Family Business Compensation: The Benefits of Good Planning

FAMILY BUSINESS: OPPORTUNITIES AND PROBLEMS

The Hill Family

This case illustrates the benefits of good planning (the family compensation plan and divisive reorganization); What can happen if advice is not taken (using voting stock for a family gift program rather than non-voting stock); and what can happen if a planning tool is used in the wrong situation (such as a qualified personal residence trust.)

THE CASE

In 1953 in Portsmouth, New Hampshire, Grandfather Hill, age 65, made the courageous decision to expand his sandwich shop business by adding an additional location to the existing one in the Strawberry Bank area of Portsmouth. The new shop was located across the bridge on Route One in Kittery, Maine. The original store was successful;  debt-free; and had a loyal and large customer base. Grandfather Hill liked to say that his Italian sandwiches provided all the funds to send his only child, Roger, to Boston University where he graduated with honors in the business management program, just in time to join many of his colleagues in the Air Force with a duty station in Korea. Roger had worked in the business since he was 10 years old. There was no age threshold for beginning to work at the time. Grandfather had help from his accountant, Linwood Reed of Reed and Cox in Portsmouth, N. H., in setting up a family compensation plan for Roger designed to provide funds to pay for college.

That plan(1) was simple: pay Roger on an hourly basis exactly what the two other store employees were paid, but at the end of the year pay Roger a sizable bonus for his training to become a store manager/owner and for the loyalty inherent in a family employee. It was those bonuses, which at Roger’s total compensation level were free of income tax that paid for his Boston University tuition. Grandfather got a tax deduction for all of Roger’s pay and Roger paid no tax so a win/win. Social security taxes were so modest then that they were not a factor. How times have changed.

Roger, age 27, came home from the Korean War just in time to take over the completion of the Kittery store and host the grand opening. The store was an instant success mostly because it was close to the Kittery Naval Yard, which was operating at capacity in its wartime mode. Roger even started a modest delivery service of the Family Italian sandwiches to the Portsmouth Naval Prison to augment the sales of the store itself.

Grandfather was pleased and decided in 1958 to make Roger his “partner” in the ownership of the business. He asked Linwood for advice which Linwood gave. The advice was to give Roger ownership but keep the controlling interest as ”you can never tell what will happen in a family business so only make gifts of non-voting stock”(2). Grandfather did not agree and gave Roger 75% of the voting stock in the corporation. Roger, thinking that “business is business” quickly used his control to add three more locations. Grandfather was very upset but could not stop the expansion. It was a sad day soon thereafter when in the heat of the recurring argument about not incurring debt, Roger fired his father and the business once again was a one-man show.

Roger was a powerful and sometimes overly aggressive person but he had the golden touch. By 1970, he had 28 locations and had built a facility to produce not only the bread needed to make all the sandwiches for his stores but to also sell to other sandwich shops. It was also successful as the recipe for the bread, the unfailing delivery schedule, and the price was pleasing to the bakery’s customers.

Roger had married and by 1970 had three children, Roger Jr., Lucy, and Tracy. He did not ignore all his father had taught him as he also set up a family compensation plan using the old formula provided by his father’s accountant. Pay family members on an hourly scale equal to what other non-family members doing the same job were paid, but recognize in year-end bonuses the special place family members have in learning the business for their own future management and ownership positions. Family members never stop working after the business day is done. The business is what they talk about at home; it is what they hear their parents talk about; it becomes part of their fabric. All three children graduated from college using “sandwich” money. Roger was proud of not only his business and his children but also his stature in the community where he was on many civic and charitable boards where he made significant contributions of time and money. His wife, Carol, came from a wealthy family and was  also a great contributor to the Portsmouth community.

Roger Jr. came into to the business after graduating from college as did his sister, Tracey. As mentioned, both had worked for the business most of their lives and understood it. Although Roger and his father’s relationship had ended poorly (grandfather died in 1972) Roger kept the professional relationship with the accountant, Linwood Reed until Linwood died in 1962. Roger had many times discussed family business matters with his new accountant, David Reed (Linwood’s son), both in general and about his own business. David had suggested that Roger require each of his two children who were interested in coming into the business to work elsewhere for at least two years to gain the valuable experience of working for someone other than a family member. Roger actually thought that was silly as why waste two years helping some other organization when the children could help him.

By 1990, competition and new business models were adversely affecting Roger’s business. The bakery had lost some of its key customers and the shops were losing sales to the fast food franchises that could underprice Roger’s sandwiches. He still had a loyal following for his Italian sandwiches but his other products were not doing well. Roger Jr. and Tracy did not agree on much and Roger seemed to spend most of his energy trying to keep them at peace. He finally had enough of the bickering and deciding to split up the ownership of the bakery and shops between Roger Jr. and Tracy with Roger Jr. getting the bakery and Tracy getting the shops. His accountant, David, told Roger it is not easy to divide up a corporate business between family members. Roger had, somewhat reluctantly, over the preceding years engaged in a gifting program where he gave mostly non-voting stock to each of the children. He gave cash and securities to the third child to even everything out. By 1990, 70% of the value of the corporation had been gifted using annual gift tax exclusions.

David counseled Roger to structure a divisive reorganization(3) to split the corporation into two new corporations, one owning the bakery for Roger Jr. and the second corporation owning the shops for Tracy. Prior to the split up Roger Sr. gave the rest of the stock to the children to facilitate their ownership in the two new corporations. David and the corporate attorney, Jack Richardson, helped the family complete this income tax free split-up. Roger and Carol had by this time accumulated a net worth exceeding $5 million dollars and at a social occasion met an attorney new to New Hampshire. The attorney encouraged a meeting the result of which was the preparation of an estate plan which included a qualified personal residence trust (4). The family home in Portsmouth was transferring to the trust by Carol, the title holder. The trust had a ten year term with the ability for the grantors, Carol and Roger, to remain in the home after the ten year term. The other estate planning documents were typical to a family with their assets and goals.

The businesses  separately owned and operated actually did worse than before. Roger Jr. relocated the bakery to a much larger facility and upgraded the technology by incurring a large SBA loan. Tracy, adverse to debt, decided not to upgrade the appearance of the stores or sell off the non-performing stores. Both children came to Dad and Mom separately asking for loans. David advised Roger Jr. not to directly loan money to the children but rather just guarantee bank loans for them so that a bank would deal with delinquent payments. Roger, ever stubborn, thought that involving a bank was unnecessary and just made loans of equal amounts stating that this was a onetime event.

Each of the three children by 1998 had children of their own. Roger and Carol loved their grandchildren and spent as much time with them as possible. They were handy babysitters. One weekend they were babysitting for Roger Jr.’s daughter, age 8. That Saturday night Roger and Carol had guests for dinner and loved showing off their granddaughter. Roger had enjoyed several of his favorite Jack Daniels manhattans when Carol said she needed some whipping cream for the strawberry shortcake. Roger jumped to the rescue and took his granddaughter with him in his red Porsche 911. Roger did not believe in seat belts so neither he nor his granddaughter had belts on when Roger slid though the stop sign at the end of his street and was hit by a pickup truck on the passenger side of the car. The granddaughter was severely injured. It was horrible. Hard to imagine a worse nightmare and it did not end. Roger Jr. fired his father as they were no longer able to work together. The world had turned. Both businesses failed. Luckily, none of the bank debt was personally guaranteed. Both Roger Jr. and Tracy were able to find other work, but could not retain their earlier lifestyles. They never repaid their parents their “one time” loans. This irritated Roger and and irritated Lucy even more as she always felt that her siblings received a lot more from her parents than she did.

Time healed most of the wounds of the family tragedy and an uneasy relationship was gained. In 2012 Roger Sr. suffered a stroke and passed away. He and Carol had been planning to move to an assisted living facility in Dover, New Hampshire. The Portsmouth family home now owned in trust had to be dealt with. Carol, after the 10-year term, could no longer be the trustee but no one had alerted the attorney who was the secondary trustee of his duty. When the trust was reviewed by the new family attorney 15 years after the trust was created, he knew that the secondary trustee had already died and that they needed to find the next trustee listed in line who was David Reed, the now retired family accountant. He was alive and was asked to assume the role of trustee, a role he did not remember he had agreed to years before. He asked if the family would retain a corporate fiduciary as trustee but no bank wanted to administer a trust holding real estate. David said he would serve and asked to see the attorney’s file. By this time, the children were cleaning out the house as Carol had moved to Heritage Acres. David saw a letter from the current attorney stating that there would be no income tax on the sale of the home as there would be a stepped up basis due to the death of Carol and the inclusion of the home in her estate as long as the home was sold after she died. David knew that was incorrect as the trust owned the home, not Carol, and thus there would be no step up in basis. The lawyer and children at first did not believe this but after further analysis the attorney agreed. This raised a substantial problem in that the sale by the trust would cause a tax measured by the difference between the sale price and the cost basis of the home, which was the cost to Roger and Carol. This meant that documents for the original purchase and all the improvements over the 45 years of ownership needed to found and preserved. It caused the family to spend hours and hours looking for these documents. In some cases it was simply a family photo of a new storage building and getting an older contractor to estimate what it would have cost years before to have any type of record at all.

The lesson to be learned is that qualified residence trusts should best be used for homes that the family will keep and live in or homes that have an ascertainable high cost basis.

Sometimes, however, luck plays a part. David, in his review of the trust document, noticed that it had an odd provision usually reserved for intentionally defective trusts. That provision meant that this trust had to be treated as a grantor trust meaning that Carol was the taxpayer on the sale and could use her $250,000 exclusion of gain on the sale of a principal residence plus the amount of historic basis that was discoverable. The property was sold within 12 months of Carol moving to the assisted living facility with only a modest taxable gain.

Carol died in January of 2014 and the family members continue on with their lives, but without their family businesses.

FOOTNOTES:

(1). There are seven principles of compensation for family business. One is presented here.

PAY YOUNG FAMILY MEMBERS EXTRAVAGANTLY

Young members of the family are or can be “tax shelters.” They can receive earned income of several thousand dollars per year income tax-free and the family business will receive a tax deduction for these payments. This tax fact allows such family members to be paid especially well for summer jobs while a student. The best procedure for such pay is during the summer pay the family member the same as other summer workers and then at year –end make a lump sum payment to further compensate the family member. That payment could be purposefully set aside in a college fund and continue to be added to as further summers are worked. If the family begins summer and part time school year work at, at the age of 14, for example, there could be as many as 8 years to employ this arrangement and more if graduate school is involved. It is essential that the family member actually work and depending on the business, such “work” could include assignments even while away at school. The rationale for the higher pay is simply that the family member is in training to become a key manager in the business and, as a member of the family, has inherent loyalty and a sense of responsibility beyond that of a non-family member of the same age.

A variation on this concept is to elect to the Board of Directors or Advisory Board family members when they reach age 18. Service on such boards should be compensated at the same rate as for non-family members on the same board. Travel expenses to and from board meetings can be paid for the family members if such expenses are also paid for non-family board members. Careful planning might mean that Board meetings are at the beginning of school vacations so that travel expenses to and from distant schools become a deductible expense.

As with most income tax strategies there are exceptions. For the family of average means who may qualify for financial aid, accumulating funds in a student’s name may be counterproductive as such funds would be counted more heavily in the financial aid computation than if the funds were held by the parents. Further, education funding obligations occasioned by a divorce could also complicate any separate funding through a family business.

This strategy gets even more complicated if the family business is owned by more than one branch of a family. It can still work, it just takes a little more process. For instance, if two brothers own and manage the business and one has children and the other does not, the one whose children benefit from the “extra pay” could reduce his own compensation (lower year-end bonus) or some other economic benefit to make all fair.(My experience is that when the brother with the children offers to reduce his pay, it is usually declined by the other brother. It was the offer that counted.)

(2). USE OF VOTING AND NON – VOTING STOCK

A basic family business planning tool is to make use of a non-voting stock gifting program. It is the cornerstone of most good plans. The concept is simple: Recapitalize the corporate structure such that the existing stock is converted, for example, to 10,000 shares (1,000 voting and 9,000 non-voting). These amounts can certainly vary and in some cases the voting portion of the stock ownership is reduced to as little as 1%. The non-voting stock is perfect for making gifts. It can be discounted for its non-marketability and minority nature (say 40%). It, by its nature, is not cash so does not lower the parents’ liquidity position and the gifted stock can be reasonably controlled by means of a carefully drafted shareholders’ agreement. Additionally, in most jurisdictions gifted property is presumed to be non-marital property and hence protects the family member receiving the stock from a successful divorce claim. If the corporation is an S Corporation, a younger family member receiving their share of the annual income will usually enjoy a lower income tax bracket. If the business is sold in the future, the sale proceeds will, to the extent of their stock ownership percentage, go to the younger family member and both an income tax and estate tax benefit would be achieved. A similar gifting strategy can be employed if the business is owned by a partnership or limited liability company.

(3) SPLITTING UP A CORPORATE BUSINESS

One of the more complicated income tax transactions is a reorganization under Section 368 of the Internal Revenue Code. There are many types of reorganizations usually referred to by the letter of the subsection in the statutory framework. A split-up is thus referred to as a “D” reorganization. It can be referred to as the most complicated of all the reorganizations. The facts have to match the statutory framework and the documentation has to be complete and accurate, otherwise the divestiture can have a very undesirable tax result. It is not the purpose here to outline the requirements just to note that a corporate entity that contains two of more separate businesses or even multiple locations of the same business meets one of the many threshold rules. The Hill Family situation met all the rules and the process of splitting up the businesses was guided successfully by a capable tax accountant and capable tax attorney.

(4). QUALIFIED PERSONAL RESIDENCE TRUSTS

Another very useful estate tax planning tool is a qualified personal residence trust (QPRT). The concept is that a principal residence or even a second residence is transferred by its owner to an irrevocable trust for the eventual benefit of its designated beneficiaries ( family members). The grantor and spouse can live in the residence for as long as they wish but will have transferred the property out of their estates as long as they out live the stated term in the trust( retained interest). The transfer to the trust is a gift, which is subject to the usual gift tax rules. The value of the gift is calculated by reducing the fair market value of the residence by the present value of the retained interest . The gift does not qualify for the annual gift tax exclusions but does qualify for transfer tax exemptions.

During the stated term, the trust is a grantor trust so the real estate taxes and any mortgage interest are deductible by the grantor. After the stated term, the grantor has to “rent” the property from the trust. The goal in using such a transaction is to remove not only the current value of the residence from the grantor’s estate but also all future appreciation. My view is that it is a great planning tool for a residence that is to be kept in the family or for a “family compound” – usually a very valuable second home located on the ocean or on a lake used by the whole family. Procedures for “administering” a Family Compound will be detailed in another case study.