The old adage that most family owned businesses fail by the third generation is alive and well today. It is actually called “shirtsleeves to shirtsleeves in three generations.” The question to be explored by most families that own a business is why and how can it be changed. For our purposes, I am creating an imaginary family business that owns and operates a 60 room motel in Oxnard, California.
3. There are two (2) children. The son, John Jr., is 33 and his sister, little Mary is 28. They both graduated from college and John Jr. is married. John Jr. and his wife have 1 child and little Mary is still single. Little Mary works in the business as the bookkeeper. John Jr. worked in the business for many years while he was growing up but he now sells life insurance for a major life insurance company. He is pretty successful and enjoys what he does for a living.
4. Financially, Mary and John have been able to put away $2,000,000 in savings over the years to be used by them for their retirement. The motel generates about $400,000 per year, net of taxes, but they both need to work in the business in order to save on the costs associated with hiring a full-time manager of the motel and a better qualified night manager.
5. Today, the motel business in Oxnard is very competitive. Once they had a little monopoly but now there is lots of motels and hotels that fight with them for the same travelers. They have spent money upgrading their motel but they need to put in some technology in order to maximize marketing involving Google and other software services.
6. They are being forced to use OTAs (Online Travel Agencies) to help sell their vacant rooms. The OTAs take about 15% of the gross that they get to rent their rooms. They are not currently part of a franchise system so it is difficult for folks to find them. One option is to join a large franchise organization and get the benefits that go with that option. However, most of the larger franchise companies would likely require expensive upgrades to the motel and they take a fee of about 10% of gross revenues in order to join them.
7. The parents believe the motel is worth about $12,000,000. Fortunately, there is currently no debt on the property. That valuation is based upon recent sales in the Oxnard/Ventura area. The recent sudden drop in the stock market is a little scary for them. Where are interest rates going in the near future is a big question for them?
8. Before they take any action they decide to sit down with a knowledgeable advisor to review their various options. After they finish with the advisor they intend to ask their children what they would like to do.
9. The income tax bases for the motel is very low. When they bought it 30 years ago they paid $2,000,000 and they allocated $1,300,000 to the building and the balance to the land. Their tax man has written off most of the depreciable part of the purchase. They only have a small tax basis left of $800,000 (land of $700,000 plus what is left that has not been depreciated of some additions that were made over the years). Their taxable gain would be very large.
10. For California property tax purposes they have been protected by Proposition 13. There assessed value is only $3,000,000. There are some planning items here that might be of interest.
11. Their financial advisor walks them through their various options:
a. They could sell and pay lots of money in income taxes to both the IRS and the State of California.
b. They could sell and use the benefits of Internal Revenue Code Section 1031. They could then purchase various rental properties any where in the United States. This is a possible and they could generate an income stream for their future financial needs. There are some interesting alternatives in this area.
c. The parents could sell the motel to an outside buyer on an installment basis and carry back a large promissory note. That note would be for perhaps 50% of the sales price. The interest rate on the note today could be 5%-6% or a little higher depending on the risks. Assuming they net $11,000,000 (after commissions, fees and costs) and can get 3% on the first $5,500,000 less the income taxes (estimated at $3,500,000) and 6% of the balance that would generate an annual income for them of $395,000 ($60,000 & $330,000). The principal payments on the note would be partially taxable based on their gross profit percentage.
c. They could use a Charitable Remainder Trust (CRT). That would have them set up an irrevocable trust that will provide them with an income stream for life on the full $11,000,000 net cash and when they are gone, their heirs would get nothing. The balance in the trust would go to charity. They get a current tax deduction in the year of the transfer equal to the value of the amount that will likely go to the charity. Say they get 5% from the CRT that would be $550,000 per year. A portion of the money would be subject to income taxes.
d. Their advisor points out to them that if they use a CRT then they could set up another trust known as an Irrevocable Life Insurance Trust (ILIT) and buy a life insurance policy to replace the money that goes to charity. Their son John Jr. would understand how that would work. When they are dead the insurance policy owned by the ILIT pays off and the children are the beneficiaries of the ILIT. There is no IRS estate taxes due on the money and there is no income taxes.
e. Next the advisor discussed selling to their children. The problem of course is that the children have no money. That can be solved by the parents acting like a bank. They would take back a mortgage (actually in California it is a note and deed of trust) on the property. If the children don’t pay then they could foreclose and take back the property. Of course, they really don’t want the property back.
f. Then they discussed selling to several key employees. This could be done by setting up an Employee Stock Ownership Trust (ESOP). The ESOP gets benefits that no other entity gets. It essentially can get a write off for tax purposes the full purchase price and the interest owed on the debt. Generally, the start up costs are too high for most folks. However, it is another option if John Jr. and little Mary are going to stay in an run the motel.
g. Lastly, the discussion was about just gifting the motel to the children. Thanks to the new Trump tax law increases to the exemption amount there would be no IRS Gift Tax on the gift. Their advisor tells them that there is actually a legal way to transfer the motel to the children and for the property not to be reassessed for California property tax purposes.
12. The parents met with the children and Mary indicated that she would like to keep working at the motel. John Jr. needs to sit down with his wife and discuss the situation.
13. The final answer will depend on many factors. John Jr. and little Mary fully understand that it takes hard work to keep the motel a success. As their own children grow up it is important for those children to understand just how much the family has sacrificed to get to where they are today. It is that lack of understanding of the need for hard work on the part of the third generation that causes the old adage to be true. If John Jr. and Mary do end up with the motel it is up to them to instill in their own children how important hard work is to the next generation keeping the motel in the family.
14. Their advisor points out to John and Mary that it could be possible to do a combination of two or more of the options discussed above all at the same time. It will be up to John and Mary to decide the future of their family. At least now they can understand their options.
15. Clearly, the most critical part of the process of reviewing the options for the family is to have an advisor who has a working knowledge of many related fields of expertise. Here is a brief list of areas that need to be considered in just about every major family decision:
a. Income Taxes- both IRS and California.
b. IRS Estate and Gift Taxes- are there ways to minimize them and minimize capital gain taxes for individuals.
c. Real Estate- a good knowledge of how the real estate brokerage world works. Also, business brokers (they sell motels/hotels) are actually real estate professionals who also sell businesses for a living.
d. Retirement Plans- not mentioned above but there are a number of ways to use pension plans to put away money for the future. By the way, it is not too late for John and Mary.
e. Asset Protection Planning- usually this is a major part of estate planning.
f. Charitable Giving- for many families it is important that they give back.
g. Investment Options- where to invest the family money so that it is safe. Most of the time the family leader(s) already have such a person available to them.
h. Life Insurance- there are various policies available to deal with many family needs.
I. Mediation- sometimes the advisor needs to help the family navigate through and around disputes between and amongst family members and their spouses.
j. Facilitation- there are times when the family needs to meet like a Board of Directors and when that happens someone needs to organize the meeting and insure that the meeting runs smoothly.
If the family advisor does not have the knowledge in one or more of these areas described above then the family leader(s) should consider adding other professionals to the team doing the analysis process. The reality is that most difficult and complicated family decisions overlap into many different and complicated areas of our daily lives. Only having one person helping might cause the family to miss an important option or a creative solution to a problem.
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