Let’s face it…good jobs are harder to find nowadays.
So count yourself lucky if you’re born into a family that owns a business. That’s assuming you are interested in the business in the first place?
Take Faith for example; she grew up in her dad’s shop from the time she was knee-high. She has never considered any other option besides the family business. Finally, her dad has decided to step back and allow her to run the show.
But before Faith jumps in headfirst, she needs to ask a few questions:
What type of business entity are they running?
Faith’s dad has always been his own man. Because there was just too much red tape involved in starting a private company, he decided to open a shop as a sole proprietor instead.
What this boiled down to was that everything in the business was owned in his personal name. If the business failed, then not only would his creditors take the business lock, stock and barrel, but they’d also grab his house and other belongings.
And what if his wife got into debt? Since they were married in community of property, anyone she owed money to could wreak havoc in the business.
Faith and her dad agreed that things couldn’t continue like this.
If Faith was going to have a stake in the business, then they’d need to form a partnership, but even that was little better than two sole proprietors working together. Since close corporations are no longer an option, they decided to form a private company.
A private company offered several advantages:
- The business was now a separate legal entity from Faith and her dad. This meant that if Faith fluffed up they wouldn’t repossess her dad’s home…or his furniture.
- It allowed them to have perpetual succession. In other words, the business would not need to be sold when her dad eventually passed away. Faith could simply take over her dad’s share of the business and carry on as if nothing had happened.
- It also meant that Faith couldn’t sell her share of the business to the competition if her dad upset her…or the other way around. Now, Faith would have to offer her shares to the remaining shareholder first, and this would be her dad.
Since Faith and her dad each owned 50% of the business, it brought up the topic of what would happen when Faith’s dad eventually passed away.
Who is really in charge of the business?
There is always going to be a clash of heads over who runs the business – Faith or her dad. What neither of them has considered is what happens to the business if the dad were to pass away next week?
Remember that relationships between her dad and creditors had been built up over twenty years. The same thing with the banks. A lot of them might get nervous when dealing with Faith instead of her dad.
What they needed was Keyperson insurance.
Keyperson insurance would guarantee that there would be cash available to take care of existing creditors and keep the banks happy.
Keyperson Insurance would take care of any cashflow problems, but it would also create a problem.
The problem being that it was a “family” business. The SA Revenue Services defines a “family company” as one where a close relative can control the company.
Remember that Faith and her dad each owned 50% of the company. So, even though the dad wasn’t the majority shareholder, they were direct blood relatives. In other words, the ‘family’ would benefit.
Keyperson insurance becomes a problem upon her dad’s death since it would be included in his Estate, with a potential tax problem. The company may have to pay any Estate duty which could amount to 20% of the proceeds.
And who would take care of mom?
Yes, Faith loves her mom to bits, but it might be a bit too much to expect of her to take care of her for the rest of her life. After all, what happens if the business fails in year five, and there’s no money left to take care of her?
The solution to this problem is a buy and sell arrangement between the two shareholders, financed by life insurance.
If Faith’s dad passes away, then Faith is guaranteed an amount which:
- she pays to her mom in terms of the agreement, and
- In return her mom signs over her dad’s shareholding in the business.
The advantage of the buy and sell arrangement, in combination with the life insurance, is that the proceeds are exempt from Estate duty.
Think about it:
- If the dad’s 50% portion of the business is worth R5 million then his Estate should reflect only that. But Faith owns R5 million worth of life insurance on his life. This boosts his Estate from R5 million to R10 million.
- With a valid buy and sell arrangement in place, the R5 million life insurance is deductible within the Estate. Without a buy and sell arrangement it isn’t.
- Faith wants to hand over the R5 million life insurance to her mom, but wait, there is no buy and sell arrangement in place. She will have to settle the Estate duty first. After paying the 20% Estate duty, Faith doesn’t have R5 million to give mom.
- Mom refuses to hand over the R5 million business until Faith comes up with the full R5 million
A valid buy and sell arrangement exempts the R5 million life insurance from Estate duty.
Other great reasons for having a buy and sell arrangement are:
- It provides the ready cash when needed. No having to borrow money and pay interest on a massive bank loan
- Faith’s mom needn’t worry about receiving her fair share for the business, and
- Faith doesn’t have to worry about having her as a shareholder
Conclusion
Owning a family business is great. Who better to trust than your spouse behind the till? But when things go wrong, it can rip a family apart.
In the spirit of “Umuntu ngumuntu ngabantu” let’s remember that we are who we are because of others. Let’s take the time to protect those close to us and make sure we think about the financial decisions we make, especially in family business arrangements.
Address the risks mentioned above and you’ll be well on your way to running a successful family business.
Until next time.
The Wise About Life Team
