Equalizing Transfers to Children

A business owner with more than one child often faces difficult decisions when planning for the business succession. Clearly, the owner’s emotions for his children and desire to treat all of them fairly can color the choices that must be made. Also, in many ways, the business is the owner’s legacy. The desire to protect the business may conflict with parental instincts to provide all children with an equal amount of wealth.

Many business families have some children who are interested in and capable of succeeding the owner and some children who are not. Children with the desire and ability to work in the business and possibly assume control are referred to as active children. Children who do not work in the business are referred to as inactive children. The owner should be aware that the active and inactive children often have conflicting goals.

Most parents want to treat each of their children fairly when dividing up their wealth. Often, they equate fairness with an equal distribution of their property among their children. Providing an equal distribution of property to each child may be difficult to achieve when the bulk of their estate consists of a closely held business. Moreover, not all children have the same needs, abilities, or goals. Even if the business owner could give each child an equal share of the business, that asset may not be appropriate for all the children.

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Active and Inactive Children Have Competing Goals and Interests

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Many business owners attempt to treat children fairly by leaving equal shares of the family business to each child—both those active in the business and those who are not. This often creates conflicts in the family after the owner’s death because of the competing goals and interests of the active and inactive children. If the owner leaves equal shares of the business to all of the children, the active child is put in the awkward position of having his business decisions second-guessed by his inactive siblings. If they collectively own a controlling interest, inactive children can force distributions that reduce the company’s working capital to unacceptable levels or force a sale of the business—perhaps even a bargain sale—in order to generate cash. In such situations the active child may resent the interference of the inactive children.

Conversely, if the owner leaves a controlling interest in the business to the active children, the inactive children may have to wait decades before realizing any value from their inheritance—or they may never realize that value. First, the inactive children often cannot sell their interests because of sales restrictions or lack of a market. Second, the controlling active children are under no obligation to make distributions or sell the business. The active children can take money out of the business in salary and bonuses without making distributions to the inactive children. If the active children mismanage the business, it is possible that the inactive children will never receive any of the owner’s assets, much less their fair share.

Even if an owner believes the children can be fair to each other, the influence of a child’s current (or future) spouse cannot be overlooked. Whether or not they work in the business, the spouses of the owner’s children have strong roles in family businesses. Including the spouses in planning for transferring ownership in the family business helps ensure that they understand and support the decisions made. If the spouses are not supportive of the plan, they are likely to exert their influence to try to change or disrupt it. Similarly, the changing needs of each child’s family may affect his or her ability to cooperate with his or her siblings regarding business decisions.

The timing of the transfers may also create resentment among the owner’s children. The goal of many business succession plans is to provide for the orderly transition of the business at the owner’s retirement. Accordingly, the successor often receives the ownership interest during the owner’s life. If the owner requires the remainder of his assets to fund his retirement, the children who are not active in the business may not receive their share of the owner’s wealth until he dies. Since this may not occur for a number of years, these children may resent the fact that their siblings who are active in the business have already received their share of the owner’s wealth.

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Equitable Instead of Equal

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Treating each child fairly does not necessarily mean an equal distribution of the wealth. Due to each child’s unique situation, it is often unwise to assume that an equal distribution of the property is the best way to achieve fairness. As discussed above, transferring the business to both active and inactive children may result in each child receiving an equal interest, but can create tension between the active and the inactive children. Consequently, a more realistic goal may be to divide the property equitably, rather than equally.

It is recommended that equitably requires the owner to consider each child’s contributions to the business when determining how interests in it will be divided. Instead of transferring equal ownership to each child, those who have contributed to the business’s success should be rewarded with a greater allocation of business rights or dollar value. Although there are mitigating factors, in most cases there should be some reward for children who make a greater contribution to the business.

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TRANSFERRING ASSETS HELD OUTSIDE THE BUSINESS TO INACTIVE CHILDREN

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One way to accomplish the business owner’s goal of dividing his wealth equitably among his children and to minimize potential conflict between active and inactive children is to leave the business to the active children and other assets to the inactive children.

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Using Existing Nonbusiness Assets

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Owners with substantial assets other than their interest in the business may be able to transfer ownership of the business to the active children while making equitable transfers of nonbusiness assets to the inactive children. In many cases, the owner makes lifetime gifts of business interests to the active children in order to transfer control at his retirement. Nonbusiness assets (e.g., an investment portfolio), which are needed to fund retirement, are transferred to the inactive children at the owner’s death. Unfortunately, this type of arrangement can create conflict among the children because those who are not active in the business may not receive their property for several years while the active children receive a more immediate economic benefit.

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Using Quasi-business Assets

Frequently, a business owns buildings, land, or other assets that are used in the business, but do not have to be owned by the business. These quasi-business assets could be distributed to the owner (and leased back to the business) without adversely affecting business operations. Segregating quasi-business assets from the business allows the owner to transfer them to the inactive children, who will benefit from the related income and any subsequent appreciation. Depending on the owner’s retirement and estate planning needs, the property can be transferred to the inactive children either during his lifetime or by his will.

If the owner transfers quasi-business assets to his inactive children, who will then lease them to the business, he should be aware of the tension this may create between the parties. As the business owners, the active children will naturally want to lease the property at the lowest possible rate, while the inactive children will want to maximize their income stream. One way to mitigate this problem is for the business owner to enter into a long-term lease agreement on the property before it is transferred to the inactive children. Then, the business is assured long-term access to the property at a fixed lease payment, and the inactive children are assured a fixed income stream.

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Transferring Assets in Trust for the Inactive Children

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Transferring assets to the inactive children, with the understanding that they will lease those assets to the company, may not be in the business’ best interest. If the owner is unsure of the inactive children’s ability to manage the property, fears the children might sell the property or is concerned that the property could be subject to the claims of the children’s creditors, transferring the assets to a trust may be a better option. Then, the assets are afforded trust protection and professional management, which ensures that they will remain in good condition and available to the business.

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Providing for a Surviving Spouse

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Often, ownership in the business is transferred to the active children during the owner’s lifetime or at his death. However, transferring nonbusiness or quasi-business assets to the inactive children during the owner’s lifetime or at his death may leave the surviving spouse with insufficient income. Many owners avoid that problem by transferring those assets to a marital trust qualified as a qualified terminable interest property (QTIP) trust. This provides income to the surviving spouse and postpones estate tax until the surviving spouse’s death. To facilitate equitable transfers to children, the owner can give the surviving spouse a limited testamentary power of appointment over the trust assets. This allows the surviving spouse to consider future events when attempting to equitably divide assets among the active and inactive children.

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