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Family Business Succession: Compensating Children Not in the Business

Posted by Concannon Miller on Thu, Sep 30, 2021

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Family Business Succession: Compensating Children Not in the BusinessOften, the senior generation of a family business goes through the process of choosing one of its offspring as the successor to lead the company in the future. Usually, the chosen successor is given the title of president or CEO.

For a period of time, he or she will work under the supervision of the senior family member, who may have founded the business. Eventually, the successor takes over complete operating control of the business.

This means that the fate of the future operation of the business is in the chosen sibling's hands and, naturally, he or she will be compensated accordingly. But what about the other siblings who weren't chosen?

It's Up To The Chosen One

Whether or not the business is successful is obviously up to the successor's efforts. To the extent that the other siblings also own a portion of the business, their financial fate is also in the chosen sibling's hands. A number of problems can arise unless you have some consideration of these issues when planning the division of the estates of the older generation family members.

In some cases, members of the senior generation may want to give each of their children part of the family business. It's a natural reaction to think: I want my children to have a piece of the business that I helped to start. However, if the ownership in the family business is parceled out to all of the siblings without investing a controlling interest in the sibling chosen as CEO, the future operations of the business could be severely hampered.

The other siblings might not like the direction the new CEO is taking the business. They might feel there are insufficient distributions of profits being paid to the shareholders. In other words, there might be a true dichotomy in thinking as to how to run the family business. Such differences of opinion can paralyze companies.

READ MORE: Family Business: 7 Tips for Selecting a Successor

The most obvious solution to the above problems (and others that could arise) is to make sure that the CEO sibling has control of the business either through ownership of an outright controlling interest or through a voting control of the business.

However, while either of these solutions can resolve the issues noted above by giving the CEO the ability to make all of the important decisions regarding the operations of the business, it puts the non-control siblings at the mercy of the control CEO sibling. This could result in a situation where a non-control sibling ends up receiving a non-earning asset that's also a non-liquid asset (an interest in the family business).

If the control owner doesn't want to make distributions, the asset will be non-earning to non-control siblings. In addition, in most family businesses, stock may not be sold without a right of first refusal to the business or to the other shareholders. This makes the interests owned by the non-control holders virtually illiquid.

The control CEO, on the other hand, might feel that it's unfair that there's an increased value of the whole business without being able to enjoy the full value of that increase because the ownership is divided among him- or herself and other siblings.

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Equalizing the Estate

So how to resolve the problem? One common-sense approach is to either gift — or gift and sell — the entire business to the control CEO sibling. If more than one sibling continues to work in the business, then some ownership provided to them would make sense, but only if they are required to sell their interests back to the company (or the control CEO and other siblings working in the business) if they leave employment.

The objective is to ensure the CEO has complete operational control of the business. In order to properly equalize the estate for all of the siblings, the senior generation should gift (or leave in a will) other non-business assets in the estate to the siblings who are not active in the business.

You might also consider gifting or leaving family business real estate to the non-business active siblings. This should be done in a manner that won't impede the business operations and will truly provide valuable assets to the siblings who are not active in the business.

READ MORE: 4 Guiding Principles for a Family-Business Succession Plan

If there are insufficient non-business assets to equalize the estate to the beneficiaries, then at least a portion of the business could be sold to the CEO sibling in order to provide the assets (from the proceeds of the sale portion). That way, the estate can be equalized for all of the siblings.

On the surface, this might sound complex or even not worth the trouble. Rest assured, it's generally worth the effort and planning. If these matters aren't dealt with, the consequences could be disastrous. Consult with us to ensure the issues are handled correctly and properly explained to all involved.

© 2021

Topics: Succession planning

Concannon Miller’s unique, holistic and intimate approach to financial health sets us apart from smaller CPA firms with more limited resources as well as mega firms where mid-sized clients struggle for attention. Contact us here to talk about improving your business.

This communication is designed to provide accurate and authoritative information in regard to the subject matter covered at the time it was published. However, the general information herein is not intended to be nor should it be treated as tax, legal, or accounting advice. Additional issues could exist that would affect the tax treatment of a specific transaction and, therefore, taxpayers should seek advice from an independent tax advisor based on their particular circumstances before acting on any information presented. This information is not intended to be nor can it be used by any taxpayer for the purposes of avoiding tax penalties.

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