Over time, the dynamics and planning techniques have changed.
Tom Brokaw wrote The Greatest Generation“to tell the story of America’s citizen heroes and heroines who came of age during the Great Depression and the Second World War and went on to build modern America.” Today, our economy sits on the foundation of thousands of businesses that were originally founded by members of this generation—most of whom were first-time business owners. These businesses often started as sole proprietorships and eventually grew into sustainable companies. As “modern America” evolved, so did family dynamics as children grew to dream of joining the family business.
The sons and daughters who joined, led, bought or inherited the family business soon became the next generation of managers and owners—a group we can call the “Great Next Generation” (GNG). Now approaching their 60s and 70s, they’re in turn passing these businesses on to their children. A simple story of a repetitive cycle? We think a closer examination suggests otherwise.
Characterizing the GNG
Many of the individuals that comprise the GNG grew up in families with established businesses and were fortunate enough to leave their hometowns for a college education. However, they often returned home because:
• their families offered an unparalleled opportunity to advance quickly in the family business;
• fortunes had changed, and their families and businesses needed their loyalty, intelligence and energy to pick up the pieces and save the business; or
• there was an opportunity for years of training and guidance from their father and his management team to prepare them for eventual ownership of the family business.
The Greatest Gen Business Model
The business transitions from Greatest Gen to GNG were simple. Business owners and their advisors preferred a streamlined governance model with the owner holding the top titles: president, chief executive officer and chairman. There was little agonizing about who should inherit the business. Primogeniture was rarely challenged, and firstborn sons were expected to act as well-meaning patriarchs. Equitable inheritance for those not in the business was often impractical, however, as businesses typically didn’t generate enough liquidity each year to support an owner and his siblings. As a result, the business was usually transferred to one person.
Estate planning, taxation and gifts. Large gifts were taxable and thus very unpopular, meaning that even if a member of the GNG took over as president, his father would continue to hold the chairman title and stock control, and the actual business transfer didn’t occur until his death. Buy-sell and stock control agreements successfully held business valuations down, estate tax attributed to the business could be paid over 10 years and life insurance didn’t have to be huge to provide sufficient liquidity. Estate tax could be deferred by leaving the stock to a marital trust with a member of the GNG serving as trustee, leaving the control in his hands. When the economic transfer to the GNG member occurred, there was rarely a strict adherence to fairness in the family. The son (occasionally, the children) in the business received the entire company, while other family members received whatever previously harvested fruits of the business still existed, such as the family residence, vacation property, investment assets or insurance proceeds.
The GNG business model and estate planning. Fast-forward to the 21st century. If the business was still free-standing and owned by a member of the GNG, then he’d likely matured into a seasoned, successful businessman with an effective management team. With 20 to 40 years of development, even a modest growth rate would have compounded the business’ valuation dramatically. He likely has sufficient cash flow from the business to enjoy perquisites, such as a vacation home, travel, paying his grandchildren’s tuition and supporting his favorite causes. He might even have a nice personal investment portfolio outside of the business.
Increase in Business Complexity
Business complexity and span of reach has changed dramatically between the Greatest Gen and GNG, primarily due to the increasing size of businesses and business growth over the decades. Those in the Greatest Gen often started their own “mom and pop shops”—such as a local store or a single product manufacturing business. Over time, if those businesses were sustained, they would have grown through product line diversification, target market extensions and technological advancements. While a member of the Greatest Gen could succeed as the sole decision maker, the complexity of the business now demands that a member of the GNG lead a respected management team composed of people with diverse backgrounds and talents. While those in the Greatest Gen had to know how to sell or manufacture, a GNG member’s most important skills are leadership and management.
What does greater complexity mean for businesses? The Greatest Gen was characterized by a high sense of confidentiality and privacy; business matters were held closely by a very tight circle of trusted individuals, generally family members. Unless specific legal or tax advice was needed, those in the Greatest Gen could be resistant to external counsel or advice. As businesses have become more complex, those in the GNG have been more open to getting help. Early on, one might have joined the Young Presidents Organization or an industry peer group. Of late, you find him establishing external boards who can offer creative, strategic insight and vision beyond the individuals in the family. Those boards may be fiduciary or advisory, but both have a high level of transparency.
Changing Family Dynamics
Family dynamics and culture shifted between the Greatest Gen and the GNG. The decades when those in the Greatest Gen were running businesses were marked with a significant distinction between male and female roles. Female children weren’t groomed for business roles; therefore, it was an anomaly for a female child to be considered for, or to even desire, a prominent role in a family business. Business succession was first offered to elder sons, who would typically own the business in its entirety.
And, because the businesses were small and sometimes fragile, the focus of the estate plan was on the health of the business rather than financial equity among siblings. Practically, those not in the business received less than those outside of the business buttressed by the rationale that the business was riskier or that the daughter would receive support through her marriage.
Changes to Planning
The Women’s Movement gained momentum in the 1970s and 1980s supported by the passage of Title IX in 1972, a federal civil rights law that prohibits discrimination based on sex. The GNG ranks were filled with men who had grown up with sisters who pursued higher education and professional degrees. Many GNG men married women who had careers before they had children. By the time daughters of the GNG members were born in the late 1980s and 1990s, divorce was more prevalent, and fathers began to ensure their daughters’ financial security with education and opportunity. As fathers aimed to afford all their children—regardless of sex—the same opportunities for potential success, female children were included in business management, and estate plans reflected this shift to enhanced equality.
To further examine business transfer and estate-planning options, here are two fairly common, but fictitious, scenarios.
Scenario 1—Preserve the family and the business; pay the estate tax. John Sr. was in his late 20s when he returned from World War II, so he was an older dad to his only son Johnny. With little thought to any other option, Johnny joined the family business right after college. John assumed his son would run the business one day and gave Johnny a portion of stock each year. After 18 years in the business together, Johnny’s father passed away. At age 40, Johnny took his role as president, CEO and chairman of the business. The remaining stock owned by his father went into a trust for Johnny’s mother, and he served as trustee until she died. He received the stock as the sole heir.
In 2015, Johnny began to realize that he had experienced a straightforward business transition from his father—it was clear who would own and manage the business, and the estate tax had been funded by a manageable loan and life insurance.
Now that Johnny’s children were grown, as the CEO and chairman, he promoted his eldest son to president. Together, they served on the board of directors alongside the chief financial officer as treasurer. Johnny’s daughter expressed interest in joining the family business, and he was pleased to envision a potential partnership between his eldest children. With two more children starting college, however, he and his wife wanted to ensure all their children were equally included in their estate-planning process.
To minimize conflict among his four children, Johnny began to address management succession issues in the business prior to drafting an estate plan. In the years he took to make this decision, his daughter joined the business and rotated through different areas of the business. With 10 years of experience in middle market commercial lending, she was a quick study. An organizational advisor was hired to assess the existing management structure and culture, to coach both his son and his daughter and to prepare the management team for his retirement. Family meetings were also conducted to help them through the transition, resulting in a family employment policy for the business. Johnny formed his first board of directors with independent directors and held meetings every quarter with his son and daughter, setting the agenda and inviting key management. In executive sessions, the organizational advisor reported on how the management team transition was progressing, and the financial advisor reported on Johnny’s progress in considering options for transfer of the stock to his children.
After stepping aside as CEO, Johnny continued to serve as chairman. Although his estate tax exemption was fully available, he decided not to use that exemption as the appraised valuation on the business allowed his children to purchase all his stock with financing from the local bank. While he paid some capital gains tax on the sale, Johnny was able to take the net proceeds plus his life savings to build an investment portfolio to support both himself and his wife. With the business positioned to purchase the business real estate at his death, his estate was liquid, and he could fairly structure a plan of bequests for his wife and all of his children.
Johnny’s highest priority was successful management and ownership succession for his family business. While he added some layers of complexity to accomplish that, he balked at more complex plans that could have reduced his estate tax. While he won’t have an illiquid and fast-growing asset like the business in his estate, he’ll likely have substantial estate tax to pay. For now, he plans to pay that tax using his liquid estate and substantial investments in life insurance trusts not subject to estate tax.
Scenario 2—Preserve the family and the business; minimize the estate tax. Another member of the GNG chose a slightly more complicated path that gave him more estate tax savings. Jim spent his lifetime buying out cousins who were passive shareholders in the family business. A father of four, he wanted his two children who worked in the business to have the stock, but he also wanted their siblings to be treated fairly in their inheritance. His pension and profit-sharing plans and a modest investment portfolio were his primary assets other than the business.
As a solution, he and his wife formed mirror generation-skipping transfer (GST) trusts and seeded them with a portion of their investment portfolios using unified credits. They sold the company stock to those trusts for a 9-year note. The cash to pay the notes would come from the initial cash gifts and from dividends from the company, a longtime subchapter S corporation (S corp). Dividends would vary significantly from year to year, meaning the note principal payments needed some flexibility. The trusts were defective grantor trusts providing an expectation that no capital gains tax would be paid on the sale of the stock to the trusts. The S corp income would be taxable to Jim and his wife.
While it would appear that these two trusts were for the benefit of the children active in the business, the other two were also trust beneficiaries. As the S corp dividends flowed into the trusts, the trusts would make the purchase note payments and cash distributions to the passive children totaling a dollar denominated amount. That number was calculated to be 50 percent of the cash gifted to the trusts and 50 percent of the value of the stock sold to the trust. Because this was a defective grantor trust, they received those funds free of income tax with no transfer tax. Once that defined sum was paid, those two children would cease to be beneficiaries, and the trusts would be divided into two separate trusts for the benefit of each of the two insider children and their descendants.
Jim and his wife sold only the non-voting stock to the trusts, and Jim remained chairman. He then re-formed the company board to include himself, three external members, his two children involved in the business and two other members of the management team. When the note payments and the payments to his two children were complete, he and his wife gifted the voting stock to the two children in the business. A shareholder agreement had been drafted at the formation of the trusts to contemplate this complete change in ownership and control.
This plan was executed and ran its course with the success of the business providing fuel to accelerate its completion. The S corp dividends paid off the notes and the two beneficiaries, and the note payments gave Jim and his wife cash to pay the tax due on the S corp earnings until the defective provisions were deleted from the trusts. The result was two GST trusts that own the stock in the business free and clear. At the end of their joint lives, Jim and his wife plan to donate whatever amount remains taxable to charity.
After successfully completing their plan, Jim and his wife report that they’re turning their full attention to goals that, for the first time, have nothing to do with the family business.
GNG Johnny and GNG Jim are just two examples of many business transitions as businesses and families differ widely. Some are ready to create their plan in six months, and others need years for a clear plan to emerge. And, there are many tools available to financial advisors to help accomplish similar results—most advisors would place spousal limited access trusts (SLAT) and grantor retained annuity trusts near the top of the list.
Planning for the Future Now
The smartest move is to get started thinking about the plan. As we passed the 70-year mark from the end of World War II, the pipeline of work in family business transfers has increased dramatically. With the unprecedented increase in the unified gift and estate tax credit to $11.18 million in 2018 and the Internal Revenue Service’s Nov. 23, 2018 announcement of its proposed regulation to eliminate a potential clawback of gift tax exemption used before 2026, I think there will be a greater sense of urgency to accelerate succession plans to use the gift tax exemption before 2026. In fact, GNG Jim may add a SLAT to his plan to do just that.