An Estate Freeze Is Only the Tip of the Iceberg in Succession Planning

This article was obtained from an interview conducted by Ian R. Campbell, the author of the differently messaged business succession book 50 Hurdles: Business Transition Simpflied, and the mind behind the business succession website BusinessTransitionSimplified.com. Purchase the book here.

Used properly in conjunction with a comprehensive family business planning best practice strategy, the estate freeze tool is potentially powerful and can do good things for a family. However, I find most entrepreneurs and family members don’t understand the implications and consequences of the tool if it is used in isolation as a tax planning tool – which in my experience, it typically is.

When Estate Freezes Put Business & Family Ties on Ice

Simply put, estate freezes driven only by income tax considerations typically do more long-run harm than they do short-term good. This is often where estate freezes seem to be perceived as a proxy for a comprehensive family business transition plan, which they are not. While estate freezes may form part of a comprehensive family business transition plan, to talk about those two things in the same breath is equivalent to saying mice and elephants are both animals.

In my experience, an estate freeze is often used:

1. Purely as a tax planning tool
2. In isolation of fulsome family business transition planning and execution
3. To create accidental business partnerships that often don’t work out in the end
4. As a panacea, but isn’t at all what business owners are led to believe

In the end, an estate freeze proves to be a disaster in the contexts of both family harmony and business success or failure. In a conventional planning estate freeze transaction that is not part of a comprehensive business transition plan, two significant things typically happen:

1. The next-generation family members pay nothing by way of real consideration at the time of the freeze and, as such, don’t appreciate their “something for being a family member” (read “something for nothing”), which can lead to entitled, or more entitled, next-generation attitudes.
2. The next-generation family members inherently are placed by their parents in a form of a business partnership that most often is not well documented by written agreements, which, in the end as things unfold, often leads to acrimonious family relationships and at extremes, family litigation.

Contrary to Succession Planning Best Practice

The following are two critical observations I have made based on my extensive hands-on experience gained by offering business succession best practices to my family business clients.

First, typically when I ask a room of advisors if they would like to be in business with their brothers and sisters, I rarely get any more than 5% raising their hands. And when I ask how many clients have implemented an estate freeze based on their advice for managing taxes, about 95% of the room raises a hand. In essence, these advisors have created partnerships for the next generation that they would not create for themselves. Therefore, a comprehensive family business succession planning best practice exercise must take place and include discussion of:

1. Future business viability
2. Likely impacts of technological advances on the business and on its prospective after-tax free cash flows
3. Post-freeze decision making
4. Post-freeze family member employment and compensation
5. Possible strategic purchasers for the business
6. Whether an arm’s length sale is a better transition strategy during normal and low interest rate economic environments
7. Post-freeze business value growth rates under continued family ownership
8. Corporate governance implementation under continued family ownership
9. And multiple other important discussion points

Second, over many years, I’ve seen very many parents implement an estate freeze and subsequently come to focus on the facts that include, but are far from limited to:

1. They (the parents), without thinking all of the consequences through, put their children into a family partnership without any robust or meaningful conversation.
2. Neither they nor their children at the time of the freeze understood all of the business and personal implications of the “income tax driven” transaction the parents initiated and documented.
3. The next-generation partners aren’t all necessarily interested in the family business other than for the lifestyle it provides them.
4. The next-generation partners aren’t all necessarily equipped to participate in the family business as either executives or employees.
5. The “children business partnership” was structured (typically) without shareholder agreements being executed and if such an agreement were executed, that likely occurred in circumstances where the children may not have been represented by independent legal counsel.
6. There may have been inadequate consideration given to problems that might arise in the next generation, pursuant to matrimonial law.
7. Their children had not focused on the fact that they were indirectly entering into a business partnership with their siblings and parents.
8. It is not a good thing to be in a business partnership with one or more people, in this case siblings, that you wouldn’t necessarily have yourself chosen as a business partner.
9. Without a common business vision and without the next-generation owners sharing a common business risk profile, the business partnership is likely to end up in disagreement and disarray, or worse.

The Chilling Conclusion on Estate Freezes

An estate freeze may prove to be an effective way to manage taxes. However, an estate freeze will often be perceived to solve short-term problems only to lay the foundation for substantive long-term problems. Stated differently, an estate freeze can, in the end, be akin to the athlete who “snatches defeat from the jaws of victory.”

At a minimum, where an estate freeze is done to better manage taxes, there should be an agreement signed by the shareholders that states how family members can monetize their interest and leave the real ownership to those who want to carry on the business.

An estate freeze used in conjunction with a well thought out comprehensive family business succession planning best practice exercise can be a great tool if all stakeholders understand the purpose and the mechanics behind the estate freeze and how it logically fits into the larger planning strategy. And that’s where robust and meaningful family and expert communication comes in.