Premium Advice: Extracting corporate value for HNW families

The majority of wealthy people’s net worth is usually tied up in corporate assets. While holding liquid investments, property and other assets, the bulk of the wealth created is often the result of rapid growth of corporate shares. Ultimately, though, how do they turn those shares in cash for legacy creation?

Many successful families “purify” their operating companies by placing their passive corporate assets (cash, stock, debt instruments, mutual funds, segregated funds, cash value life insurance) inside of holding companies. Since the majority of operating company assets must be “active assets” (such as inventory and equipment) to qualify for the small business tax rate and allow for capital gains exemptions, holding companies can end up with significant value over time. Even when small business tax rate planning is not a concern, holding companies often own the shares of the operating company, or proceeds of the sale of a business. So how do advisors working with high-net-worth clients extract this value?

Let’s consider the case of Linda and Scott MacIntosh, a 60-year-old couple. Linda’s parents were relatively successful land developers. After offering Linda and Scott partnership interest in their first property, the parents were proud to see their daughter and son-in-law reach levels of success they’d never experienced themselves. Grateful for the assistance and guidance they received from her parents, the MacIntoshes now want to ensure that their three children (22-year-old son and 25-year-old twin daughters) also receive their assistance and guidance, without receiving “handouts.”

They’ve engaged the full services of an advisor team that specializes in multigenerational planning and coaching, and plan to work in consultation with their accounting and legal team. The MacIntoshes are already aware that the purchase of life insurance is an effective method of paying taxes owing on death. So their tax professionals are working diligently to structure their affairs such that they minimize and quantify that tax payable on deemed disposition of their shares at death.

In the meantime, their advisor asked them to describe the ideal situation for their children. Linda and Scott said they wished to allow their children to learn the skills of strategic planning, negotiation and disciplined management, while eliminating any risks to the family business during their learning phase. As Linda’s father once said to her, “If you do the right things, for the right reasons, with prudent, disciplined management, success and social good are the inevitable result.” Addressing their fear of the kids becoming “trust fund babies,” their advisor reminded the MacIntoshes that money doesn’t ruin people; it simply amplifies any faults or strengths people have. Building strong character in their children will be as important as building astute financial structures to see that their family legacy not only survives, but thrives.

After further fact-finding, their advisor finds they have $5 million of free corporate cash flow that they can divert to ideas that can accomplish their goal. Their advisor suggests they set up a family trust, which will own a portion of the shares of their holdings, representing a share of the future growth of these shares. The children will be beneficiaries of this trust, and thereby allow the parents to maintain some control via the trust until such time as they feel comfortable giving the children more control.

The advisor also recommends a charitable foundation. Being civic-minded, the MacIntoshes already donate 10% of their profits to various charities. By setting up a charitable foundation and having the children direct its day-to-day affairs, the children will have the opportunity to learn operational discipline and be provided with a training ground for strategic planning, negotiation and management skills, all while giving to various needy causes. Initially funded by a lump sum and future donations of profits, the foundation will ultimately be funded in perpetuity via a lump sum death benefit provided by life insurance.

Their advisor also suggests that the MacIntoshes purchase two single life policies on Linda and Scott, rather than a joint and survivor plan, to create more flexibility. At different intervals, the passing of each parent will create a large lump sum to fund the foundation or provide liquidity into the family trust, depending on the needs at that time.

By using their holding company’s corporate cash flow to buy the insurance, the corporation will receive a tax-free capital dividend account (CDA) for the death benefit (in excess of the adjusted cost basis) and have the ability to either retain that CDA credit for future use if the money is paid out to the foundation, or use that CDA credit to pay tax-free capital dividends into the trust. Once in the trust, the cash can be invested further, or flow to the children based on the terms of the trust.

By creating a foundation, they are formalizing their desire to give back and create regular structure and flexibility around their gifts. At the same time, they create an entity through which the children can learn valuable life skills. The family trust allows the MacIntoshes future flexibility in how to involve the children in the business, yet create incentive for them today to educate themselves on how to create future success.

Chris Paterson has 14 years’ experience in the insurance industry.

(09/24/09)