[co-author: Eric A. Manterfield, Esq.]

The Advisor’s Role in Business Succession Planning

Adapted with permission from Copyright © 2016 The Bureau of National Affairs, Inc.
(800-372-1033) www.bna.com.

INTRODUCTION

As discussed in Part One of this article,¹ statistics show that most family-owned businesses fail after a generation or two. Specifically, only 30% of family-owned businesses survive the transition from the first generation to the second.² Furthermore, only 12% survive the transition from the second generation to the third.³ Only 3% of family-owned businesses remain in the same family after the third generation.⁴ Why are so few family-owned businesses successfully transitioned from one generation to the next? After all, isn’t owning and operating a family business a dream for many Americans?

The fact that so few family-owned businesses survive from one generation to another is especially curious given that there are thousands of professionals who may be retained to assist a business owner in developing a succession plan. These professionals include certified public accountants, attorneys, life insurance agents, certified financial planners, and other business consultants. With all these professionals available to assist a business owner in passing on a legacy that represents the fruit of his or her life’s work, why is it that so few family businesses last beyond a generation?

Often, as illustrated in Part One of this article, family dynamics are at the root of issues that place a strain on the continuation of a family business. There are personality issues, sibling rivalry issues, in-law issues, compensation issues, operational control issues, dividend policy issues, nepotism issues, and work ethic issues to name a few. Nevertheless, proper planning may help avoid some of these non-tax issues from adversely affecting the business or possibly causing the business to fail altogether.

Part One of this article discussed in detail the nontax obstacles that often play a role in preventing a successful transition of a business from one generation to another. It identified certain causes and then provided one or more examples of wealthy families that have had such root causes adversely affect their family business. By studying cases involving large family-owned companies with facts that are in the public domain, we can learn how we can advise our clients whose businesses are much smaller but who may have the same issues.

Part Two discusses how advisors may assist a family to identify stress factors that are likely to negatively impact their business and help them to instill a family culture that promotes the goals and virtues necessary to avoid the common pitfalls. Unity of values and virtues will help a family successfully operate a business. Part Two also discusses how an advisor may be involved with instituting a proper organizational structure of the business to anticipate and minimize family disputes. Finally, Part Two discusses the professional responsibility traps and pitfalls that often come into play for attorneys whose practice includes estate and family business succession planning.

AVOIDING THE OBSTACLES THAT THREATEN SUCCESSFUL SUCCESSION OF A FAMILY BUSINESS

As illustrated in Part One of this article, family dynamics play a huge role in whether or not a business can successfully transition from one generation to the next. An advisor can provide a great service if he or she can assist a client with analyzing the particular circumstances of that family. Each family is unique and no one solution fits all. It is imperative that a succession plan takes a look at the particular family dynamics to identify possible obstacles to a successful transition of ownership and management in the family business.

If there are signs of sibling rivalry, such concerns could be addressed and alternative solutions could be discussed. Also, if non-active embers are likely, the advisor should discuss alternative ways to structure ownership so that conflicts or disputes that arise from non-active members may be diffused. For example, the active members may hold the voting stock while the inactive members own only non-voting stock. Alternatively, the non-active family members could receive non-business assets while the active members receive the company stock as their inheritance.

An advisor should also encourage his or her client to start the business succession planning process very early. Life is too unstable and unpredictable to know exactly how long the founder of a business will be able to lead the company. An advisor should start with ‘‘low hanging fruit’’ such as simply updating the business owner’s estate planning documents and the shareholder’s agreement (or getting one in place).⁵ The advisor should avoid presenting complicated diagrams that illustrate the end result too early in the planning process. Such a presentation too early in the planning process may discourage the business owner from moving the process forward, which could resultin the owner avoiding the crucial decisions that have to be made.⁶

Identifying the Future Leaders of the Business

When developing a succession plan, the two aspects of business succession planning, ownership and leadership, should be kept separate. The business will need to have a strong leader with a vision who is capable of managing the day-to-day operations of the business. However, the management of a business does not always have to come from the family owners. Qualified non-family members may play key roles in managing a business. ‘‘[T]oday, approximately, one-quarter of the family businesses in the United States that are expected to pass to the next generation will bring in outside management to run the company, though the family (or trusts for their benefit) will still own the company.’’⁷ The plan may also call for only one person to lead the business — just like the founder was solely in charge during his or her lifetime. Alternatively, the business could be managed by a group of individuals or a team of siblings and qualified non-family members having separate roles and responsibilities.

Whatever option is chosen, the founder must mentor the chosen successor or successors over a long period of time. If more than one sibling will be involved in managing the business, it will be critical that the siblings be trained and developed to work respectfully with each other.

If the business will be governed by a team of siblings, it will be critical that the management team have a united goal to achieve the common good over the individual desires of any one of them. The siblings should each be articulate as to why they want to be in business together and each should identify his or her own business values and vision.⁸ Just because two people are siblings does not mean they have the same business values or vision. For example, one sibling might value having the family business known for how family-friendly the company is to its employees. Another sibling may value having the company known for how it is socially responsible by giving back to the community. While both business values are good, a business with a core value of social responsibility to the community may make different business decisions than one that seeks to be known for how nice its employees view the working environment. Whatever values the family brings to the situation must not be inconsistent in such a way that will cause friction.

It is beneficial for siblings to have a culture that gets beyond any self-interest and ego to seek common ground. When family business owners know why they entered into business together in the first place, it is easier for conflicts to be resolved well before there are serious disputes. Furthermore, successful sibling teams are respectful to one another, understand the business’ overall goals, and tolerate each other’s differences.

Policies, Governance and Shareholder Agreements

A more formal governance structure is also usually required when the management of a business is transitioned from a single founder to multiple siblings managing the business. This means putting in place a formal decision-making process. Rules and policies regarding who makes certain decisions and what decisions need a collective vote should be implemented. Also a code of conduct as to how to act outside of the business might be enacted so that the reputation of the business is not damaged by the actions of one family member. Policies regarding family employment should be enacted. For example, families need to decide how much education and work experience are required before a child or in-law of a family member is eligible to be hired. It might be appropriate for a family member to have experience working for another company prior to be hired to work in the family company. This will give the family member a perspective as to how other businesses operate.

Furthermore, it is prudent to have a policy regarding compensation that has been thoroughly discussed and agreed upon before any dispute arises so that no one has a vested interest in the outcome. A compensation policy will help diffuse any feelings or ideas about a family member being overpaid. It is usually best if compensation is set at a level at which family members could earn in a non-family-controlled business.

Nevertheless, if two family members have different positions but similar responsibilities, it may be better to have equal compensation. Other policies that could be addressed involve retirement age, dividends, or loans to family members. One of the most crucial elements of a successful management team is communication. A family business with multiple owners and managers must be transparent as to decisions, financial results of the business, ongoing financial commitments, and the needs of the business going forward. Periodic family meetings might not only provide a way for siblings to answer any questions that other family members may have, but also allow siblings to share their feelings and to bond together.

When a company transitions from a founding owner to a group of siblings leaders, it may be useful for the company to consider having a formal board of directors. An independent board may be able to provide guidance and advice to the new management and help the siblings resolve differences. Another approach is to have an advisory board that may help provide guidance and advice. Either approach may be particularly helpful when conflicts arise in a family to help provide a fresh perspective on the issues and possibly resolve the conflict. Either approach also may help keep the emotions from growing to a point that causes an even greater problem within the family.

A shareholder’s agreement should be put in place so that the governance rules are incorporated into a legally binding document. A properly drafted shareholder’s agreement will help maintain family harmony as it will provide a set of rules that govern the interaction of the shareholders and the transfer of their ownership interests. Such rules should be discussed and agreed upon before any events occur that might otherwise disrupt family harmony.

Accordingly, to help maintain family harmony, consideration might be given to include a provision in the shareholder’s agreement that would allow any of the family members to cash out. This may help avoid a situation where ill feelings about the company spread among the family due to the complaints of one member. The family, however, needs to agree ahead of time as to how the purchase price will be determined and over what period of time it would be paid. To balance the needs of the business with the needs of the owners, one approach in determining the purchase price would be to set the price by way of a formula or other mechanism that will likely be less than the price that would apply with a strategic sale of the company. The method of determining the purchase price would be agreed upon ahead of time with the consensus that it would result in a fair and reasonable value but may be lower than what could be achieved with a strategic sale of the company. Typically, the note would be payable with interest at the applicable federal rate and over a period of years such as 10 years. This would allow the business to buy out disgruntled owners at reasonable, but still favorable, terms.

It is critical that the manner in which the price to be paid pursuant to a shareholder’s agreement be clearly set forth in the agreement, whether it is determined by formula, fixed price, or appraisal. Regardless of the approach, the method must not be subject to different interpretations. For example, the value set forth in a shareholder’s agreement may refer to the ‘‘income’’ of the business, without specifying whether it is gross income or net income, or before tax or after tax. If the price depends upon the value of the assets of the business, it should be clear as to whether it means depreciated value or appraised fair market value. Furthermore, the document should clearly state whether or not the value of the business should be discounted to reflect various valuation discounts such as lack of marketability or minority interest.

If the shareholder’s agreement contains a formula for determining the price of stock, it may be helpful to test the formula by asking a disinterested professional to apply the formula to the actual current numbers (earnings, assets, etc.) of the business. If the value, as determined by this third-party professional, differs substantially from the expectations of the business owner, then an adjustment of the language of the formula seems to be in order. If the shareholder’s agreement contains a fixed price, has the price been kept up to date? What happens

if the shareholder’s agreement contains a fixed price and states that the owners will update the price periodically, but they fail to do so? Does the old number still govern? Is an appraisal now necessary? The shareholder’s agreement should answer all of these questions. It is certainly preferable that the agreement, rather than a judge, determine the methodology. Therefore, a shareholder’s agreement might specify that the value is to be determined by appraisal if the price set forth in the agreement was fixed more than 12 months prior to the triggering event.

If the price is to be determined by appraisal, then the agreement should set forth who selects the appraiser. If both the buyer and seller select an appraiser, what happens to the resulting different values? Are they simply averaged together or is a third appraiser appointed? In such event who pays for the cost of the third appraisal?

Consideration should also be given as to whether a shareholder’s agreement ought to include a call provision that would allow active owners to buy out the equity interests of inactive members if an irreconcilable dispute arises over the way the company is being managed. Under this approach, the price would be higher and the payment period considerably shorter. A shareholder’s agreement may also require mediation or arbitration to avoid unwanted publicity if a dispute arises among the shareholders that would otherwise trigger litigation. The agreement should address whether a party who brings an action and is unsuccessful should be required to pay all attorney’s fees. Furthermore, a shareholders’ agreement should restrict the transfer of ownership interests so that nonfamily members may not become owners of the company without the consent of all family members.

Dealing with a Parent/Owner Unwilling to Give Up Control

Sometimes a parent/owner will be hesitant or unwilling to give up control of a business until he or she dies or becomes incompetent. Such control often stifles the growth and business acumen of the next generation. The parent’s attorney or other professional advisor can do a service to his or her client by advising him or her of the advantages of passing control to a succeeding generation provided the next generation is ready to take on such leadership. In fact, a parent might be more receptive to discussing retirement with his or her professional advisor than having this discussion with his or her children. The advisor might be able to address concerns over retirement income, which might be the underlying reason for resisting change. The advisor may also be able to convince the parent that the business legacy has a greater chance of surviving if proper planning is conducted.

As mentioned above, one of the reasons a parent/business owner may be unwilling to give up control over the business is his or her desire to maintain an income stream not only for himself or herself but also, and probably more importantly, for his or her spouse. In fact, it may be easier for the business advisor to get the owner to start addressing business succession issues by identifying the need to provide an income stream for a spouse as one of the primary objectives of the plan.

In regard to this objective, the owner must be counseled that his or her spouse may not necessarily receive the desired cash flow without proper planning. While a business may continue after a founder’s death, a plan must be put together to determine how the business earnings may be made available to the surviving spouse. Even if the ownership interest is passed to the surviving spouse or to a trust for his or her benefit, the business owner may incorrectly assume that the company will issue a dividend to provide a cash flow to the surviving spouse. If the business rarely issued a dividend while the owner was living, why would such business start issuing a dividend upon the owner’s death? Furthermore, a business advisor must counsel his or her client that it is the trustee of a trust that must vote the shares that are held inside a trust. If a child who is active in the business is the trustee, the child may not automatically vote in favor of a dividend when such child believes that the corporate earnings must be reinvested in the business to allow the company to continue to grow and be competitive. While the estate planning documents may be drafted to require the net income of a trust be distributed to the surviving spouse, there may not be any income to actually distribute.

Furthermore, it is possible that family disputes will arise if the surviving spouse is the trustee and unilaterally votes in favor of a dividend. A widow who forces a dividend upon the managers of the company at a time when such managers believe the company needs to retain its earning may trigger severe damage to the family harmony, especially if the widow is a childless second spouse.⁹ It is therefore critical that, as part of the business succession plan, the business owner and his or her advisors address how the surviving spouse will receive a cash flow from the business. The worst time to start this discussion is after the owner’s death.

There are certainly possible solutions to this issue that may be suggested to a client. First, non-business investments will be available to be set aside for the benefit of the surviving spouse, and such investments will generate income for the benefit of the surviving spouse. Also, if the shareholder’s agreement requires the owner’s interest to be purchased at his or her death, the proceeds from such sale may be set aside and invested for the benefit of the surviving spouse.

However, there may not be any proceeds from the sale of the owner’s interest if the business is designed to stay in the family and be passed to children. If this is the case and the business will, in fact, not be sold at the owner’s death, the advisor may want to recommend that the owner buy more life insurance as a way to create more income-producing investments for the benefit of the surviving spouse. If more insurance is purchased, the advisor must determine how the life insurance policy will be owned. If the business owner purchases the policy and designates his spouse or a trust for the spouse’s benefit as the beneficiary, such policy will be included in the owner’s gross estate for federal estate tax purposes pursuant to §2042.¹⁰ The purchase of the policy will therefore add to the estate tax burden if the owner’s assets are in excess of the applicable exclusion amount.

Alternatively, the life insurance policy might be owned by an irrevocable trust. Under this approach, the business owner could create an irrevocable trust for the benefit of his or her spouse and upon the spouse’s death the balance of the trust assets could be distributed to the owner’s descendants. The owner would transfer cash into the trust in order for the trustee to make the first premium payment. The trustee would then apply for life insurance on the life of the business owner and name the trust as the beneficiary of the death benefit. Under this approach, no part of the death benefit will be subject to the federal estate tax under §2042. Furthermore, because the business owner would never own any incidents of ownership in the life insurance policy, the three-year rule under §2035 will not apply if the owner happens to die within three years of creating the trust.

Another alternative to generating a cash flow for the benefit of the surviving spouse is for the business owner to implement a deferred compensation plan payable to the owner upon his or her retirement and continuing for the benefit of his or her spouse upon his death. Finally, the business might consider creating a written dividend policy while the primary owner is living to become effective upon the owner’s death. Such a policy could provide that the business shall declare a dividend or make a distribution to the owners in a stated percentage if earnings reach a certain defined level.¹¹ The beauty of such a policy, if enacted, is that it will allow the implementation after the owner’s death to be viewed as carrying out the wishes of the deceased owner and not being done at the insistence of the surviving spouse.

The Issue of Choosing a Trustee

Often the estate planning documents of a business owner will create a trust for the benefit of his or her spouse or children and have the ownership interest in the family business pass to such trust. In such cases, it is critical that the choice of the trustee who will be able to vote the shares of stock be carefully examined. Such choice could either increase or decrease the likelihood of a family dispute.

A business owner may choose either an individual or a corporation, such as a bank, as trustee. However, many corporate fiduciaries will be unwilling to serve as trustee when part of the trust assets will be an interest in a closely held business. Many corporate trust departments do not want the liability which accompanies the responsibility of owning a closely held business. Even if the trust owns only a minority interest in the family business, many corporate fiduciaries will still be reluctant to serve as trustee and assume the state law duties of a minority shareholder in order to fulfill the fiduciaries responsibilities to trust beneficiaries.

If a business owner nominates an individual to serve as trustee, he or she must also identify a successor trustee in case the primary trustee is unable or unwilling to serve after the owner’s death. Perhaps the estate planning documents will include a series of individuals with a default provision authorizing the beneficiaries to appoint a corporate trustee to serve if all of the nominated individuals have failed or ceased to serve. But as mentioned above, it may turn out that no corporate fiduciary is willing to serve. What happens if the estate planning documents require a corporate fiduciary be appointed? Perhaps in such circumstances the applicable local law will require the state probate court to appoint a successor trustee. Will the business owner be comfortable leaving the decision as to who will serve as trustee to a judge? If not, an alternative would be to have the estate planning documents allow the beneficiaries to appoint a successor trustee, but not require a corporate trustee. It may be better to merely require that the successor trustee not be a beneficiary and not be related or subordinate to the beneficiaries within the meaning of §672(c).

Sometimes a business owner will want to designate his or her spouse as trustee. If the spouse may distribute trust principal only for his or her health, education, maintenance and support, there is no tax reason that would prevent the spouse from serving as trustee. However, in such circumstances, the family advisor must counsel the client that the spouse, as trustee, may be in a position to control the operation of the business. The business owner must be comfortable with the fact that his or her spouse may end up controlling the operations of a business. If the spouse has never been active in the business or is a second spouse, perhaps someone else should be designated as trustee. Even if there is no business reason to name someone other than a spouse, a widow or widower who serves as trustee may have an interest in arranging for the business to periodically distribute cash to herself or himself which may create a conflict of interest. Furthermore, as a trustee in control of the business, the surviving spouse owes a fiduciary duty to the other owners of the business and its employees. This fiduciary duty will be in conflict with the desire of the spouse/trustee to enhance his or her own cash flow.

The business owner may also decide to name a child who will manage the family business after the death of the owner as trustee. However, as discussed in Part One of this article concerning the Rollins family, it is likely that the child’s responsibility in managing the business will conflict with his or her fiduciary duties as trustee.¹² As trustee, there will be a fiduciary obligation to take those steps that are in the best interest of the beneficiaries of the trust. As the manager of the business, the child will have to take those steps that are in the best interests of the business and its owners. ‘‘Those two obligations can easily come into conflict over decisions about dividends or other distributions to the owners, expansion of property, plant and equipment and new business ventures.’’¹³

Some business owners may want to designate a key manager of the business as trustee. The concept being that such person knows the operations of the business as having served as manager with the owner over several years. Who else would be better suited to continue managing the business as the owner would have done if still living? However, this manager still has fiduciary duties as a trustee.

If the business owner decides to nominate an individual as trustee in spite of the above conflicts of interest, as discussed in the Halas case¹⁴ in Part One of this article, it is critical that the estate planning documents acknowledge and waive the conflicts. Exhibit A to this article sets forth sample language that may be used to waive such conflicts of interest. Family harmony is more likely to be maintained if disagreements are handled outside of a court proceeding. Once a family disagreement is brought in front of a judge, the likelihood of having any family harmony in the future is almost non-existent. By having the estate planning documents waive the rules against self-dealing and conflicts of interest, the business owner helps ensure that disagreements can stay out of court.

Furthermore, if a corporate trustee is contemplated, it is critical that the estate planning documents give the beneficiaries a power to remove the corporate fiduciary. The experience we have had with the financial industry over the past decade would suggest that no one should be forced to work with a corporate trustee which cannot be fired. There are numerous examples of a decedent who nominated his or her local bank as a fiduciary, only for the primary beneficiary to later learn after a merger that he or she is now dealing with a bank in another state.

Consideration must also be given to the possibility of removing an individual trustee. The trustee who was the trusted advisor or friend of the business owner and a fair-minded individual when he or she was young, may become irrational, stubborn and even an angry person as he or she becomes older. The business owner may want to consider having a stated retirement age for any individual who is serving as trustee. If the business owner is reluctant to force a trusted advisor to retire as trustee, perhaps the beneficiaries of the trust may be given the power to remove the trustee for stated reasons. For example, if the individual trustee arbitrarily refuses to exercise a discretionary power to distribute trust principal or if the trustee arbitrarily abuses his or her power as the majority owner of a business, or if the trustee seeks to sell the business over the objections of the beneficiaries, the estate planning documents could grant to designated beneficiaries the power to remove the individual trustee for cause.

Certainly a trustee removal power would be preferable to a court proceeding. If, however, the trustee brings a proceeding in court in regard to such removal provisions, provisions of this type may be very persuasive to a judge seeking to gain some insight into the business owner’s intent.

Another way to provide a procedure to allow a trustee to receive feedback from an owner’s family after his or her death in regard to making decisions as trustee concerning business matters is to include in the estate planning document a provision that appoints a Family Advisory Committee. The Committee may be made up of family members that could give nonbinding advice and direction to a trustee concerning certain significant matters involving the business. The trustee would not be obligated to follow the direction of the committee but it would allow a method of communication between the trustee and family members as to the business decisions the trustee confronts. Exhibit B contains sample language in regard to the appointment of a Family Advisory Committee.

Issues that Arise when Two Trustees Serve

It is quite common for a business owner to want to designate two trustees. Perhaps the business owner will want to designate a family member to serve as co-trustee with a manager of the business. In such situations, however, depending upon state law, it is likely that the trust administration decisions must be unanimous unless the document provides otherwise. Consequently, deadlocks between the co-trustees are possible. Whenever the co-trustees disagree with a proposed course of action, that trustee who wishes to take a specific course of action loses. In effect, each trustee is given a veto power over the decisions of the other trustee.

One solution is to provide in the estate planning documents a method to break the tie. The business owner, for example, could provide in his estate planning documents that the decision of the key manager/co-trustee will control in the event there is a disagreement over the management decisions of the business and that the decision of the family member/co-trustee will control over discretionary distributions to family members.¹⁵ The disagreeing co-trustee must be relieved of any liability for going along with the controlling co-trustee.

Furthermore, the estate planning documents must be very clear as to the procedure if one of the two trustees resigns, becomes incapacitated, or dies. The documents should state whether a new co-trustee must be appointed or whether the surviving co-trustee may serve alone. Also, the estate planning documents should make sure it is clear as to whether there must always be a representative of the business serving as a co-trustee or on the other hand whether there must always be a representative of the family.¹⁶

Planning for the Possibility of Divorce

In the context of planning for divorce, the best approach is to provide for the disposition of an ownership interest in a family business through a prenuptial agreement. The prenuptial agreement should make it clear that any appreciation in the value of the business after the date of the marriage remains separate property even if the spouse owning the property actively works in the business. Another alternative when planning for a possible divorce is for the donor of a gift of a business interest to transfer the property into a trust rather than giving the business interest outright. This will prevent the business interest from becoming community or marital property.

Many shareholder agreements provide that any ownership interest that is awarded to a spouse of a business owner pursuant to a divorce shall be purchased from the spouse. This is because many business owners do not want an ownership interest to be passed to a former spouse of another owner. A critical question to ask is who gets to buy the stock? Many shareholder agreements are drafted so that the business itself or all of the shareholders get to buy the stock in the event a court awards stock to a spouse of another owner. But what about the shareholder who just went through a divorce? It seems appropriate that he or she should have the first opportunity to purchase the shares that the divorce court has awarded to the former spouse before the business or the other shareholders have an opportunity to purchase such shares.

Use of a Trust Protector

When drafting the estate planning documents for a client, one of the issues discussed is at what age will it be appropriate for distributions to be made outright to the business owner’s children. Obviously, decisions made by business owners with young children are merely educated guesses about what the future may hold.

To hedge against making incorrect assumptions, it is possible to appoint an independent third party as a ‘‘Trust Protector,’’ who can direct the trustee to withhold or to accelerate the scheduled distributions based upon the facts and circumstances that exist in the future. Of course, the estate planning documents must relieve the Trust Protector from any liability he or she may have as a result of the exercise or non-exercise of these discretionary powers. The Trust Protector should also be indemnified by the trust assets.

Creative Use of Preferred Membership Interests

Often a business owner will be faced with a situation in which not all of his or her children want to be involved in a family business. One or more children may have other interests or pursuits. Nevertheless, the business owner may want to provide an equal inheritance among his or her children without favoring one child over another. However, if the ownership of a business is bequeathed in equal shares among active and passive children, the chances of disputes arising over compensation or other issues rise significantly.

This is where preferred membership interests may be useful. Ownership rights in a limited liability company as to allocations of income, distributions, voting, or other matters may be divided into separate classes. The differences in rights are set forth in the operating agreement. The preferred membership interests can be designed to have no voting rights but could be given preference to distributions and liquidations. With such a structure, preferred members would be entitled to be paid an annual distribution or a liquidating distribution before the common membership holders receive a share of the profits or a portion of the liquidation proceeds, as the case may be. Let’s set forth a hypothetical fact pattern to illustrate how this planning device would work.

Factual Background

Peter and his wife, Roberta, each own a 50% interest in a limited liability company that owns commercial office buildings. Peter and Roberta have three children, namely, Patrick, Anna and Luke. Luke is the only child that is active in the business. Patrick has pursued a career as an electrician and Anna is an elementary school teacher. Peter and Roberta do not have substantial assets outside of the business as they have kept most of the profits of the limited liability company inside the entity rather than distributing the profits to themselves. Peter and Roberta would like to have the family business continue after they die but also wish to leave their assets to their children in substantially equal shares. They are concerned, however, that they have only one child who is active in the business.

Patrick and Anna have no interest in becoming involved in the family business and would rather see the business sold upon both of their parents’ retirement or upon the surviving parent’s death. If the business is not sold, Patrick and Anna would only be interested in receiving an income stream from the profits of the business. Luke is very interested in continuing the family business and has ideas of his own as to how to further grow the business. Unfortunately, he also realizes that, to grow the business, much of the profits will have to be invested in the business. Luke also expects to control the business after his parents’ retirement or death and does not want his siblings to interfere with his management decisions.

Peter and Roberta want to discuss ideas as to how to leave the family business to their children. They realize that it is financially impracticable for Luke to immediately buy out his siblings. While Luke may seek to obtain a bank loan to buy out the interests of Patrick and Anna, such a loan would require monthly payments to pay off the loan. Luke may find it difficult to make such monthly loan payments, especially in years in which the profits from the business are somewhat modest.

Peter and Roberta are concerned that Patrick and Anna will ultimately force the sale of the business or at the very least demand substantial distributions that will prevent Luke from growing the business. This, of course, would ruin the sibling relationship, the thought of which is devastating to Peter and Roberta. They realize that the organizational structure could be changed so that Luke receives voting interests and Patrick and Anna receive non-voting interests with no other differences between the ownership interests. However, Peter and Roberta are concerned that the family relationship will deteriorate if the organizational structure does not give Patrick and Anna some assurance that their inheritance will generate a cash flow.

A Possible Solution

Merely giving Patrick and Anna non-voting equity interests will not meet the objectives of the family. Luke will be able to retain the profits inside business entity and Patrick and Anna may not receive the cash flow they are looking to obtain.

One possible solution to this dilemma is changing the organizational structure of the entity to include preferred membership interests.

Here is how it might work for Peter and Roberta. Peter and Roberta recapitalize the limited liability company into 100 preferred membership units and 50 common membership units. The preferred membership units have no voting rights, but each unit has a liquidation preference entitling the holder to a priority upon liquidation of the company. The preferred units also are entitled to fixed annual cumulative preferred payments. The preferred membership units would not receive any participation in upside growth of the assets of the limited liability company in excess of the preferred coupon and liquidation preference. The aggregate liquidation preference is equal to two-thirds of the estimated date of death value of the company on the death of the survivor of Peter and Roberta. The operating agreement provides a call feature so that the common membership units have a right to purchase the preferred membership units at the liquidation preference value plus any accumulated and unpaid coupon. The testamentary estate plan for Peter and Roberta leaves the preferred membership units to Patrick and Anna in equal shares and the common membership units to Luke. Therefore, upon the death of the survivor of Peter and Roberta, Luke will be able to manage the family business but Patrick and Anna have preference rights to distribution of profits and distributions as a result of the liquidation of the entity. Luke will be entitled to the profits and growth of the business that exceeds the preference rights of Patrick and Anna.

Does this plan accomplish the objectives and concerns of Peter and Roberta? Let’s analyze each objective:

Objective #1: Leave the Family Assets to the Three Children in Equal Shares

This objective has been accomplished in that all three children receive an equal share of the family business.

Objective #2: Give Control over the Family Business to Luke

This objective has been accomplished because the common membership units have voting rights. The preferred members units given to Patrick and Anna do not have voting rights. Therefore, Luke will be able to appoint himself as the manager of the limited liability company. Nevertheless, depending upon the structure of the preferred units set forth in the operating agreement, Luke may have to obtain the consent of Patrick and Anna in regard to extraordinary matters such as selling substantially all of the assets of the business or having the business acquire substantial debt. Therefore, for certain matters, Luke may still need to get the approval of his siblings.

Objective #3: Provide an Income Stream to Patrick and Anna

This objective has been accomplished in that the preferred units are entitled to a fixed annual cumulative distribution right. Therefore, Patrick and Anna are guaranteed an income stream on a periodic basis from the preferred membership units. The net cash generated from the operations in excess of the coupon rate may be kept inside the business. The limited liability company will be able to take advantage of a significant depreciation deduction for tax purposes to reduce the income from operations yet still maintain a positive cash flow to reinvest in the business.

Alternatively, to allow more flexibility to Luke, the operating agreement could require that only a portion of the coupon rate be paid each year and the balance of the coupon rate be carried over into future years if the manager of the company elects. For example, the operating agreement might say that the preferred members must be paid the coupon rate to the extent it does not exceed 50% of the income of the company before interest, depreciation, and amortization, with any unpaid distribution carried over to future years (so long as Luke’s units do not receive a distribution). This would allow Luke to retain funds inside the business in years when the income is low. Nevertheless, Patrick and Anna know that in such years the unpaid distributions will be carried forward into future years.

This structure offers the passive owners assurance of a return on their investment but allows the active owners to reap the reward of the growth in the business that is achieved by their hard work.

Nevertheless, if bank financing is required to operate the business, it is likely the bank will require any payment to the preferred members to be subordinate to such bank loan. Therefore, it is possible that a bank may prohibit any distribution to be made to the preferred members. Consequently, the objective of providing a cash flow to Patrick and Anna may not necessarily be achieved when the preferred units are subordinate to bank debt (absent bank approval).

Objective #4: Allow Luke to Buy Out His Siblings’ Interests (or Either of Them) If Circumstances Make It Financially Possible

This objective is satisfied in that under the operating agreement, if Luke grows the family business, it will be possible at some point for him to exercise the call feature and buy out one or both of his siblings’ interests. The value of the growth of the business will belong to Luke in that the value of the preferred member units is capped at the coupon rate.

Objective #5: Eliminate the Tension that May Exist Between Passive Owners and Active Owners

This objective is only partially satisfied. Luke will certainly be able to manage the business without interference from his siblings in the day-to-day decision-making. Also, Patrick and Anna certainly know that they will be entitled to a distribution of profits before Luke. Nevertheless, Patrick and Anna could argue that Luke is receiving excess compensation as the manager of the business. They might believe that a lower amount of compensation would allow Luke to make a greater profits distribution in regard to the preferred distribution right in years when the full distribution right is not paid. Also, Patrick and Anna may not receive any money (or very little) from the inheritance if Luke is unable to profitably manage the business and it enters into bankruptcy.

Luke will also likely become unhappy with the entity’s structure if his siblings continue to own preferred units over a long period of time and the profits of the business do not significantly exceed the coupon rate. Luke is the only family member spending his time trying to grow the business. Yet, his siblings are entitled to the first fruits of his labor on a cumulative basis. Therefore, it is possible that Luke will become dissatisfied with the organizational structure the longer it takes for him to buy out his siblings if the profits do not significantly exceed the coupon rate.

Objective #6: Minimize Estate Taxes

There are possible estate tax savings if Peter and Roberta anticipate the value of the limited liability company to grow during their lives and are willing to make inter vivos transfers of ownership interests. In this case, Peter and Roberta may give (or sell) the common membership interests to Luke during their lives. They might retain the preferred membership interests which will essentially freeze the value of their assets for estate tax purposes as all of the growth in the value of the company will vest in the common membership interests. The preferred units will receive a step-up in basis upon Peter and Roberta’s deaths as such units will be included in their gross estate.¹⁷

Based upon the above analysis, this solution is not always appropriate when a family business anticipates having passive owners. However, it seems appropriate for a situation where the active members have the business acumen to profitably manage and grow a family business but need a few years to generate enough profits to be able to buy out their siblings’ equity interest. It also seems appropriate when the profits of the business will significantly exceed the coupon rate on the preferred interests so that both the active members and non-active members are satisfied with their share of the profits.

Another solution would be for Peter and Roberta to help Luke maintain a life insurance policy on their lives (the owner of the policy might also be a trust for Luke’s benefit). The death benefit could be used to buy out the equity interests of Patrick and Anna.

Use of a Third-Party Consultant

It is often helpful for family business owners to hire third-party professionals to assist the family in developing rules, policies, procedures, or succession plans to minimize the risk of family disputes arising and to help resolve any disputes or miscommunications when they do arise. Consultants often get involved to discuss leadership succession, mentoring issues, and governance systems. They can be useful in facilitating family retreats in order to help the family communicate with each other over important and sensitive issues. The professionals understand how other family businesses have resolved certain issues and can offer advice as to the variety of approaches a family may use to solve family business issues. A consultant may also be retained to help a business owner identify who are the best candidates to take over the leadership of a business and how to mentor such persons to develop the skills required to take on such leadership roles at the appropriate time.

Mediation

Another option for families when serious disputes arise is to voluntarily opt for mediation rather than initiating a lawsuit. Mediation allows the parties involved to control the process. There is no forced judgment from a judge. Rather a solution or settlement arises from the owners themselves with the help of a mediator. The goal of mediation is to achieve a mutually acceptable solution that resolves the current dispute and decreases the likelihood of future conflict.¹⁸ While the focus of mediation is on substantive issues, the process is informal and designed to address constructively the relevant factors that a court proceeding would not consider.

Other Business Succession Ideas

As part of a business succession plan, it is often helpful for the senior generation to arrange for an independent team (such as a third-party professional consultant as discussed above) to interview the senior member’s children to get an idea as to the children’s thoughts about the future of the business. The interview process must be conducted in a way that assures the children that all communication will be kept confidential so as to encourage open and highest communication. In this interview, the children’s thoughts about the current operation of the business and their existing plans for the future should be discussed. Each child’s personal goals could be discussed to determine if there was any conflict with the personal goals of other family members and the business goals.

As part of the interview process, the team conducting the interviews would look for any signs of personality clashes or hidden rivalries. Identifying any personality clashes or sibling rivalries will allow such clashes or rivalries to be discussed and possibly ironed out.

When a dispute or conflict arises in a family business, it is important that the conflict or dispute is not ignored so as to allow it to fester and grow to a point where a resolution will be more difficult to achieve. Also, it is critical that any discussion among the family over a dispute or conflict must be done in a respectful, honest and open way. A resolution will be unlikely if anyone is belittled in the process.

Family meetings or retreats are often helpful to provide a venue to discuss family issues in a relaxed setting. Also, a number of family businesses have established family councils to deal with family issues. The council is a forum where family members may discuss ownership and family issues that arise. This council allows all family members to participate in the discussion whether or not a person is involved in the management of the business. This reduces the potential for family disputes to grow to a level that will be destructive or harmful to family relationships or the business itself. No matter what decisions a family makes, it is crucial that the process be fair. The entire family must be committed to having each branch of the family being treated fairly and no differently than other branches of the family. A professional consultant may be useful in facilitating such family retreats.

Four Additional Hypothetical Case Studies

The following hypothetical business succession fact patterns illustrate a few additional points or suggestions.

Case 1: Use of a Dynasty Trust

Consider a family business in which the senior generation very much views the business as a family legacy but nevertheless foresees a time when the business might be sold in the best interests of the family. The founder also does not want the illiquidity of his business to prevent a family member from being able to go his or her own way and cash out of the business. However, the senior generation is concerned over how the company will afford such a buyout if multiple siblings decide to sell their shares. The senior member is well aware that the company needs to retain sufficient cash to be able to acquire other companies when opportunities present themselves in order for the company to stay competitive in a consolidating industry.

How can the family strike the right balance of providing cash to those family members who may want to be bought out while being fair to those who want to keep the equity of the company strong? One possible alternative is for the owners to place some of their shares in a dynasty trust. The idea being that the shares placed in the dynasty trust will not be redeemed but will be held as an investment in the future of the family business. If the business is ever sold to a strategic buyer, the cash received would then be in a vehicle that could pass the family wealth on to succeeding generations.

The creation of such dynasty trusts will also reduce the number of shares still in the hands of the children which will, in turn, reduce the amount of cash that will be required if anyone wants to redeem their shares and cash out. Clearly, it requires planning to balance the cash flow needs of the business with the desires of the non-active members of the family.

Case 2: Disadvantage to Selling Business and in Return Receive a Long-Term Promissory Note

Let’s examine a less successful fact pattern. Let’s say that two parents own the majority of shares of a corporation with the minority of shares being owned by two sons active in the business. The parents have three children who are not active in the business. In this hypothetical, the parents sell their shares to the two sons who are active in the business in return for two promissory notes. However the notes are subordinated to bank debt and payable over a 10-year period.

The business falls into some hard times which results in the promissory notes being thereafter restructured and the term of the notes being extended to 30 years. The parents view the business as their legacy and agree to the changes in the promissory notes to give their two sons an opportunity to keep the business afloat.

Eventually the parents die and the business continues to struggle. The bank forces the company to stop payment on the notes until the business improves its financial condition. Consequently, following the parents’ deaths, the promissory notes the non-active children inherit may very well never be paid.

In this hypothetical situation, the non-active family members may feel slighted as the two sons who are active in the business continue to draw a salary yet the non-active siblings are not able to receive payment on the notes. The promissory notes are much like stock representing a minority interest in a company that pays no dividends. The piece of paper is worthless to the non-active members until the company can turn itself around. The notes are payable over such a long period of time that prevents the non-active siblings from realizing any real benefit from the sale of the stock by the parent. In this case, the parents are willing to risk diminishing the inheritance of their other children in order to give their business legacy a greater chance of surviving. But in so doing, they may cause a rift in the relationships of the siblings following their deaths.

How can the parents approach the business succession differently? Perhaps the parents can purchase life insurance to provide a death benefit to the non-active siblings. The promissory notes could then be bequeathed to the two-active children and in essence have their debt obligation forgiven. Alternatively, perhaps the parents can sell the company to a third party that provides cash to the entire family to enjoy.

In Case 1 and Case 2, both senior generation members want to take action during life to transition the ownership of the family business to the next generation. However, in Case 2, both of the parents favor the business and desire that the family legacy be kept intact to such an extent that they risk the inheritance of the non-active shareholders. The parents decide that they prefer that the business continue even if it results in some of their children not receiving an inheritance in the form of cash for many years after their deaths, if at all. Case 1 is much different than Case 2. In Case 1, the father wants to provide an inheritance to all of his children, even those who are not involved in the business. This father arranges for the wishes of each child to be known and solutions are sought for those children who decide to cash out. Case 2 shows a father and mother wanting the family business legacy to succeed so much that they put the inheritance of the nonactive family members in jeopardy. In the end, the structure of the plan adds family stress and creates tension between siblings that can be avoided by structuring the succession plan differently.

Case 3: Dividing Hard Assets from the Operating Entity

Peter owns a business that operates a wholesale distribution of beverages. The business operates out of two warehouses. He has five children but only two of them are active in the business. Peter would like all five of his children to benefit from the business after he dies, but he is concerned about conflicts that might arise from his three children who are not active in the business because they have different interests than those two children who are active in the business.

One solution might be to place the buildings in a separate entity, have the wholesale business operate out of the buildings, and enter into a lease agreement with this real estate entity. All of the children may be owners of the real estate entity, and, thus, all of the children may share in the profits from leasing the buildings to the wholesale distributor. However, the entity that operates the wholesale business may be owned only by the children who are actively involved in the business. This will allow all of Peter’s children to benefit from the wholesale business but not have the non-active children as shareholders in the wholesale distributor.

Under this plan, it would be preferable to give control over the real estate entity to the children who are active in the wholesale business. This will avoid requiring the active business owners to obtain the consent of the non-active siblings every time the parking lot needs to be repaved or the roof needs to be repaired. If control over the real estate entity is given to the non-active children, such non-active children may not readily give consent to the active owners of the wholesale business as they may have hard feelings over such active owners taking out earnings from the wholesale business in the form of compensation and still benefitting from being owners of the real estate business. The future relationship between the wholesale business and the real estate business should mirror the current situation.¹⁹ That is, while the founder is alive, the same person controls the real estate entity and the wholesale business. The relationship should not change after the founder dies.

Case 4: A Sale to a Grantor Trust in Return for a Private Annuity

A common situation involves a business owner who would like to retire and wants to use the proceeds from the sale of his business to fund his retirement and pass on the ownership of the business to his children. Often, however, the business owner cannot afford to give up his income stream that is generated from his business. A sale of the business will certainly provide some cash to help fund his or her retirement. However, the business owner will incur a taxable capital gain if he or she simply sells the business to his children or another third party. A sale to a grantor trust in return for a private annuity is an alternative to an outright sale.

This solution involves having the business owner create an irrevocable trust which is a grantor trust for income tax purposes. The trust will be drafted so that the assets of the trust will not be included in the business owner’s estate for estate tax purposes. The business owner funds the trust with the appropriate amount of seed money. He or she thereafter sells the business interest to the trust in exchange for a private annuity. This transaction will not result in the business owner incurring a taxable gain because the trust is a grantor trust. The value of the private annuity will equal the value of the business interest sold pursuant to actuarial assumptions.²⁰

This strategy will allow the business owner to pass on the ownership of the business with no gift or estate tax exposure if he or she is healthy at the time of the transaction. The payments from the trust to the business owner will not be subject to income tax because the payments are being made from a grantor trust. When the business owner subsequently dies, the payments cease and the grantor trust terminates in favor of his children with no trust asset being subject to estate tax pursuant to §2036. Of course the business must be able to generate cash distributions to the grantor trust in order to fund the private annuity.

ETHICAL ISSUES

The conduct of attorneys in the practice of law is governed by various sets of rules. There are certain standards that govern whether or not an attorney has committed malpractice and is liable to his or her client for damages resulting from such malpractice. However, short of malpractice, an attorney’s conduct is also regulated by state law that governs the professional conduct of attorneys practicing in a particular state. An attorney who violates such code of conduct may be disciplined in various ways, ranging from public reprimand to disbarment. The American Bar Association’s Model Rules of Professional Conduct is a set of recommended rules for states to consider adopting that regulate the conduct of attorneys. However, it does not discuss malpractice standards. Generally, in regard to such Model Rules, a ‘‘[v]iolation of a Rule should not itself give rise to a cause of action against a lawyer nor should it create any presumption in such a case that a legal duty has been breached.’’²¹

This Article will use the American Bar Association Model Rules of Professional Conduct (hereinafter MRPC) as a basis to discuss the ethical rules that often come into play when an attorney engages in multigenerational planning such as business succession planning. Each practitioner must be familiar with the specific state code of professional responsibility that is applicable to the jurisdiction in which he or she practices.

Consider this hypothetical fact pattern. Harry, the founder of a family business, begins to think about his business legacy after he has successfully managed the business for 20 years and has attained the age of 60 years. Harry calls his attorney, Catherine, who has assisted him with various business issues over the years and drafted Harry’s last will and testament years before. Harry informs Catherine that he needs to update his last will and testament. Consequently, the two of them meet and they confidentially discuss how Harry wishes to divide up his assets among his four children. Naturally, Harry indicates that he wants to treat all of his children equally even though only two of them (his youngest son, Joe, and his daughter, Sarah) are involved in operating the business. Harry is, of course, cash poor since he has invested much of the profits of the business into the equity of the business. Over the years, Catherine has also been retained by Harry’s four children to prepare estate planning documents. Two of the children also are married, and Catherine represented both of these children with regard to a prenuptial agreement.

When Catherine meets with Harry, she may recommend that Harry start giving away his ownership interests to his children over time to take advantage of the gift tax annual exclusion and, consequently, save estate taxes. Catherine might also suggest that Harry make a gift of business interests to a grantor-retained annuity trust because the company is growing in value. Perhaps a sale to an intentionally defective grantor trust is also discussed or the creation of a family limited partnership. At the end of the discussion Harry tells Catherine that all of the discussed strategies are simply too complicated for him to digest right then and directs Catherine to draft a last will and testament that leaves all of his assets to his four children in equal shares. Catherine thereafter drafts such a will, and Harry signs it.

Harry subsequently dies. As a result, all four children become partners in the family business. It turns out that Harry’s estate is not subject to estate tax due to the rising estate tax exemption. With no succession planning done (other than a discussion regarding estate taxes and the signing of a simple will), the ownership interest in the business is divided equally among Harry’s four children. While Joe and Sarah have been involved in operating the business during Harry’s life, no one asked Joe whether he wanted to stay involved in the family business after his father’s death. If asked, Joe would have revealed that he has a passion for theater and dreams of leaving the family business to pursue a career as a producer of stage plays. After Harry’s death, Joe does, in fact, leave to pursue his dream and Sarah takes on the responsibility of managing the family business. Thereafter, Catherine continues to give legal advice to Sarah involving business and family issues.

Over the next few years the business does not grow much. It turns out that Harry, being a traditionalist, mentored Joe but not his daughter, Sarah, in dealing with vendor demands or with labor and sales issues.

Four years after Harry’s death, Joe approaches Catherine to update his will. In that meeting, Joe complains to Catherine that his sister is ruining the family legacy and that he is considering joining with his two other siblings to vote to sell the business. He says that no dividends have been issued over the years and his sister is simply using the family inheritance for only her benefit as Sarah is the only family member receiving any compensation as an employee. Short of a sale of the company, Joe says that he may accept a change in the board of directors that would ensure that dividends are paid. However, over the years Sarah has continuously argued that all of the profits must be plowed back into the company in order for it to stay competitive. Joe also says that he would like Catherine to represent him if the business is sold. Joe recognizes that Sarah may not have the resources on her own to buy out her siblings. Nevertheless, he very much wants his inheritance in the form of cash and is willing to destroy his relationship with his sister and the family business in order to receive the inheritance to which he is entitled in the form of cash.

Obviously the succession plan set forth in Harry’s last will and testament has not been successful. But now, Catherine also has ethical concerns that must be addressed. Clearly, she has multiple clients with conflicting interests. Furthermore, Catherine has been told confidential information about Joe’s intentions. Does Catherine have a duty to inform Sarah (also her client) of Joe’s thoughts about selling the company? She recalls an ethical rule that requires that she keep her clients reasonably informed about the status of matters for which she has been retained. Does Joe’s intention fall within this rule since it directly affects the business about which Catherine has routinely given legal advice to Sarah, and as it also directly affects Sarah’s estate plan?

Catherine now has complicated ethical interests to resolve by reason of representing multiple clients with conflicting issues. She began to represent Harry while Harry’s children were very young. It was at Harry’s recommendation that each child called Catherine for their own legal needs. There were initially no conflicts between Harry’s interest and his children’s interest. Therefore Catherine did not breach any ethical duty or responsibility when she began to represent each of Harry’s children.

However, did Catherine explain to each child any future potential conflict of interest that may arise? At the time Catherine began providing legal counsel to each child, did she explain to each child the differences between joint representation, independent representation, and concurrent but separate representation?

With ‘‘joint representation,’’ one attorney represents all of the family members as a single client. If joint representation is undertaken, the attorney cannot be an advocate for any individual family member but would serve the entire family and would encourage the family to resolve differences in an equitable manner for the best interests of the family as a whole. In this type of representation, the attorney typically meets with all of the family members at the same time to discuss the matter together and all information relevant to the matter is disclosed. Therefore, there is no confidentiality of information that is relevant and material to the engagement among the family members. The lack of confidentiality of information among the family members can be very sensitive and could result in dissension among family members.²²

With ‘‘independent representation,’’ each family member retains his or her own attorney. Therefore, each family member has an advocate for his or her interest and receives independent advice. Confidential information is not shared among the family with this type of representation. The disadvantage to separate representation is that it is more costly to the family because more than one lawyer is involved. Additionally, separate representation could result in the various family members developing different plans that result in inconsistency among the members.²³

With ‘‘concurrent but separate representation,’’ one attorney represents all family members but the representation is structured so that each family member would have the same relationship with the attorney as if each family member was represented by separate counsel. This type of representation results in each family member receiving independent advice. The attorney meets with each family member separately and the confidential information of one family member is not disclosed to other family members unless authorized in advance.²⁴

An attorney who has multi-generational clients must be sensitive to the likelihood that conflicts of interests will arise at some point in the representation. As discussed below, it is important for the attorney to have an engagement letter signed by all clients that defines the scope of the representation and the type of representation when multiple representation is contemplated.

There are essentially three ethical duties and responsibilities that often arise when representing multigenerational or multiple clients. They are the ethical duties of loyalty, confidentiality and communication. The engagement letter should discuss the clients’ expectations as to each duty and responsibility.

Ethical Duty of Loyalty

The ethical duty of loyalty is fundamental to any lawyer/client relationship. A client retains a lawyer so that he or she may have an advocate protecting his or her individual interests. The lawyer/client relationship falls apart if a client has to be wary of his or her lawyer having divided loyalty with another person.

One of the rules concerning the duty of loyalty is set forth in the MRPC Rule 1.7 which states:

(a) Except as provided in paragraph (b), a lawyer shall not represent a client if the representation involves a concurrent conflict of interest. A concurrent conflict of interest exists if:

(1) the representation of one client will be directly adverse to another client; or

(2) there is a significant risk that the representation of one or more clients will be materially limited by the lawyer’s responsibilities to another client, a former client or a third person or by a personal interest of the lawyer.

(b) Notwithstanding the existence of a concurrent conflict of interest under paragraph (a), a lawyer may represent a client if:

(1) the lawyer reasonably believes that the lawyer will be able to provide competent and diligent representation to each affected client;

(2) the representation is not prohibited by law;

(3) the representation does not involve the assertion of a claim by one client against another client represented by the lawyer in the same litigation or other proceeding before a tribunal; and

(4) each affected client gives informed consent, confirmed in writing.

MRPC Rule 1.0 defines informed consent as meaning an ‘‘agreement by a person to a proposed course of conduct after the lawyer has communicated adequate information and explanation about the material risks of and reasonable available alternatives to the proposed course of conduct.’’

After Harry’s death a significant conflict of interest arose between the interests of Joe versus the interests of Sarah. Catherine is continuing to represent Sarah and the family business, yet Joe is aggravated that he is not receiving any dividends or other compensation from the company. Joe is willing to try to force the sale of the company against the wishes of Sarah.

At the very least, Catherine’s loyalty to Joe may be questioned because of the continuing legal relationship she has with Sarah. The commentaries to Rule 1.7 indicate that if a conflict arises after a representation has been undertaken, an attorney must ordinarily withdraw from the representation, unless the attorney has obtained informed consent from each affected client and has satisfied the other conditions of paragraph (b) of such rule. The commentaries further state that where more than one client is involved, whether the attorney may continue to represent any of the clients is determined both by the attorney’s ability to comply with the duties owed to a former client and by the attorney’s ability to represent adequately the remaining client, given the duties to a former client under MRPC Rule 1.9.

At this point, if may very well not even be possible for Catherine to get informed consent so that she may continue to represent Joe and Sarah. As stated above, in order for the attorney to obtain informed consent from Joe and Sarah, she would have to describe to each client the conflict that has arisen and the material risks that are involved with her continuing to represent both of them and the alternatives that are available. However, Catherine does not have the authority to describe the conflict to Sarah without Joe’s consent, which brings up the attorney’s duty of confidentiality. A fundamental principle in an attorney-client relationship is that, without informed consent, the attorney may not reveal information relating to the representation.

Ethical Duty of Confidentiality

The MRPC Rule 1.6 states:

(a) A lawyer shall not reveal information relating to the representation of a client unless the client gives informed consent, the disclosure is impliedly authorized in order to carry out the representation or the disclosure is permitted by paragraph (b).

(b) A lawyer may reveal information relating to the representation of a client to the extent the lawyer reasonably believes necessary:

(1) to prevent reasonably certain death or substantial bodily harm;

(2) to prevent the client from committing a crime or fraud that is reasonably certain to result in substantial injury to the financial interests or property of another and in furtherance of which the client has used or is using the lawyer’s services;

(3) to prevent, mitigate or rectify substantial injury to the financial interests or property of another that is reasonably certain to result or has resulted from the client’s commission of a crime or fraud in furtherance of which the client has used the lawyer’s services;

(4) to secure legal advice about the lawyers compliance with these Rules;

(5) to establish a claim or defense on behalf of the lawyer in a controversy between the lawyer and the client, to establish a defense to a criminal charge or civil claim against the lawyer based upon conduct in which the client was involved, or to respond to allegations in any proceeding concerning the lawyer’s representation of the client;

(6) to comply with other law or a court order; or

(7) to detect and resolve conflicts of interest arising from the lawyer’s change of employment or from changes in the composition or ownership of a firm, but only if the revealed information would not compromise the attorney-client privilege or otherwise prejudice the client.

(c) A lawyer shall make reasonable efforts to prevent the inadvertent or unauthorized disclosure of, or unauthorized access to, information relating to the representation of a client.

This confidentiality rule applies not only to matters communicated in confidence by the client but also to all information relating to the representation acquired by the attorney no matter from what source.

Joe will most likely not authorize Catherine to disclose his intentions to Sarah. May Catherine disclose Joe’s intentions to Sarah anyway? MRPC Rule 1.6(b)(3) might, at first, seem to apply if Catherine believes that a sale of the company will substantially injure Sarah’s financial interests with the loss of an income source. However, Joe is not committing a crime or fraud in wanting the company sold. Therefore, this exception does not seem to apply.

If Catherine does not disclose Joe’s intentions, will Sarah accuse her of breaching a duty of communication by not letting her know that the business she operates and depends upon for her income may be forced to be sold by the other shareholders?

Ethical Duty of Communication

MRPC Rule 1.4 addresses the duty of communication by stating:

(a) A lawyer shall:

(1) promptly inform the client of any decision or circumstance with respect to which the client’s informed consent, as defined in Rule 1.0(e), is required by these Rules;

(2) reasonably consult with the client about the means by which the client’s objectives are to be accomplished;

(3) keep the client reasonably informed about the status of the matter;

(4) promptly comply with reasonable requests for information; and

(5) consult with the client about any relevant limitation on the lawyer’s conduct when the lawyer knows that the client expects assistance not permitted by the Rules of Professional Conduct or other law.

(b) A lawyer shall explain a matter to the extent reasonably necessary to permit the client to make informed decisions regarding the representation.

It appears as though Rule 1.4 requires Catherine to disclose Joe’s intentions because the conflict is one in which Sarah’s informed consent is required. However, Rule 1.6 may not authorize her to make such disclosure. Catherine may need to withdraw from representing both Joe and Sarah without disclosing any reason other than to inform them that a conflict has arisen that adversely affects the attorney-client relationship. This disclosure in and of itself might give Sarah a hint as to what the conflict might be. However, that may be the only course of action that Catherine can take.

Engagement Letters

Based on the above analysis, it is critical for estate planning and family business attorneys to discuss conflict issues with their clients at the time the representation commences. As with representations between a husband and a wife, conflicts of interest are often present when an attorney represents multiple family members. In fact, it is more likely that a conflict will arise at some point when an attorney represents multiple generations.

The engagement letter should fully address the scope of the engagement and potential conflicts that might arise in the future. The attorney should explain the differences between joint representation, independent representation, and concurrent but separate representation. The engagement letter should also address the ethical duties and responsibilities that may be involved in the representation and come to an understanding with the clients as to how the representation is structured.

For example, in a family business setting where multiple family members retain the same attorney, there should be an understanding as to how the lawyer should respond if he or she obtains information from one client that might defeat the plan of another client, or where the possible future actions of one client may affect the interests of another client. For example, what if a senior generation member decides to sell a business rather than to bequeath it to a child. What are the communication responsibilities or expectations of the attorney? Specifically, do the family members consent to the disclosure of all confidences among all family members or do the clients prefer that all confidences be maintained only between groups. Another issue is whether the estate plans of various family members should be shared among all family members. Also, if conflicts do arise and the multiple representations fall apart, do the clients consent to any of the representations continuing.

CONCLUSION

Transitioning the ownership and management of a family-owned business from one generation to the next is difficult and requires careful planning. Most family businesses fail to accomplish this feat. There are many professionals who counsel or consult with business owners as to how to structure a succession plan, but much of the attention is focused on minimizing estate and income taxes. While tax planning is important, as illustrated in this article, it is also critical to focus on the non-tax obstacles that may prevent or hinder a client’s business from successfully transitioning to the next generation.

EXHIBIT A

Language Regarding Closely Held Business Interests

Closely Held Business Interests. The Grantor recognizes that the trusts administered under this Trust Agreement may own an interest or interests in what are commonly called ‘‘closely held’’ business entities, including corporations, limited liability companies and partnerships, and further recognizes that the ownership of such interests will, or may, impose added burdens of administration and management upon the Trustees. Without in any manner wishing to reduce or limit the generality of any other powers or discretion conferred on the Trustees by this Trust Agreement, the Grantor specifically grants to the Trustees with respect to any such closely held businesses the following powers to be exercised by the Trustees from time to time, in the Trustees’ absolute discretion, without prior authority of any Court:

(a) To retain and continue any interest in any such business or any successor thereto, for so long as the Trustees shall deem advisable, with no requirement for diversification and without regard to the proportion which the value of such stock, membership interest or partnership interest may bear to the value of the total assets of any trust created under this Trust Agreement. Such investment shall be deemed for all purposes to be a proper investment by the Trustees serving hereunder.

(b) To direct, control, supervise, manage, operate or participate in managing or directing any such business, either directly or by appointing agents, managers, officers or employees, including themselves or either of them, any beneficiary hereunder or any member of the Grantor’s family, to whom any necessary power, discretionary or otherwise, may be delegated.

(c) To engage, compensate or discharge, or, as stockholder or member, to vote to engage, compensate or discharge such directors, managers, agents, employees, attorneys, accountants, consultants or other representatives as the Trustees shall deem advisable, including themselves or either of them, any beneficiary hereunder or any member of the Grantor’s family. The Trustees may deal in an individual capacity or as a director, officer, member or manager of such business with themselves as Trustees hereunder, in spite of any selfdealing prohibition otherwise applicable, and shall have no higher standard of duty than if such trust were not so interested. Any such actions shall be binding and conclusive upon all of the beneficiaries hereunder as though no relationship or possible conflict of interest existed. The use of this power by the Trustees to elect themselves or either of them, a beneficiary or members of the Grantor’s family as directors, managers, agents, employees, accountants, consultants or other representatives, and the receipt by such individuals of any salaries or other compensation shall in no way be deemed to be in conflict with the loyal performance by the Trustees of their duties and responsibilities and shall not reduce their commissions.

(d) To engage third-party independent vendors and contractors (including any vendor or contractor which is related or affiliated with a member of the Grantor’s family) to provide products and services to the trust for a commercially reasonable cost.

(e) To sell or liquidate any interest in any such business at such time or times, for such prices and upon such terms and conditions as the Trustees shall deem advisable, and in connection therewith to make any such sale to anyone including a person who is interested as beneficiary hereunder.

(f) To participate in mergers, consolidations, reorganizations or liquidations involving such business. (g) To invest or employ in any such business or to lend any such business, or to use as collateral for loans to any such business any other assets held in trust hereunder.

(h) To organize a corporation or corporations, limited liability company or companies or other legal entity or entities under the laws of the applicable state law or country and to transfer thereto all or any part of the property or operations of any such business; and to receive in exchange therefor such shares of stock, of one or more classes, such membership interests, or such bonds or other obligations of such corporation, limited liability company or other entity as the Trustees shall deem advisable.

(i) To treat any such business as an entity separate from any trust hereunder. In any accounting, the Trustees may report the earnings and condition of the business in a manner conforming to standard accounting practice and, for the determination of what is income and what is principal, they may employ the standard practices observed in the management of business entities of like character. Allocations between principal and income made by my fiduciaries pursuant to the foregoing authority shall be accepted as final.

(j) To borrow money and to pledge or mortgage any property of any such business for any term.

(k) To value any such business annually or less frequently for any purposes including the determination of the commissions or compensation due the Trustees. In arriving at such valuation, the Trustees may use any methods which they, in their sole discretion, deem advisable, including, without limitation, any method appropriate to determine the value of such business for purposes of federal gift or estate tax proceedings, or may obtain the opinion of an independent valuation company. In the event that the Trustees shall obtain valuations as aforesaid, they may pay the reasonable costs of such appraisals from the principal of any trust created hereunder. In addition, the Trustees may estimate the value of such business from year to year and retain their commission based on such estimates. Any such estimate made in good faith shall be conclusive and binding on all persons interested in any trust created hereunder.

(l) To exercise, with respect to retaining, increasing or disposing of an interest in any such business, all rights, powers, privileges and discretions which the Grantor might exercise if personally present and acting for her own account and to make any contract or agreement, whether or not with any person otherwise interested herein, binding on any trust hereunder.

(m) S Corporation Stock. If at any time any trust administered under this Trust Agreement holds stock in an S Corporation, the Grantor intends such trust to qualify to be an S Corporation shareholder. No share shall be set apart pursuant to this Trust Agreement for any person who does not make a valid QSST election or on whose behalf such election is not made, unless either (i) such trust is a grantor trust for income tax purposes and such an election is not necessary to qualify such trust as an S Corporation shareholder or (ii) such trust is an electing small business trust; provided that the Trustees shall have the power to eliminate this requirement with respect to any such share. For purposes of the foregoing:

(A) The term ‘‘S Corporation’’ means a corporation so defined by Section 1361 of the Internal Revenue Code.

(B) The term ‘‘QSST election’’ means the election required to qualify a trust to hold S Corporation stock under Section 1361(d) of the Internal Revenue Code.

(C) The term ‘‘electing small business trust’’ means a trust defined in Section 1361(e) of the Internal Revenue Code.

Being aware that risks must be taken in operating a business, the Grantor directs that the Trustees shall incur no liability for any loss which may be sustained by reason of retaining, selling, managing, or in any way administering any such closely held business interest, whether caused by the Trustees’ action or inaction, except if such loss is the result of the Trustees’ bad faith, deliberate wrong or gross neglect. Any compensation which the Trustees may receive while acting as an officer, director, manager, agent or employee of any such closely held business, shall be theirs absolutely, and shall not be applied against any compensation otherwise payable to them as trustees hereunder. The Trustees, however, may not take any action or be limited in any way which would in any way jeopardize any federal or state marital deduction for property passing at the Grantor’s death and nothing herein shall contravene the right of the Grantor’s spouse’s with regard to unproductive property held in a marital trust.

EXHIBIT B

Language Regarding a Family Advisory Committee

Family Advisory Committee. The Grantor hereby establishes a Family Advisory Committee. This Committee shall have such purpose and shall operate as follows:

(a) Initial Members. The initial members of the Family Advisory Committee shall consist of the Grantor’s children, namely, ______, ______, and ______.

(b) Purpose. The purpose of the Family Advisory Committee shall be to provide non-binding advice to the Trustees, if and to the extent, the Trustees request advice in regard to Family Group Decisions as defined in this Trust Agreement.

(c) Voting of Committee Members and Rules of Procedure. The Family Advisory Committee shall act by majority decision. The Trustees shall provide all Family Advisory Committee members with notice of and information concerning a proposed Family Group Decision no later than 10 days prior to making such decision by the Trustees and shall arrange for a meeting or conference call at which at least a majority of the members of the Family Advisory Committee are available to participate; provided, however, no notice or information shall be required to be provided prior to making a decision and taking action if a decision must be made immediately in the sole discretion of the Trustees, and in such case, the Trustees may make such decision and take the related action without providing notice or information to the Family Advisory Committee, but instead, shall notify the Family Advisory Committee of the decision made and action taken within the 10-day period following such decision or action. The information provided by the Trustees prior to making a decision and taking action shall include in reasonable detail the benefits and detriments of such decision and action and the proposed course of action.

(d) Trustee’s Decision Binding. The decision with respect to how to proceed concerning a Family Group Decision shall be made in the sole and absolute discretion of the Trustees notwithstanding any advice provided to the Trustees by the Family Advisory Committee. Any decision of the Trustees shall be binding upon all persons interested in the trust estate even if inconsistent with or contrary to the Advice provided by the Family Advisory Committee.

(e) Compensation. Each Family Advisory Committee member shall be compensated in the amount of ______ per month which shall be treated as an expense of administration.

(f) Succession of Committee Members. Only descendants of the Grantor are eligible to serve as a member of the Family Advisory Committee. A member of the Family Advisory Committee may resign, without the necessity of obtaining the approval of any court, at any time upon 30 days’ notice in writing by registered mail addressed to the other members of the Family Advisory Committee, the Trustees and the Grantor’s other children who are then living. A member of the Family Advisory Committee shall be deemed to have resigned if he or she becomes incapacitated. Upon the death, resignation, or incapacity of a member of the Family Advisory Committee, the majority of the remaining members of the Family Advisory Committee who are then living shall appoint the successor member of the Family Advisory Committee, and if a majority of remaining members who are then living cannot agree, then the Trustees may appoint a successor member of the Family Advisory Committee.

(g) Exculpatory Provisions. Each member of the Family Advisory Committee shall serve in a nonfiduciary capacity and shall not be liable to any beneficiary of the trust for exercising his or her powers (or failing to exercise his or her powers) as provided under this Trust Agreement. Without limiting the generality of the foregoing, each member of the Family Advisory Committee shall have no liability to each other or to any other person with an interest under this Trust Agreement.

(h) Family Group Decisions. Family Group Decisions are decisions the Trustees have discretionary authority to make under the terms of this Trust Agreement involving:

(i) The annual budget for the operation of a closely held business entity;

(ii) The sale, lease, improvement, finance, refinance of or other transactions involving an asset of the business entity if the amount of the transaction exceeds $250,000, which was not included within an annual budget previously disclosed to the Family Advisory Committee; or

(iii) Any other matter which a majority of the members of the Family Advisory Committee shall designate as a Family Group Decision.

ENDNOTES

1 See Eric A. Manterfield & Patrick L. Emmerling, Family Feud — Hollywood May Call It Entertainment But It Is No Laughing Matter for Family Businesses, Part I: An Analysis of Business Succession Planning from the Perspective of Maintaining Family Harmony, 41 Est., Gifts & Tr. J. 179 (Sept./Oct. 2016).

2 Karl Bareither & Tom Reischl, Planning a Family & Business Legacy: A Holistic Approach to Wealth Transfer Planning for Entrepreneurs, Business Owners & Family Members 20 (2003).

3 Id. at 20.

4 Id. at 20.

5 Eric A. Manterfield, Getting Family Business Owners Off the Dime: How to Get Them Started on Estate and Succession Planning, 41st Notre Dame Tax and Est. Plan. Inst. at 25-9 (2015).

6 Id.

7 Avi Z. Kestenbaum, Avi Z. Kestenbaum & the Family Business Succession Planning Crisis: A Call to Action, http://www.leimbergservices.com.

8 Bareither & Reischl, n. 2 above, at 36. See also Kestenbaum, n. 7 above.

9 Manterfield, n. 5 above, at 25-9.

10 All section references are to the Internal Revenue Code of 1986, as amended, and the regulations thereunder, unless otherwise specified.

11 Manterfield, n. 5 above, at 25-11.

12 See Rollins v. Rollins, 741 S.E.2d 251 (Ga. Ct. App. 2013).

13 Manterfield, n. 5 above, at 25-15.

14 See Miller v. McCaskey, 568 N.E.2d 170 (Ill. App. Ct. 1991).

15 Manterfield, n. 5 above, at 25-17.

16 Id.

17 There are gift and estate tax rules when engaging in preferred partnership freeze techniques. Section 2701 provides special valuation rules for transfers of junior equity interests in a corporation or partnership when the transferor or an applicable family member retains certain interests. This article is not intended to discuss the tax rules of preferred partnership freeze techniques but is limited to discussing how preferred interests may be utilized in addressing the dynamics that come into play between passive owners and active owners.

18 David Gage, Avoiding Costly Legal Battles Through Mediation (Apr. 1990), http:/bmcassociates.com/resources/articles/avoiding-legal-battles-through-mediation.

19 See Manterfield, n. 5 above, at 25-13.

20 If the annuitant is ‘‘terminally ill’’ (defined as having at least a 50% probability of dying within one year of the transaction) the general actuarial assumptions cannot be used. However, if the annuitant lives for 18 months after the transaction, he or she is presumed not to have been terminally ill unless the contrary is established by clear and convincing evidence. Reg. §25.7520-3(b)(3).

21 Model Rules of Prof’l Conduct, Preamble and Scope §20 (Am. Bar Ass’n. 2016).

22 See ACTEC — Engagements Letters: A Guide for Practitioners (2d. ed. 2007), http://www.actec.org/assets/1/6/ACTECEngagementLetters-2ndEd.pdf.

23 Id.

24 Id.

Authors

Eric A. Manterfield, Esq. (Retired)*, Krieg Devault LLP, Indianapolis, Indiana
Eric A. Manterfield is a retired partner in the Indianapolis, Indiana law firm of Krieg DeVault LLP, where he concentrated his practice in estate planning, family business succession planning, charitable planning and probate and tax litigation. Eric is an Indiana Board Certified Trust & Estate Lawyer by TESB. Eric is a magna cum laude graduate of Denison University (Phi Beta Kappa). Eric received his law degree from the University of Michigan Law School in 1972. He was identified in 2009 by Worth magazine as among the top 100 estate planning attorneys in the United States. Eric is listed in ‘‘The Best Lawyers in America,’’ ‘‘Indiana’s Best Lawyers,’’ and ‘‘Indiana Super Lawyer.’’

Patrick L. Emmerling, Esq., Bond, Schoeneck & King PLLC, Buffalo, New York
Patrick L. Emmerling, is a member of Bond, Schoeneck & King, PLLC and concentrates his practice in estate planning, family business succession planning, charitable planning and estate administration. He is also a certified public accountant. He received his B.S. (summa cum laude) from Canisius College and a J.D. (magna cum laude) from the University of Notre Dame. Patrick is listed in ‘‘Best Lawyers in America’’ and ‘‘New York Super Lawyer.’’