Fair vs. Equal

When the Affordable Care Act (ACA) went into effect in January 2013, it came with an unexpected consequence that family business shareholders are still scrambling to understand. The new 3.8% tax on earnings hits shareholders who are considered passive investors in S corporations — generally those who work fewer than 500 hours a year in the company. As many of our clients are discovering, the financial impact of the tax can quickly jump to the six figures and continue to increase as the company becomes more successful.

In the case of one founder who left his thriving business to his three children in equal one-third shares, the tax has raised an important question: What if “equal” isn’t equal after all? One sibling works in the business and sits at the helm. Another works full time in a separate industry. The third, a homemaker, prefers to focus on family life. All three feel strongly connected to the legacy that their father created and wish to pass the business down to their children. But now two of them must pay sizeable taxes as passive investors, while one does not. Even in the most loving relationships, this can cause stress — both in the family and in the business.

This family business earned $15 million in taxable income last year. As shareholders of a passthrough entity, an S corporation, the two siblings who do not work in the business must pay $190,000 each to satisfy the ACA tax. This means that the company must distribute $380,000 to them just so that they can pay the additional 3.8% tax to the government. But since the company cannot make unequal distributions to two of the shareholders without making a pro rata distribution to the third, the active investor also receives a distribution of $190,000 — which goes directly into his bank account.

Is this “fair”? None of the siblings created this situation, yet two are personally penalized, and one is seemingly rewarded. Some advisers are suggesting to clients that all passive investors become active ones by creating employment opportunities for them within the company. In our experience, this is a nearsighted approach that does not take into account the complex reasons why some family members choose not to work in the business. Would it be worthwhile to leave behind a promising career, albeit in a different industry, or a satisfying home life? What would it take to ramp up and make a meaningful contribution to the family business? The flip side of this argument — that outside family members should remain outside the business — is equally compelling. Many family businesses don’t employ some family members precisely because of the impact this practice could have on key nonfamily staff, morale or a hard-won merit compensation system that would be compromised by “makework” activities in the business merely for tax-planning benefits.

Three Alternatives

If switching passive owners to active ones is not the solution for most families, then what is to be done? Broadly speaking, there are three alternatives: (a) change the corporate structure; (b) live with the difference; or (c) find some ways of equalizing the differences. A change in corporate structure may be a workable solution in some cases, but our experience suggests that the owners will pay a heavy price in terms of their overall tax burden by choosing this alternative. There’s a reason why so many businesses choose the S structure in the first place.

The second alternative — living with the differences imposed by the new tax — is certainly possible for some ownership groups. Beyond the potential for conflict that it can cause, however, this solution can also impede a healthy transition of leadership and ownership to the next generation. It can be costly both to the individual and to the company for active owners to leave the business, which encourages them to stay active as long as possible, even they no longer have the relevant skills, passion, or energy to add real value. Staying on at the helm can get in the way of the leadership transitions that are necessary for long-term success. Owners may also be discouraged from passing shares to the next generation, such as through GRATs, if the recipients must pay a tax for being passive that the donor didn’t have to pay at all. Unbeknownst to the policymakers responsible for the Affordable Care Act, the legislation created a tax “bias” that will carry serious estate plan consequences and delay the process by which the next generation will become responsible stewards of the family enterprise.

Therefore, we recommend considering other options to “equalize” the tax burden. These solutions may lessen the emotional toll on the family and the strategic consequences on the company. These options may not be perfect, but they are worth exploring.

  1. Establish a family understanding of what to do with the “extra” distributions. Active investors may choose to contribute any additional distributions they receive to fund the family foundation or a retreat for the broader family. This would be an informal family understanding and not a legally enforceable rule, but it could lessen the emotional sting of one branch profiting more than others.
  2. Consider cross-gifting. Active shareholders could consider making gifts to their nieces and nephews in the other branches. Gifts up to $14,000 per person are excluded from gift taxes. A married couple can give $28,000 to each niece and nephew a year without incurring gift taxes. While this may not make up for the full financial difference, it could promote family harmony by spreading the wealth.
  3. Compensate passive investors through director fees. Passive investors may be compensated for assuming roles on the company’s board. Active employees may consider their board role as part of their overall responsibilities and not receive compensation. It is important, however, that all board members be appropriately qualified to take a seat on the board, and a development program may be needed to get shareholders up to speed.
  4. Look at the broader portfolio. If the company has multiple business entities, it may be possible to make distributions from the other lines of business. This strategy would need to be carefully examined in order to avoid unintended tax consequences.

These options are just a few ways to make the ACA’s tax bias less inflammatory to all family owners of an S corporation. Some solutions can be implemented through discussions within the family; others may require detailed analysis by the company and outside tax and legal specialists. We strongly advise family business owners to carefully evaluate all options before making drastic, irrevocable decisions as a way of avoiding the ACA tax. After all, the tax is relatively new and may be revised at some point.

Fair vs. equal

As with so many issues in family businesses, this one comes down to values rather than money. In tax as in life, “fairness” is often a matter of perception rather than fact. A shared philosophy about what fairness means to the family owners will go far to set the stage for addressing perceived inequalities in the manner that’s least disruptive to the family and its business.

For example, consider two starkly different beliefs about fairness and equality:

  1. All owners should receive the same slice of the dividend pie even if doing so reduces the total size of the pie.
  2. Owners should maximize the size of the total pie and make each slice as close to the same as they reasonably can.

Those who ascribe to the first viewpoint may believe that sacrificing some returns for the sake of harmony is a trade-off well worth making. Adherents of the second may believe that “what comes around goes around,” since ownership status may change in the future (such as in the next generation) and it is most important to retain as much wealth as possible for the family overall.

If strict after-tax equality is the family’s understanding of fairness, then corporate restructuring may be required to accommodate that goal. Even with the most dramatic of restructurings, however, differences in state, federal and even international tax regimes may make exact equality elusive. On the other hand, if equality is an aspiration rather than an absolute requirement, the family may exercise creativity in considering the options described above, like differential director fees for non-employee directors. Doing so can realistically and pragmatically share the tax burden without imposing a burden of full equality on the business.

By making this a discussion about the underlying principles, family owners are much more likely to achieve a lasting consensus that can guide decisions in the future as the tax laws evolve. If family members can sit down and have difficult but fruitful conversations about what fairness means to them, an unequal situation may even feel fair.

First Published in the July/August 2014 edition of Family Business Magazine