Equality Is Often Unfair
Almost all parents, in their estate planning, say they want their assets to be divided equally among their children. This concept seems so obviously “fair” that it's rarely even challenged. Psychologically, the transfer of wealth is perceived as a symbol of love. So when parents divide their estate equally among their children, they're expressing that they care for and love them equally.
What a trap! Is it “fair” to give two brothers equal shares of stock in the family firm when one has worked hard for 20 years building the business while the other has had nothing to do with it? Of course not. I suspect that when parents think about their estate, they rapidly retreat to equality because it at least has the appearance of being fair and is simpler than creating a meaningful division of assets.
There are many ways to fairly dispense family wealth that don't depend on equal treatment of one's heirs. The alternatives just take some extra thought and creativity. When children are given equal shares of stock, a battle often follows. In some cases, those who participate in the business end up with no more value than those who don't. In other cases, the non-participants don't receive a return on their equity, while those who are employed do. To make more informed decisions about dividing their wealth, parents need to review the differences in estates in assets, as well as differences in their children's needs, capacities and goals and the family values parents want to promote. Ideally, a conscious choice made after considering all of these factors—even if it ultimately does result in an equal division—will be more loving, and therefore more rewarding to parents as well as children.
No matter what kind of split is finally adopted, the goal is to create a rational system that is also clearly explained to the heirs, to head off any lasting resentments among them.
Define the challenge first
When the business is the largest single asset in the estate—the usual case—parents face an immediate dilemma: how to divide it among children who are working in the company and those who aren't working there. Usually they pass on equal shares of stock. If pressed as to how this will work from the younger generation's standpoint, they usually respond by saying that those in the business should be given voting control. But while that will tend to protect the business from interference by siblings who know the least about its operations, it will only increase the tension among the group.
Before coming to this ready decision, parents should explore the issues more deeply. First, they need to question what they're trying to accomplish by dividing ownership equally. Is it just to avoid any impression of favoritism? Or do they assume that the family business should be able to provide support for all of the children, just as it did for the parents? Perhaps parents are attempting to perpetuate the family as a unit, by keeping all its members in the business.
However worthy these goals, an assessment needs to be made of their feasibility in a given situation. If the idea is to provide equal wealth to the children, an equal share in the family business will be equal in name only. While working siblings can benefit from salary and bonus increases, non-participating siblings hold a very illiquid investment, which offers them little or no opportunity to use their capital for their own purposes. Unless a great deal of preparation has been done within the family, even an equal split of stock will lead to a perception of “unfairness“ and disharmony among siblings.
Even when dividends are paid, there's still stress because the non-participant's capital is locked in the business. Electing S corporation status will enable the business to make distributions to the passive shareholders without incurring a double tax. But the fact that the shareholders' income taxes will be affected by their share of the corporation's taxable income usually leads to demands by the passive shareholders for more involvement in corporate decisions.
If the parents' goal is to keep the family together as owners, they must begin training their offspring from an early age in owning and managing a business together. The children must learn how to work with one another in a partnership situation. And they must learn how to view the needs of the business objectively and separate their own needs from those of the company.
If the parents' goal is to have the business be the goose that lays the golden eggs for all the children, a rigorous financial assessment of the company must be made. Even though the business supported the family while the children were being raised, it's unlikely that it will be able to provide comparable income for all of the children and their families.
If the prepatory work for joint ownership by participants and non-participants isn't likely to occur, then it's far better to divide the estate on the basis of “rough justice,” whereby the heirs in the business receive the business, and the rest receive other assets of comparable value. Frequently the business represents 80% or more of the parents' net worth, however, which means it's impossible to divide the family's wealthy equally without breaking up the business. But even if it's only 70%, and there are several children, it's unlikely the parents will be able to find enough “outside” assets to create equal treatment.
In these situations, the parents can increase their estate in various ways—for example, by investing in life insurance that will benefit one or another of the heirs. It may also be possible to allocate the burden of all of the estate tax liability to the offspring who are to receive the interest in the business, so that other children who inherit lesser assets don't pay anything. The estate plan simply specifies that the tax bill will be paid by the heirs receiving the business assets.
If non-participating children who have been given stock want their inheritance in cash, arrangements can also be made for the participating children to eventually buy them out. This approach can be difficult, however, since it's unlikely that the business will be able to support a buyout program in the near term as well as payment of the death taxes, unless insurance has been purchased for both those needs.
Other complicating factors must be taken into account in the “rough justice” approach. One key issue is how the interest in the business will have to be valued for federal estate tax purposes. The executors, or trustees, will seek the lowest possible valuation in order to reduce the estate tax liability.
Where the succession plan has been integrated into the overall estate plan, it's likely that substantial gifts will have been made during the owner's lifetime, in an attempt to reduce the parents' interest to a minority holding in the company. A minority interest will be valued at a substantial discount when theowner dies because it lacks control and has no market. Even if the parents had retained 100% ownership until death, there may be other justifications for discounting the stock for lack of marketability.
Apprasiers, however, will often first value the business as a whole, as if it were being sold to one outside buyer. In establishing fair market value, they then make appropriate adjustments or discounts to reflect a partial interest in the business. The non-participants, however, would normally expect to receive their proportionate share of full value, rather than the discounted value, which was “only for tax purposes anyway.“ This expected conflict must be headed off in advance and guidelines established for the value to be used for purposes of dividing the estate.
The second complication comes from the expectations of children who have been longtime employees. As such, they feel they have contributed to the growth of the business and want their contribution to be taken into account. They feel they already own a sweat equity, which they created as they helped build the business. They my also feel they should be compensated for the fact that they stayed in the family firm and gave up other opportunities in order to keep the business in the family.
Their non-participating siblings may feel the opposite: They may believe they weren't given the opportunity to enter the family business, which they regarded as “an easier job for higher pay,” and that their siblings who stayed have already received more by way of compensation than they contributed to the value of the business. Again, the family must discuss and resolve these issues before the parents' death, or resentment and conflict will arise.
Using real estate for balance
In many smaller companies, the principal asset “outside“ the business is real estate. As such, it provides the main leverage in trying to work out the “rough justice” scenario. Usually, the parents have purchased the real estate (typically for tax purposes) and lease it to the company. In my experience, the parents are usually reluctant to allow the real estate to be separated from the business, since they've spent their lifetimes gaining the real estate to serve the needs of the business. As a result, if the real estate goes to children who won't be owners of the business, the parents will want the business to be protected with a long-term lease. They may also want to give the company a right of first refusal in the event the property is offered for sale, and even an option to purchase the property at its fair-market value at any time during the term of the lease. These are sensible goals that sound reasonable.
The method of setting the rent, however, must be worked out in advance o that it's equitable to the non-participating children who will own the real estate. Further, an option to buy the property at its fair-market value at any time during the lease will constitute a negative factor in the salability of that property. Real estate investors aren't interested in buying property that can be taken away from them at any time. Further, it creates a feeling among the children who own the real estate that they are “warehousing” the property for the benefit of the siblings who received the business.
It's possible to balance these needs by an agreement creating a right of “first negotiation.” This would provide that before the inheritors sell the property, they must first offer it to their siblings. If the siblings make a purchase offer that the owners don't wish to accept, the owners are free to sell the property at any price and on any terms above what their siblings offered; they can't, however, accept a price equal to or lower than what the siblings offered.
There are other ways to handle outside real estate. But just as with the alternatives already mentioned, each of them must take into account the relationships among the children and not be seen purely as a way to even out the disposition of wealth. For example, one couple who owned several pieces of land were thinking about putting them into a partnership, with each of their three children holding a one-third interest. They intended to start this plan while they were alive, by establishing a limited partnership. The parents would be the general partners, and each of the children would be a limited partner. When the parents died, the general partnership interest would be divided equally among the three children.
When I asked the parents how they thought the children would get along as partners, they agreed that the children had never gotten along about anything. Clearly, continuing the partnership after death would have been futile. Yet the partnership was the most effect way to minimize estate taxes as well as pass along equal portions of the estate.
To prevent fighting in the future, our firm provided that the partnership would be dissolved three years after the last parent's death, about the time of a final reckoning of federal estate taxes. By then each child would know what would be left to be divided. This plan was agreeable to the parents and had another desired feature: None of the children would have to be the “bad guy” and initiate the dissolution of the partnership.
Accepting less than equal
Sometimes because of the type of estate and the number of offspring, it's impossible to treat all the children equally as to value, or even to implement “rough justice.” In such cases, if the children in the business are to own it fully, the other children must be given a lesser inheritance. An unequal division of assets has a chance of succeeding only if it's thoroughly explained by the parents prior to their deaths, and if they clarify why the plan is necessary. Otherwise, there will be bitterness and, in some cases, litigation.
In these situations, it isn't fair to ask sons and daughters for their permission to be treated “unequally.” It's the parents' decision to make, and they must take full responsibility for making it. Those asked to consent to a lesser inheritance will feel exploited. To say yes to the parents' request may mean agreeing to something they feel isn't right. To say no is to risk the relationship in the family, and perhaps to appear greedy.
If, on the other hand, the parents make the decision but don't communicate it to the children, the siblings are left to decipher the message after the parents are gone: “Did they love my brother or sister more than they loved me? Did they think it was fair because he or she has greater needs? Did my brother or sister receive more because he or she unduly influenced my parents by playing up to them?” If the children who receive less haven't been given a satisfactory explanation beforehand, they will inevitably blame the favored child.
The Biblical stories of Cain and Abel, Jacob and Esau, and Joseph and his brothers show how ancient the feelings are of sibling rivalry and jealousy that stem from perceptions of favoritism. What's more, the “favored child” will never be able to explain his innocence to his siblings; thus, his or her inheritance comes with a curse.
One family was faced with a dilemma because they wanted their farm to continue in the family. There were four children, but only one son had stayed in the business, which represented 60% of the parents' net worth. After much discussion, the parents decided to leave the farm to that one son and divide all their other assets equally among the three other children. They purchased a life insurance policy to benefit the three children, to provide more balance in their estate. Still, the value of the estate left to the son was more than double that left to the others. To ameliorate the impact of the plan, we provided in the parents' trust that if the son puts the farm up for sale or otherwise takes it out of farming activity, he has to pay his siblings an amount equivalent to the difference in their respective shares of the estate.
The overall plan was introduced to the family at a family meeting. The three siblings weren't happy but did seem to understand why the arrangement was made. It might take them a while to accept the result, and changes might still be introduced, but the family is on its way to resolving this difficult matter.
Communicating the plan
A family meeting should be called only after an estate plan is hammered out by the parents and their advisers. At the meeting, the parents should present the plan to the heirs. Time should then be left for the heirs to ask questions and express their feelings. Sometimes spouses are invited as well; it's better for them to be included be cause they, too, will be emotionally affected by the decisions.
It's important to make clear at the outset that this isn't a session to vote on, or even agree to, the plan for dividing the estate. It's simply the opportunity for the parents to explain, as fully a possible, why they have made certain decisions and to hear how their children feel about them. The proceedings may lead to further refinement of the plan to alleviate unintended hardships.
In most cases, it will take more than one family meeting to discuss the estate plan and resolve any issues that arise. It will take time for each child to sort out what those feelings are, and why he or she has them. Over time, if the dialogue is allowed to continue, a resolution will result.
If heirs will have to work together to maintain the business, they should be trained in how to cooperate as soon as the plan is discussed, or even before. A program of family charity is one way to accomplish this. Some families have established family foundations or taken an active role in funding community projects. This creates a family activity separate from the business that provides an excellent forum for the children to learn to work together. It puts the children on an equal footing with one another and with their parents. It enhances the opportunities for them to become familiar with their respective values—and the parents' values—and aids in their own maturation as members of the community.
Business owners who initiate an early process for dividing their assets—and who openly communicate decisions, concerns and the family's values—will realize several benefits. The process will enable them to make wiser decisions about how to treat their children. It will help train the children to become good stewards of the wealth they will eventually hold as their own. It will also allow the children's feelings to be heard and for them to hear the feelings of their parents. Finally, it will make it much more likely that the parents' hopes for their children will be realized.
John F. Hopkins is a principal in Hopkins & Carley, a law firm in San Jose, Calif. He specializes in estate planning and probate and tax law.
Principles for achieving ‘rough justice'
1. When dividing your wealth, take into account your children's needs, goals and capacities instead of arbitrarily giving each an equal portion of your assets.
2. Think twice before dividing business assets equally between heirs who are working and not working in the company. Like the judgment of Solomon, the decision can ultimately kill the baby.
3. Appreciate that it's usually impossible to be perfectly fair, particularly if you have few liquid assets and several children.
4. Diversify your assets to make it easier to apportion them among heirs.
5. Explore ways to mitigate any imbalances, such as arranging to have those who inherit the business pay all the estate tax.
6. Set up a buyout plan for non-participating shareholders who may wish to cash in their stock after your death.
7. Work out your estate plan with your advisers first. Then explain it, with them present, to your heirs at a family meeting.
8. Invite family members to express their feelings and raise questions about the plan. Hold more than one meeting if necessary to resolve issues that arise. But retain the right to make the final determinations.