Antonin Scalia already had experience working with a group of nine when appointed to the Supreme Court in 1986. He was the father of five sons and four daughters.
Being a conservative on matters of law, he was questioned about his oldest offspring, whose opinions were more liberal than his own.
“In a big family, the first child is kind of like the first pancake,” the Justice replied. “If it’s not perfect, that’s okay. There are a lot more coming along.”
When children of a High Court justice fall far from the tree, the event makes good media copy. But when the offspring of an owner of a family business choose not to follow in the footsteps of their entrepreneurial parent, it can create significant planning problems.
Consider three common concerns when only some of a business owner’s offspring expect to become active in the business.
Playing Percentages In The Will
The most typical dispositive instruction for an estate left to children gives each an equal fraction of the property. This is fine, as long as the testator is confident the children will receive equal shares of every asset and can resolve their differences about particular items.
But when a business owner intends that certain children are to inherit the business and others are not, his or her intentions must be expressed by directing that the business go to the intended future owners. As obvious as this might sound, clients often need be told that instructions about who should inherit a business must be exact and unambiguous in a will or trust and understood by all before death.
Specifically designating who will get the business usually won’t alter a testator’s intention that all children be treated equally. This can be a problem, however, if the business accounts for much of the estate’s value. For example, two children may have difficulty dividing an estate if one is to inherit a business whose value is more than half the value of the estate.
One solution: If the parent is insurable, life insurance can be used to bring additional value (and liquidity) to the estate, thus allowing for equitable treatment of heirs without giving ownership in the business to disinterested children.
But this strategy presents other concerns. Among them: (1) Does the purchase of life insurance to enlarge the estate create financial underwriting issues that might give a carrier reason for pause? (2) Is the estate large enough that the insurance proceeds might create or aggravate estate or inheritance tax problems? If so, can the insurance be held outside the estate in a manner that still treats all children impartially and as intended?
Using an intra-family buy-sell agreement, the child who will take ownership of the business can be given the right to purchase interests transferred to other children, the price will be determined by an agreed-upon formula. The buying child can own the coverage on the parent, using the proceeds to make the purchase. This strategy might also alleviate financial underwriting questions and keep the proceeds out of the estate.
If the parent is uninsurable, steps should still be taken to arrange an unfunded agreement that would allow for purchase of scattered interests on manageable terms.
Employing Peter To Pay Paul
As a rule, a child who goes to work in the family business becomes more capable, more valuable and more beneficial to the company as time goes by. He or she accepts more responsibility and is involved in more decisions that increasingly contribute to the success and net worth of the enterprise.
After a number of years the child can make a legitimate argument that at least a part of the company’s value that will be included in the estate is a result of his or her work and shouldn’t be considered in the hotchpot that is to be divided equally among siblings who did not contribute. If such an inequity, perceived or otherwise, is acknowledged only at the time of death, it is usually too late for the heirs to reach an equitable solution.
What to do? During the business owner’s life, it is impractical and unpopular to revise and enlarge a participating child’s share in the inheritance to reflect present contributions to the business. Two common planning techniques that could recognize a child’s role in enhancing company value are (1) an increase of compensation and (2) adoption of a program of lifetime transfers of interest in the business.
The second is usually accomplished with the formation of a family limited partnership or family limited liability company. In addition to acknowledging a child’s contribution to the business, the organizational structure allows the parent to maintain control of the business regardless of the percentage of interest transferred during his or her life.
Done properly, the process removes the transfers from the estate and from the reach of estate and inheritance taxes. In addition, marketability and minority valuation discounts could make use of gift tax exclusions and estate tax exemptions to make tax-free transfers of the interests and to reduce liability where the gift tax may be unavoidable.
Working With An Imperfect Pancake
Unfortunately, family businesses are not as comparable to pancakes as some other things. If the first one is not perfect (or even okay) and fails for lack of planning, another one is probably not coming along. The work of many years is lost for good.
Fortunately, there are abundant opportunities for the planner to whom a business looks for guidance on managing the first one correctly–including on matters of succession to the next generation.