Why It's Better to Buy Out Than to Receive
Gifting the business to "the kids" may well create more problems than it solves. Steve Bradshaw owned three successful funeral homes. As he approached 65, he wanted to spend less time in the business and more time pursuing other interests. At the same time, Bradshaw kept resisting his advisor's recommendations to gift family corporation stock to his three sons, all active in management.
Whenever Steve's advisors suggested gifting stock, Steve's answer was always the same: "They're not ready." Steve was concerned about the boys' inability to get along. Granted, Joe and Mike had been in the business with him for seven years each, but Pat, the youngest son, had joined his two brothers only six months ago. Steve also believed the boys weren't committed the way he and Susan, his wife, were when they started the company.
Frustrated, the three boys, with the help of an industry consultant, approached Steve with a buyout plan. The proposal reflected the value of the business on the open market and included a structure allowing Steve to maximize his cash flow and minimize his income tax liability. No gifting was involved. The sons' cash flow projections indicated that the deal was affordable and provided them an opportunity to increase their income and net worth.
Everyone was surprised how readily Steve was willing to discuss a buyout. All documentation was completed and signed within three months. The three boys purchased the business for $3.5 million, including a modest cash down payment and notes with terms that avoided any adverse estate tax issues. Steve let go of the business and the boys are learning to work as a team.
The buyout solved several problems which gifting could not address. Steve was impressed that the boys were willing to make a buyout offer and saw this as evidence of increased cooperation between them. Their business-like approach and willingness to shoulder payment obligations indicated they really were committed. For Steve, who had built his business from zero to $3.5 million, gifting wouldn't have realized the value of what he had created.
After the closing, Steve enjoyed bragging to his friends that he sold his business to his boys instead of "giving it away." Since Steve's friends had recently sold their businesses also, this was an important feature for Steve when he considered letting go.
For Steve, his kids, and his company, a buyout proved more beneficial than gifting would have. There are additional compelling reasons to question gifting as an appropriate transfer strategy:
- Gifts often have strings attached. Kids can't challenge parents without appearing self-serving or jeopardizing "the next gift." What's more, although the kids own some stock, they know it's still Mom or Dad's company. Gifts are usually made with the understanding that "nothing really changes."
- Gifting doesn't create family heroes. Often the family culture is built around the parents' struggles to build the business and overcome substantial obstacles. Mom and Dad's early poverty creates family stories that bind family members to a heroic ideal. When the kids receive their ownership via gift, any struggle that might make them heroes in their children's eyes is eliminated.
- Gifting makes estate planning and estate equalization planning very complex when there are children active as well as inactive in the family business. If the owner gifts stock to all children, later family problems are almost guaranteed — when the current owner is no longer around to referee. If only active children are gifted, what is done for the inactive children? And when? If other assets are gifted, are they assets the owner will need for financial security in retirement? The owner may even fail to complete the gifting program because of concern about fairness to different children — at just the time that the reins should be handed over to the next generation.
Also, if a company is healthy and growing, gifting may not even cover the growth. In Steve Bradshaw's case, if he and his wife made maximum use of the gift-tax exclusion, they could give up to $60,000 in stock annually, tax-free, to their three sons. If the $3.5 million business were growing at a modest 5 percent per year, that $175,000 increase in value would dwarf their gift. The fewer shares of stock retained by Steve would be worth more in his estate than the prior year's greater number of shares. As Alice observed in Wonderland, "You have to run harder just to stay in the same place."
Finally, what should be a business decision — continuity and management of the business — gets confused with family issues. The demands of a family "system" (equal treatment for all) conflict with business "system" requirements (rewards on the basis of performance). These conflicting issues cause confusion, procrastination, and indecision for the owner who wants to "do right" and simultaneously "be fair."
The Bradshaw family's action — the children buying out the owner — is an alternative. The leveraged buyout, so prevalent in large corporate takeovers, works especially well in the family business. The current owner is able to realize full, fair market value.
Psychologically, the sale cuts the strings associated with gifting. In addition, the children's commitment is evidenced by their willingness to assume personal guarantees on the debt associated with the transaction.
For tax purposes, there are many ways to structure the transaction to assist the buyer group in making the payments, while simultaneously providing the owner satisfaction of realizing full value for his business.
Most importantly, the buyout simplifies some of the emotional dilemma associated with estate planning. If the owner sells his company to active children for fair market value, then he has the satisfaction of equal treatment of both the active as well as the inactive ones. The value received (cash, notes, and so on) by the owner's estate can be worked into an estate plan that is equal for all children. The estate plan can thus be untangled from business-continuity issues.
Mike Cohn, president of The Cohn Financial Group, a financial planning firm in Phoenix, is the author of Passing the Torch: Transfer Strategies for Your Family Business.