Personal Wealth Law News

An interesting article in Private Wealth magazine- “Why Wealth Disappears”- examines the seemingly iron law that wealth created in the first generation disappears in the third one. The author uses several well-known families where this took place, which always makes for a fascinating story. What causes this to happen? Of course, the first generation has to work hard and for long years to create the wealth, and for that reason has a better appreciation of what it took to achieve that level of success. The second generation saw the wealth being accumulated, but did little, in many cases, to help in its accumulation, and the third generation seems to see it only as a pile of money.  At least, that’s the scenario in families where wealth disappears. But that need not happen. Where succeeding genarations are given a chance to work in the family business and achieve something on their own, rather than being given only a silver spoon, family wealth from a family business has a better chance of continuing beyond the third generation.

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A recent article in the Wall Street Journal highlights the importance of the revised estate and gift tax law for owners of family businesses. The article appeared in the February 19, 2011 edition, and focuses on the enhanced lifetime gift tax exemption, which has risen to $5,000,000, at least for this year and next. Another important topic of the article is the issue of how business owners will fund their retirement. It might not be enough to live off what they have accumulated, and the article suggests ramping up retirement plans, perhaps establishing salary continuation plans. Another possibility is the sale of business assets to what is called a defective grantor trust, which can offer significant tax benefits. Whatever choice is made should be based upon the particular facts of each situation, but as the article makes clear, now is the time to start planning.

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My client Jim struggled for years over the decision when to give up his ownership of and active involvement in the family business.  He had transferred some of the company stock to the one son who had opted to work in the business, but he held on to most of his stock and continued to work every day, even into his 70s, by which time his son seemed able to run the business.  After much discussion, it became clear that Jim’s issue was maintaining a regular income after he gave up his ownership of and salary from the company.  Jim worked out an arrangement with his son and the company to pay him an informal pension for the rest of his life, in recognition of his long service to the company.

Jim was satisfied with a promise from his son and the company to pay him a retirement income from the earnings of the business, but this is not always acceptable.  Some business owners, confident in their own abilities but not those of their children, feel sure that once they have moved on, retired, or whatever course they take, the business will begin its inevitable decline; so a promise of an income stream from the company won’t be worth much.  What many owners want is an independent source of income, so that they are not dependent on the fortunes of the family business.  The solution to this concern might be a qualified retirement plan.

The term qualified retirement plan refers to the fact that it satisfies the requirements of the Internal Revenue Code and enjoys valuable tax benefits.  Qualified plans come in numerous forms, and can be tailored to the needs of the company and its owners and their ability to fund the plan.  Contributions to the plan will be tax deductible by the company, and not taxed to the participants in the plan until they withdraw the money, possibly many years later.  The plan assets are protected from creditors of the company, and can build up a large retirement income for the owner that is not tied to the fortunes of the company. 

If a qualified retirement plan doesn’t work because of its expense, including the need to cover a broad range of employees with the plan, the company could set up a nonqualified deferred compensation arrangement.  Arrangements of this type are covered by another section of the Internal Revenue Code, but they can provide for a more “pinpointed” benefit for owners of the company.  The tax benefits aren’t as robust as in a qualified plan, but a nonqualified plan can be less complex and expensive.  And although the protection from creditors of the business isn’t as good, there are steps a company can take, including setting up a trust, that can provide at least some level of protection from creditors.  The knowledge that there is some other source of income being developed can be a tool to help business owners let loose of control of a business with fewer concerns about the future.

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The passage of last year’s Tax Relief Act (it has a longer name that no one can remember and no helpful acronym) included changes in the law that have made transfers of business interests more tax efficient. The lifetime gift tax exemption has been increased from $1,000,000 to $5,000,000, and the estate tax exemption and the exemption from generation-skipping tax have both also advanced to $5,000,000. This makes lifetime gifts of large amounts feasible. If you have a family business that is closely held, you may transfer pieces of the ownership at a considerable discount, and the $5,000,000 gift tax exemption allows you to give more during life than has ever been possible. With business values still far off their peak, and IRS interest rates still very low, now is the time to consider transfers.

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This fact pattern , which I wrote for a seminar, sets forth the many challenges and opportunities presented by family businesses:

The History of a Family Business 

In 1965, Jeffrey Spalding decided he had worked for others long enough-about 12 years. Feeling that the US economy was in good shape and would continue to prosper, he developed a plan to go into the home improvement products business. His idea was to open a store in his community in the suburbs of Philadelphia, stock it with tools, building products and related items and see if he could survive. He felt sure he could fairly well working for others, but doubted that he could attain an ownership or high level management where he was, a family-owned business where he was not part of the family, and to which various family members were being added at executive levels, despite having little or no experience. Besides, he didn’t think his current employer, an older man who had been in business for many years, had the energy to expand a business that Jeffrey thought he had. Clearly, he thought, this is the time to see if I can achieve something on my own.

But to carry out those plans, Jeffrey needed capital, And he didn’t have nearly enough on his own. He might mortgage, or re-mortgage his home, but even that wouldn’t provide enough of a cushion to cover the startup period for the business. He spoke to several members of his family, and his wife’s brother agreed to contribute some capital and go into business with him.

Questions to ask: How will the business be set up? Will all of the money contributed be capital contributions, or will some of it, from either or both parties, be set up as debt? How will the ownership be divided up between the two owners? Is any ownership attributed to the fact that Jeffrey thought of the business idea and was the founder? Or is it just a matter who puts cash in the business? At least initially, both Jeffrey and his brother-in-law will work full-time in the business. They will share the decision-making for the business, and understand that they will only take steps on which they have both agreed.

The business begins. Either the two owners can work together smoothly and share similar ideas or goals, or they clash, either initially or after some period of time. A number of issues, legal, psychological and business, are suggested if they can’t get along, but assume that they do get along for about 20 years. The business has done reasonably well, and they now have four stores in various Pennsylvania and New Jersey suburbs of Philadelphia. At this point, Jeffrey’s son David has more or less finished college and Jeffrey would like him to join the business. His brother-in-law also has children, but they have gone astray and become lawyers, so there is little chance they will want to enter the business. The brother-in-law would like to do something else with his life, and the prosperity of the business has allowed him to think about other possibilities. He asks Jeffrey if he would like to buy him out.

Jeffrey might say that he doesn’t want to do so, because he doesn’t have the resources to do so. He might suggest that the brother-in-law withdraw from working in the business and receive some payment each year of a portion of the profits of the business. What kinds of problems would that create, and how could they be dealt with? The brother-in-law might suggest that the business borrow money to buy him out. This would create a burden on the business and cramp its ability to continue to grow.

The parties agree that Jeffrey will buy his brother-in-law’s stock over time, with a cash down payment and periodic payments for ten years. The brother-in-law is taking a chance that Jeffrey can continue to do well in the business, at least for the ten year payment period. What kinds of issues are presented by this arrangement?

For the ten year period of the note payment, the business does extraordinarily well. Is this because there is now one boss, or would that have happened anyway? Just about the time when the note is paid off, one of Jeffrey’s nephews, a son of his brother-in-law, comes to him and says that the practice of law wasn’t as much fun as he thought it would be, and that he would like to join the business. The nephew has no other experience than being a lawyer, so Jeffrey considers him unskilled labor. Jeffrey considers whether he should bring the nephew into the business, partly because his father helped to start the business.

In the event, Jeffrey decides that he will not bring the nephew into the business, thinking that it’s now his family’s business. Perhaps he’ll hear from his brother-in-law, suggesting that he owes his nephew a chance to take part in the business. Jeffrey won’t agree to this. Is there any way of dealing with this problem that will minimize the damage to the family?

The business continues to prosper for a number of years. David’s younger brother announces his interest in working for the business. So does their sister, but Jeffrey tells her she cannot work in the business. Perhaps he has some ideas about women in the work force from a different era; perhaps he can’t see her in a management situation in the business; perhaps he’s concerned that she’ll get married and he’ll have a son-in-law who wants to come into the business. In any case, he says no. His wife objects. She says the daughter is just as smart and dedicated as her two brothers. It may be that Jeffrey will relent and allow her to join the business. What possible jobs might and/or should he give her? Follow this thread for some number of years. What if she is, in fact, the best of the three in managing the business? Shouldn’t she then become the heir?

The second son is a different problem. He’s not very motivated. He tends to come in at 9:30, three hours after his brother and sister have arrived. He is sometimes difficult to deal with and condescending to non-family employees. This annoys Jeffrey, but it really annoys his siblings. But Jeffrey and his wife are not anxious to turn him out, fearing that he can’t make a living on his own. What should they do? In the end, he has an idea for a business of his own. His parents give him a sizeable sum of money to help start this business, which is unrelated to the family business. After a few years, the second son is doing very well, better in fact than the family business. Or, which is more likely, his business has failed, and he wants to come back into the family business. But this time, Jeffrey says no. Instead, he buys him another business. The siblings notice that a large part of the family assets have been devoted to helping the second son find his way. The new business also fails, and Jeffrey has a genuine dilemma: whatever he does, some children will be unhappy.

Suppose there is a fourth child, who has no interest in the business, but instead chooses an unrelated career as a teacher. Does she have any claim on the wealth created for the family by the business? If the business constitutes most of the family’s wealth, and it is to pass to only some of the children, should there be some sort of “evening up” and, if so, how? Or should Jeffrey listen to the two children who are in the business, who believe that much of its value comes from their efforts?

Perhaps that’s true, but much of the value also came from non-family employees. They are reasonably sure they won’t become owners of the business, or should they make an effort to become owners and, if they do, how should Jeffrey react? Are there any acceptable substitutes for actual ownership of the business?

After more years have passed, Jeffrey thinks about retiring from the business. Some business owners refuse to step aside, no matter what their age, which causes a different set of problems. Does this happen because they have put too much of their lives into the business, and have nowhere else to go? Or do they believe that no child could possibly do as well as they did? Or are they afraid of leaving the business, their source of retirement income, in the hands of others? Are there solutions to any of these concerns? Consider, for example, a separate retirement plan to fund Jeffrey’s comfortable retirement.

But Jeffrey decides he wants to retire, to go on that African safari he’s always dreamed of. Is this the first time he thinks about giving the ownership of the business to some of his children? If so, it might be too late to do careful, tax-efficient planning on how to transfer the business. He should have thought about the possibility of transferring the business at least ten years earlier. Let’s assume that he did think of it. This opens up a long discussion of methods of transferring business interests by various tax-saving methods.

Suppose the children don’t want to continue the business. What should be done with it? Sale to employees is one possibility, or sale to some employees. Of course, it’s also possible to sell to outsiders. After that, the proceeds can be divided among the owners, mostly Jeffrey. It is also possible that outsiders approached Jeffrey years earlier, with an offer to purchase, that was too good to pass up. This would certainly raise issues of family dynamics.

Or suppose the children do want to continue the business. Now, there is a third generation, some of whom want to join the business and, as before some don’t and, also as before, some just aren’t cut out for it. The multiplicity of family members, some of whom are cousins, seems to create an exponential increase in the problems described above, which is why few family businesses make it to the third generation. Can the older generation impose its will on the family and “make them” get along? Can they help to create structures or agreements that provide a template on how to run a family business that will continue provide a basis for family wealth, financial and otherwise?  

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A business school professor told the son of a client: “there’s nothing like working in a family business.” That’s true in several ways. Working in a family business can give someone a clear, eventual path to ownership and allow him or her to learn about all aspects of the business by moving from job to job within the business. But there are also pitfalls to consider: is there really a path, or will the family member not be taken seriously, by the family members and the non-family employees? Will the family member feel that it was all fixed for him or her, no matter how hard he or she works in the business? An interesting article in the Business Section of the 8/1/10 New York Times discusses some things to consider before joining a family business.

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A bill has passed the U.S. House making changes in grantor retained annuity trusts (GRATs). The bill would require that GRATs have a term of at least ten years, and would eliminate the zeroed out GRAT. These changes would make GRAT planning a little less advantageous, although transfers of wealth involving GRATs remain an excellent method of minimizing taxes. They are particularly helpful in transferring closely held business interests. With the right kind of assets, GRATs are a valuable planning technique. The change in the law hasn’t been acted upon yet by the U. S. Senate, and they might delay for some time yet. The changes are to take effect when the bill is signed into law, so there is still time to do some effective planning under the existing rules. And, even if the changes are made, GRATs remain a technique to consider in transferring assets while “holding on to them” for a while. 

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“PEOPLE ARE FUNNY”

By Robert H. Louis

Was a classic TV show in which people did humiliating things for money. Sound familiar?

Sometimes, you can suggest  to a client a very sensible course of action in deciding on the future of a family business, but find that the client doesn’t want to do it.  Often, it’s because lawyers are acting in a logical way to think of a solution to a problem, taking into account tax and corporate law.  But the client is thinking in a different way, adding in the cost in personal relationships in doing or not doing something.  The client might agree that the proposal makes sense, but know that members of the family will view it from an emotional viewpoint, with the baggage of family relationships that have developed over many years.  So the lawyer might find that carefully made plans go nowhere, for reasons that aren’t always clear or clearly explained by the client.

A situation of this type was faced by a client a few years ago.  The client had a son and a daughter working in the business.  He had hoped that both of them would be successful in the business, but that didn’t happen.  One child was a hard worker, in at 6 AM, while the other drifted in at 9:30.  The right planning technique would have been that the industrious child be recognized as the business successor, but the parent didn’t want to do that.  The client loved and cared for both children and didn’t want to hurt either of them.  The problem this created, obviously, was that the more industrious child began to feel that hard work was not paying off.  It took several years of talking around the point for the client to understand that two paths were necessary.  The children could be treated fairly equally from a financial standpoint, but one would become the business owner, while the other would be guided into another endeavor.  Was this entirely fair?  Perhaps not, but it reached a resolution that allowed a family-owned business to continue on and to prosper, which surely would not have happened if both children had remained in the business.

The psychological aspects of family business planning were brought home in a recent meeting in Philadelphia.  A group of lawyers, bankers, investment advisors, accountants and other professionals is organizing a chapter in this region of the Family Firm Institute, an international organization for family business advisors that sponsors research and study on the issues facing family businesses and how to resolve them.  At the meeting, which featured members of a family who described their history of forming a business, growing it and selling it, there were a large number of psychologists, psychiatrists and family business consultants in attendance.  In discussions at the meeting, they brought home the value of bringing their expertise into the mix of family advisors, for the express purpose of helping businesses to run more smoothly and their transition to be accomplished successfully. 

Lawyers often act as counselors to family businesses, stepping a little beyond the task of telling clients the law.  But there are circumstances in which psychological/family issues interfere with carrying out worthwhile planning ideas in ways that go beyond the lawyer’s ability to help.  It’s here that the lawyer might consider bringing in, and sharing the stage with, professionals trained in a different discipline who can help clients reach an understanding of personal and family concerns that interfere with the success of a family business.  In doing so, the lawyer can increase the likelihood that the clients will adopt the lawyer’s planning suggestions and improve the chances of family business success.

(from the Legal Intelligencer)

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What Philadelphia Has Plenty Of

by Robert H. Louis

It’s family businesses. Actually, it’s a worldwide phenomenon.

Throughout the world, family ownership is the predominant form of business operation. This is true in India, Australia, Germany and, of course, in the U.S. The Philadelphia area, including New Jersey, Delaware and southeastern Pennsylvania, has many thousands of family-owned businesses. They are the primary engine of business and employment growth in this region.

Family-owned businesses offer many advantages. A business school professor told a client’s son who was in one of his classes: “there’s nothing like a family business.” But there are challenges in family-owned businesses. The ability of a family-owned business to continue for succeeding generations is dependent upon finding the right leadership qualities in the next generation and also navigating family relationships to minimize discord.

There are many areas of family business that benefit from the help of lawyers, as well as accountants, financial advisors and business planning consultants. The services that lawyers offer include business counseling, gift and estate planning, buy-sell agreements, retirement planning and other assistance in helping the older generation feel secure in turning over the business and the younger generation feel confident in taking over.

One organization that helps lawyers and others to understand family business issues and to serve the needs of business owners is the Family Firm Institute. This national and international organization provides books, courses and web site information to help business advisors throughout the world understand and guide business owners. A group of lawyers, accountants, financial advisors, psychologists and other consultants has decided to establish a chapter of FFI in the Philadelphia area, and FFI has approved the formation of the Mid-Atlantic Chapter. We plan numerous kinds of programs in Pennsylvania, New Jersey and elsewhere in the coming year. If you would like more information about the new chapter of FFI, contact me at rlouis@saul.com.

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The combination of continued low interest rates, a struggling economy and uncertainty about taxes makes planning important right now.

IRS interest rates used in valuing various kinds of gifting techniques fell again in November, making the use of Grantor Retained Annuity Trusts, for example, more valuable. And compared to the situation a few years ago, they are far more effective. Many commentators suggest that interest rates will begin to rise, and it’s difficult to see how they could go any lower. Eventually, we’ll return to an interest rate regime that is closer to normal, if we still know what normal is. The hope is that rates don’t fly past normal to the levels seen in the late 1970s. But for now, methods of transferring business interests, which are generally done within family units, are more efficient with the current historic low rates.

Valuations of business interests are also low right now. Few businesses have escaped the economic downturn. A valuation done now will certainly emphasize the most recent past, and that will lead to lower valuations. Lower valuations mean that more business interests can be transferred within the constraints of the limits imposed by the federal gift tax. Lower interest rates also lead to lower valuations. Many believe that the recession has ended, and that there is reason for belief that next year will bring a strong recovery. That is, of course, similar to what President Hoover said in 1930, but perhaps history won’t repeat. But right now, for most businesses, valuations have probably hit lows that won’t be seen again for many years. So healthy businesses suffering a cyclical downturn are ideal candidates for transfers right now.

The bizarre result enacted into the federal estate tax law, repeal for 2010 and then a return of the tax at higher rates and a lower exemption in 2011, is now about six weeks away. No one believed that this taxation scheme made any sense, or that Congress wouldn’t fix it long before now. We now hear discussion of a one-year fix in the statute, continuing the 2009 law into 2010. But that needs to happen soon. And, although there have been some general proposals regarding changes in the federal estate, gift and income tax law, we have yet to see anything really concrete from the administration. It might be that change is coming in 2010, but for now we have the existing law, with many good planning techniques, intact. So, for a third reason, balancing the certainty of current law against the uncertain future, now is the time for family business planning. 

Reprinted from the Legal Intelligencer

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