How to pass the business baton peacefully
Avoiding family business conflicts after a trust is wound up
By: Samantha Prasad, Tax and Estate Planning Lawyer
Last time, I discussed the wind-up of a family trust and how to ensure that you avoid specific tax traps in doing so. But after the trust is wound up, your kids will have significant assets, so how do you control this? If the distributed assets are shares in a private company, control will now be subject to a larger group of shareholder voices, with the potential for disputes and acrimoney detrimental to the longer term health of the business. What to do?
In some instances, this may not be an issue if the beneficiaries are no longer minors and are fully involved in the business or perhaps the parents are ready to fully retire and enjoy life. But this is not always the case for all families. And so some pre-planning may be necessary.
Any successful estate plan whereby the next generation has been introduced into the corporate structure for private companies should contemplate the so-called unanimous shareholders’ agreement (USA) as the final step. The USA sets out the rights and obligations of the shareholders as they relate to each other and the subject company. From an estate-planning perspective, the USA also serves as a “family constitution” for future generations once Mom and Dad are no longer in the picture. That way, having a “rule book” as to how the business should be run could potentially avoid any sibling in-fighting, which only serves to hurt the business in the long run.
So here’s my summary of some of the issues that could be dealt with in a USA, keeping in mind the family business in an estate planning context:
Keeping the business in the family. The agreement can direct that any transfers of shares in the company are made only to those persons that qualify as a “family member” in order to ensure that the company remains within the family structure (this could also limit the ability of a child’s spouse from being involved in the family business). A family member could be defined as the parents, their children and grandchildren (including adopted children), the estate of any of the above, a corporation of which any of the above are shareholders, or a partnership, joint venture or trust controlled, directly or indirectly, by any of the family members and that are for the benefit of any of the family members.
Decision-making. The USA would set out who gets to sit on the board of directors, which could include a nominee from each “family group” (i.e., each sibling group). There may also be a provision made for an “independent director” who is a trusted advisor and who does not represent a specific family group to provide an unbiased perspective.
Although most decisions could be made by the board of directors, the USA could provide that certain substantive decisions will require the unanimity of the voting shareholders (with an proviso that if a family group owns less than a certain percentage of equity, they do not have a vote – this would prevent minority shareholders from holding up the process). These substantive decisions could include:
- Sale of all or substantially all of the assets of the company (or of the assets of a subsidiary of the company).
- Dissolution or wind-up of the company.
- Distributions of retained earnings from prior years.
- Distributions of retained earnings for the current year in excess of a certain percentage.
Dividend policy. The agreement could set out how dividends should be paid and when. An agreed-upon policy on how money is distributed out of the company is the surest way to avoid arguments when some shareholders want distributions and others want to keep the money in the company.
Financial statements. A clause could provide whether audited statements are required or not and who can insist on an audit (and who would bear the cost for such request).
Chief Executive Officer. The powers of the CEO could be set out in the USA, as well as who actually gets to fill that role (or who would be a successor CEO) so as to avoid future arguments as to who gets to run the business once the parents are no longer around. Compensation of the CEO can also be set out in the USA as well as how a CEO could be removed and replaced.
Other family members. The participation of other family members in the running of the business could be set out in the USA (and whether spouses should be included or not).
Disability of the Chief Executive Officer and/or Director. The agreement is an appropriate place to deal with the consequences of the CEO and/or director/officer becoming disabled (i.e., deemed resignation?). The USA would also set out the threshold of when a “legal disability” would be met.
Voting rights. Voting rights can be dealt with (subject to the governing corporate statute for the company) and whether certain shareholders (i.e., minority shareholders) should agree to vote their shares with a controlling shareholder or not.
Restrictions on transfer and default. Restrictions on the transfer of the shares (unless the transfer is to a family member) could be spelled out, as well as restrictions on the ability to pledge the shares of the company as collateral.
Events of default could also be set out where a shareholder acts contrary to the USA. A consequence of an event of default could include the defaulting shareholder being deemed to waive all dividend and voting rights, as well as giving the other shareholders the ability to purchase the defaulting shareholder’s shares at a discount.
Sale of the business, drag-along rights, and right of first refusal. The agreement would set out the process of selling the business and include such clauses as “drag-along” and “tag-along” rights in the event that a shareholder receives an offer to purchase. This could include the requirement that other shareholders have to sell their shares with the selling shareholder, or could provide that the other shareholders have the ability to require a potential purchaser to buy all of their shares in addition to selling shareholder’s shares. Alternatively, a shareholder who receives an offer to purchase may be required to first offer their shares to the other shareholders pro rata before they can sell to a thirdparty purchaser.
Death/disability of a shareholder. One issue to be addressed would be what happens on a death or disability of a shareholder. Would there be an automatic buyout of such shareholder’s shares or would there be an ability to leave the shares to the next generation (or guardian/power of attorney)?
Liquidity/divorce proceedings. The USA would also deal with the ability of (or restrictions on) a shareholder to liquidate his/her shares or redeem such shares. Alternatively, if all or some of the shareholders want to “divorce” themselves from the rest of the family or the company, provisions could be included to deal with how that would happen (if at all).
This is not by any means an exhaustive list. Rather, it is a starting point of some of the key issues to be addressed in a USA in an estate-planning context. More importantly, it’s one way to ensure that all of the estate planning that the parents put in place does not go up in flames in the event that the children now running the business can’t agree on how to work together. Distributions of retained earnings for the current year in excess of a certain percentage. Distributions of retained earnings from prior years.
Previously published in The Fund Library on September 28, 2021 by tax and estate planning lawyer, Samantha Prasad. Portions of this article first appeared in The TaxLetter, ©2021 by MPL Communications Ltd. Used with permission.