Family Business Heir

Family Business Heir

By: Martin M. Shenkman, CPA, MBA, JD

If your children have received, or will receive, interests in your family business, what steps can be taken to protect the business?

Active Involvement: Carefully evaluate if and when to make your heir an officer or director of the family business. Involving an heir may increase loyalty and motivation. However, bestowing officer or director status may also increase the claims the heir's spouse may have in the event of a divorce. Depending on state law, active versus passive involvement can have significant implications to the determination of what a spouse is entitled to in equitable distribution of assets during a divorce. Active involvement can entitle a spouse to much more than passive involvement.

Lifetime Trust: Set up a trust for your child and gift the equity interests into a lifetime trust (sometimes called an inheritor's trust). This can protect the business interests from the child's divorce or malpractice claims. A lifetime trust, if GST exempt, can hold the business interests in trust forever without them ever being subject to estate taxes. Distribution provisions may expressly prohibit distributions of family business stock. Trustees should be carefully chosen to carry out your wishes to preserve the family business. This is one of the most important safeguards.

Revocable Living Trust: While these trusts can avoid probate they can do more. If you are married and you have inherited assets or received gifts, setting up a revocable trust designed expressly to only hold inherited/gift assets can be powerful tool to protect those assets from becoming tainted as marital assets subject to distribution if you divorce. Name the trust to highlight its limited purpose, limit trustees to your direct family members (not your spouse), transfer only inherited/gift assets to the trust, and never to marital assets, and operate it so as to avoid commingling trust and marital assets. It's not only avoiding probate, it is a supplement to a pre-nuptial agreement or "divorce insurance".

Prudent Investor Act: This law, enacted in various forms in most states, mandates that estate and trust assets be diversified and invested in accordance with an investment policy. Be certain that your will and any trusts you establish (including insurance trusts) modify these rules to permit your executor and trustees to hold family business interests. Be sure that they are part of your investment policy.

Shareholders' Agreement: Be certain to have a comprehensive shareholders' (or other) agreement governing the operation of the family business and severely restricting the right of any single owner to transfer business interests. When you gift shares to an heir (or preferably a trust for that heir) the heir, or trustee, must obviously sign the agreement acknowledging that they are bound by the restrictions. You should also have the heir's spouse sign and acknowledge that he/she has read and understood the agreement, and knows whether or not she is entitled to any of the assets, and if she has any authority in the business.

Pre-Nuptial Agreement: If your heir balks at a full blown pre-nuptial agreement as being contrary to his/her professed love, at least a limited pre-nuptial agreement addressing family business interests should be signed. Do it right! The new spouse should have his/her own counsel, it should be done with full disclosure (attach a business financial statement, tax return, and shareholders' agreement as exhibits), consummate it well in advance of the marriage (not on the Church steps!), and make reasonable provisions for the new spouse (e.g., life insurance, etc.). In case of divorce, the spouse will not have access to the family business, and the pre-nuptial will be considered a valid document.

Voting vs. Non-Voting: At certain points in time it may be advisable to only transfer non-voting equity interests to maintain consistency in the control of the family business. Caution: This might raise estate tax issues under Chapter 14 of the Internal Revenue Code, so review this with your estate planner, not only your corporate attorney. You might even consider mandating that if stock is distributed from certain trusts, that distribution will trigger a conversion to non-voting status. In some instances a voting trust arrangement might be helpful. In such an arrangement the heirs could continue to own the beneficial interest in the stock but a named voting trustee may be given the right to vote. Caution: Have your estate planner review Code Section 2036 issues in this regard. Following this plan allows your children to receive finances from the family business, and still allows you to have a stronger say in how the business is run.

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