My name is Mark Goodfield. Welcome to The Blunt Bean Counter ™, a blog that shares my thoughts on income taxes, finance and the psychology of money. I am a Chartered Professional Accountant. This blog is meant for everyone, but in particular for high net worth individuals and owners of private corporations. My posts are blunt, opinionated and even have a twist of humour/sarcasm. You've been warned. Please note the blog posts are time sensitive and subject to changes in legislation or law.

Monday, June 9, 2014

Are Estate Freezes the Wrong Solution for Family Business Succession?

Last week I discussed how an estate freeze provides an efficient income tax solution for the succession of your family business by allowing you to lock in the value of your business and pass the ownership tax-free to your children. However, a freeze does not provide you with immediate liquidity, nor does it require your children to risk their own capital. Some family succession experts believe an estate freeze is a misplaced income tax solution; when what is really required, is a business
solution.

A few months ago, I was one of the “experts” on a panel that discussed family succession. The guest speaker and main attraction for the night was Tom Deans (yes, believe it or not, I was not the draw). Tom is the author of Every Family's Business: 12 Common Sense Questions to Protect Your Wealth, the best-selling family business book of all-time with more than 300,000 copies in circulation. Tom is an outspoken advocate of parents taking care of themselves, which often means selling their business, whether to a competitor, their own child or management, rather than just handing it over to their children for free (via an estate freeze). 

Tom's suggestion to monetize your business, rather than hand it over to your children, runs counter to the commonly held belief that your business is your legacy and that the ultimate family business is multigenerational. For many business owners, I would suggest that Tom’s advice to sell and safeguard your retirement is often the prudent decision.

Tom says an “estate freeze usually sets the stage for what I like to describe as the beginning of the ‘perpetuity project.’ This is when a family shifts its thinking away from the business as a money-making asset and toward the business as a legacy, with the goal of ‘longevity’ trumping all other strategic options for creating value.”

With statistics suggesting that only 30% of family businesses transition successfully to the 2nd generation and a meager 10% to a third generation, Tom may be correct that many parents are compliant in destroying their business by trying to ensure its perpetuity.

Why Parents May Choose to Undertake an Estate Freeze


In my experience, parents often cite three reasons for preferring an estate freeze over an outright sale to an arms-length party or to one of their children.

1. They see the family business as an annuity, so why sell for $4,000,000 ($3,200,000 or so after-tax) when it will make $4,000,000 every 4 to 5 years indefinitely if the business continues as it is or grows.

2. They feel they can easily redeem enough of their frozen shares each year to cover their living expenses so why burden the children with additional debt.

3. What is the point in selling shares to their children, if their children need to borrow from the bank to purchase the shares; especially since if the business goes sour, the parents figure they may need to step-up and cover the default anyways?

What Is so Bad About an Estate Freeze?


As many accountants can attest to, often a well- intentioned estate freeze that has saved the family thousands or even hundreds of thousands of dollars in tax ends up being the catalyst to family conflict and/or the ruin of the families business. Here are some of the downsides to an estate freeze:

1. In undertaking a freeze, shares are issued for no consideration. The children have no risk capital invested in the company, which can alter their commitment to the business. (More on this on Wednesday.)

2. Whether a company’s share value increases due to market forces or because of the children’s efforts or non-efforts is irrelevant; your children may end up making far more than you ever did, despite you handing them a turnkey operation (that may be fine with you).

3. An estate freeze requires decisions regarding which child(ren) will work in the business, how they will be compensated and which of them get shares and what percentage of the shares. All these decisions can blow-up. For example, let’s say you undertake an estate freeze and give your daughter who will work in the business all the shares of the business (which are in theory worthless at the date of the freeze, since you have all the current value in your special shares, say your shares are worth $2,000,000 in this example). You leave your other two children say $100,000 each in your will to “compensate” them for not being involved in the freeze. Imagine the sibling conflict if the business grows to $3,000,000 in value. The child working the business has benefited to the tune of one million dollars ($3,000,000- $2,000,000 freeze value) plus a full-time job, compared to the $100k the other children will receive in the will.

4. Parents often like the concept of freezes because it locks in the maximum amount of income tax they will owe on death, however, the freeze is also often viewed as a way for them to slow down and move away from the business. If the child who takes over the business makes a mess of the family company, mom or dad or both are often forced to step back in to save the company – not exactly the stress-free retirement they imagined.

5. In a blog posting by Tom, he states that an estate freeze “magnifies family genius – and incompetence – precisely because the market rules of ownership were violated through gifting, all in the name of saving tax. Families pay the highest price when they lose their mutual trust and respect for one another when gifting goes bad. And when trust is lost, family members resorting to litigation is the saddest progression of a family business in decline”.

The Benefits of Estate Freezes


My personal experience with estate freezes has been good. While the overwhelming majority of my clients over the years have sold their businesses, there have been several that have frozen their companies and everything worked out. I would say that is because most of these clients were able to distinguish which child(ren) deserved to work in the business and were committed to the business (in most cases, the children have been uniformly intelligent and often academically brighter than their parents, though not necessarily as street smart). The parents also gave significant thought to how they would compensate the children both involved in the business and those excluded from involvement. Finally and probably most import, the parents tried to understand the sibling dynamic within their families and whether a freeze made sense within these family dynamics.

When I spoke to Tom about this before his speech, he asked me “If all these children were so committed to the business and so bright, why would they not have agreed to purchase shares from their parents?”

After reading this post, you may be thinking to yourself that an estate free may not be the succession planning panacea it is marketed as; at least from the non-tax perspective. On Wednesday in part two of this post, I will discuss the issues Tom considers vital in regards to selling or transitioning your family business. In addition, I will give away two copies of a 4 CD set of Every Family's Business narrated by Tom.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs. Please note the blog post is time sensitive and subject to changes in legislation or law.

2 comments:

  1. As the Beneficiary of an estate freeze I think the accounting world misses the point that the preferred shares should be purchased by the next generation and not redeemed by the parents. The money comes out of corp anyhow and your basis is so low you have a cap gain problem

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    Replies
    1. Hi anon

      That is Tom Deans basic premise although probably most people would suggest the original common shares should be sold

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