A Family Business ConundrumMay 31, 2019
Putting your children in charge of your business isn’t always blue skies and sunny days. But what do you do when they want to run it all – or not at all? I’d like to share a story with you; the story of Jim and Jan. By the way, we’ve changed the names and some details.
Jim and Jan, a well put together middle-aged business owner couple, sit down in my beautiful, wood-paneled conference room for an initial consultation. “Hi, I’m Greg, one of the partners here at Bennett & Bennett, how can I help you today?”
“I just don’t know what to do”! said Jim in a tone of exasperated resignation. “Jan and I have worked our butts off getting our printing business to where it is today. We started small print runs on a laser printer in our garage twenty years ago and now our business has grown to where we have 25 employees and annual gross receipts of over $2,000,000, but we still can’t seem to make much of a profit. Now, to make matters more complicated, two of our three children (Jim Jr. and Bob) work in the business and are wanting to be made part-owners, but I don’t know how to do that or if it’s even a good idea.”
“How is it having your children working with you in your business”? I ask. Jan answers, “It’s a real blessing! We get to see two of our children every day, we are able to help them make a good living and learn a trade, it’s wonderful!” Jim whispers under his breath, “It’s not all wonderful.” “What do you mean by that Jim?” I ask. “Well, don’t get me wrong, I love all three of my children equally, but it is sometimes difficult to have the two boys working in the business. Jim Jr. is my operations manager and has worked in every aspect of the business since he was 14 years old. He is a diligent, intelligent hard-working young man who is a great benefit to the company.”
Bob, on the other hand, is a different story. Bob is our youngest child and has always been a bit of a free spirit. Don’t get me wrong, Bob is intelligent, having gone to college and obtained a degree in art and music therapy, but he was never able to keep a job in his field. He was fired from three jobs in his first year out of college, before coming to work for us in the printing business. When we asked him what happened, he always blamed someone else. Since starting work for us, we have tried to put him in multiple different aspects of the business (marketing, customer service, and admin.), but he hasn’t been happy in any of them. We now have him as the manager of our sales department, but a number of our top salespeople have since left and sales are down 20% since we put him in that position. Now Bob wants to be made a part-owner of the business, has gotten his brother all riled up and is really causing a lot of morale problems on the floor. If he was anyone else, I would have fired him long ago.”
“You can’t fire him!” Says Jan in a tone of fear and anxiety. “He’s my baby. We can’t just throw him out into the street! We just need to keep putting him in different positions in the business until one clicks for him, and the boys should be part owners of the business after all our will has the business going to each of them equally when we die!”
“Jan, does your third child work in the business?” I ask. “No,” she answers, “Mary lives in Seattle with her husband and young children, working as a child psychologist, she has no interest in the business and just wants everybody to get along”. “Do you have an employee benefits program, such as a “Health Savings Plan” wherein your employees can set aside a part of their pre-tax income to pay medical bills and insurance co-pays?” Yes, we have that”, answers Jan.
“Boy, you have a lot going on, let’s see if we can unpack and work through some of these issues,” I calmly reply.
1. How To Not Succeed In Business Without Really Trying.
As you can probably glean, Jim and Jan have multiple problems in their business on multiple layers. The first is that they have their business set up as a Sole Proprietorship. A sole proprietorship is where the business owners simply own their business and all of its assets in their own names. This set up was probably fine when they first started out printing jobs in their garage, but now that they have grown and their business has become much more complex and their exposure to liability has increased along with their business, they need to set their business up in a business entity, such as a corporation.
A corporation is one of three main types of business entities appropriate for a for-profit business such as Jim and Jan’s printing business. The other two types of business entities are a Limited Liability Company and a Limited Partnership. There are different types of corporations as well. All of that detail is another article for another day; nevertheless, in this instance, I would set Jim and Jan up in a type of Corporation called a “California Close Corporation” with a C corp. tax designation.
A corporation is a separate legal person through which business owners can run their business while gaining many tax and liability protection benefits. A corporation also has stock that is issued to its owners and that can be issued to investors and key employees, either as a stock option or a stock bonus, and passed onto heirs upon the death of the shareholder. A Close Corporation is a type of corporation specifically designed for family owned businesses with less than 35 shareholders and only one class of stock issued (common stock). This is perfect for Jim and Jan, since they are the only shareholders and there is currently no need for more than one type of stock.
A very common misconception is that a “C corp.” and an “S corp.” are types of corporations. They are not. “C corp.” and “S corp.” reference the Internal Revenue Code through which the corporation is taxed. A “C. corp.” is taxed as a separate entity and the amounts paid to the shareholders in any way other than W2 income is double taxed, once at the corporate level and once at the individual level. You may ask if there is a double tax, why would anyone ever choose a “C corp.”? The answer is that a “C corp.” is much more flexible and can do a lot more in the way of employee benefits than can an “S Corp.”. In this instance, the printing company much elect to be taxed as a C corp., because it offers a “Health Savings Plan” and other employee benefits that are only allowed in a C corp.
2. Rewarding Gentlemen Jim Jr.
In the example above, Jim Jr. has been diligently working in the business since he was a child. Junior knows every part of the business intimately and has been promoted through the years to the point that he is the Chief Operating Officer. Can Jim and Jan reward Junior for his hard work by issuing him stock? Certainly, they can. They can offer Jim Jr. stock directly as a Stock Bonus under a Stock Bonus Plan, establish an Employee Stock Option Plan (“ESOP”) and give him stock options or, thirdly, they can gift Junior stock with a value below the Gift Tax threshold (currently around $15,000 per gift, per year).
An ESOP is relatively expensive to set up and is generally used to incentivize numerous key employees. Since it appears that Jim and Jan only want to give stock to their children, an ESOP isn’t the best choice.
Gifting stock valued at less than the Gift Tax threshold is an excellent way to give stock to children. Jim and Jan could give stock valued at less than the Gift Tax threshold to any combination of their three children every year, for as long as they live. If the gift is below the Gift Tax threshold each year, neither Jim and Jan, nor the gift recipient child would owe income taxes on the gift.
But what if they want to issue Jim Jr. stock valued at, say, $50,000 per year? The answer is that they would Gift the first $15,000 to avoid both gift tax and income tax. How would they give the balance of $35,000 to Junior? In this scenario, they would enter into a “Stock Bonus Agreement” and issue Junior $35,000 worth of stock as a “Stock Bonus”. This would be taxed as income to Junior; however, he can elect to defer paying the income taxes on this until such time as he sold the stock.
Of course, Jim and Jan will want to include Junior in their Estate Planning and can transfer the balance of the stock (or any portion thereof) through their trust.
3. What About Bob?
As can be seen from the hypothetical situation above, Bob is Jim and Jan’s ne’er do well third child, who has been brought into the family business only because he has failed at life. What should Jim and Jan do with Bob? Should they make him a shareholder in the company? Do they have an obligation to reward Bob the same as they reward Jim Jr.?
Loving parents have a very hard time treating their children differently. I believe it is a natural reflex to want to treat their children equally because they love their children equally and don’t want to hurt anybody’s feelings. Unfortunately, this type of thinking can destroy a family business. Bob should not be in the family business. He isn’t equipped for it, doesn’t want it and is dragging the business down to his disfunctional level. Jim and Jan should fire Bob immediately, it is the most loving thing they could do for him. Once out on his own and required to make his own way in life, Bob will either succeed or fail, but he is an adult and it is up to him where he lands.
Of course, Jim and Jan should still include Bob in their Estate Planning. He can inherit cash or investment accounts; really anything but stock in the family business!
4. There’s Something About Mary.
The hypothetical doesn’t tell us much about their middle child, Mary. In the scenario given, there is no need to give Mary stock in the company at this time, since she has no interest in running it. Jim and Jan can certainly include her in their estate planning and either give her stock in the business then or grant her other assets equal to the value of the stock given to Jim Jr.
Family business can be tricky. We all have multiple layers of emotion attached to our family members. Am I being fair, am I hurting my child’s feelings, am I really acting in my child’s best interest? Each situation is different, so there is no single answer that works for every family, but there are a few basic principles we can apply to guide us to the best result in each situation:
- There is no law that says we have to treat our children equally. Each child has different needs, only some of which can be met by the parent;
- Diligence, loyalty and hard work should be rewarded;
- Once a child becomes an adult, you need to let them go. This can be hard, especially with the youngest child, but letting go is essential for everyone’s future growth;
- There are different ways to benefit different children. Not every child will benefit equally from a particular parental gift. If you own a business, a house and horses, each child may benefit more from an “in-kind distribution”, than a pro-rata distribution. The kid who loves business will derive a greater benefit from a gift of the 100% of the business, than from 1/3 of a horse.