By Edward D. Hess,
Adjunct Professor of Organization and Management, and
Executive Director – Center for Entrepreneurship and Corporate Growth,
As successful first generation family business owners age, most consider gifts of stock to their children and/or grandchildren in order to save estate taxes. Such gifts can create divisive family and business issues.
The Smiths, Jim and Jean, have built a family business which supports the family nicely, and they wish their children to carry on the business. Now, being in their late 50s, Jim and Jean start making gifts of stock to their three children. Of the three children, only the son works in the business and the two daughters do not. The daughters are married and one lives out of state. The son is a vice president and is paid a salary of $75,000 plus health, dental, and life insurance, car and accounting benefits. The company pays a dividend to each shareholder of $5,000 at Christmas.
A common occurrence. So what is the problem? As the daughters age, have children and have the financial pressures of house, education costs, etc., it is human nature that they (or their husbands) will start asking the question: “What are we getting from the business?” “Look at how much brother gets compared to us. How will we ever get meaningful money – our share of the business?”
In many cases, these questions mask feelings of jealously or even worse, feelings of not being treated fairly or not being loved as much by the parents. These feelings, if not dealt with, will incubate and bubble up until they reach the boiling point, resulting in either pressure for larger stock dividends, or pressure to sell stock or even to sell the business.
The Common Response
Sometimes, the parents dismiss the issue by saying: “The son is being paid because he is doing work, work which needs to be done by someone and the daughters are free to work somewhere for money”. In such a case, the family shareholders not employed in the family business can intellectually understand that the brother is doing work for money but they ask, “Why can’t I have a $75,000 a year job?” Logic does not necessarily override feelings of being treated unfairly and the need for love, recognition and respect.
If the son is either 1) not qualified for his position and/or 2) being paid above market compensation and/or 3) is not being held to high performance standards, these feelings of favoritism toward the son will only increase.
The parents’ dream was to build a business, which could provide financial security for the family for generations. The business is their legacy. The parents wanted all the children to share in the rewards and be a big happy family. However, by making the daughters shareholders, they have inadvertently increased the probability of family strife and the potential for the sale of the business.
This is a common occurrence. The purpose of this commentary is to raise the issue and to have you think through the potential unintended consequences of gifts of stock to children not working in the business. Some general principles are:
- Family business issues need to be proactively managed;
- These issues only get worse if you try to ignore them or if you delay frank and honest discussion;
- Amongst the family shareholders, you need to discuss and have rules for family employment and compensation;
- You should consider ways to have non-working shareholders more emotionally committed to the business: board seats, participation in benefit programs, company support for their favorite charities, company support for their business interests or careers; and open and frank discussions of what’s in it for each shareholder and for the family as a whole; and
- Educating shareholders on what the business can afford – the conflict between the business’s cash needs and individual shareholders’ financial needs.
- Assess in this hypothetical situation whether you should bequeath other assets equitably to the daughters instead of family stock;
- Assess whether the business can pay meaningful dividends to the shareholders;
- Assess whether the business, over time, can liquefy or monetize the daughters’ stock;
- Assess the daughters’ interests in having their children work in the business someday; and
- Assess how the daughters can feel more connected to and be a part of the business.
Be aware of the long-term potential for problems arising from these tax motivated gifts, especially when some of your children do not work in the business. Most parents want to treat their children equitably. However, as children age, their financial needs change and these needs can create pressure on the family business. Think through these issues and seek professional advice as you proceed.