Family Dynamics – Can Owners of Small Businesses Be Fair in Their Estate Planning?

Sep 8, 2023

Those of us working in the trusts and estates area see the strain when mom or dad dies, and no estate plan is in place.  Siblings often go to war.  Holidays and other celebrations will never be the same.  Long-held resentments resurface.  Even if mom or dad is very sick or dying when estate planning is brought up, we hear, “Mom always liked you better!” or “Eileen always took my teddy bear away.”  Our simple response, “Oh, just grow up!” can only be said in our heads.

While planning an estate’s distribution is always difficult, business owners face an especially tricky situation – “How can I be fair to everyone when my biggest asset is my business?”  As with many decisions when family is involved, the question is seen as overwhelming.  This essential planning never starts.

Being fair is relatively straightforward when the assets are cash, investments, and homes.  Appraise the house, add the investments and the cash, split the total among the heirs.  When a business is involved, the definition of fair becomes nebulous.  Consider the following example, business owner Mr. X has one operating business and one real estate company whose only tenant is the business.  Mr. X has one daughter who is a key employee in the business and is slated to take over when Mr. X passes away.  Mr. X’s two sons, however, do not work in the business.  How can Mr. X divide the estate fairly?  Let’s assume the daughter is not paid market compensation.  Few small businesses pay market rate salaries to their family employees.  Let’s also assume market rent is not paid.  Rent paid to related companies usually is just enough to cover mortgage payments, real estate taxes and other miscellaneous costs.

Solution 1:  Leave the building to the two sons and the business to the daughter.  Make up differences with cash, investments, or insurance.

  • As the building’s owners, the two sons deserve market rent. But imposing market rent on the daughter may adversely affect the business’ profits and her income.
  • Without control over the building, the daughter may feel at risk. Barring a formal and very long-term lease, the two sons can sell the property and leave the daughter’s business homeless.
  • The business may falter or even fail through no fault of the daughter. COVID provides innumerable examples of this.  The daughter now owns a company that is worth less or is even worthless.  the two sons still hold a valuable building.

 

Solution 2:  Evenly divide the ownership of both companies among all three children. 

  • The daughter may resent putting in the sweat equity required to increase profits – profits the two sons share though they have not lifted a finger.
  • The two sons may want the daughter’s salary to be at market rates. While the business may show more profits, the daughter may now be taking a pay cut.
  • There are three sibling-owners. As children the siblings could never agree on the restaurant the family should go to for dinner.  Can the business owner expect them to agree in the future on important issues?

 

Solution 3:  Sell the business to an Employee Stock Ownership Plan (“ESOP”) and divide the proceeds among all three children.  An ESOP may be the right solution for the right company. 

In short, an ESOP is a trust that purchases stock from the owner(s) on behalf of the company’s employees as a retirement benefit.  The ESOP must comply with various federal (and sometimes state) regulations including annual filings. It is subject to audit/review by the IRS and the Department of Labor. 

As a trust, it is tax exempt, providing more cash flow to the company.  Contributions to the ESOP are tax deductible, even principal payments on loans taken to finance the share purchase.  Limits to these benefits exist. 

Among the pros and cons of an ESOP are:

  • Pros
  • An ESOP is typically income tax exempt, company cash flow is improved.
  • ESOPs can be financed at lower interest rates and loan repayments can be tax deductible.
  • The sale can be accomplished over time.
  • The owner/seller can realize potential tax deferral benefits.
  • Employee morale often rises.

 

  • Cons
  • The Company must produce strong and consistent cash flow.
  • There are expenses to set it up, often well over $50,000 plus.
  • There are annual expenses for filings, valuations and if the plan is large enough, audits.
  • There is risk of audit by the IRS and the Department of Labor (“DOL”). An unhappy or disgruntled employee can lead to an audit by the DOL.
  • A trustee must be engaged. While often the trustee is not involved in day-to-day decisions, they are entitled to ask questions.

 

These few but typical issues certainly should not stop a business owner from planning.  They often do, however, there are always alternatives.  As hard as family conversations about the estate’s division are guaranteed to be, they must occur.  Without them, the minor fights that may occur are nothing in comparison to the guaranteed chaos that will follow the owner’s demise.