As Exit Planning advisors, we base our actions on our clients’ goals, one of which is to transfer their companies to the successor they choose. If clients tell us that they want to transfer their businesses to the next generation and have more than one child, the related (and almost universal) goal is to do so in a way that is fair to all of their children.
The Equality Problem
What could be fairer than dividing everything equally? Let’s look at a fictional, but typical, scenario.
Herbert and Denise Asquith, owners of Asquith Dairy, met in high school, married and had been inseparable for 65 years. When Denise died after a long illness, Herb died a few days later.
His will left everything—including the company—equally to his son (Gilbert) and daughter (Peggy). Gilbert continued to run the business, while Peggy (a high school Spanish teacher in a nearby city) rarely visited the farm. She had never been interested in the dairy farm and, as a child, had dreamed of moving away to embrace the city life.
The dairy farm prospered under Gilbert’s leadership. For ten years, he paid himself a reasonable salary while reinvesting the earnings in acquiring more land, more dairy cows, a second, and then a third milking operation.
Peggy watched the value of her ownership grow. At first, she wondered, but over time grew concerned that she had yet to see a penny from it. Her brother’s salary increased, but the dividends he did distribute all went to paying taxes. When Peggy talked to Gilbert about it, he explained that, “I’m just doing what Mom and Dad did. I am putting everything into this farm.”
When the first of Peggy’s three children reached high school, she realized that her teacher’s salary would not cover the cost of college. She called the only lawyer she knew, the estate planning attorney who had prepared her will years before.
“The farm produces a lot of income,” Peggy explained, “but Gilbert insists that by plowing everything back into it, he’s just doing what Mom and Dad wanted. Well, I don’t think Mom and Dad wanted me to be left out in the cold. Is there anything I can do?”
“What can we do indeed?” thought Peggy’s lawyer.
Had Herb and Denise (or their attorney) considered the consequences of splitting everything down the middle, their children would not be in a standoff. Peggy’s attorney first suggested that Gilbert buy Peggy’s interest in the farm.
“I already suggested that,” she replied. “He’s not interested.”
“Perhaps we could force a liquidation,” the attorney offered.
“I can’t do that. I know that my parents wanted the farm to continue and Gilbert to run it. What they didn’t realize is that I would not benefit from owning half of it.”
Peggy’s lawyer shook his head and said, “I don’t think there is much you can do then.”
Peggy’s lawyer was what I once was: an estate planner who was seldom present when the plans we created were implemented. Had Peggy’s attorney added Exit Planning to his toolbox, he would likely have witnessed the results of planning that did not take into account the voices of children who are not active in business (or NBACs).
Splitting all assets equally is the easiest path for parents/owners and their estate planning advisors, yet this story stands as an example of why “equal” is not always fair. It’s easy to split cash, investments, and even real estate down the middle. Unfortunately, splitting an operating business is not as simple. The challenge is compounded when one child is active in the business and others are not.
In our example, one child controls the business and the distribution of its income. The other child has no voice. The business-active child is content but the NBAC receives no benefit. Exit Planning advisors are well aware of the inequalities of "equality based" planning; they know that assets may be equal, but income is not. Without proper planning, a child who receives a minority, or even an equal interest in a business may inherit assets that have no benefit to them.
The Fair Solution
In transfers of family businesses, we must include non-business assets and any NBACs in the planning process. Also keep in mind that “equal” may not always really be “equal” to all parties involved. Owner/parents have several options:
- Transfer ownership only to business-active children and other assets to NBACs.
- In larger businesses, ownership can be shared.
- Sell the company.
- Approach an equal division of business ownership among business active children and NBACs very cautiously.
- Owners/parents typically do not intend to position one child to benefit over his or her siblings. Unfortunately, sometimes in their efforts to treat everyone equally, they do just the opposite.
- Review the estate plans of your family business owner clients as you begin lifetime Exit Planning. Determine whether there is an alignment between their lifetime transfer wishes and their wishes as expressed in their estate plans.
- As Exit Planning advisors, we can offer more thoughtful solutions to the question of transferring ownership of family businesses because we understand (and can help our clients understand) the intended and unintended consequences.