Matters Column

Addressing issues of a family-owned business

October 5, 2018
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What makes a business a "family-owned business?" Well, that is easy, it is a business owned by a family. But must all of the interests in the business be owned by the family or just a controlling interest? One family or two? Is there more than one generation involved? Do family members run the business or just own it? Is ownership limited to family members who are active in the business? What about spouses? What about nonfamily management employees as owners?

Yes, there can be many views on what constitutes a family-owned business and many issues and considerations in addressing ownership in the context of a family-owned business.

Active or not in the business

Especially with a family business that has been around a while, some owners may be active in the business while others are not. This can, of course, create tension within the family. Those running the business might get the credit (or the blame) for the success (or failure) of the business.

Is the family member leading the business carrying the burden of dealing with issues that other family members lack the skill or desire to address? And are family members who are not active in the business resentful of the compensation paid to those who are? Are the active family members resentful that too much of the economic benefit of their hard work goes to others?

Dividing ownership interests into voting and nonvoting interests can be a useful technique to permit a senior generation to retain control while gifting nonvoting interests to a younger generation. The voting interests also can be concentrated in those family members who are active in the business since, hopefully, they have a better perspective on the business.

While it is easy to understand the logic of that approach, it can make the tension even worse since the nonvoting family members have little or no say in decisions regarding the business or its leadership. To avoid these issues, some families try to follow a policy that you must be active in the business in order to be an owner.

Family harmony can be fostered if family members and owners who are not active in the business are involved in other ways. For example, family members who are not involved in the operating business could be owners of real estate used in the business. This provides a different ownership stake and opportunity to receive cash flow from the business while not being an employee.

Family members also could be involved in family philanthropy or in other family activities such as a family council or being involved in the ownership or management of other family assets, such as a family cottage or cabin. Using a family council or having family meetings helps facilitates discussion and keeps family members connected. This keeps the family goodwill intact so that tough issues can more easily be addressed when they arise.

Nonfamily owners

Have key employees expressed a desire to have an ownership interest? Providing an ownership interest can align the interests of the family and management and tie management to the long-term success of the company. The big question for the family is whether to do this with "real" shares or a contractual incentive compensation plan (sometimes known as phantom shares).

As an owner of stock, the management employee may have voting rights and might be owed duties by the family that controls the company. This could potentially expose the family to liability for poor decisions or for claims that compensation or rent paid to family members are above market rates.

On the other hand, an incentive compensation plan generally can create the same economics that would arise from actual ownership, but as a contractual arrangement, it does not create the same issues as "real" ownership.

Accordingly, many family businesses are well advised to restrict actual ownership to family members and use an incentive compensation plan for management employees. The payout on an incentive compensation arrangement generally will be taxed as ordinary income, while ownership of stock can create a potential for capital gain treatment. However, the economic difference can be addressed in the design of the plan.

Control of ownership

Tools exist to help families address many of these issues. As mentioned, dividing ownership interests into voting and nonvoting interests can reserve voting control to the senior generation or family members active in the business.

Restrictions on transfer, either in an entity's governance documents or in a separate agreement among owners, can restrict an owner's ability to transfer shares except to certain family members. These agreements also can give the business the right to purchase the shares of one or more owners, as well as giving owners the right to require the business to purchase their interests in certain circumstances.

In any case, there are many issues to consider and work through. As always, it is best to proactively address these issues and not wait until a problem surprises you.

Bruce Young is a partner at Warner Norcross + Judd LLP. He can be reached at byoung@wnj.com.

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