In entrepreneurial families, it can be tricky to support all members of the next generation equitably, especially when not all have found a role within the business.
The challenge can become even greater in the estate-planning process. It’s impossible to prepare for all future outcomes, so, in this second of two pieces about equalizing wealth among heirs in business families, three experts offer advice on finding the best arrangement for the present. (Click here to read Part 1: Levelling the playing field for heirs to the family business, whether they work there or not.)
“When it comes to estates, in my experience, people change, and not for the better,” says Cindy David, president and estate planning advisor with Cindy David Financial Group Ltd. in Vancouver.
“That’s why we have an estate plan, to try to avoid the headaches and the heartaches, and to try to minimize the work for the people we leave behind,” she adds.
Anxiety about capital gains
Though the duty of documenting and distributing an estate can be onerous, the biggest headache for executors—especially when business assets are involved—is figuring out how to finance capital gains and other estate taxes without having to liquidate the business or real-estate holdings to do so.
David points out that prepayment of the taxes, perhaps via a sinking fund, is a smart move, as long as beneficiaries agree to use the money as directed.
Also, joint last-to-die insurance is still affordable and is a great way to handle it, she adds. “It costs less than the tax. Just to be clear, the devil’s in the details; it’s the estate that owes the tax.”
The insurance option is most likely to benefit people who plan their estates while they are still in their 50s or 60s.
“People usually start asking questions about estate planning in their 60s,” David says. “The younger the better, obviously, but when you’re in your 40s you’re still putting your children through their education and probably paying off some debt. If you’re in your late 60s, you’re quite likely to have endured some health issues that can cause the insurance to become less affordable or not attainable.”
Valuing business and non-business assets
Once the taxes have been covered off, business interests are often left to family members who are already involved with them, and the value of that gift is then equalized by leaving other types of assets to the non-involved children.
“Cash, other liquid assets such as a promissory note from an operating or holding company held by the business owner (for example as a result of the payment of capital dividends), or insurance are all tax-free assets that can be used for equalization purposes,” says Rhonda Rudick, a partner in the tax and private client group of Davies Ward Phillips & Vineberg LLP in Montreal. “However, it can be difficult to ensure the operating and non-operating assets will be equal.”
This approach raises the daunting spectre of valuation. A letter that clarifies the wishes of the deceased business owner can help to dispel the difficulties.
“To address potential inequities with different after-tax values, the business owner can express his or her wishes in his or her will. For example, in determining the shares of each child this should be done on an after-tax basis, taking into account any inherent gains,” says Rudick. A letter of wishes could be useful to set out guidance as to how individuals should be equalized.
Where each child lives is also relevant in planning, she adds. “For example, there could be adverse tax consequences to a U.S. child holding shares of a Canadian corporation.”
Different rewards for different roles
Children who take an active part in the business are generally compensated for their contributions like any other executive through wages, bonuses and job perks.
But ownership is a birthright, says Kathy Bright, a consultant with Trella Advisory Group in Vancouver. “And that tends to be a more sustainable model, because at some point it’s possible that no family members will work in the business anymore, and we have to attract and compensate outside experts,” she adds.
Estate planning requires some skill with a crystal ball.
Among the helpful solutions might be “kicking that can down the road by utilizing trusts, insurance and lifetime capital-gains allowances,” Bright says. “But when you get to a certain point in your business, a $1.5 million capital-gains exemption doesn’t go very far.
“Families that do not engage in adequate tax planning do put their children and their business at risk.”
By the time a third generation is rising, Rudick says, “you will typically have a fulsome shareholders’ agreement setting out things like who is the family representative for voting purposes, rules regarding how many people from each branch can work in the business, and exit rights. By G3 you also likely have geographic diversity, which complicates matters.”
If the family business accounts for the majority of the business owner’s assets, “he or she may wish to leave the equity interests equally to the next generation but have different arrangements for the management and voting control,” she says.
“For example, the business owner may carry out an estate freeze and take back fixed-value preferred shares as well as a separate class of ‘skinny voting shares’ with nominal value and bequeath these to the child who runs the business or to a voting trust with voting trustees comprised of individuals who are well positioned to oversee the running of the business,” Rudick adds.
“The non-voting common shares could be split equally between the children. In this way, each sibling receives assets of equal value,” she adds.
Of course, a remedy for some of these ills is simply to give away assets while you’re still around, says David, “but you always want to own and control a certain amount of your assets during your lifetime.”
If the retiring generation can get over the fear that they will run out of money and decide to distribute their wealth ahead of time, Bright says, “it can really help the next generation while they are in those years of buying a house and putting children through education.”
In considering all of these possibilities, one thing that Bright advises is using facilitators to help reach decisions. “They can really help families come out the other side. Involve as many people in the family and as early as you can within reason and with the blessing of the ownership generation.”
It’s never too early to start, David says.
“Answer all the questions for the people who are trying to implement your wishes to the best of your ability,” she says. “When you’re six feet under, there’s no back and forth.”
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