Fair versus equal legacy planning with a family business


Planning for the succession of a family business can go beyond a discussion of equal versus fair. Should the business be transitioned now or later? Is the current owner willing to cede the reins of the business and retire, or is it not yet time to ride into that proverbial sunset?

Should the business be transferred later, perhaps after a few more years of retirement savings, or after the owners are satisfied the heir-apparent is truly ready to take on the responsibility?

Let’s examine the word “fair” from two perspectives. Parents believe they are being fair when they have their estates split equally among their children, because they may believe it is the most logical thing to do. Further, they may feel that doing otherwise would create animosity among their children.

However, a child who works in the family business, who wants to continue the business and is capable of doing so may feel that a legacy plan leaving part of the business to siblings who aren’t also co-workers is extraordinarily unfair. Why?

Use of profits: Should the business produce profits, there may be a conflict in what to do with the profits. The child in the business may very well see a need to reinvest those profits in equipment, systems, inventory or employees. The child who is only an investor by virtue of her inheritance may prefer a distribution of cash.

Distribution of profits: If the business is a C corporation, tax is paid at the business level on business profits. Shareholders pay tax only if a dividend is declared or if they sell their shares. Flow-through entities, however, pass through profits and losses to all shareholders, members or partners. Here’s where the conflict can occur: A child working as an employee in a business she owns earns income, some of which can be used to pay tax on the profits allocated to her as a shareholder. The child who is merely an investor, however, may not have or may not wish to use “other” money to pay tax on profits from the family business. That may lead to heated discussions about distributions. If the employee-child is not the majority owner, her siblings could vote against her and force a distribution, whether it’s in the business’s best interest or not. If the employee-child is the majority owner who refuses to make a distribution, she may find herself without an invitation to Thanksgiving dinner next year.

When parents are made aware of the conflicts that can develop as a result of a desire to treat their children equally, many realize the consequences are not a legacy they’d want to leave.

Planning the legacy

Planning begins with an inventory of assets and a discussion about the owners’ goals and objectives for both the business and their estates. There is much to be learned about the working relationship of the family members and the confidence there may or may not be in the next generation’s ability to continue the business.

Let’s assume the family has three children, only one of whom, April, is directly involved in the long-standing and profitable business. The husband and wife owners would like to have all three children share in their legacy equally, but they understand the conflicts discussed above.

There are at least three ways to approach this, all involving a buyout agreement:

Buyout at second death: fair and later

April and her parents enter into a buy-sell agreement where April will buy any remaining business interests when her last parent passes away. April purchases survivorship insurance on her parents to facilitate funding the buyout. In conjunction with the buyout planning, the parents amend their wills so April receives one-third of the business at Dad’s death. Assuming Dad dies first, Mom has continued income and still owns two-thirds of the business. When Mom passes away, April uses the life insurance to purchase the remaining stock, making cash available in the estate for any estate taxes as well as for equalization. April essentially received her inheritance at the death of the first parent, so the remaining estate assets pass to her siblings.

Buyout at first death: fair and now

Mom and Dad gift a minority interest in the stock to April now. Using a promissory note, April will purchase any remaining stock not passing during life at the death of the first parent. Mom and Dad create an irrevocable grantor trust for the benefit of their other children; trustee purchases survivorship life insurance on Mom and Dad. They adjust their wills to pass remaining stock to April at each of their deaths. At the second death, the insurance is used to create liquidity for remaining estate assets and a legacy for April’s siblings.

Buyout of siblings: fair and equal

Mom and Dad handle the business disposition entirely with their wills, which specify that one-third of the stock will pass to April when the first parent dies. The decedent’s remaining share of the business passes to the surviving spouse, and if no spouse survives, then the stock goes into trust for the other two children. The wills stipulate that the trustee must sell the business to April after both parents are gone. April purchases survivorship life insurance on her parents, and she uses the life insurance proceeds to purchase the balance of the business from her siblings’ trust.

Any of these three methods allow Dad and Mom to treat their children equally, but also with fairness. April is allowed to continue the business without the need to consult her siblings about profit use or sharing. April’s siblings see that the business will continue to support the parents during life, and they’ll be treated fairly — with substantial cash — after their parents have passed away.

Lynne Stebbins is senior vice president, advanced planning, at Marsh Private Client Life Insurance Services.

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