By Hugh Roberts, The Rawls Group
In the 37 years I’ve worked with car dealers and their attorneys to develop estate plans, I’ve never heard anyone say, “my goal is to pay more taxes, create a mess for my family and business and then let them figure it out!”, yet it is often what my partners and I encounter when we first start working with a new client. Dealers spend a great deal of time and money developing an estate plan in an effort to protect their family and business. Intentions are good with clients but there is often a lack of understanding regarding the potential downside of their decisions that may have been done without the advice of experts.
To help dealers, here are some mistakes we often see that can be avoided along with potential solutions that result in minimizing estate taxes, and the creation of a greater likelihood of family harmony and continued business success:
- Equal distribution of all assets – Unfortunately, all too often this is what parents want. Parents love their children equally, however what we find is that not everyone believes they are getting a “fair” deal and often not everyone ends up happy!! Those working in the business feel they are unappreciated for their efforts, while those not working in the business generally have little understanding of why they are not receiving the same income and perks as their siblings. We also see that those not working in the dealership feel they are entitled. For instance, distributions might not be made to shareholders due to the capital needs of the business and/or expansion needs. While equity is being built for all shareholders, the non-actives only measure the cash that is being put in their pockets. Equal is not fair and fair is not equal!
Solution: Consider giving each child ‘meaningful assets’ which usually implies ‘income producing’. Children active in your business can expect to create income from the business, while those inactive might receive income producing real estate.
- Equitable Vs. Equal – In terms of “meaningful assets,” we often see mom/dad planning to leave the business to those family members actively working in the business, but the real estate to those who are not actively working in it. Easy peasy-right? The pot hole we often find waiting out in the future is the lease. Without a comprehensive lease that takes into consideration the viewpoint of both those who own the dealership stock and those who own the dealership real estate, trouble is on the horizon! This leads to negotiations between the siblings who have two totally different objectives. Those running the business want to keep the lease low so they can make more profits in the business. Those owning the real estate want the lease to be ‘highest and best use’ which often translates into a rent in excess of what a dealership can pay and still remain profitable. Thus, you end up killing the golden goose! It is inevitable the manufacturer will require updates to the real estate that may be extensive. Unless the real estate renovations are financed by the dealership and treated as leasehold improvements, the need to finance these improvements will inevitably lead to reduced rents for the owners of the dealership real estate.
Solution: This can be overcome by creating a long-term lease that considers both viewpoints of shareholders and leaseholders. To account for manufacturer required upgrades, consider raising the rent paid by the dealership to provide for the cost of the renovations.
- Inactive shareholders receiving stock in the dealership(s) – When Mom and Dad push for each child to own stock regardless of their involvement in the dealership, this can lead to a train wreck! If there is disharmony among the shareholders, yet one owns the controlling interest, often required by the manufacturer, the minority “inactive” shareholders are at the mercy of the majority stockholder. This can lead to no distributions paid so each shareholder receives taxable income, but no actual income to pay the tax. Or the majority shareholder elects to take a substantial bonus involving most of the profits, before distributing the remaining profits among the shareholders. Clearly, both situations will cause family turmoil! Inactive shareholders are less likely to understand business pressures such as why a capital call is required to meet manufacturer capital requirements. “What do you mean I have to contribute dollars to capitalize the business?? I wasn’t counting on that and clearly that means my brother/sister are doing a lousy job running the business!” Family harmony just left the room!
Solution: A well written shareholder agreement requiring distributions to minimally pay the income taxes of all shareholders is step one to preventing these problems. Step two would be incorporating in the shareholder agreement language that requires a ‘super majority’ vote on ‘issues of major importance’ such as selling the company, purchases over a set dollar figure, taking on debt over a set dollar figure, income for shareholders, etc. There should also be language making it possible for your inactive children to be bought out should they choose to do so. In that case, to protect the business, the buy-out needs to be over a significant period of time.
- Misaligned Expectations – Often parents give the impression that everyone will be treated fairly or equally, leading family members to fight over whether they were treated as they expected. Usually the parents have been vague as to what this means, and the fight is on! For example, there is a sibling who is the leader and is responsible for making much of the continued success of the business happen. Unfortunately, this is often not black and white leading other family members to feel they also had a big part in the business success, and this is all subjective. Therefore, every ongoing decision made by the leader can be viewed as self-serving, while the leader often feels he/she is not given credit for their efforts which lead to all family members receiving benefits. FAIR becomes a nasty word interpreted differently by all parties resulting in family and business disharmony.
Solution: There is no simple solution. Regular communication with everyone in the same room, hearing the same message with the family meeting facilitated by professional advisors will definitely help avoid misinterpretations. These Family Business Council meetings must be held consistently and regularly in order to be effective.
- Not Utilizing Generation Skipping Trusts (GST) in your Plan – Often clients remark that they don’t want to skip anyone, so they never considered this planning concept. GST trusts are usually designed to skip taxes but not family members. In addition, we have seen GST language written by unqualified professionals which has led to adverse tax implications. The concept is simple but the drafting is complex and must be done by an experienced estate planning attorney.
Solution: GST language, when written correctly, allows parents to provide millions of dollars of assets to their children, which are creditor proof and divorce proof! That alone is a BIG DEAL! Additionally, while the assets in the GST trust can be set up to be totally available to your children (and not skip a generation), the assets remaining in the GST trust will pass estate tax free to your grandchildren at the death of your children, saving millions of dollars! This is a tremendous planning tool which most dealers should seriously consider.
Additional Estate Planning Minefields To Avoid:
- Drafting the Exemption Trust to specify that all the income ‘shall’ be distributed to the surviving spouse. ‘Shall’ is a legal term for ‘must’ which means that the surviving spouse must receive this income whether or not she/he needs it. Today, the Exemption Trust can be allocated $11.4M. If you make 4% on this money, the trustee would be required to distribute $456,000 each year to the spouse. Why is that potentially a bad deal?? Because if the beneficiary does not need this money, you have just moved $456,000 from a trust that will never be taxed in the estate of the surviving spouse, to the spouse’s taxable estate. If the surviving spouse lives 10 more years, you have just subjected $4.5M to estate taxes, creating $1.8M of estate taxes that wouldn’t need to be paid if the document was drafted properly for high net worth individuals. All the document needed to state is that the distribution “may” be paid to the surviving spouse. If she/he needs this money, by all means they should get it, but by making the payments discretionary you avoid the estate tax.
- Failure to insert Qualified Sub-Chapter S language or Electing Small Business Trust language in your trust, which is necessary for the trust to be able to own S-corp stock. Failure to do so may result in losing your S-corp status resulting in your dealership becoming a C-corp. Since C-corps are subject to double taxation, this could be an extremely costly omission!
You want your life’s work to result in your family enjoying holidays and family gatherings together, and your business legacy continuing, both in harmony. This requires working with professionals experienced in dealing with estates the size of yours – being their biggest client is not necessarily in your best interest. The devil really is in the details!
Hugh Roberts, CFP® is a Partner/Director of The Rawls Group, a business succession planning firm. Hugh specializes in dealing with the issues that must be resolved by car dealers and their families in order to preserve assets and develop succession plans geared towards building business value. For additional information, contact him directly at hbroberts@rawlsgroup.com or through The Rawls Group at 407-578-4455. www.rawlsgroup.com.
