Who should get the real estate?

In planning for succession, well-meaning parents make a mistake when they separate ownership of the business from ownership of business property.

By Randy Bliss

Julie Robinson has tears in her eyes and anger in her voice as she talks about her brother, Tom Robinson Jr. "He has absolutely no respect for his father, that's why he did this," she says, looking out over the abandoned buildings that once housed the family business. "He never thinks of anyone but himself."

Julie has good reason for her bitter feelings. Her father, Tom Robinson Sr., ran an auto dealership in Boston for 44 years. He died in 1987 and left the dealership to his son, Tom Jr., who had worked with him for 15 years. Wishing to be fair to both his children, he left the land on which the dealership stood and the buildings to his only daughter, Julie.

She continued to lease the real estate to the business until two years ago, when Tom decided to move the dealership to a new, larger facility in the suburbs. Today, the downtown location that he left behind remains vacant. The land is piled with debris, and vandals have covered the buildings with graffiti. The value of the property has declined considerably, and Julie Robinson no longer has a rental income.

Tom Jr. defends his move by noting that most of his oldest and best customers had moved to the suburbs and the business had to follow. Whatever the reason, however, the move undermined the father's desire to provide for both his children and to preserve family harmony.

In their succession and estate planning, families that own businesses seem to give little thought to the future ownership and uses of real property assets. They pay far more attention to how stock in the company will be divided, since those who own the stock will control the business, which is the family's biggest asset.

But business real estate is both an important component of the family's wealth and a tool that can be used by the business in its financial planning. Sometimes, however, these two potential benefits can come into conflict if no planning has taken place. To illustrate, let's look at a few other actual examples (with names changed to protect confidentiality).

The Healys and Smiths

Four cousins in the Healy and Smith families own and operate a large but struggling distributorship in a growing metropolitan area. Over the years, through a series of complex and mis-guided succession and estate plans, numerous relatives have come to share ownership of the firm's warehouse and real estate. None was involved in the management of the business.

When the four cousins recently faced cash-flow deficiencies and other capital needs, they went to the relatives who owned the real estate and requested that the lease be renegotiated; the four also asked for permission to use the business real estate as collateral for a short-term loan from their bank. Although these requests were part of a carefully thought out business plan, the landlords said no to both proposals. The property-owning relatives insisted upon the full rental income to meet their own needs; in fact, they wanted to raise the rent. Further, under no circumstances would they allow their own security to be encumbered by loans in any way.

This was the beginning of what is rapidly becoming a very serious problem. The lease expires in a year, and the struggling business owners will face an increasingly uncertain and difficult future. Even though their real estate is owned by relatives, it can't be used to help the business.

Every owner-manager knows how important it is to control the company's physical assets. Such control makes business plans for expansion, consolidation, short- and long-term financing, and even planning for retirement far easier. Without control, the owner-manager's options are much more limited.

Earlier generations of the Healy and Smith families must take most of the blame, for they lacked foresight. They would have been well advised to keep real estate ownership in the hands of those who were running the business and to seek other ways to address their concerns for family fairness.

Fred and Louise Schmidt

For many years, Fred Schmidt was the driving force behind the family printing business. In his time, he had plowed much of his profit back into the business. Today he and his wife, Louise, are retired in Florida, and take great pleasure in golf, gardening, and fishing. Their income in retirement comes largely from rental to the company of the up-to-date, well-maintained printing facility which Fred and Louise continue to own.

About a year ago they received a disturbing letter from their two sons, John and Ted. Five years earlier the parents had turned over most of the business stock to the two brothers. John and Ted had shown great confidence when they took over management of the company. But in time the steady growth in sales and profits slowed down and finally stopped. As sales began to decline, operating costs increased along with competitive pressures in the industry.

John and Ted's management skills were tested to the limit. They struggled, then one day decided they had no choice but to write to their parents for help. Apologetically, they asked in their letter if the parents would forego a few months rent in order to relieve some of the financial pressure on the business.

Fred recalls the thoughts he had at the time: "What could I do: Tell them no? Evict them? You know what that would have done to our Thanksgiving get-togethers?"

The few months have now stretched into a year and something has to change soon. The relatively modest reserves that Fred and Louise had set aside for themselves are drying up and the future of their rental income remains unclear.

Many other owners similarly view business real estate as a rock of security for their retirement. As the Schmidts' situation demonstrates, income from such real estate is only as secure as the continued success of the business.

David and Lisa Samuels

The Samuels' two children work in the family business, which makes replicas of rare, antique furniture. David and Lisa had jointly owned the company's buildings and real estate. Before his death in 1987, however, David had clearly stated his intention to leave his share of the real estate to the two children. In fact, his intention was written into his will.

But David never bothered to have the title to the property changed from joint ownership with Lisa to separate ownership of equal shares. At David's death, the real estate passed by title and not by the will, so Lisa became the sole owner. Much time and expense was involved in correcting this oversight.

Sound Real Estate Planning

In planning for the future ownership and management of a business, real estate assets must be considered an important part of the overall strategy. To avoid pitfalls in the transfer of these assets, the following basic principles should be kept in mind:

Keep ownership of real estate in the hands of those who own and operate the business. This will allow successors to make the most of these assets for the benefit of the business. It will also help the family avoid possible conflicts that occur when non-participating relatives own real estate. Owners who strive to achieve fairness in distributing wealth should use other assets to meet the needs of family members not involved in the business. Quite often, a carefully designed life insurance portfolio suffices.

Don't place business real estate in long-term trusts, which leave questions about the final disposition of assets. Generation-skipping trusts, for example, sound appealing and do provide some tax advantages. But such trusts (usually set up to benefit grandchildren) also make it very difficult to ensure that real estate will remain in the control of family members who run the business.

Retiring owners who depend on rental income from business real estate should get written guarantees that the income will not be interrupted. Retirees should ask their successors to sign a long-term lease for the property. Both the successors and other management personnel should understand the terms of the lease and how the property will be disposed of when the lease ends or the owners die.

Make maximum use of estate planning techniques that help you transfer real estate at low tax rates. The simplest way to transfer business real estate is through gifting or bequests. But other transfer strategies can be more effective. For example, an owner can create a family partnership or a family realty corporation to hold the property. Under both, shares of the partnership or corporation can be gifted in increments to the successor generation. As part of an estate freeze, for example, an owner can transfer property to the corporation and freeze its value at the time of the transfer. Any appreciation in property value accrues to the successors and is thus not taxed as part of the estate.

You can leverage gifts of real estate for greater tax advantage. A Grantor Retained Income Trust (GRIT) or Grantor Retained Unitrust (GRUT) allows you to transfer shares of real estate to a short term trust and thereby reduce the eventual estate tax. The grantors can make all or part of this gift tax free, using their unified credits. During the term of the trust, the grantor retains all rights to income from the property. At the termination of the trust, the real estate and all appreciation in value pass to designated members of the next generation.

Don't overlook the minority-ownership and lack-of-marketability discounts. The same tools available for lowering the value of stock in estate planning may be applicable to real estate. In valuations of real estate, owners of a minority interest can often claim a discount because they lack full control over the asset. Like privately held stock which is difficult to sell, buildings and property that have been used for a particular type of business do not find a ready market. The discount on valuation can be substantial and result in significant tax savings.

Resolve any questions about future ownership now. Before the second generation receives some or all of the property, there should be a clear agreement, in writing, regarding contingent ownership. The agreement should resolve such questions as: If a family member leaves the business, is he or she obliged to sell the shares of real estate to family members remaining in the firm? What if a family member who owns a share of the property dies? Where will the money come from to buy out heirs of deceased owners or family members who leave the business? In all such situations, arrangements similar to stock-control and buy-sell agreements can be very helpful.

Communicate provisions for future property ownership to the family in advance. It's generally a good idea to let all family members in on the details of succession and estate plans, so they are not left in the dark later on. Owners should explain what will happen to the business real estate upon their retirement or death as well. The family should discuss how the property might have to be used if hard times hit the business. If everyone understands the goals and reasoning behind the use of business real estate assets, there will be a lot less confusion — and conflict — later on.

Randy Bliss, is president of YHB Consulting Inc., a firm in Farmington, Connecticut, that advises family businesses. He specializes in planning for ownership transition and management succession.

Discounts on business property: A recent ruling

By William O. Cranshaw

In their continuity and estate planning, some family groups have successfully obtained discounts for minority interests and lack of marketability for business property held for some time in family holding companies or partnerships. In a recent court test, the U.S. Tax Court confirmed for the first time a methodology for arriving at these discounts that was proposed by the IRS's own expert witness.

One of the best available yardsticks for appraising these interests has been the stock prices of publicly traded real estate investment trusts. Because the market price of REITs has plunged in recent years, the value of holding company stock or partnership interests held by family groups has declined correspondingly; thus,the correct application of these discounts to valuations used in tax planning has resulted in substantial tax savings.

In Estate of Edgar A. Berg, T. C. Memo 1991-279, the heirs of a family owned real estate holding company in Grand Forks, North Dakota, based their claim on a 1985 opinion by their accountant on the size of the two discounts. The court did not agree with the accountant's assessment. Instead, it accepted the arguments of a qualified appraiser hired by the IRS.

In approving discounts of 20 percent for minority interest and 10 percent for lack of marketability on property in the holding company, the court accepted a methodology described in an article, by Robert P. Oliver, ASA (Real Estate Review, Spring 1986) entitled, "Valuing Fractional Interests in Closely Held Real Estate Companies." REIT stock prices are an integral part of the method.

REITs have continued to perform poorly, so the magnitude of the discounts in today's market could be even higher — perhaps 60 percent to 70 percent. For family businesses with extensive real estate holdings, this translates into sizable discounts on gift and estate tax valuations for these types of interests. The government will find it difficult to retreat from discounts calculated in the same way in the future, since the method was originally proposed by the IRS's own expert.

William 0. Cranshaw is a principal in Management Planning Inc., a Princeton, New Jersey, valuation consulting firm.