Families face many challenges when passing ownership of the family business between generations.
A key component to succession planning is determining how to treat children equally when dividing assets among them while doing what is best for the business and the family.
A desire for equality among children adds tremendous stress to the planning process and is one reason that less than a third of family-owned businesses are eventually owned and operated by another generation.
It helps to remember that the transfer of ownership and the transfer of management are very distinct components of succession planning. Often families understand that the senior generation will transfer the management of the company to the active children, but they struggle with how to transfer ownership.
When thinking about how to transfer the family business, consider that fair is not always equal and equal is not always fair. Each child of the senior generation does not necessarily need to receive a pro rata share of each asset in the estate, including the business, and there are good business reasons to divide ownership of the business disproportionately among the children. Allocating all, a larger share, or a controlling share of the business to the active children allows them to retain voting control of the company and be in charge of selecting the board of directors for a corporation or managers of a limited liability company.
This may be important if the active children and inactive children do not agree on business decisions, such as whether to reinvest the proceeds of the company back into the company or to distribute the profits to the owners.
If the senior generation is comfortable dividing assets among children differently, deciding how to split the family business remains a very difficult task. Fortunately, there are several approaches that senior generations may employ to balance the playing field for their children while maintaining an appropriate ownership structure.
Strategic asset allocation. One approach is to transfer the family business to the active children and transfer other non-business assets of equivalent value to the inactive children. A variation of this approach is to give inactive children the business real estate, and give the active children the operating company. If there are insufficient assets in the estate to provide equivalent value to the inactive children, life insurance can be a good vehicle for creating additional wealth.
Keep in mind that not all assets are equal and some assets may generate income taxes. For example, IRA distributions are subject to income taxes which reduce the benefit to the recipient.
Voting and control. If there are insufficient other assets to transfer to the inactive children, consider recapitalizing the company to create voting and nonvoting interests. This may facilitate an equal distribution of value among the children while still ensuring that active family members control the operating business.
The voting interests allow the owners of them to make important decisions, such as electing the board of directors or managers. Owners of the nonvoting interests share in the profits of the company but do not have a vote in most decisions. This allows the inactive children to share in the value of the business but keeps the active children in control of business decisions necessary to effectively grow and manage the company.
Purchase of the ownership interest. Active children may purchase the business from the senior generation or a buy-sell agreement may provide a means to enable the active children to purchase the interest at a later time. This purchase can take different forms but commonly involves the senior generation providing seller financing for the sale, avoiding the need for the active children to obtain third party financing. The sale can be structured as an installment sale, with the promissory note secured by the interest being purchased. The active children can use compensation and company distributions to make the required payments on the notes. To protect the sellers, the senior generation or other family members may receive security interests in company stock or assets to secure repayment and may be named as beneficiaries of insurance on the lives of the active children purchasing the company.
Done during lifetime, a sale has the added benefit of removing a potentially rapidly appreciating ownership interest from the senior generation’s estate, and replacing it with cash and promissory notes that do not grow in value. This swap of assets likely will reduce transfer taxes. If there are sufficient other assets, the estate plan may allocate each active child’s note to him or her upon the senior generation’s death causing the cancellation of the note. When the dust settles, the active children receive the ownership interest in the company and the inactive children receive other assets.
Succession planning for the management and ownership of the business is one of the most important strategic activities in which a family business can engage. Working with experienced and trusted counsel can help minimize challenges associated with succession planning.
When going through the process, keep in mind that fair is not always equal and equal is not always fair.
Jennifer L. Remondino is a partner with Warner Norcross & Judd LLP and has counseled many family-owned and closely held companies in developing plans for the transfer of ownership and management to the next generations. She can be reached at (616) 396-3243 or firstname.lastname@example.org. To learn more about succession planning, contact Jennifer or any other member of the Trusts & Estates practice group at Warner Norcross & Judd LLP.