Family Owned Business And What To Do About Succession

We have seen a number of instances where some of the children of business owners are involved in the running of the family business, while other children have either chosen to work elsewhere or were not given the opportunity to participate in the family owned business.

A family owned business, such as the now famous Hobby Lobby,  have achieved notable success.  But when success has been achieved in creating a valuable business enterprise which remained closely held, many founders are ready to slow down and enjoy the fruits of their labors.  That is when they seek to transfer ownership to their children or other relatives.  This blog discusses just one aspect of that situation: reducing the potential for fights among the founder’s children.

The founder usually wants to leave the family owned business in the hands of the child or children who have actually been involved in building the business and know and understand what is needed to continue in the success of the enterprise.

However, the intention often is to treat the involved and non-involved children on a relatively equal basis so that the potential for hurt feelings or other friction causing issues are less likely to arise.  Where the family has significant other resources outside of the family business available to gift or leave in a will for the non-involved children, the question of fairness in division of assets among the children is more readily resolved as a matter of simple math. However, the typical business owner has the majority of her net worth in the business itself.  What to do/what not to do.

Let’s start with what not to do.

Gifting equal ownership shares to both the non-involved children and those helping to build and run the business is one avenue, but, all too often it results in conflicts and even litigation. Why is this so?  One of the most frequent reasons for the resultant conflict is the different and conflicting needs, goals and understandings that arise as a result of the differences in the lifestyles of the involved and the uninvolved children. For example, the children running the business need and are clearly entitled to compensation for their time and efforts in running and building the business whereas the uninvolved children are going to be more interested in the income their share of the business can throw off on a current basis as dividends or from “jobs” that do not require much of their time and energy.

The result often is disagreement, and even very contentious litigation, about salaries, expense reimbursements, benefits and bonuses taken or sought by the children.  The compensation packages to the working children serve to reduce the profits of the business.  This, in turn, serves to reduce dividend or other payouts that would otherwise be available to all of the children who are the shareholders in the business. Moreover, if, indeed, the working children are taking excessive salaries, benefits or incurring high and unnecessary personal expenses under the guise of business expenses, and are unwilling to act in a fair manner, they may be breaching duties to the non-working shareholder children.  Of course, in many instances, the children act fairly to one another, and undue advantage is not taken. Or, the uninvolved children simply do not object to what is done with the business so long as a certain amount of income or other benefit is realized by them. Where the children do not have a strong relationship with each other, even minor disputes can lead to major disagreements which, if not resolved, lead to litigation.  Such litigation has been seen to cause significant family disruption, a result the business owner would clearly not have intended.

So what can be done to protect against litigation between the children?

Here is one solution.

Create an Employee Stock Ownership Plan. An ESOP can not only help to avoid conflict between involved and uninvolved children, it can also provide significant tax and other benefits to the business owner, the company and the children.

An ESOP provides a method by which a business owner can monetize the ownership interests of the children who are not active in the business. Those children never receive ownership interests in the family business, thus eliminating a key potential source of friction. What they receive instead, over time, are payments through the ESOP.  The owner and his family benefit from various tax and other benefits made available through the use of the ESOP, or from the owner who can retain what is, in effect, control over the company, even after the sale of a majority of the shares of the business to the ESOP.  The way it can work, is for the ESOP to borrow funds from the company itself that are used by the ESOP to purchase shares of the company. The company funds the loan through itself borrowing the purchase amount from a bank, a mezzanine or other lender, or from the business owner, and then loaning the purchase price to the ESOP.  Although the ESOP winds up owning a majority of the shares of the business, the owner’s minority shares still control the running of the business because the ESOP is structured so as to not be participatory in business decisions other than sale of the business, merger or acquisition.  The loan is repaid over time, with pre-tax dollars out of the company’s revenues. There are other tax related benefits, such as reduced value of the shares being transferred to involved children, and estate tax benefits of reduced value of the shares as a result of the loan.  Gifting shares to the involved children soon after the ESOP transaction results also results in reduced or eliminated gift tax consequences.

In a family owned business where the owner wishes to divide the business among the children, the ESOP can be a valuable solution to the pitfalls of family disagreement over control of the business by creating a fair and reasonable distribution to the children of the realizable value of the business, while at the same time alleviating some tax concerns involved in transfers of valuable assets.