How To Really Screw Up Your Business At Death (And What You Can Do To Avoid This)
In my last article, I wrote about some of the steps you could take to wreak legal and financial chaos on those you love. I originally wanted to also include those important steps you could take to also drag down the family business / farm or start a family squabble that could hopefully last for generations. When I started writing, however, I quickly saw that this needed an article all to itself, as the opportunities seem almost endless. Even so, I won’t have time to address the extra level of problems that can arise if your immediate family aren’t the only owners of a business.
Before going any further, I need to clarify that although I’ve written almost exclusively about small businesses in this article, the same basic premises apply if you own a farm. On the other hand, there are some additional tax benefits available to farmers who keep the farm in the family on their deaths. In specific, it’s essentially possible to transfer the assets with triggering any income tax at that time although there will be eventually a day of reckoning when it’s finally sold to an outsider.
Anyway, I won’t add any more on the subject of farms for now, as this article already promises to be another long one. Accordingly, in an effort to save both your eyes and as many trees as possible, let’s cut to the chase. Most of the mistakes regarding your estate planning if you own a businss can be broken down into 3 main areas:
• Working really had to build a successful family business / farm then putting no effort into the logistics of how the company will operate without you and how to make things work at that point without your children engaging in a bloodbath;
• Failing to think about taxes and other expenses that can cripple your business, force your heirs to sell out or result in a much higher tax bill at your death than anyone deserves; and
• Not getting the proper legal documents and advice in advance.
Planning for the survival of your business, how to treat all your heirs fairly and minimizing things that can go wrong when you’re 6 feet under, is nothing to leave to chance. It is also something that most of us can’t do without quality professional guidance. Even more important than getting the right people is getting them at the right time. As most of us have no idea how much longer we have to make widgets and increase profit margins, it’s a really good idea to have a plan in place every step of the way. Moreover, some of the plans to get the right assets into the right hands and to keep your tax bill microscopic need to be in place years or decades in advance. After slogging through the next few pages, I’m hoping that you see things the same way.
Failing to Address the Logistics of How the Business Can Survive If You Don’t Without Your Kids Learning to Loath Each Other
One of the most important decisions you’ll need to make is whether to sell the business or pass it along to the kids. In some cases, the best decision you can make is to sell the business during your life when it’s at its peak rather than either delaying until a time it’s been autopilot for 5 years or passing it along to the kids at your death so that they can slowly watch it circle down the drain while constantly sniping at each other every step of the way. If you opt for Plan B and handing the reins over to the kids, the next question is how to do this without triggering a civil war. This gets more complicated if not all your kids are involved in the business and your estate doesn’t have enough money to provide fairly for the non-business kids.
To begin, here are some of the potential things that can cause friction and money problems between your kids when you’re no longer around to play the referee:
• The business kids run the business into the ground and destroy not only their own stake in the business but the non-business siblings’ stake as well. It only gets worse if the non-business kids had no real say in the business along the way and had no realistic shot of getting their money out of the company at a fair value before stuff starting hitting the fan. In other words, the non-business kids get to watch their inheritance slowly evaporate with their hands tied firmly behind their backs unless they want to start a court action against their siblings to force a sale or buyout using something ominous known as the “oppression remedy;”
• The non-business kids end up controlling the company or blocking the business kids from keeping things afloat. Although you may have a daughter or son you’ve groomed for decades, it could be the kids that haven’t yet seen their first spreadsheet who call the shots and ensure that everyone will soon be looking for new careers while the business kids watch with impotent rage.
• Unless the business kids are getting a fair salary from the company (and the non-business kids are on board with it), the business kids may resent their siblings for getting an equal share of the profits without having to put in an equal share of the heavy lifting. Conversely, perhaps the non-business kids feel that their siblings are living too high off the hog when eyeballing both salary and the extra perks their brothers and sisters are costing the company;
• Deciding whether business profits should be used for growing the business rather than paying out siblings. The non-business kids may want / need to get bought out as soon as possible or to use profits to fund their current lifestyle rather than grow the business. It could be that they want more than the business can realistically give and their demands will ultimately destroy the company. Conversely, the business kids may have no appreciation for their siblings’ current needs or desire to get out of the business and may force the non-business kids to stay the course as unwilling business partners unless they want to lawyer up;
• Forcing the kids to work together after you’re gone, even if they are all already involved with the business before then. It could be that you are the glue that keeps your kids together. Without you, perhaps the kids either won’t be able to work as a team or lack the skills to keep the business afloat. Moreover, consider how the kids react if you pick one of them to call the shots in preference over the others.
• Giving all the kids equal shares, when perhaps the business kids feel like they’ve earned sweat equity along the way and that an equal division of shares is not a fair one. Alternatively if you have given a bit more to your business kids for their past efforts, the non-business kids may feel like second class citizens; and
• Making your kids run the business while they’re still too young to know what they don’t know. Although your kids might be good business owners one day, perhaps that day is not now. Do you have someone who can advise them along the way or even make the decisions for a few years until the kids are presumably able to fly on their own? Even better, do the kids have any sort of relationship with that person now so that they’re not saying their initial hellos at your funeral.
Obviously, many of the problems raised above can be eliminated if the non-business kids can get their share of your estate from non-business assets. If your estate isn’t big enough to do justice to your other kids and other heirs, then you might need to look at some of options raised below. Before going there, however, I need to point out that the problems I’ve just raised don’t even include the legal mess that can arise if you also need to support a spouse (particularly one that isn’t related to or particularly fond of your kids.) Some of the same concerns and solutions discussed previously and below can still apply when trying to do take care of both your kids and surviving spouse but the chance of serious problems seem a lot higher. Anyway, potential solutions include:
• Reorganizing company assets so that the business kids get the active business and the other kids get other business assets, perhaps in a separate holding company. If the non-business kids inherit shares in a company that only owns the building, they could either rent the building to their siblings, sell it back to them on terms that are fair to all or even potentially sell it to outsiders without necessarily destroying the business. They wouldn’t have to be part of the operating business and they won’t get dragged down if their siblings aren’t quite as good at managing the business as you all hoped;
• Instead of gifting common shares to the non-business kids, gift them either preferred shares that provide a promised payout out each year but which don’t share in the future growth or structure their share of the business as loans at a set interest rate. In either case, you could consider setting up a payment schedule for the company or their siblings to buy them out so that the siblings aren’t forced to stay involved in a business they don’t know or like indefinitely. For example, perhaps the loans effectively give the business kids 5 years to arrange their own financing or to raise enough cash within the business. If they can’t get it done, perhaps this signals that they should be selling the business anyway or perhaps your kids can enter into a new agreement on their own terms so that non-business kids don’t feel like they are prisoners of the business or their siblings without receiving fair value. Giving the non-business kids preferred shares or loans also gives them more protection if the business goes under than if they just owned common shares in the company, as both loans and preferred shares would get paid out before the business kids took their cut. In other words, the non-business kids aren’t penalized for their siblings’ screw ups unless the business can’t also pay out its other lenders and creditors without leaving also leaving enough money in the till to pay out the non-business kids;
• Use legal documents like shareholders agreements to put some structure and protection in place for your kids, such as ensuring minority owners retain a say and buyout provisions to protect the non-business kids;
• Reorganizing the share structure if the business kid is in the minority so that all the kids own an equal or fair amount of the shares but so the business kid owns the voting shares and the others own shares that participate equally but don’t give them the right to make business decisions. Perhaps a shareholder agreement can also protect the non-business kids by setting up a schedule for when they get bought out or a mandatory sale provision if the business doesn’t look like it’s going to be able to survive for the long term; and
• Life insurance. If there is enough life insurance money, then the non-business kids (or your grieving spouse) get compensated through cash and the business kids can run the business in peace. Insurance can also provide extra funds for the business to cover off the extra expenses it may incur as discussed elsewhere in this article. The amount, type and proper owner of the insurance is always an open question. The amount may be a fixed value if you don’t foresee additional growth in your hands or it might fluctuate if your shares are still going to grow. If you’re in the latter case, I generally suggest planning at least 10 years out, especially since we have no idea whether you’ll still be insurable by that point and also so that buying life insurance doesn’t have to become an annual event in your world. I also hate to see scenarios when the insurance is probably going to be needed for life but the family decided only purchase term coverage. Often, unless the company is going gangbusters, the insurance becomes unaffordable and lapses at exactly the time your family needs it most. Accordingly, if it looks like you’ll need the coverage for life, consider buying permanent insurance sooner rather than later while it’s still affordable.
Failing to Prepare for How Expensive Death and Its Aftermath Can Actually Be
Death can be expensive, especially when including some of the extra costs that might plague your heirs. It’s important to get an idea of these costs in advance, make sure the money to pay them is in place and that you’ve done everything possible to minimize the bill, other than fudging tax returns. The most obvious expense is the income tax bill, unless everything is going to your spouse or you are using the special tax rollovers available for farmers. Here are some of the things you can do to drive down the cost or at least ensure that there is money on hand to pay it:
• Looking at estate planning techniques to cap or reduce the tax bill at your death. You may need to talk to your lawyer and business account about the mysterious “estate freeze” your accountant may have mentioned in passing and how this can make the kids and your business’ future a lot brighter. A freeze is essentially a way of reorganizing shares in your business so that any future growth accrues to shares that won’t be taxed at your death thus “freezing” your final tax bill. As you’ll only be taxed on the shares you own at death, having new shares owned by a trust you control or owned directly by your kids is a way of hopefully deferring tax on this growth for an extra generation. It is even possible to eventually reduce this bill going forward by having the company buy back some of your shares in exchange for dividend payments by way of an even scarier sounding technique called a “wasting freeze;”
• Maximizing use of the $800,000 Qualified Lifetime Capital Gains Exemption that we all receive. If you own all the shares, you’re only tapping into a single exemption. Both you and spouse own shares? Congratulations, you’ve doubled your savings. Of course, don’t forget about the kids, especially if you and your spouse’s shares have already grown by $800,000 each and you are thinking of potentially selling the business several years down the road. Tapping into your kids’ own exemptions is also part of an estate freeze to cap your ultimate tax bill at death. As explained in elsewhere, it is possible to use the kids’ exemptions without actually giving them the shares or votes by using a family trust that you control;
When planning to use the $800,000 exemption, the key thing to remember is that it takes time to make this work. Not only do you need to reorganize shares, but you need to wait for the new shares to actually grow in value so that there are capital gains for them to shelter. In other words, unless your company is growing in leaps and bounds, the real benefits of reorganizing shares to tap into others’ $800,000 exemptions won’t appear for many years until your company has had a chance to significantly grow the value of the new shares. Moreover, even if you’ve planned ahead, you still might also lose out on the exemption if your business has too many non-business assets or your shares are owned by holding companies rather than personally or in a trust. As a result, you also need to find out if you need a more complicated corporate structure, potentially involving holding companies, to separate the assets you need in your business from some of the investments and extra cash your business has generated along the way without having to flow it out to you personally at egregiously high tax rates;
• Gifting some shares to your kids during their lifetimes so that the tax bill is lower on your death and so that the business kids feel like they’re receiving some of the sweat equity along the way. Does giving shares to your kids at this point give you the shakes, especially if you’re not overly fond of their spouses? If so, you can put the new shares in a family trust that you control that promises the kids nothing, as perhaps the shares can alternatively go to your spouse or to your holding company if necessary. This gives you essentially an extra 21 years to control the shares. If you sell the company or die during that period, the gains on those shares aren’t part of your personal tax bill and you can tap into your kids’ $800,00 lifetime capital gains exemption to nullify some or all of the tax otherwise payable on the growth of those shares;
• Taking steps to reduce your probate fee bill in high probate provinces like B.C. and Ontario. Although I generally compare probate fees to a nick and income taxes to an amputation, it is also possible to die the death of a thousand cuts, one of which is your probate fee bill. In B.C., the probate fees are essentially 1.4% of your estate. This amounts to $14,000 for a $1,000,000, which is unpleasant but probably not worth too much of a concern. If your business is worth $10,000,000 and the bill rises to $140,000, perhaps your perspective changes. There are ways of avoiding probate fees that can cost a fraction of amount saved. Two common techniques are having older business owners owning shares inside special trusts called Alter Ego or Joint Partner Trusts, and using a multiple Will strategy. If you go with the trust option, you avoid probate because it’s the trust document that says what happens to the shares after you die rather than your Will. Since it’s thus not part of your estate, you’re able to bid probate fees adieu. If you go with the multiple Will option, you have different Wills for your business and personal assets. If your family doesn’t make you probate the business Will, these assets won’t be subject to probate fees. There are also some of the other techniques used for income tax planning we discussed earlier that can help with your probate fees as well, such as gifting during your lifetime, doing estate freezes and setting up family trusts.
There are also some other expenses that can sidetrack your business when you’re six feet under:
• Banks and suppliers reducing credit to the business or calling in loans / increasing interest rates. If your kids can’t get additional credit, perhaps by pledging their own homes and personal assets, the business may not be able to survive. In some cases, even if the tax bill doesn’t kill the business, the banks, creditors and suppliers might;
• Clients loyal to only you might leave at your death or your kids aren’t able to attract new clients if they don’t have your contacts, experience and reputation;
• your business defaults on contract underway at your death due to the chaos;
• The business needs take on new employees to replace you or to cover your kids’ old positions, particularly if the company needs someone to manage it if your kids are not ready to assume this role;
• General chaos resulting from the change in ownership and everyone trying to adjust. This also usually means spending a lot of time on administrative functions rather than the actual business; and
• The cost of paying for your kids’ learning curve. It’s probably not realistic to expect them to learn and grow without making a few mistakes along the way or to run the business as successfully as you do unless they’re already essentially doing so already.
When looking at both the taxes and other expenses, the first question is whether your estate has enough to cover the costs. The next question is what happens if it doesn’t. Life insurance can be a great solution in many cases. If that isn’t an option for you, the kids might need to cover these costs themselves through their own assets or personal guarantees. This consideration should also be part of the mix when deciding whether or not to sell the company and the best way of dividing up estate assets if you want the business kids to have their time to shine. This might mean requiring some of the non-business kids to take some of their inheritance in loans to the company in order to ensure that there are extra dollars in place to give the business kids some breathing room until they find their stride.
Failing to Get the Right Legal Advice and Documents in Place to Implement Your Plans and Thwart Troublemakers
It’s one thing to have a good plan, it something entirely different to have actually implemented it. That’s where some of the legal documents play such a huge role. People may “plan” to get shareholder agreements and to take steps to avoid a Will challenge but unless they get the right advice and sign the right documents, then they’ve accomplished nothing. Part of signing the right documents is getting timely tax and legal advice. I find that sometimes business owners don’t get proper advice on the all the legal challenges and obstacles that can derail their plans quicker than you can say “litigator.” A lot of those problems are addressed in my previous article, but here are a few big ones:
• Will Challenges. In all provinces, spouses and dependent children can challenge your Will. In B.C., we’ve taken things one step further and Wills Variation Act challenges are something of a cottage industry for lawyers. Out here, adult kids of any age or means can challenge your testamentary wishes. To make things even worse, the standard for determining when these decisions can be appealed is lower than pretty much any other area of law in this province. In other words, every one essentially gets not one but two expensive kicks at the can, which usually involves the different parties retaining different lawyers. Even if the good guys “win,” it will probably be an expensive victory.
If you have a blended family or are planning an uneven distribution to your kids, good legal advice is a must. Part of the solution might be using trusts rather than Wills to distribute assets (since Will challenges wouldn’t apply to assets already in a trust as far as your adult kids are concerned.) You might also gift during life, use life insurance and other assets with beneficiary designations, own assets jointly (along with proper documentation explaining your intentions) and get spouses and partners to sign prenuptial and cohabitation agreements that also cover off the deceased’s estate;
• Ensuring your Will allows your trustee and executor to both carry on your business without responsibility for most losses and giving them the right to do all business-related functions. If your trustee isn’t given the power to continue on running a business, his lawyer will probably tell him to shut it down in order to avoid risk being sued by your heirs. It’s also a good idea to give your trustee the power to do pretty much what you could do in order to take advantage of some tax savings opportunities and so s/he isn’t hamstrung trying to react to unforeseen circumstances.
• Wills that gift assets rather than percentages of the estate. Ignoring how different assets are taxed differently, perhaps the shares are worth a lot more or less than anticipated. Over time, a fair distribution may become an injustice. Accordingly, dividing the estate into shares and saying that one child’s share should come out of the business is a safer solution than eyeballing the value of assets and gifting them accordingly. On a related note, you may also want to determine a way of fairly valuing the company at your death or picking a specific person or a specific type of person, such as business valuator, to come up with the magic number. Another solution is to let different people pick their own experts and then have the experts jointly agree on the person who is actually going to crunch the numbers. Another option is hiring multiple experts and averaging their findings.
• If you have a Shareholders’ Agreement, it is a good idea for your Will to say that you abide by its terms. In reality, you will probably have to anyway.
There are also a few other legal documents (other than the ones mentioned as potential Will challenge solutions) that should be part of your business plan. The biggest is your Shareholder’s Agreement. I’ve mentioned it in passing earlier so won’t add much more at this point. It can be extremely useful for things like fairly valuing the company and covering off what happens at different scenarios, like death, disability, divorce, disagreement, bankruptcy and retirement. It can also ensure that minority shareholders still have a voice in the company, discuss sales to outsiders, compensation and pretty much anything else you want to include.
Even if there is no point to getting one now (i.e. you and your spouse are the only shareholders and that isn’t going to be changing), the kids will definitely need one for the reasons just mentioned. It is particularly important for covering off what happens if one of the kids dies and widows / children are involved. Ideally, there should be life insurance in place for that contingency but, if not, a way of fairly valuing the business and perhaps a timeline for paying out these dependents and appropriate interest or dividend rates owing on their share of the company in the meantime.
Finally, I generally recommend getting Powers of Attorney in place or at least ensuring that someone else has signing authority in case you are incapacitated. Powers of Attorney can name one or multiple people and allow them to act jointly or individually or a mix of both depending on the circumstances. You can also give different people power over different assets and put restrictions into the document if you don’t want to take chance. If you grant the power to a family member with his or own separate company and small business tax rate however, be sure to mention this to your lawyer before proceeding, as this may have negative tax consequences.
I hate to see people who’ve worked so hard and sacrificed so long to unintentionally leave behind a financial and legal quagmire, along with a horrific tax and legal bill, when this is entirely unnecessary. Many of them have scrimped, saved and endured so they could provide a better life and future for their families. Failing to put even a fraction of the energy they have poured into their business to planning for what happens on their deaths threatens to undo so much of what they have fought so hard to achieve. Even worse, the resulting mess is often enough to tear the remaining family apart. Although most business owners seldom have enough hours in the day and few people really enjoy this sort of morbid planning, this is one of those occasions when it’s important to find the time and energy. Good, timely planning can save hundreds of thousands of dollars and, even more important, drastically increase the chances that your kids will continue to celebrate the major holidays together long after you’re gone. Strange as it may seem, spending some time and money with right professionals at the right time can be one of the most important gifts you provide to your family.