Resolve All the Problems. Sydney Commercial Plumbing Final Installment
by John McAlister
Welcome back to the final chapter in our series sharing the story of Nancy Sydney, the president of Sydney Commercial Plumbing. She was facing a potential buyout by a national P.E. firm that was trying to exploit a major rift between her active and inactive shareholders. As we prepared to repel the barbarians at the gate, we reviewed her business and personal documents and quickly realized that her problems ran even deeper:
The threat of losing control of the business: Because Sydney Commercial Plumbing only issued a single class of stock, both active and inactive shareholders owned voting shares. It would only take one of Nancy’s “active” shareholder partners to side with the inactive to force a vote to sell.
Massive estate tax liability for her family: When Nancy passes away, her children would receive an enormous estate tax liability along with her shares, and her life insurance policy would only cover half of it. Her brother, Steve, was in a similar situation, but his health was in decline. There was no way her children could afford to pay the taxes when she passed, and Nancy worried they might be forced to sell out. Steve’s health issues were already a daily conversation, and she worried he might consider selling now. Additionally, it was unclear precisely where the voting control would end up after their deaths!
Pressure to employ family members: Family members (whether shareholders or not) had come to expect lofty positions within the company, complete with generous salaries and perks, simply by virtue of being in the family. Five 3rd & 4th generation family members were in college now, and at least three of them expected jobs and executive-level compensation soon after graduation.
Millions of dollars in real estate-driven income tax liability: The company owns the land its facility sits on directly within its C-Corp. The real estate has appreciated about $20 million since its purchase. If the real estate is ever sold, the gains will be taxed at ordinary income tax rates, generating close to an $8 million liability.
These problems were significant, and they needed to be addressed immediately. Fortunately, we have seen many similar problems in our decades of experience, and we are well-versed on how to solve them!
The Threat of Losing Control of the Business
Nothing shook Nancy like the potential of losing control of Sydney Commercial Plumbing. It is very common for family-owned businesses to have only issued a single class of stock when they were founded, and all the owners worked for the business. However, as shares are passed on to subsequent generations, a misguided desire to be “fair” in splitting estates often leads parents to leave shares to both active and inactive children. Unfortunately, giving non-working family members voting shares of the business simply creates the potential for future chaos. In this case, the inactives were frustrated that they weren’t receiving dividends as the company continually reinvested for growth, and they were being courted by private equity.
When we explained to Nancy and the Board that George and any other P.E. firm would not make a “hostile” offer to buy Sydney. They would need Nancy and the rest of her management team to remain in place and “happy” for the transaction to work as planned. The Fire Drill should have been a wake-up call to shore up the next generation of management so that the enterprise can remain strong and continue to grow. In fact, she and the Board should let their banking partners know what they are up to. Being bought out was no longer an issue as they had much bigger problems to resolve.
The solution was clear: Only active shareholders would hold voting shares. Active shareholders could hold both voting and non-voting shares, and inactive shareholders would hold only non-voting shares. This would be a significant change that the inactives might initially resist. How could we construct an agreement that would be beneficial for everyone?
“Although my brother and I own the most shares, we can’t just ram this change down the throats of everyone else in the family,” Nancy said.
At the Beringer Group, we believe in building consensus whenever possible. In Sydney’s case, we worked hard to negotiate a win-win arrangement for both the active and inactive shareholders that addressed everyone’s concerns.
Active shareholders now control all the voting shares. A change was made to issue non-voting shares. Voting Control will be held only with the active shareholders. They will own both A & B shares of stock. Inactive shareholders will only own non-voting shares.
Inactive shareholders now have cash flow. The Sydney Board agreed to issue a one-time dividend to all shareholders, and a mechanism for any shareholder to “apply” in advance to redeem their shares during a certain time each year using a preset formula during a 60-day window following the release of the annual audited financial statements. Future dividends would be considered against the financial needs of the enterprise so it can remain strong.
A Looming Massive Estate Tax Liability
After addressing Nancy’s initial concerns over control of her company, the gigantic estate tax liability needed to be tackled. Like many business owners, Nancy and Steve initially mitigated their estate tax liability with life insurance. However, because Sydney had nearly tripled in value while Nancy was at the helm, the existing insurance policies were no longer adequate, and their heirs would inherit stock so valuable that there was no way they could pay the estate tax without either borrowing money from the bank or putting together an IRS Section 6166 installment arrangement! Furthermore, Steve’s health was deteriorating with every passing month, and Nancy was anxious that his death and hers soon afterward could cause irreparable harm to the family enterprise.
The Beringer Group worked closely with Sydney’s CPAs and attorneys to design a set of strategies to dramatically reduce the tax liability for Nancy, Steve, their heirs, and the other shareholders.
Greatly reduced estate tax liability for all shareholders. We were able to secure a favorable independent valuation of the voting & non-voting shares. This one move significantly reduced the estate taxes on the transfer of shares whenever an active or inactive shareholder dies or redeems their shares back to the Company.
Laid the foundation for generational wealth by deferring Nancy’s children’s and grandchildren’s estate tax liability for 360 years. TBG recommended GST (Generation Skipping Transfer) trusts for each member of G3 and G4 to take full advantage of the $12,920,000 lifetime gift tax exemption per person in 2023. Nancy gifted the maximum legal amount of her newly-created non-voting shares to benefit each of her inactive children and grandchildren. If Sydney Plumbing were ever sold, the proceeds can remain estate tax-free for generations as long as they remain in Trust!
“The Beringer Group’s strategy along with our other advisors was truly amazing here. You took a huge estate tax liability and turned it into tax-free growth on our legacy assets for generations. Instead of worrying that my heirs may have to sell out, I now have peace of mind that their financial futures have been completely secured. Now it’s up to them to preserve it.” Nancy was beaming.
Endless Pressure to Employ Family Members
“I love my family, but if you want to be employed here, you need to work here!” Nancy shared in frustration during an early discussion.
When first starting, Nancy’s grandfather, the founder of Sydney Commercial Plumbing, worked his fingers to the bone, missing many family dinners because he was working late. Her father always fretted about every new hire during his tenure, concerned that he would have sufficient cash flow to make payroll as the enterprise grew steadily.
Sydney was now a much larger, more successful enterprise, but Nancy still found hiring to be stressful, albeit for a very different reason. Over time, the number of family members working in the business had grown, and some of the third and fourth generations considered jobs at the company to be their birthright. Five of them were currently in college, and at least three expected jobs upon graduation.
At the Beringer Group, we have seen many otherwise successful family-owned businesses struggle under the weight of the salaries of unqualified or unneeded family members. Often the first generation has 2 or 3 family members working in the business, but as it grows more successful, other relatives join and the number grows to 6 or 8. “Come work for the family. Times are good and the harvest is bountiful. We need you!” is frequently the mantra. By generation 3, there may be 10 to 20 family members employed by the company, and the number just grows exponentially from there.
“Gosh,” Nancy said. “We will sink under our own weight. We’ve got to make some changes.” We helped her do just that.
Reset expectations on familial employment. We worked with Sydney’s HR department and the legal advisors to create a formalized process for current and future family members who wish to seek employment in the family enterprise. There would no longer be an expectation that the company would absorb every family member looking for a job.
Support family members with investments in their passion. Rather than employ family members that are not truly excited about the family business, we recommended considering supporting them with an investment in a business centered around their passion.
$8 Million Real Estate-Driven Income Tax Liability
With pride, Nancy explained how her father had the foresight to buy the 20-acre property on which their facility sat for next to nothing over 40 years earlier. He felt it was a better idea to invest in his property instead of paying rent to someone else, and history has proven him correct. Over time, the value of the property had exploded, and it was now worth about $20 million!
The real estate is held inside the main Sydney Commercial Plumbing C-Corp., which was the norm when her father purchased it. Unfortunately, when the property is sold, the appreciation will be treated as ordinary income and not long-term capital gains.
Nancy was shocked to learn that Sydney would have nearly an $8 million income tax liability if the property was sold!
When our clients purchase real estate, we always advise that they purchase the real estate in an LLC and lease it to the C-Corp., which allows the future sale of the real estate to be taxed as long-term capital gains.
In Nancy’s case, Sydney already owned the property in their C-Corp. If the tax liability was not as great, we would have advised her to “bite the bullet”, sell it to another entity structured as an LLC and pay the tax now, and ensure more favorable tax treatment on future appreciation.
Develop a road map to address real estate income tax liability. Sydney’s Board of Directors retained TBG and their legal team to explore the possibility of converting to an S-Corp. and moving the real estate to a separate LLC. We are researching the costs to do so.
In the end, it truly felt like a win for everyone involved. The active shareholders had control of the company (and their own destiny). The Board authorized a special one-time special dividend to all shareholders and created a plan for ongoing payments. Those who wanted to sell could do so without creating a threat to those operating the company. Emily decided to use her special distribution to place a sizable down payment on her first home, and Nancy’s uncle was finally able to see some value for his “pet rock.”
With the creation of the non-voting share class and favorable valuations, we reduced the estate tax liability for all of Sydney’s shareholders. By leveraging the GST rules, we laid the groundwork for their family to grow its LEGACY wealth tax-free for generations to come.
We helped build a process for hiring family members that treats the candidate fairly without unduly burdening the company with an expectation of absorbing all family members in need of work.
We uncovered a huge real estate tax liability and agreed to investigate the costs and implications of the S-Corp./LLC strategy in more detail. With $8 million at stake, if there is a way to execute this concept, we will find it.
“My gosh, we were sitting on a ticking time bomb, and now you’ve defused it! I appreciate how you worked with our attorneys, CPAs, and the valuation firm to get us the answers and a workable solution.” - Nancy Sydney
Remember, your business is unique, but your problems are not. Since 1979, The Beringer Group has worked with over 2,200 families and with many of the premier attorneys, CPAs, and valuation firms in the country. What makes us unique is our intellectual capital and our approach to solving problems. Our ideas work because we think like our clients - like business owners. Call me today at 678-392-4337 and let’s discuss your problems and how we can help!
About the Author
John McAlister
After working with CIGNA Financial Advisors, John co-founded an advisory firm in 2000, focussing on complex family transitions. He sold his practice in 2012 to become part of TBG. He is a graduate of the University of Georgia.