In the non family business the issue of control and transfer of stock to the possible future owners who will eventually replace the current owners is relatively straight forward. First, If you own 51%of the outstanding stock you own control of the company regardless of how much minority stock is owned by others. If you want to be safe, make sure you maintain that 51% control until you are ready to retire or be bought out or until you have contractual protections that counteract the loss of control. Second, once you decide to sell stock to others, you sell the stock for as much money as you can or transfer blocks of stock as bonuses to good employees to maintain loyalty and as a part of their "pay package."
For a full discussion of these tools, see the article on Corporate Buy and Sell Agreements on the retainer web articles page.
The family business, however, has both complications not encountered by the non-family business in transferring control to the next generation as well as many estate planning tools that create tremendous benefits, both tax wise and structural, for the family. To avoid the complexities and maximize the benefits should be the goal of any family engaged in business together and this article, the second in a series concerning the family business on this web site, shall discuss how to accomplish both goals.
THE NEXT GENERATION: WHEN DO YOU GIVE THEM A PIECE OF THE BUSINESS?
All businesses eventually confront the question of when is the correct time for the original owners to transfer as bonus or sell stock to employees to maintain loyalty and create the younger group of owner-executives who will eventually buy and run the business. Most owners have to confront the balancing act of having the detriment of losing some control of the company but risking that in order to have the benefit of creating the "owner" mentality in the employee and encouraging the employee to remain with the company that may some day be his or her own.
Quite often the owner will create a multi year system of bonuses by which the employee may either earn or buy stock over the years in increasing amounts, thus encouraging the employee to remain faithful to the company. Until the stock transferred approaches fifty percent, control is not lost. The danger that the employee may quit after owning stock is solved by the traditional Buy and Sell Agreement discussed in the article on this web site on that topic and by having the price of the buy back of employee stock by the company being low if the employee quits. If structured correctly, the cost to the company is minimized while the motivation to the employee to remain is maximized.
Additionally, by selling their stock the founding owners can at times bring capital to the company or to themselves, at last seeing some return for the stock that they have owned for so long. By bonusing the stock rather than selling it, owners can at times avoid having to give raises in cash since the employee gets stock instead and the owners can use the money saved to increase their own take home from the company.
How does the above typical situation compare to the family business?
First, the need to create such loyalty is usually relaxed in the family business setting.
It is anticipated by the family that the younger generation will inherit the stock in any event, thus transfer of ownership during the life of the elder generation may not seem so vital.
Second, the danger of losing control seems often less critical for the previous owners. The children or younger relatives are seen as tied to the older generation by bonds of love and respect or by feelings of deference. Most parents are not fearful of losing control as the stock percentage owned by the next generation increases.
However, both beliefs above are often misguided. Most young executives, whether relatives or not, want and need the "ownership" of stock or partnership interest not only to assure themselves that they are more than mere employees, but to assure spouses and friends that they both own and eventually will control the company.
And for the departing owners, the loss of control to the next generation can be every bit as dangerous in a family business as in a non- family business. This writer has seen well over a dozen families in which the younger generation ignored the wishes and eventually the economic interests of the founders of the company once control was transferred to the younger generation. Protection for the mother or father leaving the company is as vital in the family setting as in the non-family setting. Often more.
But as discussed in the first chapter in this series, Family Businesses: Their Unique Advantages and Problems: Power in the Family Business: Structural and Emotional, emotional issues often confuse and delay the transfer of ownership and stock far more in a family business than a traditional business. It is one thing to tell a young employee that they will not get control for fifteen years and must earn their way to your trust. It is quite another to tell your daughter or son that you do not trust them enough to give up control for another fifteen years, especially when it is over a family dinner with grandchildren looking on. More than one family has self destructed after such a scene as the son in law or daughter in law becomes enraged and insists that in such a case his or her spouse should leave and get "a real job" outside of the family business.
Equally dangerous in the family business is the premature retiring of the elder generation who mistakenly feel that because the younger owner is "in the family" that knowledge of the business is somehow innate or that the younger owner will automatically act in the interests of the elder generation.
Yet, in reality, it is not difficult to create a long term plan for transfer which both protects the elder generation, reassures the coming generation, and achieves tremendous tax benefits for the entire family.
The key is to implement the plan in an affirmative proactive manner before it becomes an emotional issue. Being proactive will avoid defensiveness and will give the generations a chance to "check out the waters" before diving into the transfer of real control.
When should that be done? As soon as the next generation shows interest in joining the business, some ability to learn the business and has committed the time necessary to learn the basics of the business. The plan should be created as soon as that criteria is met since if done correctly, the plan will be one that will take five to fifteen years to implement fully, with tax benefits being achieved right away, emotional scenes being avoided, yet security for the elder generation being maximized.
Most of our clients wait at least three years after employment of the next generation began before adopting a plan for bringing in the next generation as owners, and the average is five to seven years before the plan is adopted. Waiting longer than seven years is probably a mistake unless a divorce of the son or daughter occurs or some other such event occurs that requires some delay. (More on the effect of divorce in later articles and the reader is again invited to read the web retainer page article on Buy and Sell Agreements.) Remember, though the plan may begin in three to seven years, control by the elder generation is not surrendered for a decade or more thereafter - if then. It is a slow but steady plan we recommend, one in which ownership is transferred but control maintained by the elder generation until skill and commitment of the younger generation is demonstrated without doubt and the elder generation well protected by additional structures or assets outside the business.
THE PLAN FOR INTEGRATING IN THE NEXT GENERATION
Experienced legal advice is necessary to create the complex and effective plan required, but this article will give a general idea of the essential structure we recommend be implemented. Some basics as to Gift and Estate Tax law is helpful.
One pays taxes for gifting property to another whether the gift is made when you are alive or dead. If gifted during life, there is a gift tax to pay. If one inherits, there is an estate tax to pay.
In reality, they are the same tax and the life time exemption (about one million dollars now and increasing gradually over the next several years) allows one to make gifts whether alive or dead and not pay tax - but only up to the exemption amount. (Thus, if I give you two hundred thousand dollars during my life and then two million dollars upon my death, I would have already used two hundred thousand of my life time exemption before my death and would have eight hundred thousand left of the exemption to apply to the two million dollars upon my death - and would have to pay estate tax on 1.2 million dollars. Since the rate can approach fifty percent quite quickly (that too is altering over the next several years) the tax could easily be in excess of five hundred thousand dollars on that inheritance! See the Web Article on Wills and Trusts and the Newsletter on the New Tax Law.
In addition to the life time exemption, one can give ten thousand dollars away each year without paying gift tax - and without using up the lifetime exemption. Thus if I give you ten thousand dollars each year for fifteen years, then one hundred and fifty thousand dollars goes to you tax free - and my one million dollar exemption remains untouched.
And, of course, the value of the asset gifted is determined as of the date of the gift, thus none of the later appreciation will be counted in your estate. Lastly, if the gift is a minority interest in a company, it is normally discounted significantly in computing values for gift tax purposes.
The above basic rules demonstrate that significant taxes can be saved if stock is slowly but surely gifted away over a period of time. Assume a five million dollar company. If a father dies and leaves the stock to the daughter, she would pay estate tax on four million dollars of it (after the life time exemption is applied) and that tax would likely be close to two million dollars.
Assume instead that for the last ten years of his life the father had gifted ten thousand dollars worth of stock each year - and that his wife had done the same with her community property interest in the stock. In that manner, the two of them could have gifted two hundred thousand dollars worth of stock, saving about one hundred thousand dollars in estate taxes. If the stock had also appreciated during that time, even more would have been saved and if the stock was discounted since it was a minority interest, then the two hundred thousand dollars worth of stock could easily be equal to three hundred thousand dollars worth of stock, perhaps more, thus saving one hundred and fifty thousand dollars in estate taxes.
There are many other ways such transfers can reduce estate tax but the general idea can be easily seen in the above example. (Do not begin such transfers without professional tax and legal advice. Such aspects as losing the stepped up basis in the stock for income tax purposes must be factored in.)
It therefore makes good tax sense to begin a slow but steady program of gifting stock. Until and unless more than 49% of the stock is transferred, the elder generation maintains control while maximizing the tax benefits.
Further, a slow but steady increase in the amount of stock owned by the younger generation gives all a chance to determine if there is skill and commitment necessary to keep the company effective after the elders retire and maintains interest in the younger generation as they see their holdings increase over the years.
Thus, both tax law and good business sense recommend strongly that the elder generation begin a planned program of gifting small blocks of stock to the next generation over time, checking to see how the younger generation is doing with the responsibility and motivation of stock ownership, but retaining at least 51% of the stock (thus control) until further protections are created to make sure the elder generation does not find itself without power in their declining years to protect themselves.
FAMILY NON OWNERS: NON FAMILY OWNERS: COMPLICATIONS AND POSSIBILITIES
Often there are family members in the younger generation who wish to remain outside the family business. How to handle the fair distribution of an estate between owner children and non owner children is discussed in the first chapter of these articles on The Family Business.
Of equal import is the effect on key employees who may also wish to own some of the stock but are not in the family. Using "shadow stock", discussed in our first article on Family Businesses, and other means of compensation are possible, of course, but let us assume that the elder generation wants to include non-family members in the company.
That can be accomplished by either selling, bonusing or gifting stock as if to one's own children. Gifts can be made to anyone and bonuses, while taxable to the recipient, are tax deductible to the company.
But it must be recalled that in California the person or group of persons who own fifty one percent of the stock effectively have total control of the company. See the web article on Corporate Struggles: Who Has What Power When Push Comes to Shove? In dividing stock between non family and family, the elders must carefully determine if the non-family can form a block and achieve effective control to the detriment of the family as a whole. Thus, if stock is held 48% by each child and 2% by X, X can effectively act as the swing vote and has far more power than one would expect from 2% of the ownership.
The elder generation must also be careful that ill will is not created by forcing a key employee to buy stock at high prices while gifting stock to children. The key employee may very well feel angry or contemptuous of the children-owners who did not have to "work" for their stock. (Another good reason to gift stock to the children over time, of course.)
The advantage of having outside owners may overshadow the dangers above. It often helps to have a voice from outside, not immersed in family history, who can overcome the "baggage" of emotions that even the best family can accumulate over the years. With a good Buy and Sell Agreement and careful structural planning, there is no reason why the family cannot bring in outside shareholders without facing the danger of losing control.
LETTING GO: WHEN DOES THE ELDER GENERATION GIVE UP CONTROL, IF EVER?
As vital as integrating in the next generation is protection and security for the last generation and it is a foolish business owner, indeed, who does not create a structure that allows retrenchment and reversal of the plan to gift control or stock should things go wrong.
Things can go wrong for myriad reasons. A child may decide that the family business is not attractive and may have other dreams for his or her future. A child may not get along with a brother or sister, father or mother, or may simply not be good at the particular business. Often, a marriage may result in a change in attitude or plans of a child - even the need to relocate to another state. Marriages may also result in parents no longer trusting that the child will protect them down the road since the child seems under the influence of a new spouse.
Whatever the reason, the elder generation must retain effective security of some kind until they are fully ready to leave and no longer depend on the company for their livelihood. This security can be created in several ways, such as the following:
- First, by retaining 51%, the elder generation retains effective control of the company and can always terminate the child from employment and buy back the stock - assuming they were wise enough to have a Buy and Sell Agreement created.
- If for some reason the elder generation wants to surrender control by ownership of a majority of the stock, by use of written enforceable employment contracts and options to perhaps buy back majority control, the elder generation can still have the security that is needed until they are ready to fully retire.
- Further, such business assets as customer lists, intellectual property rights, the name of the company and the like can be retained in the name of the parents and licensed to the company with the right to terminate the license if the younger generation does not act in ways that protect the next generation.
Other tools are available, but the point being made in this Article is that the elder generation must maintain some protection and not simply rely on the younger generation to protect them in their declining years-but such protection can be accomplished in many ways that do not interfere with the ability of the younger generation to assume increasing control of the company and gradually obtain effective control.
An underlying problem is that the elder generation often always sees the younger as "children" and often does not realize that they have matured and are ready to run the business and, indeed, anxious to do so if the parents would simply make room. When to step aside and how to do so without needless risk is perhaps the most difficult problem a parent can face who has elected to make the business a family business and each family must develop their own way to approach and resolve that dispute. Certain truths should perhaps be remembered by the entire family:
- The elder generation does not "have to" give the business away. They have the choice, not the obligation, and the younger generation should not consider the business their own until it actually is.
- The younger generation must be expected to want to gain ownership and control. If they do not, then they probably do not have the mentality that will make a business successful. Aggressiveness and desire to take over the company are useful for running a business.
- There will be struggles for control and decision making in any family business just as in any non family business. Expect them and do not overreact.
- There is no reason to assume that the entire next generation will want to be in the family business. Each of us has unique abilities and unique dreams. Indeed, that is the best part of the "American" way of life - the ability to follow your own goals and dreams. Parents should accept a decision by a child to refuse participation in a family business as testimony to the parents, success in creating an independent individual.
- Children are not slaves. They should be paid as well as any other employee occupying the same job. Parents are not slaves. They have a right to be paid as well as any other employee occupying the same job. And owners of stock have the right to expect a return on their investment.
- Key employees must be considered as one grooms a child for future ownership. If plans are not made to make key employees happy, the child may very well inherit a business that cannot succeed.
- Do not expect that you will be able to judge your own child or own parent objectively. Try to get outside advice whenever it seems to you that your family member is either very very good - or very very bad.
- And be ready to give up the effort to pass the business to the next generation if the effort is beginning to destroy the family. The family does not exist for the business and should not be sacrificed on the alter of the business.
The next generation can be brought in without undue risk or disastrous upheaval if careful planning, professional advice, tax planning and structural creation is all blended with the type of care that any major business decision must entail. It will not "just happen," any more than anything else good "just happens" in business.
But it will happen and happen in a way to give joy to a family if the elder generation undertakes the responsibility to do it both well and well in advance.