Invest in Your Kids Through a Family Bank

By Mike Cohn

It’s one way to teach them business fundamentals and avoid the guilt of borrowing from parents.

Parents who want to spur entrepreneurialism in future generations should consider setting up afamily bank to fund new ventures by family members. Such a bank can be particularly important insecond- and third-generation firms that have many family members and not enough room in top managementfor all of them. The bank can grant loans based on a more impersonal assessment of risk, avoiding muchof the emotionalism that often surrounds intra-family borrowing. It also offers opportunities to teachmembers of the next generation something about fundamentals, such as the preparation of a businessplan.

There are several ways that you can fund a family bank. One relatively new way is to create what isknown as a Megatrust — or "dynasty trust." Another way is to form a family limited partnership, withmembers of the next generation as the limited partners.

Congress made the dynasty trust possible when it enacted the Technical and Miscellaneous Revenue Actof 1990. The law permitted a $1 million exemption to the generation-skipping transfer tax ($2 millionfor married couples), which meant that assets held in trust for several generations could be protectedfrom the GST's maximum 55 percent rate during that time.

A dynasty trust can last as long as the lives of any of your descendants who exist at the time youcreate the trust, plus 21 years. Or the term can be measured by how long the descendants of awell-known American such as Joseph P. Kennedy, patriarch of the Kennedy clan, live. If Kennedydescendants who were alive during his lifetime are taken as the yardstick, the trust could easily last120 years.

I usually recommend that the parents fund the trust initially with life insurance, so that the valueof contributions will balloon at the death of the parent (or both parents if they purchase asecond-to-die policy). When the insured dies, premiums deposited in the trust can increase ten or moretimes in value, thus providing a source of capital for several generations.

For example, assume that a married couple, both age 55, transfers $100,000 a year to a dynasty trustfor 12 years — a total of $1.2 million. If they report the deposits as gifts, they can offset gift taxesby using their unified credit (the total tax credit of $600,000 the Government allows for gift and/orestate taxes). Over the next dozen years, the trust will use the $1.2 million in deposits to acquire a$10 million survivor life policy; the policy is constructed so that no further premiums are due afterthe 12th year. After the death of the second spouse, the trust would thus have $10 million in assetswhich are completely free of income and estate taxes.

The trustees (in this case, the children) are allowed to distribute or loan 70 percent of the trust'sannual earnings to fund business ventures by family members. If the trust earns a tax-free 7 percent ayear, then 5 percent ($500,000) can be loaned or distributed each year. The trust would reinvest theremaining 2 percent ($200,000) of income, allowing the fund to double tax free, to $20 million in 36years, and to $40 million in another 36 years — all from an investment of $1.2 million.

The family bank also provides great asset protection in the event that the kids' brilliant businessventures fail: Angry creditors or litigants cannot stake a claim on assets in the family bank. Nor aredivorced spouses of the parents or of the beneficiaries entitled to any portion of such assets.

If the dynasty trust is funded with life insurance, of course, the family bank does not beginfunctioning until after the creator's death. What if you want to make venture capital available toyour children and grandchildren during your lifetime?

The family (or the business) can fund the dynasty trust with cash, stock, or other assets. The gifttaxes in this case would be the same as on insurance premiums paid into the trust, but the fund itselfwould not benefit from the ballooning effect from the insurance payoff at the end.

 

Another option — one that I prefer — is the family limited partnership. I set up such a partnershipfor three siblings who are second-generation owners of a $6 million manufacturing company. Together,the siblings have a total of 15 children (including sons- and daughters-in-law) but only two have sofar joined the company. The parents didn't want the others to come in unless they were committed tothe business as a career. By setting up a fund for new ventures, they would give those who had notmade up their minds another choice.

The parents had other objectives as well. They wanted to create a vehicle that would enable thechildren to acquire sophistication in handling money. They also wanted to give family members anotheractivity to share and talk about; somehow, at family get-togethers, the conversation always seemed tocome back to the company.

The three second-generation owners became general partners of the family limited partnership, eachmaking annual gifts to the partnership of $40,000. The 15 children became the limited partners who asa committee must decide how to invest the annual combined contributions of $120,000. They can investin stocks or real estate, or treat the limited partnership as a family bank, offering capital tomembers of the third generation. To get a loan, a member of the group must convince the other limitedpartners that his or her venture will meet the committee's requirements for return on investment.

The partnership is barely a year old, and so far none of the funds has been loaned to anyone. However,the parents are delighted with how well the children have cooperated in organizing the bank anddeveloping criteria for loaning the money.

Susan K. Smith, a partner at Olsen-Smith Ltd., certified tax specialists in Phoenix, points outanother side benefit of the family limited partnership: If assets such as real estate are used to fundthe partnership, the parents can claim tax discounts of 35 percent or more if they retain only aminority interest in the property and it is not easily marketable. "Parents can divide the propertyinto general and limited partnership units and gift limited-partnership units to each child," Smithsays. Typically, the parents can claim a combined 35 percent discount for minority interest and lackof marketability on a $15,000 gift to each child each year, bringing the value of the gift to belowthe $10,000 annual exclusion from gift tax allowed by the Government. "And the parents can stillcontrol the whole piece of real estate," Smith adds. (The discounts are subject to IRS restrictionsthat apply to limited partnerships made up only of family members, but Smith suggests there are legalways around them.)

 

Regardless of how a family bank is funded — with future proceeds from life insurance or withcurrent contributions to a family limited partnership — the trustees or limited partners should demandthat applicants for a loan present a clearly thought out business plan that shows how they intend torepay it. The plan should be updated regularly so that the trustees know how their investment isperforming. If a borrower isn't capable of creating a sophisticated plan, with a budget and cash flowprojections, the trustees are duty-bound to reject the application as a poor risk, just as any bankwould.

Mike Cohn is president of The Cohn Financial Group, a family business consulting firm inPhoenix.

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Issue: 
Autumn 1992

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