An effective succession plan is one of the most vital strategies for a business to have, with countless factors that can lead to a change in business circumstances, whether it be retirement, disputes, health or something else.
A recent case highlights what can go wrong in business succession where expectations are misplaced, resulting in litigation between members of a family. It is a cautionary tale for all business owners, no matter how big or small your business is.
The story
Here’s what happened
- A couple ran a business through a discretionary trust. The couple’s son worked in the business for many years.
- The trust’s business profits were mostly appointed to the father and mother, but much of it was reinvested back into the business. This meant that a growing unpaid entitlement accrued over the years, owed by the trust jointly to the couple.
- The son was never paid a proper wage, but the arrangement with his father was that the son was “building equity” in the business, and that one day it would be “his”.
Sadly, the father died, which led to the following:
- The trust’s unpaid profit entitlement of about $1 million was now owed solely to the mother.
- The son succeeded his late father as the Appointor of the trust. This meant the son now held the power to remove the trustee of the trust and appoint a new one.
- The son removed the existing trustee, and appointed himself and his sister as trustees. The son was now in control of the trust and all of its assets.
- Through a series of journal entries in the trust’s accounts, most of the accrued $1 million profit entitlement owing to the mother “disappeared”.
The mother sued her son and daughter (as trustees) for the $1 million profit entitlement owed to her.
What went wrong
The main cause of this business’s problems is that the owners did not have an adequate or effective succession plan in place, and no one in the family really understood the wider, albeit quite normal, implications of the business being operated through a discretionary trust (a stock-standard, every-day small business structure). The son seemed to think he would inherit the business in return for his years of underpaid contribution. However, the business assets in the trust cannot be dealt with through anyone’s estate. There was nothing for the son to “inherit” that would become “his”, and he was not building equity in anything. Rather, it is the control of the trust that is passed on.
Although control did pass to the son, it seems that he mistakenly thought that the trust came only with the business’s assets. That is, it seems he was unaware that the trust also came with over $1 million in liabilities (owed to his mother). After all those years working in the business for no real money, he now discovered that what he got out of the “family arrangement” was of little net value. We can only speculate that he perhaps felt a little ripped off.
The son’s “solution”
The son’s apparent solution was to eliminate most of the liability the trust owed to his mother. The supposed result was that the trust no longer owed his mother anywhere near that $1 million. Again, merely speculating, but perhaps the son thought this would make up for the wages he had forgone over the years, and the promised “equity” in the business that turned out to be non-existent.
The problem, however, was that the solution was clumsily implemented by a series of journal entries in the trust’s accounts that were not readily explainable, and did not seem to represent any real transactions. And that’s the key – the mere passing of journal entries achieves nothing. All journal entries do is record an already executed transaction. But if there is no validly executed transaction in the first place, mere journal entries are meaningless.
In the end, the Court determined that the journal entries had no effect. That meant the accrued $1 million entitlement owing to the mother still existed, and the trust was liable to pay it.
The lesson
This saga came about because the business’s owners did not understand that their “family arrangement” conflicted with commercial reality. Unfortunately, a lack of effective succession planning can have consequences which are stressful, expensive, and cause long-lasting rifts which drive the remaining family members apart.
It is critical for business owners to work with their trusted advisors to guide them through this crucial phase to ensure the best solutions are reached for themselves, their families and their business. It is also key that the details of the plan are communicated early and clearly to all parties involved so that there are no surprises.
Talk to your trusted Nexia advisor about any informal arrangements you might have in your business – with family or non-family. They might have created false expectations, and better to resolve it now than leave open the possibility of things going the way they did with this family.
Article by David Montani2021
