FAMILY-OWNED BUSINESSES form the backbone of our American economy.
They comprise 90 percent of all business enterprises in the United States and 62 percent of total U.S. employment, according to the U.S. Small Business Administration.
Yet, the prospect for survival from one generation to the next is discouraging, at best. Only 30 percent of all family-owned businesses survive into the second generation.
Twelve percent will still be viable into the third generation, with just 3 percent operating at the fourth-generation level and beyond, according to a Mass Mutual survey.
While reasons for this discouraging outlook vary, a significant contributor is that parents often hang on too long before transferring the reins and/or ownership of the business. Why? Because, they haven’t reached financial independence.
Or, they don’t feel that their offspring are ready to assume leadership. Or, they are uncertain as to the best method to transition ownership, particularly when not all of their offspring are actively involved in the business.
What family business owners often are certain of however, is their objective of treating their children equally when it comes to their asset/estate distribution. The question that arises though, is whether equal distribution, particularly when the majority of the family’s wealth is comprised of an illiquid business enterprise, is fair.
Different perspectives
The answer depends upon whose perspective you consider. Parents believe that fair must mean equal, while children’s perception of fair often depends upon their involvement in the business, active or inactive. Both camps are likely to agree that equal distribution of the family business is not fair. Why? From the business active child’s perspective:
- Each offspring was likely offered the same opportunity to participate in the business and assume whatever level of involvement they desired. Yet only one may have seized the opportunity and worked themselves into a leadership role, perhaps the more ambitious, risk orientated of the bunch. Now he/ she is being asked to share profits and rewards with those siblings that chose a “safer” route. Hardly seems fair, does it?
- The business active child is likely to retain profits for growth/expansion Meanwhile, the non-active siblings, as mandated co-owners, would likely prefer to receive income distribution. These two competing risk profiles/objectives often lead to conflict.
Even with controlling interest and/or common vision for the company’s future, the business active child assumes full fiduciary responsibility for maintaining the underlying value of the company, once again, often the largest asset in the parent’s estate. Big responsibility!
Lastly, the business active child likely perceives his/her contributions over the years as having helped grow enterprise value. Personal efforts or “sweat equity” may seem to have been completely ignored when parents distribute business ownership equally, regardless of active involvement.
Non-active children also have reason to view equal distribution of the family business as unfair.
- They chose not to join the family business for a reason, one of which may be due to their risk avoidance Given such, they would far more likely prefer a liquid, low risk asset to comprise their share of inheritance.
- Without controlling interest, non- active siblings cannot dictate company operations and/or profitability, including cash distributions. Yet, in Subchapter S corporations (or other “flow through” entities) they owe tax obligation on their pro-rated share of profits, for which they may or may not have the corresponding liquidity to pay the tax.
Market or liquidity for their minority interest is dismal, if nonexistent. Why? Not many investors are interested in an illiquid asset, where they cannot control decision making, And while the business active child is the most likely suitor, lack of available capital often prevents a liquidation event.
And that assumes they could even come to an agreement on a fair purchase price.
Lastly, should the business active sibling’s talents result in increasing enterprise value, upon the non-active sibling’s death, his/her heirs may owe estate taxes, again with no guarantee of having the liquidity necessary to satisfy the bill.
Given these conflicting perceptions, parents would be wise to reconsider their judgement of what they considered to be fair, when distributing ownership in the family business.
In an ideal situation, they would pass the business (either during lifetime or at death) to the business active child and leave other assets, of equal value, to the non-active children. That way, everyone ends up with equal and fair distribution of family wealth.
Insurance options
What if there are not enough other assets to make equal monetary gifts (quite common, by the way)? Life insurance can offer an efficient equalizer. Mom and Dad designate the non-active children as beneficiaries of a life insurance policy in an amount that provides each child equal inheritance.
Yes, premiums may be an issue, but consider the alternatives. In the event that life insurance is not an option due to health issues, consider a joint and survivorship life insurance plan. These policies insure both mom and dad under one policy, but pay out after the second death.
They may offer a viable option, even when one of the spouses is deemed uninsurable. Granted, the non-active children may have to wait for their share of inheritance, but liquidity and lack of any risk may be well worth the delay.
On a final note, family business owners should always retain a back-up plan should things turn out differently than planned. What happens if Junior decides he made a mistake and wants to pursue his true passion outside of the business.
Or, his/her lack of leadership skill/talent become increasingly apparent and detrimental to the viability of the business. What if one of the children should get a divorce and their ex-spouse is deemed entitled to a share of the family business. Binding “Buy Back” agreements, with a predetermined purchase price, between parents and children are critical once ownership transfers.
Parents need to understand the delicate balance between fairness and equality when considering the transfer of the family business. Equal distribution, regardless of involvement, is rarely fair.
With early planning, proper guidance and open communication family businesses can beat the odds of survival. And in doing so, keep our economy strong.
