Sometimes a family has to divide a business if it's going to conquer problems that threaten family unity, as David Boyd recently learned. His younger son, Kevin, had been managing the family's building materials distribution business for seven years while David's older son, Steve, wandered through a variety of jobs. David worried about Steve, who hadn't quite found himself. He invited Steve to join the family business. Steve accepted.
Kevin, who considered the business his company, resented his older brother's new involvement and found numerous reasons to criticize his behavior. Steve, on the other hand, resented Kevin's favorite son status. Kevin was further dismayed when, a year later, David began to consider transferring the business in equal parts to his two sons. Previously, he had made a gift of 20 percent to Kevin and 10 percent to Steve and retained the rest of the stock.
David had noticed that the boys' sniping was not confined to family meetings and secretly wondered if the business's recent downturn in sales could be attributed to his sons' arguments. They seemed committed to sabotaging each other's efforts.
David's temporary solution: Appoint each son as manager of one of his two warehouses, located about 45 miles apart.
Our firm was asked to design a more permanent solution. After extensive interviews with family members, our recommendation was to divide the business with a tax-free transaction called a "split-off," or corporate division. A split-off is a division of a business in which the owners of the original company do not maintain the same proportionate ownership of the newly created entity. Typically, one owner retains ownership of the original company and holds no stake in the new company, while the other owner gives up all claims in the original company for ownership of the new entity. This differs from a spin-off, in which the owners of the original company keep ownership in the new entity in the same proportion as in the original.
A split-off or corporate division can be an extremely effective method of solving family conflicts when the business has multiple locations, branch operations, or different operational components. The division can be especially attractive when there are several successors to the business who may not be able to work together.
Even though this division created operational inefficiencies for the Boyds, it was less costly than a partnership, which would have allowed the sons' bickering to hurt business.
The division involved an exchange of assets of the corporate parent for the stock of a newly created, wholly owned subsidiary (call it Newco), created to acquire those assets. Existing assets were allocated to the parent company or the subsidiary and a determination of value was made for each of the assets.
Steve surrendered his 10 percent of the stock in the parent company in exchange for new shares in Newco. David surrendered one-half of his shares in the parent for shares of Newco. Steve then owned 22 percent and David 78 percent of Newco. The parent corporation is now owned 36 percent by Kevin and 64 percent by David. The exchange by the parent company of David and Steve's stock for their interest in Newco was a tax-free transaction under Section 355(a)(1) of the Internal Revenue Code.
David is now free to proceed with his retirement planning. He can use different timing for each son's takeover of his shares in the two companies if he chooses, pegged to each son's readiness to assume full ownership.
In addition, the impact of dividing the business into fractional parts can reduce future estate taxes when David becomes a minority shareholder in the divided corporations. The value of the stock of a minority shareholder maybe discounted, resulting in a lower valuation in the estate and a reduced estate tax liability.
Each son now has the assurance of knowing that he will not be forced into a partnership with his brother. Each has a renewed sense of commitment to his corporation, and now realizes he will own his entire company eventually.
Most importantly, family get-togethers are more harmonious. As David's wife says, "We feel like a family again."
Mike Cohn is president of the Cohn Financial Group, a Phoenix-based firm that designs and implements transfer strategies for family businesses nationwide.