ESTATES AND TRUSTS

February 2000

THE DILEMMA OF THE NONOPERATIVE CHILD

By E. Kenneth Whitney

The couple's one son, age 36, had done a remarkable job in the business; in fact, the father could not have been more pleased with the increase in cash flow and general progress. Their two daughters, however, showed no interest in becoming involved in the family business. The couple had always operated on the basis that the value of the business would be split equally in three ways. Now, however, the son's resourcefulness had taken the firm to a new height. The one-third each split no longer appeared fair.

A Successful Family Business

Assume a fact pattern as shown in Exhibit 1 . How much does each heir contribute to the increase in wealth? The operative child, the one active in the business, certainly deserves to be rewarded for the contribution. The nonoperative children step into the parents' shoes somewhat in providing a running start for those who remain operative. This becomes the parameter for quantifying a future division.

In this example, we might set a value on the business at the time the son began to work full-time. The business value prior to this point is attributed solely to the parents. But, should all growth that occurs after the son joins the business be allocated to him? Probably not.

Most business owners have a fair idea of what their businesses are worth from the sale of competitors' businesses. This is the best way to determine value--focus on competitors' sellouts and acquisitions.

The Example

Assume, for purposes of discussion and as shown in Exhibit 1, the following:

* Business value, 1985 (Son begins work): $500,000
* Business value, 2000 (Father cuts back regular work): $1.5 million
* Expected value, 2020 (Father's expected death): $20 million.

Such growth would not be unexpected in a going, well-organized business, farm, dairy, or other asset management operation. An approach to calculating the son's contribution is shown in Exhibit 2 .

This method is subjective, of course, but it is a useful starting point. The most arbitrary factor is the arguable percentage the son has contributed and will contribute, 65% in the illustration. Death transfer documents of the parents can recite such a formula.

In our illustration, the value of the parents' share of the business is $11,805,237 [35% of the growth above a "normal" 8% ($12,607,328 x .35 = $4,412,565) plus their original $500,000 compounded at a normal rate of 8%: $7,392,672]. One-third of that value goes to the son, two-thirds to the daughters. The operative son would receive the value derived from his efforts plus one-third of the parents' share in the business [$8,194,763 + 1/3 x $11,805,237] for a total of $12,129,842. Assuming he wishes to continue the family business on his own, he would be obligated to pay the two nonoperative daughters a total of $7,870,158 ($20,000,000 ­ $12,129,842).

The Result

Note that the business has been divided in three pieces:

1) the son's earned contribution for his work in the business,
2) the parents' original capital when the son came on board, compounded at an 8% return, and
3) the balance attributable to the parents' active involvement in the business after the son became involved.

The inactive daughters have received an equal share of what the parents would have had if they had sold the business to the son immediately prior to death. That is, the parents' share is the corpus before the son entered employment, accumulated at a compounding market rate, here, 8%. In addition, the parents have received 35% of the earnings in excess of an 8% investment target.

In this sort of division, we see insurance proceeds and investments disproportionately spread to the inactive children, the daughters. This, in the parents' mind, furthers fairness and equality.

The Business Must Survive

Satisfaction of this obligation must be on a manageable basis to the son, something like interest only for two years or so, balanced over a 10-year period at the prime rate. Cash is likely to be short in this scenario, because the business is growing. The son must have friendly financing to continue operations without impairment.

One device that accomplishes this is an option. The option would give the son the absolute right to buy the business according to a formula, such as outlined, or at a fixed price. Such an option would be binding on the parents' estate.

A fixed price approach, wherein the price is $500,000 in 1985 with a built-in reevaluation every year to recognize a capital growth rate, might work. In our illustration, year two would be $540,000 and year three, $583,200. The growth part of the formula would involve the difference in the fixed price and the actual value at death per appraisal.

Of the appreciation, the son only has to pay the parents' portion: 35%. His 65% does not escape the estate and tax of the parents, however. An alternative is to have the parents gift the son a portion of ownership each year, utilizing their annual gift exclusion. This saves the transfer tax on the appreciation from the date of the gift to the date of the surviving parent's demise. Furthermore, it saves the son's cash for the ultimate purchase of the business. If the business is in a form other than a proprietorship, minority/marketability discounts are available to expand the amounts of annual gift exclusions. The parents can give the son a jump start early on by utilizing some of their lifetime "unified credit" exclusion. This saves the estate tax on the appreciated portion of such gifting.

The Downside

There are two trade-offs to this approach: 1) the son obtains no step-up in basis for the gifted portion and 2) the process is complicated by requiring annual gifts to the operating son. Our formula requires one more calculation for estate dispersion.

The example of the operative son is presented to stimulate the thought process in planning for family business succession. Every family profile is different and must be evaluated on its unique facts and circumstances. *