I am particularly fond of the quote from the noted author, Stephen R. Covey. He commented: “Did you ever consider how ridiculous it would be to cram on a farm – to forget to plant in the spring, play all summer and then cram in the fall to bring in the harvest? The farm is a natural system. The price must be paid and the process followed. You always reap what you sow; there is not shortcut.”

And so it goes with many things in life. There is no shortcut in establishing a durable relationship with your spouse or partner. (Yes, I am indeed skeptical of those online dating advertisements I see on TV where shiny white – tooth actors find immediate bliss as soon as they plop down their $1,000 entrance fee to find the perfect mate online!)

Additionally, there are no shortcuts to building sustainable business enterprises that can withstand the winds of change that afflict every segment of our economy.

Finally, for families, there are no shortcuts in wealth transfer planning for family owned enterprises. There simply is no such thing as signing some magical legal agreement that captures a family’s values and visions while simultaneously propelling that family down some imaginary road of blissful tranquility.

That just does not happen.

Human nature prevents families, especially high net worth families with complex business interests, from making rash decisions. Emotions run high; differences of opinion must be heard and respected, not trounced; family dynamics are complex; and finally, legal planning simply takes time and effort. All of which, in this author’s opinion, is fi ne.

However, families with business interests need to start somewhere. And families whose business interests are owned by S corporation stock need to be mindful not only of the important planning opportunities, but also of the very technical legal and tax nuances that accompany this type of stock ownership as it intersects with a family’s wealth transfer planning.

THE OPPORTUNITIES

Like any farmer, obtaining a successful harvest in one’s wealth transfer planning takes time, effort and planning. The same is true for owners of a company with S corporation stock. Thus, I find the first step in educating business owners on this subject is to discuss how such stock should be structured as it relates to a shareholder agreement. Only then can a client fully understand the wealth transfer planning opportunities and the proper timing of transferring business interests to the next generation. Proper structuring of corporate interests is akin to the fertilizing of a farmer’s crop. It helps ensure that future planning will be easier to accomplish with a higher likelihood of client satisfaction!

ISSUES TO CONSIDER

S corporations can only have one class of stock. However, the tax regulations permit companies to issue voting and non-voting stock, even if the voting stock only represents 1% of the issued and outstanding shares. Thus, differences in voting rights are disregarded in determining whether an S corporation has more than one class of stock. Also, carefully structured shareholder agreements and the restrictions on the transfer of shares (or the voice given to non-voting shareholders) are also disregarded unless the only principal purpose of the agreement would be to undermine and sabotage the one class stock requirement.

So, families with business interests should not fear such bifurcation of stock rights. Non-voting/non-management rights means control and management will reside with those owners of the voting interests. It is indeed interesting to note that the internal revenue code regulations permit the use of voting trusts. Thus, a trust created primarily to exercise the voting power and rights over S corporation stock may be a shareholder of a corporation. Indeed, this is a vital planning option for many family-run businesses.

Both voting and non-voting stock can qualify for valuation discounts attributable to: (1) minority interest, (2) lack of marketability, and (3) in the case of non-voting shares, lack of control. Thus, it is extremely important to make sure that such stock structure is in place as it leads to greater future flexibility in planning. Moreover, such planning will likely save estate and gift taxes later on. Finally, and most importantly, a bifurcation of stock rights allows a family to have more options when considering (at some future point in time) how to make cost efficient transfers of business interests.

While beyond the scope of this article, families with business interests denominated in S corporation stock need to be careful to make sure ALL legal agreements correctly identify only those entities that can own such S shares. SOME, NOT ALL OF these entities are:

• Voting Trust. As noted above, this vehicle is primarily used to establish management and control over the family enterprise. Generally, only voting control is involved and there would not necessarily be a diminishment of economic rights such as the right to receive dividends or other corporate distributions.
• Testamentary Trust. i.e. a trust that is created under one’s Last Will and Testament
• Subchapter S Trust or QSST, a Grantor Trust and an electing small business trust (ESBT).

NOW THE HARD PART

So, you followed your team of advisors’ recommendations carefully and have done what you believe is model contemporary corporate planning for a family enterprise which owns S corporation stock by properly structuring an operating agreement with your other family members. Now what?

I ask this question because I find that all too often families, and in particular the generation that started the family business, feel compelled to do something further, i.e. to make virtually simultaneously transfers (by gift or sale) of their equity interests in the family enterprise while the “iron is still hot,” so to speak. Some of this admittedly stems from many different professionals advocating such ideas in the hopes of performing more complex services. Many times, such advice is indeed well founded and must be represented (dispassionately) to the client.

But such analysis misses the point. At the heart of most, if not all, estate planning is the word “de-capitalization.” In essence, transferring your wealth (for whatever reason) is taking something off of your balance sheet. At certain points in time in one’s life this should be carefully considered. But it does not necessarily mean that it must be done just because one took steps to properly structure their company.

Making significant transfers of wealth in family-held enterprises mostly happens, in my opinion, when a few issues are balanced out and resolved in the client’s mind. Some, of these issues may include:

1. What is the purpose of the family enterprise – to endure or be eventually sold?
2. How have the children matured in life?
3. Are any of the children in the business?
4. Does one’s personal financial and tax planning considerations and opportunities align with the transference of equity in the family owned business?
5. If gifting is indeed appropriate to consider, are there other assets on a family’s balance sheet that might be more prudent at this time to transfer? Which assets will not necessarily trigger the same set of questions and present the same set of obstacles as business interests?

For the vast majority of clients, tackling these questions will take time and effort. Discussions should be held collaboratively with your key trusted advisors. Clients who rush to make large gifts of capital without carefully weighing all financial and human considerations usually, at some future point in time, regret the fact that their balance sheet is noticeably smaller.

Finally, it cannot be overstated how important it is to make sure that ALL family estate planning documents (trusts, wills, operating agreements) reflect contemporary planning. We live in a society where our writings and agreements do matter. Wishfully hoping that the dots will connect usually leads to family disharmony.

Like the farmer recognizing that the farm is indeed a natural system and can’t be rushed, so it is for the owners of family businesses. Fruitful harvests await careful planners.