Business Structuring is a critical component of succession planning that can have a huge impact on family harmony.
Throughout the course of this article, I’m going to describe three different family business situations that I’m currently involved with where Business Structuring is causing havoc.
Situation 1: Active and Inactive Shareholders
The first story is a highly complex 3rd Generation Family-Owned business which consists of a real estate and a separate investment business with 4 family shareholders. Two shareholders, father and son, are active in the operating businesses and two shareholders, sister and a sister-in-law, are not active but are financially dependent upon the business. The ownership of the separate entities add even further complexity to the situation in that, the operating businesses own a piece of the real estate, numerous trusts own a piece of the real estate and investment businesses, and the operating businesses have multiple owners consisting of other entities that the family shareholders control. I have done my best to explain this situation as simple as possible, but due to the bizarre nature of ownership, I have likely confused you.
When we got involved, none of the family members, or any of the family’s advisors for that matter, completely understood the structure. And for a simple family, it didn’t make sense and was causing relationship stress. The two inactive family shareholders were growing increasingly frustrated because they could not predict their income stream with any reasonable accuracy and consequently, could not plan their lives accordingly. The son was growing increasingly concerned about his fiduciary liability with his siblings.
This structure has worked under the father’s leadership because the daughter and daughter-in-law have believed that things are being done in their best interest. However, nothing could be further from the truth. To create dependence in any human being is never in their best interest. If these issues are not worked out with a new, simpler structure, the likelihood of the next generation living under these conditions is highly speculative at best, and more likely pointing toward volcanic explosiveness.
Fortunately, all family members have come to understand the issues and are cooperatively working toward a straightforward structure that is easy to understand and that creates predictable and meaningful sources of income. The initiation of the process towards an uncomplicated structure, in and of itself, has created a more harmonious family environment. The inactive family members’ frustration levels have subsided, and the son’s fiduciary liabilities have been reduced, as they all see movement and growth toward independence.
Situation 2: Blended Family Business
The next situation involves a blended family business that has two children from each side. Two of the four children are actively involved in the business, one from the dad’s side and one from the mom’s side. Both active kids want to be able to run the business at some point, but the entire family has strongly suggested, if not warned, against the two active kids working together.
Here’s the problem, the business is made up of five different franchises underneath one corporate umbrella. That’s right; all five businesses are inside the same corporation. And, the bulk of the family’s net worth is the operating business. What’s a family to do?
Well, you could start by forcing the kids to grow up and learn to cooperate with each other, so they could work together. On the other hand, if the family is right in that there is absolutely no way to make this happen, we’d then be setting them up for failure and family disharmony. So, why not build in some flexibility? An IRS Section 355 divisive re-organization, or tax-free spin-off, of the separate businesses is in order.
While this will most certainly be a costly initiative that is dependent on IRS approval, it will create the flexibility for the active kids to remain in business together if they show that they can mature beyond their sibling rivalry issues. In the event they cannot, well, we then have the flexibility to divide the businesses up and allocate one or more to one child and one or more to the other child.
Further, we will also segregate the real estate that each business is sitting on into separate entities to provide additional planning flexibility, not to mention, much needed additional liability protection. While this environment is not perfect by any stretch of the imagination, it most assuredly creates an environment that is more conducive to the maintenance of family harmony in the long run.
Situation 3: Good tax planning but not necessarily good succession goals.
The tax-driven planning accomplished in this case is particular to the client’s state of residence. Similar to the situation in situation number two, this one involves an operating family business and business related real estate, with two children active in the business and one not. The typical structure is to have a lease agreement between the operating business and the entity that owns the real estate, thereby generating a long term and reasonably dependable source of income for the owners of the real estate. Many business owners establish such a structure to provide them with retirement income once they decide to leave the business. Others, as in this case, use this type of structure as a way to create equality between their children, with those active in the operating business paying rent to those not active in the business, and giving the actives the option to buy the real estate. Not perfect, but it works in a lot of cases.
In this particular case, however, the owner did not set up a lease agreement between the two entities; rather, he established a joint venture between the operating business and the underlying real estate to avoid paying sales tax on the rent transaction. The way this works is that the real estate and the operating business share the net profit of the business. Makes sense, huh? Except that in this most recent economic downturn, the operating business lost money a couple of years in a row, thereby generating no profit to share with the real estate. Rather, the operating business, which thankfully was well capitalized, loaned money to the real estate to pay its share of the income taxes. Now, the real estate (inactive child) owes money to the operating business, with no other source of income to pay the loan. The actives could buy the real estate, but then it would be a reduced figure due to the loan that would be due them.
Obviously, this is not a great deal for the inactive child. Unwinding the joint venture is not going to be an easy thing to undo. But for the sake of family harmony in the long run, that’s what this family has chosen to do.
In sum, when structuring your business and your acquisitions of other businesses, real estate, etc. that you make along the way, please keep in mind that someday you will likely be in a position of leaving it all to your kids. Always ask yourself, “What impact will the decisions I’m making now have on the long term continuity of the ‘golden goose’ and the maintenance of family harmony?” You owe it to yourself and your family to make these decisions as wisely and with as much foresight as possible. It impacts more than just today.
Business structures and agreements have a direct impact on areas such as, but not limited to, taxation, ownership control, shareholder access to cash flow, and family governance. Agreements preclude disagreements. Click the following links for more drill-down resources on Business Structuring.