Problem:
Clients are husband and wife and own a Dancing studio and retail store that sells related accessories, clothing and shoes. It serves approximately 1800 students and customers per week from ages four to adult. It has been in existence for over 20 years and enjoys a steady growth and strong cash flow. Clients have three adult children, two of whom are employees and have management responsibility in the business, and one of whom has an independent and successful career.
The business is organized as a Subchapter-S corporation the stock of which is owned by one of two revocable living trusts, and rents its facility from a limited partnership that is controlled by another revocable living trust. Only five percent of the Subchapter-S corporation’s stock is voting stock. Because of the pass-through nature of the Subchapter-S entities, there are substantial distributions to the respective revocable trusts. In addition, Clients are paid salaries and bonuses and management fees.
Clients are planning for retirement and want to transition the businesses to the two children who are now involved, and who want to expand the business, but also treat their third child equitably. The children have an amicable relationship and are close personally.
Solution:
The two children who are now involved in the business will purchase the business over a period of years, not more than ten if all goes well. Because only 5% of the stock is voting, they will purchase this stock first so as to assume voting control in a short time. The Clients will have no ownership of the expansion into a new business but will provide debt capitalization and management assistance with the development of the new business, compensated on an arms length basis. The new business will be located in a separate facility on nearby real estate. Clients will acquire the real estate and lease it to the new business.
During and after the transition, the existing business will continue to generate substantial distributions, from which Clients can make provisions for their third child by lifetime gifts and testamentary bequests.
Result:
Voting control of the existing business will be transferred early in the process to the two children who will continue the business. Pass-through distributions will continue for a longer period of time, generating cash for retirement income and for testamentary and lifetime gifts for the third child. The financing of the expansion by the Clients will ensure that they will be involved in the business as it moves forward, to the degree they may desire, but will free them from day-to-day management responsibilities.
Lessons Learned:
(1) The capital structure of the Subchapter-S corporation, consisting of 5% voting stock, facilitated the transfer of voting control to the children but retained substantial distributions to the parents who will gradually sell the remaining stock.
(2) In family businesses, at the end of the day, strong family relationships are at least as important to success as is the legal structure of the transaction. All of the parties are invested in the success of the entire project.
(3) The ability of the Clients to capitalize the expansion of the business by their children has the advantage of enabling them to retain a degree of control over the business and minimize the risks of expansion.
