Equal distribution of wealth usually considered fair: An equal distribution of wealth is usually considered a fair distribution. When each of your children receives an equal share of your wealth, it is difficult to argue that any child has been treated unfairly. An equal distribution eliminates hurt feelings, jealousy, bitterness, and family discord.
Sometimes equal isn’t necessarily fair: Under certain circumstances, an equal distribution may not be a fair distribution. Suppose a child has contributed a significant amount of time and effort to the success and profitability of your closely held business. This child has helped you to acquire your wealth. It may be fair to leave this child more than an equal share of your wealth when you are gone, especially if your other children have not contributed to the success of the family business.
Value of an asset may vary depending upon who receives it: If you are trying to divide your assets into equal shares, you may find that the value of a particular asset to a particular child may vary from the value of that same asset in the hands of another child. For the child who has always worked in the family business, succession may be equal to job security, status, and opportunity. For the child who has never worked in the business, succession may be equal to little more than the liquidation value of the company.
Equality of distributions is still up to you: There is no law that requires you to equalize distributions to children. It is legal to disinherit a child if you like. However, most parents seek to achieve a distribution of their assets that is at least equitable. When a closely held business is involved, this task can be challenging.
When Does Equalizing Distributions Become a Problem?
Equalizing distributions to your children may become a problem when some of your children participate in your closely held business and others do not. The participating children may be in the best position to take over and own or manage the business. However, if they succeed you as owners, you may have insufficient nonbusiness assets to ensure that your other children receive an equal share of your wealth.
What are the Primary Planning Solutions?
If you plan to sell your business, then you do not have an equalization problem. Cash proceeds are easily divisible. If, however, one or more of your children will succeed you in the family business and you have few nonbusiness assets, then you may be facing an equalization problem.
If you decide you want to achieve a more equal distribution between your participating and nonparticipating children, you should consider the following planning solutions. Two or more of these plans can be combined or modified to help you achieve your goals.
Joint Ownership: Joint ownership, also known as joint tenancy, is one of the ways two or more people, called joint tenants, can own something together. As joint tenants, each owns the whole property and is entitled to use it as he or she sees fit. Joint tenancy allows you to avoid probate, which can be time consuming and costly. If one joint tenant dies, the property automatically passes to the surviving joint tenant. You can equalize distributions to your participating and nonparticipating children by granting them joint ownership of your closely held business. As joint owners, they each own an undivided and equal interest in the entire business.
Example: Hal owns a home heating oil business worth $200,000 and nonbusiness assets worth $120,000. He has two children, Bob and Ken. Assuming that Bob and Ken want to be involved in the business, Hal can divide his nonbusiness assets equally between them and leave his business to them as joint owners. As joint owners, they share ownership of the company. Each will possess an undivided one-half interest in the entire company and have an equal distribution of the company.
Caution: Granting joint ownership of your closely held business may be a taxable gift, subject to gift tax.
Nonvoting stock: Nonvoting stock is stock that is issued without voting rights. It allows your nonparticipating children to share ownership of the business without having any control over business decisions and operations.
Example: Ken works in the family business. Nellie-Mae does not. Ted can create voting stock that will be left to Ken and nonvoting stock that will be left to Nellie-Mae. Ken will have control of the business, free from any interference from Nellie-Mae. Nellie-Mae can sell her stock back to the company for cash or keep it and collect dividends, assuming dividends are generated.
Minority position with buy-sell over time: A minority position with a buy-sell over time is a way to pass control of the business to your participating children and draw cash out of the business for distribution to your nonparticipating children. The cash is generated by forcing the company to repurchase your shares of stock upon your death using a buy-sell agreement.
Example: Ted transfers stock to Ken to make him a minority shareholder. Ted, Ken, and the company agree that, upon Ted’s death, the company will repurchase Ted’s remaining stock by making payments over a period of time. The payments will go to Nellie-Mae.
Spin-off: A spin-off is a way to leave a portion of your business to your participating children and sell off the remaining portion. Proceeds from the sale will provide cash for your nonparticipating children.
Example: Ken works in the installation and service department of the family business. Ted can create a new company by spinning off his installation and service department. He can then transfer the new company to Ken and sell the remaining portion of the original business. The proceeds from the sale will be available for distribution to Nellie-Mae.
Life insurance: This is a way to leave the family business to your participating children and leave life insurance proceeds of equal value to your nonparticipating children.
Example: Ted’s business purchases a life insurance policy that will pay Nellie-Mae $80,000 upon Ted’s death. Ted will also leave $120,000 of nonbusiness assets to Nellie-Mae. Ted will leave the business, valued at $200,000, to Ken. Each child will receive assets worth $200,000.
Shareholder agreement: A shareholder agreement can be used to leave equal amounts of stock to each child, ensure that the stock remains in the family, and allow children an option with respect to their inheritance. Participating children have the opportunity to buy their siblings’ stock, while nonparticipating children have the option to sell their stock, but only after offering the participating children the first option to buy.
Example: Ted arranges to have appropriate rules and restrictions regarding future transfers placed on the stock. He will leave equal shares of stock to both Ken and Nellie-Mae. If Ken chooses, he can repurchase Nellie-Mae’s stock according to the rules. Similarly, Nellie-Mae can sell her stock but must give Ken the first option to buy.
Will or trust with equalization clauses: A will or trust with an equalization clause directs your executor to equalize treatment among children before making final distributions of your wealth. This works only if you have sufficient nonbusiness assets to distribute to the nonparticipating child.
Example: Ted adds an equalization clause to his will or trust, instructing his executor to ensure that Nellie-Mae receives a distribution that is equal in value to the value of the business received by Ken.
What are the Factors to Consider when Reviewing Planning Solutions?
How much control each child has over business: Several factors will likely play a part in your decision to adopt any of the aforementioned planning solutions. You may want to consider who will control the family business and whether that control should be shared. When you transfer business assets to your nonparticipating children, you may also be transferring a degree of control to them, so you will want to determine whether this is appropriate and plan accordingly.
What sources of funding are available: Another factor is funding. Many planning solutions require funding. Often an equalization plan provides that stock must be repurchased or redeemed. The source of funding might be a life insurance policy, future profits of the business, a partial sale of business assets, or the personal savings of your children. The source and availability of funds may be a factor in determining which planning solution you adopt.
Whether timing of distributions will affect children: Timing of the distribution is also a factor.Several planning solutions provide that nonparticipating children receive a stream of payments over a period of years rather than a lump-sum inheritance. Some planning solutions may require participating children to temporarily share ownership of the family business until a future date. Timing considerations should be evaluated in accordance with your family’s needs.
Whether business is likely to remain liquid: Finally, the success of several planning solutions is contingent on the future success of the business. Some of your children may be relying on the performance of other children for their inheritance. The degree to which you are comfortable with such an arrangement may help you in choosing a strategy for equalizing distributions.
If you have questions, contact the Experts at Henssler Financial: