-life situation I was involved with recently helps illustrate the issues and flexible resolutions available. John Smith Sr.–age 60 and in good health–has decided, after much agonizing, to develop an estate plan under whose goal is to “treat all of my children equally.” The Smith family includes:
- John Jr., his eldest son, 32 years old, married, the father of twin daughters, and vice president, marketing, of the family business, Smith Fabrication Company.
- Bill, his youngest son, 28 years old, single, and currently doing genetic research at a federal government facility.
- Jill, his daughter, 25 years old and in her last year of medical school.
- Martha, his wife, also 60 and in good health, and uninvolved in the business.
John’s estate is valued at about $6 million, including the following assets:
- Smith Steel Fabrication Inc., $3,500,000
- Primary Residence, $650,000
- Vacation Home,$200,000
- Life Insurance, $1,200,000
- Investment Portfolio, $600,000
- Total, $6,150,000
For John to treat all his children equally in the classic sense would require him to leave each child $2 million after he and his wife, Martha, are deceased. Of course, this figure doesn’t take account of estate taxes; these could be reduced to $1.6 million or so via effective estate planning devices and could be covered by the $1.2 million of life insurance plus most or all of John’s investment portfolio.
The question that remains, then, is how can John accomplish his goal of treating all his children equally based on what is left–the family business, the primary residence, and the vacation home? The family business comprises nearly 80% of the estate, yet only one child, John Jr., is actively involved in the business.
An Unpleasant Alternative
What some families do in this situation is to leave shares of stock in the company equally to all the children. In my experience, though, that is the worst possible solution, especially from John Jr.’s perspective. The only interest the other two children would have in the company would be its ability to produce income; a downturn in business might push them to force the company’s sale, since they would own two-thirds of its stock.
Similarly, if John instructs that the company be sold on his death so that the proceeds can be divided equally among his three children, John Jr. will be cast adrift to hunt for a job while in his 50s.
The Key Issues
In the process of working with family businesses facing this dilemma, I have learned to view potential solutions as something not unlike putting together a jigsaw puzzle. Underlying the puzzle’s harmony, though, is family harmony. All the children–those in the business along with those with no interest in active involvement–must feel reasonably satisfied with the outcome. Otherwise, resentments will simmer for years and, in some cases, boil over.
A key to producing a satisfying solution is satisfying everyone’s most pressing needs. Most immediately, John’s most pressing need is to retain control of the business until such time as he chooses to relinquish it. For the children actively in the business, the most pressing need is assurance that they will similarly control the business’s future once the older generation passes on. For the children uninvolved in the business, the most pressing need is to receive an equitable inheritance.
An Attractive Alternative
Taking the three previously mentioned considerations as primary, here is how we worked out the case of John and Martha:since Smith Steel is operated as an S corporation, anyone who owns its stock may receive a share of its income. In addition, while an S corporation cannot have two classes of stock, some of the shares of its one class of stock may carry voting rights while other shares do not. That presented an opportunity that allowed us to accomplish the following:
- John re-classified his S corporation stock into voting and non-voting shares.
- He gifted 49% of the non-voting shares to John Jr. immediately. Because special IRS rulings allow discounts of up to 40% on the value of such gifts of a “non-controlling” interest in a family owned business, there would be no gift tax on these shares and they would be out of his estate when the tax collector comes calling. John and Martha used their combined $1,200,000 unified gift credit to make this gift.
- He gifted 12.5% each to Bill and Jill (total 25%). They would, therefore, begin receiving income immediately in amounts equal to their proportionate share of the company’s stock.
- The 26% of the company’s stock that John retained carries 100% of the company’s voting rights. When John dies, he will leave his 26% stock interest to Martha; no estate tax is due on property passing between spouses. Martha will then receive 26% of the company’s net income for the rest of her life, which will be in addition to her income from the $1.6 million in life insurance and investments.
While this plan during John’s lifetime doesn’t provide for technical equality, it does meet three of John’s other key objectives:
- Reduction of estate taxes.
- Creation of an income stream for Bill and Jill (their 25% of the S corporation’s income).
- Maintenance of his control over Smith Steel Fabrication Inc.
The Legal Side
Two additional legal agreements solidified the plan for all concerned:
- A purchase and sales agreement between John Jr. and Martha for the 26% stock interest she inherits when John dies.
- A mandatory call on the non-voting stock held by Bill and Jill, exercisable by John Jr. when John Sr. dies.
To provide funding for these events to occur, John Jr. purchased a life insurance policy on John’s life in the amount of $1,785,000. He owns the policy, but the corporation pays the premium, the expense being allocated among all the shareholders. When John dies, John Jr. will use the proceeds to buy Martha’s 26% from her “estate” (read Bill and Jill), in addition to their 25% interest as well. Bill and Jill will receive $1,375,000 for (a) their mother’s estate and (b) their own stock interest.
When the balance of their inheritance (the interest in the residences) is added to these insurance proceeds, Bill and Jill’s total legacy equals $2,225,000, free of income, estate, and capital gain taxes.
Bill, or course, winds up with Smith Steel! While this distribution pattern appears somewhat askew, it must be remembered that Bill and Jill, during John Sr.’s lifetime, received 25% of the distributive income of Smith Steel, attributable to their stock interest. Given John Sr.’s life expectancy, that income stream was expected to last for twenty years!
In summary, Martha is secure (should she survive John) without relying on Smith Steel Fabrication Inc. or her children for income, John Jr. gets the business, and Bill and Jill each receive $1,112,500 in cash and property, and the total of their income stream from the date of John’s gift to the date of his death–twenty-plus years given his life expectancy at age 60…and they all lived happily ever after.
Joseph F. Blum is an insurance planner for MassMutual. His firm, Joseph F. Blum, C.L.U. and Associates of Hingham, Massachusetts, specializes in estate preservation techniques. He is also a founder of the Northeastern University Center for Family Business and chairman of its Advisory Board.