Blog Post by Keith R. Butler
Absent unusual and compelling reasons to the contrary, most parents desire to treat their children equally upon death. The standard “I love you” estate plan provides that upon the death of the first spouse, all property of the deceased passes to the surviving spouse. Upon the survivor’s death, all property passes equally to the children, either outright or in trust. This is very standard stuff.
However, this dynamic does not work well when the parents own a business. The business is typically the dominant asset of the older generation, in many if not most situations exceeding half of the value of the estate. Unless there are also outside owners who will purchase the decedent’s interest in the business by virtue of a buy/sell agreement of some sort, great care must be given in deciding how to pass on the business upon the death of the surviving spouse.
The problem occurs when, as is often the case, one or more children are active in the business. Let’s assume a case where the facts are as follows:
- Two surviving adult children, one of whom is active in the business, and the other is not.
- The second spouse has just passed away, leaving a $5,000,000 estate, of which $3,000,000 is the value of the business.
- The parents established a life insurance trust which is essentially used to replenish any assets lost to estate taxes.
How should the deceased parent leave his or her estate to the children? Here are some options.
- The estate passes equally to the children, with each individual asset divided equally so each child receives half the business (worth $1,500,000 [discounted value is not relevant]) and $1,000,000 cash.
- The estate passes equally to the children, with the active child receiving his entire share in stock ($2,500,000) and the other child receiving the remainder ($500,000 stock and $2,000,000 cash).
- The entire business is left to the active child ($3,000,000 stock) and the remainder to the other child ($2,000,000 cash).
Now let’s analyze these scenarios. First, under A, we have created a problem for each child. The active child can be put into deadlock by the child who is not active. Also, to the extent the hard work of the active child grows the business, the inactive child benefits equally. In the event the company is an S Corporation, any S corporation distributions must be pro rata to the stock ownership. For the inactive child, closely held stock does not pay dividends (other than distributions necessary to cover tax liability on an S corporation), so unless the business is sold, he has a $1,500,000 asset that produces no income or return, and for which there is no market to sell.
Scenario B solves the deadlock issue, but that is about it. But it adds an element of unfairness. First, there is a very good chance that the value of the business is what it is due in no small part to the efforts of the active child over the years. This child’s only inheritance is an asset that has value only to the extent the business continues to succeed, as opposed to cash which is liquid and can be used or invested in the discretion of the recipient. Also, the non-active child still has some ability to question his sibling about the running of the business. The non-active child still has an asset that has no real value unless the business is sold.
Scenario C is a little better for the active child, but doesn’t solve all the problems listed above.
So, what is the answer? Well, there isn’t a perfect answer, because treating the children “equally” is impossible. The older generation has to understand and accept this. I have had many business owners struggle with this concept, leading to a very long planning process. Most situations are not nearly as simple as my illustration, which doesn’t address the problem of multiple active children.
Strive for treating them fairly. As is the case with all estate plans for people of at least some means, communication is the key to success. Of the scenarios above, C might be the closest. I would recommend use of life insurance in an irrevocable trust to fund an inheritance for the active child, so he has some liquid assets to use in addition to the stock. The non-active child must realize that $X of stock is not the same as $X of cash, especially where one beneficiary has contributed to the value of the stock.