We are blessed in West Michigan with a large percentage of family-owned businesses. These businesses provide significant employment for the area. Family-owned businesses also tend to be good corporate citizens and more generous with their communities compared to other businesses. I am blessed to be part of a local business that has made the transition to the third generation.
Much is written about how to be one of those family businesses that survive into the second and third generations and beyond. One aspect of that is making sure the business itself lasts, with appropriate strategic planning, succession planning, estate planning and good old hard work. Another aspect is making sure that the shares remain in the family. This article focuses on this second point — having agreements or other restrictions in place that address ownership of the family business. In addition to dealing with this in my own family, I have had the opportunity in my work as an attorney to address these issues with other family businesses.
Why have restrictions? As a general rule, a shareholder can transfer shares to anyone he or she chooses. An appropriate agreement or provisions in an entity’s organizational documents can create a set of rules and procedures for the current family members and for family members in future generations. It is not enough to protect the controlling interest in the company; a shareholder with just a small number of shares can make life difficult.
One common mistake I see in transfer restrictions is not adequately addressing ownership by trusts. You need to consider both a trust’s beneficiaries and the identity of trustees, as the trustee is the one able to cast votes and otherwise make decisions regarding the shares. The challenge is giving the owners some flexibility to do their own planning while still having some limitations to meet the family’s objectives. Another approach is to permit transfers to persons or trusts as approved by the board of directors or perhaps a required percentage of shareholders.
An agreement can also provide for mandatory or optional purchases of shares in specific circumstances, such as death, divorce, ceasing to be employed with the company, an attempted sale to another person, or other circumstances. Some families decide to restrict shares (or perhaps voting shares) to those actively employed.
These agreements frequently require the corporation or the other shareholders to repurchase shares upon the death of a shareholder. This certainly restricts the transfer and also may accomplish the goal of providing liquidity to a deceased shareholder. Liquidity may be needed to pay estate taxes or to provide for survivors. One common mistake, however, is automatically requiring a purchase when it may not be necessary. Liquidity, estate tax reduction, or providing for survivors can be addressed with other planning. In some cases, the purchase of the senior generation’s shares can trigger an unnecessary tax and shift wealth in the wrong direction.
In addition to the company having the right to buy shares, shareholders can be given the right to force the company to purchase shares. Care must be taken not to impose on the company a burden that is greater than what the company can afford.
Depending on the terms of the agreement and rights to purchase or sell shares, the agreement may need to set a price for the shares. Many approaches are possible. A common mistake is use of a provision that seems right at the time of the agreement but does not establish a fair value at the time the price is actually calculated. Sometimes it is simply a matter of periodically updating a mutually agreed price. Often, a formula can be developed to arrive at a value. In other cases it may be best to require an appraisal at the time.
There are significant tax consequences to these agreements; some can be good and some not. An appropriately drawn agreement can reduce the value of shares in the hands of the recipient of a gift, thereby reducing the estate or gift tax consequences. An agreement can also fix the value for estate tax purposes. On the other hand, if the pricing in an agreement is not respected by the IRS, a shareholder’s estate can end up in the unpleasant situation of having the stock taxed for estate tax purposes at a level much higher than the actual proceeds that will be received. And here is a really big tax disaster: If the agreement retains too much control in the hands of the senior generation, shares gifted to younger generations may be treated for estate tax purposes as if they are still owned by the person making the gift.
These agreements must be carefully coordinated with a shareholder’s estate plan to avoid any adverse consequences. They can also be a handy place to set forth other family agreements regarding confidentiality or arbitration of disputes. If the company is an S corporation, it is appropriate to include restrictions to make sure that status is preserved, and that a shareholder doesn’t have the ability to terminate it for everyone.
Having an agreement that accomplishes the family’s objectives in an effective way can make the difference in whether a business will continue to be owned in the family. The Family Business Alliance offers programs and resources to help with this and other issues faced by family-owned businesses. For more information, visit www.fbagr.org or call (616) 771-0575.
Bruce Young is a partner with the law firm of Warner Norcross & Judd LLP specializing in corporate and transaction work with an emphasis on family-owned businesses.