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Two Realities for a Business Owner

Many business owners fail to spend enough time to assure the survival of the business they devoted their lives to building.

By John J. Scroggin, J.D., LL.M.

In the course of my practice as an estate planning attorney, I have found two consistent certainties in estate planning for businesses which might be added to Mr. Franklin’s quote. Both certainties assume that the owner of a closely held family business has family members who will continue to operate the business after the current owner’s retirement or death. If the owner instead desires to “cash out” by selling or liquidating the business, these realities cease to be an issue.

First reality: “The business’ equity value is not an asset. Rather it is a liability waiting to happen.” When the owner intends to pass a business to family members, the equity value provides no significant benefit to the owner. In most cases, when the issue is properly addressed, the owner is interested in control of the entity and its income more than the equity value. Using readily available planning approaches (e.g., partnerships and trusts), the income and control of the business can be separated from the equity, and then the equity can be passed at a reduced tax cost to family members using various valuation adjustment techniques (e.g., minority and lack of marketability adjustments).

Because of the federal estate tax and state inheritance taxes, when the owner retains the equity value of the business, the family will bear a tax liability which might have been reduced or even eliminated. By retaining ownership to death, the owner loses the ability not only to discount the present value of the business, but also causes the family to pay estate taxes on its appreciation. For example, assume in 2006, a married taxpayer has a $7 million company. He or she transfers $3 million of the business to a family trust and dies 12 years later. Such a gift has a number of benefits:

  • If the minority interest which was transferred was discounted at 35% and thedonor’s spouse agreed to gift-splitting, the donor’s and spouse’s unified tax credit would cover the entire gift (e.g., $3 million discounted at 35% is worth $2 million—the amount of the couple’s combined unified tax credit). Because of the valuation discount, even if the business did not grow, the estate tax savings would be approximately $550,000.

  • But what if the business continued to grow at a 10% annual rate? At the end of 12 years, the prior transfer will have moved $9.4 million out of the donor’s estate, saving the family an additional $4 million (e.g., $7.4 million in appreciation taxed at 55%).

With top estate tax brackets at 55% to 60% (and due nine months after death), the tax burden may make it financially impossible for an entrepreneur to pass the business to family members. The payment of 55% to 60% of the value of the business (even when electing tax deferral under Tax Code section 6166) can result in such significant cash drains on the business that it cannot survive.

The thoughtful entrepreneur recognizes this problem and realizes that transferring current equity (and its related appreciation) can reduce the future tax burden on the business without harming the owner’s income or control. Contrary to the owner’s intent, the emotional retention of ownership can actually destroy the business.

Second reality: “Conflicts are inevitable between operators of the family business and family members who are outsiders.” Many entrepreneurs intend to pass down their businesses to one or more designated individuals who will run it after the entrepreneur’s death or retirement. But because the business is often the largest asset of the estate, the owner may also pass ownership in the business to other family members.

During the owner’s lifetime he or she has been able to keep peace in the family and serve as the “benevolent dictator” of the business. Unfortunately, this powerful role disappears with death or incapacity. Sibling rivalry and other issues then begin to come to the fore front, particularly between those who are operating the business and those who are outside.

Almost inevitably, outsiders feel that the compensation and perks provided to the insiders are “excessive.”

Outsiders will question business decisions (e.g., capital expenditures) even when they know little about business operations or competition. Outsiders often believe that the income paid to them should match the compensation paid to the insiders.

Meanwhile, the insiders (who often feel they are working much too hard) resent that their sweat is increasing the value of the business interest of the outside family members who are continually asking for more and more income to which they are not “reasonably entitled.” The insiders often fail to see that the outsiders have a right to a return on their investment. Many family businesses have paid inordinate legal fees because of this and/or have been forced to sell to alleviate the problem.

This conflict is inevitable as each owner attempts to direct his or her own financial destiny and feels increasingly unable to do so because of the common ownership with other family members. This is not a matter of “good” and “bad” family members. It is a matter of increasingly different life goals.

The solution lies in setting up a structure in the estate plan which assures that those in the business own and control as much of it as possible, while giving outsiders other assets so that they can effectively control their own financial destiny. Life insurance is often a necessary element of this planning. This process traditionally must be done by the entrepreneur while he or she is alive so the entrepreneur can dictate the terms.

Many business owners fail to spend enough time to assure the survival of the business they devoted their lives to building. This failure to focus on the survival of a business often results in its destruction from either tax liabilities or inherent family conflicts. With proper advance planning both problems can be avoided.

John J. Scroggin, J.D., LL.M., a graduate of the University of Florida law school, practices tax and estate planning at his own firm, John J. Scroggin & Associates, in Roswell, Ga. He can be reached by phone at 770-640-1101 or by email at scrogginlaw@aol.com.

 


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