By R. Jeremy Wilson
The wealthy family often has a myriad of entities and assets to manage. These typically include real estate holdings, trusts and various operating and investing companies, designed through the collaboration of skilled professionals. This complex structure provides the family a level of asset protection and a way to effectuate the transfer of wealth from the senior generation to junior family members.
When these structures are initially created and funded, the overall enterprise reflects the desires and wishes of the family (or at least those of the patriarch and matriarch). However, with the passage of time, transactions occur, distributions are made, assets are sold and replacements are purchased. Without careful consideration, the once-beautiful plan looks more like a tangled spider web. When this occurs, value might be lost and asset protection compromised. To prevent such negative effects, certain best practices should be implemented, particularly related to communications and the flow of funds.
Communication is crucial
The failure of a family enterprise to maximize its value is frequently traced to a lack of communication. Typically, communication lapses occur between the family and their advisers or among family members.
Family communication. Every family, especially those with high net worth, should have a mission statement and set of core values, which can provide guidance in making decisions. Of course, this is helpful when the senior generation is transitioning management and control, but it is imperative when the patriarch and matriarch are deceased. The family should make it a practice to formally review the values and mission when deliberating major decisions affecting the family enterprise. This emphasizes to family members that decisions are made based on merit rather than as a matter of personal preference. This understanding helps mitigate the likelihood of hurt feelings and personal agendas.
Another best practice in the area of family communication involves holding regular family meetings, including an annual meeting. The purpose of the family meeting is to encourage open and honest dialogue among family members. The style and content of the family meeting should mesh with the family dynamics. Some families choose the company boardroom with a formal agenda, while others conduct meetings over dinner. Some families include spouses, while many do not. Regardless, the goal is to facilitate dialogue and encourage cohesiveness among the family members.
Adviser communication. Lack of communication among family members can give rise to discord and interpersonal conflicts. Lack of communication between advisers and family members tends to result in technical problems, such as unintentional gifts, income tax issues or legal titling problems. Many of these can be corrected, but lost value or a missed opportunity is a potential consequence of each misunderstanding. The most common problems occur in the transfer of money, whether between the entities, between the family members or between entities and family members.
An annual review is a great way to ensure that transactions and arrangements are structured in the most advantageous manner. The scope of the review varies by family, but the adviser will generally analyze the financial records, the titling of new assets and the latest legal documents to determine the need for revision. Conducting the review annually enables the advisory team to identify issues in a timely manner and recommend modifications if needed. The adviser can present findings from the annual review at the annual family meeting. This assists the family in understanding the overall plan and structure while illustrating the importance of coordination within the plan.
Analyzing the options
Many arrangements involving entities within the family enterprise are made to satisfy a tax, legal or financial requirement. Failure to consider alternatives or to properly document the transaction can cause a variety of issues. Frequently, the problems within a family enterprise arise from trust distributions, promissory notes and family member compensation.
Trust distributions. Entities are typically created to accomplish one of two goals: to provide asset protection or to allow for fractionalized ownership. When distributions are made from the entities to the individuals, these benefits are lost. If assets are distributed from an irrevocable trust to an individual beneficiary, they become available to the claims of creditors and predators. If the goal of the trust is to provide asset protection, careful consideration should be made as to whether the distributions are necessary or even appropriate. In recent years with rising tax rates, particularly for investment income within a trust, the solution presented by many CPAs is to make income distributions to the beneficiaries. Since the individual beneficiaries are taxed at a lower rate than the trust, less money evaporates from the family in favor of the government. Although recommended by a tax accountant, this might not be in the best interest of the family. By making the distribution, there are significant tax savings but at the cost of lost asset protection.
For instance, consider Trust A, which has $100,000 of taxable income, taxed at a combined rate of 49.4% (a federal rate of 39.6%, plus net investment income tax rate of 3.8% plus a state income tax rate of 6%). The beneficiary, A, is taxed at a combined rate of 31% (a federal rate of 25%, plus a state income tax rate of 6%). If a distribution is made, more than $18,000 of tax savings is realized. The problem is that a distribution must occur to realize these savings. In this case, $100,000 moves from Trust A into A's personal bank account. Net of taxes, A is left with an additional $69,000 in his bank account, subject to the claims of his creditors and predators. In contrast, if the assets remain in Trust A, $49,400 will be paid in taxes, but the remaining $50,600 will stay beyond the reach of A's potential claimants. The question becomes, how important is asset protection to the family? If it is important, do not let tax strategies trump the overarching themes of the family plan.
Promissory notes. Family enterprises often include multiple partnerships or limited liability companies (LLCs), each containing a different collection of assets. Some entities generate positive net cash flow, while others do not. Similarly, some contain liquid assets, while others are highly illiquid in nature. This disparity frequently requires one entity to fund the operations of another. When this need arises, the structure must be carefully reviewed.
Each entity has a distinct reason for existing. For example, one company may hold real estate that has a higher risk for potential claims, while another might house a business enterprise that must file financial statements related to a government contract. Assuming both entities have cash reserves in excess of the anticipated operating needs and related contingencies, either could provide cash for another family entity. The structure for the movement of the cash, however, might be different. To get the cash from the real estate LLC, a member distribution makes sense. Assuming sufficient member basis, no adverse tax consequences result from a distribution. Additionally, the cash is theoretically out of reach from potential claims related to the property (subject to fraudulent conveyance statutes and applicable statutes of limitations). In contrast, the operating entity likely wants to show the strongest capital position possible. If a distribution is made, the company's capital is decreased. For this reason, the use of a promissory note might be the preferred mechanism. This way, an asset of equal value is still on the company's books, leaving equity unaffected. This is a simple example, and all facets must be considered to make the determination, such as ownership structure, asset growth rates and inclusion in the taxable estate. The advisory team should be consulted to determine the most appropriate course of action.
When a promissory note is deemed appropriate, a legally binding, written document should be drafted and executed. The note should incorporate proper language under the laws of the governing state, bearing interest at a rate equal to or exceeding the applicable federal rate prescribed by Sec. 1274(d) of the Internal Revenue Code to prevent any adverse transfer tax consequences. To corroborate the validity of this promissory note, payments should follow the terms of the note. Additionally, if there is a fee for untimely payments and a payment is late, the fee should be remitted. In short, do not ignore the substance of the document because of the relationship of the entities.
Family compensation. A family member providing services to one or more entities within the family enterprise needs a written agreement outlining the terms of service, executed by both parties. From a tax perspective, this provides support for the deduction taken on the corresponding tax return (though it is still subject to the reasonable compensation standard under Sec. 162 of the Internal Revenue Code). Perhaps more important, the agreement demonstrates to other family members that the compensation is being received for specific services and that terms were considered in advance of the payment. This arrangement is most valuable when one child is participating in day-to-day company operations while other children are inactive shareholders. In many instances, the non-participating children deem it unfair that the participating child receives compensation from the business in addition to any value from his or her ownership interest in the company. Again, an employment agreement spells out the requirements of the participating child in his or her role and the total compensation received (salary, bonuses, insurance, memberships, vehicles, vacation, etc.) and shows that the compensation received was neither arbitrary nor unwarranted. The degree to which the details of the arrangement are shared will vary from one family to another. However, at a minimum, the non-participating children should be aware that such an arrangement is in place and that the terms have been fairly negotiated. This communication can be as simple as mentioning it at the annual family meeting or the annual shareholders' meeting.
Creating an enduring legacy
The enterprise of a high-net-worth family often has a complex structure—and for good reason. Frequent and transparent conversations among the family members allow the family enterprise to grow in a unified direction. Consulting the advisory team regularly ensures that the structure of the enterprise matches the goals of the family. Through careful planning and meticulous execution, the overall enterprise will be positioned for efficient growth and protected from potential claimants. With clear goals, genuine consensus and adviser input, the family enterprise becomes something greater—an enduring legacy for future generations.
R. Jeremy Wilson, CPA, CFP is a manager in Draffin & Tucker's tax service group in Atlanta, where he focuses on high-net-worth individuals, closely held businesses, family-owned businesses and estates and trusts (www.draffin-tucker.com).
Copyright 2015 by Family Business Magazine. This article may not be posted online or reproduced in any form, including photocopy, without permission from the publisher. For reprint information, contact bwenger@familybusinessmagazine.com.