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Your Family Business And Your Estate
By Dave Kauppi, Fri Dec 9th
As Penn State professor William Rothwell ominously points out inthe forward to Exit Right: A Guided Tour of Succession Planningfor Families in Business Together, more than 40% of the peoplewho run the closely held operations that comprise 80% of theNorth American economy will retire by 2007. Those businesseswill either be sold to a third party or management team, closeddown, or passed on to the next generation. In this article Iwill focus on passing the business on to the next generation.Tax laws still favor home ownership with mortgage interest as atax-deductible expense. The government has also encouraged thepassing of a business from one generation to the next withseveral favorable estate and gift tax rulings. Estate planningattorneys have utilized IRS ruling 5960 to minimize the estateand gift tax owed for a business either gifted to or inheritedby the next generation. The business is often placed in one ormore LLC’s and divided up into minority pieces to take advantageof very substantial and legal minority discounts, often as highas 40%. As is often the case, a business owner will have, forexample, 4 children. Two sons will be actively involved inrunning the businesses and two daughters have built livestotally separate from the business. Because 85% of the value ofthe estate is tied up in the value of the business, to be “fair”the business is gifted and willed to the four siblings in almostequal proportion. Because the sons are running the business,they will get slightly more of the business and slightly less ofthe remaining estate. This gives them majority interest in thebusiness. After dad leaves the business, the two sons willcontinue to run and grow the business without any input orparticipation from their two sisters. Typically the businessdoes not pay any dividends and the two sisters’ portions arenon-liquid because there is not a good market for sellingminority stakes in a privately held business. Also, there isgenerally a very restrictive buy sell agreement that favors themajority holders. The sisters have no idea what the “fair value”of the business is and the only indication they have ever gottenis an official IRS gift tax or estate tax return with 40%discounts applied. If the enterprise value were, for example,$50 million and the two sisters owned a combined 40%, you wouldthink that they had an asset worth $20 million. The onlydocument they have seen, however, is the gift or estate return,valuing their portion at only 60% of that number, or $12million. The brothers feel entitled to the lions share becauseAnn and Julie had nothing to do with building this business. Thebrothers pay themselves big salaries and benefits and pay outlittle of no dividends. They may approach the sisters with gifttax return and restrictive buy sell agreement
in hand and offerto generously buy out the sisters for a combined 8 million,because that is “all the company can afford to pay.” After thistransaction takes place, let’s look at the result of how dad’sestate was fairly divided. Originally the brothers were leftwith 60% of the $50 million business, or $30 million and a minorportion of the remaining estate. The sisters were left with 40%of the business, or $20 million and the bulk of the remainingestate of $10 million. That appears to be fair. However, thebuyout of the sisters for a combined $8 million results in aneffective estate distribution of $42 million to the brothers and$18 million to the sisters. This is not what dad intended, butit happens all the time. This is a very complex and emotionalissue and there are no simple answers. Generally, dad had hisidentity tied up in the business and wants it to live on throughhis sons after he is gone. This is a noble, yet impracticalthought if all the siblings are not actively involved in thebusiness. The children often inherit the restrictive buy sellagreements that favor the brothers running the business andscare off investors that may have been interested in a minoritystake in the business. Much of the value from a privately heldbusiness is derived from the benefits of working in thebusiness. There is the very real concern that the integrity ofthe gift or estate tax business valuations will be compromisedif the sisters are bought out at a price approaching a pro-rateddivision of total enterprise value. Unfortunately, in mostcases, nothing is done and as a result there are literallyhundreds of billions of dollars of minority interests inprivately held business that are providing little return or noreturn to their owners. We are working with estate planningattorneys, tax accountants and investors to come up withsolutions. One of the keys to unlocking the liquidity in theseminority interests is for the business owner to recognize thissituation prior to building his estate plan. Unfortunately, weare often brought in after the fact and a fair outcome then iscontingent upon the majority owners honoring dad’s originalintent of fairness and working toward that end. About the author:Dave Kauppi is a Merger and Acquisition Advisor with Mid MarketCapital, Inc. MMC is a business broker firm specializing inmiddle market corporate clients. We provide M&A and divestiture,succession planning, valuations, corporate growth and turnaroundservices. Dave is a Certified Business Intermediary (CBI), alicensed business broker, and a member of IBBA and the MBBI.Contact (630) 325-0123, davekauppi@midmarkcap.com orwww.midmarkcap.com.
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