August 1, 2014

How a Family Holding Company Can Be Used to Transfer Wealth and Bind a Family’s Economic Future Together

We’ve talked about how a holding company works in the past, provided a beginner’s explanation of holding companies, and even looked at two high profile private holding companies, Walton Enterprises, LLC and Cascade Investment, LLC.  I even gave a very basic explanation over at About.com as to how family members can invest together through a limited liability company.

Tonight, I thought I’d go over a very basic, very simplified explanation of a much more advanced concept that isn’t appropriate for most people but will show how a family holding company can be used to gift millions of dollars tax-free to heirs and others, while retaining control of assets and binding a group together economically.  This is a high-level, conceptual explanation.  Do not act on any of this without consulting with your own tax attorney, tax accountant, and other qualified advisers.

The Basics of a Family Holding Company

Imagine you wanted to setup a family holding company to serve as a central investment vehicle to teach your children or grandchildren about money, business, finance, economics, and create a central entity that held everyone together through regular family meetings.  You approach a good attorney and accountant and, in compliance with your specific tax situation and the legal rules in your state, you setup the entity.  

It would be easier to walk you through the basics of the process in a fictional illustration.  In this example, let’s pretend I am a 65 year old retired manager with four kids, all of whom are married, and twelve grandchildren.  In our pretend world, I am sitting on a portfolio worth $5,000,000 that I want to begin transferring to the next generations in a tax-efficient way.  That means there are twenty people involved besides my spouse and me: four kids, four sons-or-daughters-in-law, and twelve grandchildren.  I establish a company called Kennon & Kennon, LLC in the state of my choice, most likely Nevada, Delaware, or my home state.  I opt for partnership taxation on an individual level, bypassing the personal holding company tax.

Kennon and Kennon Family Holding Company

Next, I contribute some common stocks to our fictional family holding company, all of which have built-in capital gains.

Family Holding Company Stocks

Finally, I contribute some real estate holdings, local businesses, and shares of a community bank to our fictional family holding company.

Private Businesses and Real Estate in a Family Holding Company

Now, in our made-up entity, my theoretical 65-year-old spouse and I are sitting on 100% ownership of a company called Kennon & Kennon, LLC that holds common stocks, real estate, and shares of private businesses.  The firm’s assets are $5,000,000.  It has no debt.  Thus, net worth is also $5,000,000 before accounting for capital gains taxes due on the built-in profits from appreciated securities.

Over the long-run, based on the holdings in Kennon & Kennon and current market levels, imagine I expected a long-term rate of return of 8%.  That means the company has a net worth of $5,000,000 but I’m expecting it to earn $400,000 through a combination of profits, dividends, interest income, rents, and capital gains.  

My attorneys write-up a great limited liability operating agreement.  In it, I am named the Managing Member and have a range of powers specifically delegated, including the sole right to determine distributions, including dividends or return of capital, to the various members.  The document also divides Kennon & Kennon, LLC into 100,000 membership units, or “shares”, each of which would be worth $50.  After all, the company has $5,000,000 in net worth and is now cut into 100,000 pieces.  At this moment, I own all of them so not a lot has changed.  

Gifting the Shares of the Family Holding Company to Family Members

The next step is to take advantage of the gift tax exclusion.  As of the current tax year, you can give $13,000 away to a person without any gift tax consequences or using up your lifetime exemption.  With your spouse, that rises to $26,000 per year.  

With twenty family members that I’d like to bring in as shareholders, this would mean my spouse and I gifting $26,000 per year to everyone, or $520,000 in total.  But the catch is, you can often go for special discounts.  For one, we are going to be able to back off the capital gains taxes that will be owed on the transferred shares, lowering the value of each gift.  For another, we can take deductions for illiquidity and limited voting rights.  It’s entirely possible you could transfer, in the right circumstances, $50,000 worth of assets to someone and claim it as only $26,000.  But this requires a lot of very good tax advice and full transparency and disclosure to the IRS as to the claims you are making.  It is not something you would do on your own without the expert guidance of good tax accountants and attorneys.  

Let’s ignore those discounts for now, which are often a vital part of lowering estate taxes and getting more money into the hands of your kids and grandkids prior to death.  Instead, let’s say that everyone gets precisely $26,000 worth of assets, or 520 membership units of Kennon & Kennon, LLC.

That means the first Christmas, I would transfer 520 shares of Kennon & Kennon membership equity into the capital accounts of each family member.  Nothing has changed.  As the managing member, I still have control over the business.  I still have control over the investments.  They can’t get their hands on this money unless I want them to, allowing me to use it as a forced savings account, if that is my intention.  In total, I’d transfer 13,520 membership units, leaving my spouse and me 86,480 membership units.

In other words, my spouse and I now own 86,480 / 100,000th of the company.  Each of the kids and grandkids own 520 / 100,000th of the company.  My stake is worth $4,324,000 and each kid and grandkid has $26,000.

The Growth Is the Secret to Giving Away a Lot of Money with a Family Holding Company

Next year, imagine the business does, in fact, grow by 8% after taxes.  The $5,000,000 in net worth would expand to $5,400,000.  With 100,000 shares outstanding, each membership unit would now be worth $54, not $50 like the prior year.  My 86,480 shares are worth $4,669,920.  Each kid and grandkid has $28,080.  In effect, I was able to gift them the extra $2,080 without counting it against my gift tax exemption because the asset is now held in their name.  It’s theirs.  

The same formula would be followed and I’d gift everyone $26,000 only this time, that would mean transferring 481 membership units to their account, not 520 shares like last year because the shares are more valuable at $54 each than they were last year at $50 each.  They are getting the same total gift value but fewer membership units.

For our second Christmas, then, I would gift 9,620 shares in total, or 481 shares per person.  This would bring my total ownership to 76,860 shares and each of the family members to 1,001 shares.

You know what?  Let’s just look at a spreadsheet to see how this would play out if you kept it up each year for a decade.

Kennon and Kennon Family Holding Company Membership Units Fictional Example

Click Image to Enlarge

Looking at our fictional Kennon & Kennon family holding company, it would be possible to give away $8,467,795 in wealth to children and grandchildren without paying a single penny in gift taxes or estate taxes.  Furthermore, this only required the transfer of $26,000 x 20 recipients for 10 years, or $5,200,000 in total.  The extra $3,267,795 that was gifted came from the transfer of economic ownership of assets to the heirs who now collect the dividends, interest income, and rents.

Let’s look what happened:

  • The fictional 65-year-old me started with $5,000,000 that he wanted to give away to children and grandchildren
  • Through joint spousal gifts, $26,000 was given of 20 recipients every year for 10 years, all in the form of shares of Kennon & Kennon, LLC
  • I retained total control, submitting tax payments for each member but reinvesting earnings without paying dividends so capital expanded at 8% per share per annum, on average.
  • At the end of the period, I was left with $2,319,205, my heirs had $8,467,795, not a penny went to the government in the form of estate taxes or gift taxes, and the total Kennon & Kennon family holding company business has a net worth of $10,787,000.

And remember: This doesn’t even include those liquidity discounts and other exemptions that would have made it possible to transfer more than $26,000 per year to heirs, while still claiming only a $26,000 gift.  Done right, you might have been able to give away much more money.

Maintaining Control of the Family Holding Company

If the operating agreement were well-written, it would permit me to retain control save for a vote of 90% or so of the membership equity, meaning I could always have the option of voting myself a salary if I ever needed cash.  I wouldn’t have to worry much about a coup or finding myself kicked out on the street.  (We aren’t discussing inter-personal issues for now.  If you need to use money to control your kids or are worried about conflicts due to dividend payouts, you have much larger issues that need to be addressed.  That is far beyond the scope of this article.)

You can also get complex.  You could, for example, create a series of trust funds and gift the shares to the trusts and deal with things such as the generation skipping tax.  You could add provisions forcing in-laws to sell out their stake in a divorce, depending upon your jurisdiction.  You can do a lot of things.  You could even match share gifts for those who saved and invested in the company dollar-for-dollar; e.g., a grandchild worked after school and earned $5,000, so you gift him an extra $5,000 in the family firm.  It really is a blank tablet upon which you can carve your own manifest destiny depending upon your family’s assets, dynamics, cultures, and values.  Many families that build family holding companies will hold required annual meetings to get everyone together and share a common bond.   

With a setup like this, you could live another couple of decades and transfer millions upon millions of dollars to your family without hitting the estate tax or gift tax, while retaining a significant equity portion yourself if you manage the capital well enough.  That is because the faster the net worth grows, the higher the share value per membership unit, meaning you transfer the same amount of money each year, but fewer shares or equity percent.  In fact, at only 8% growth, it would take only 10 years with no dividends to get the value of each share to around $108.  

There Are A Lot of Other Applications for Family Holding Companies

There are many other applications for family holding companies.  A family with a few great managers who wanted to all kick in and buy a $3,000,000 hotel together could do it whereas it may be beyond the resources of any individual branch of the family.  Of course, you don’t want to go into business with someone just because they are friend or family.  Love them all you want, but there is no reason to do something stupid with your money by investing alongside those with financially sub-optimal tendencies such as drug or alcohol dependency or gambling addictions.

You can get creative.  Imagine if you were J.K. Rowling.  You could transfer ownership of the copyrights to the Harry Potter books to a family holding company and slowly give a portion to your children, grandchildren, non-profit-charities, and other entities all while retaining total control of your characters to ensure their literary integrity. 

  • Gilvus

    This is relevant and well-presented; thank you for writing it!

    One design gripe I have is the readability of the curly font you’ve been using in your headers and titles. Other recent changes to font and layout have been wonderful – the site looks cleaner, is more readable, and loads much faster! I feel the curly font is elegant but ultimately out-of-place.  Just my humble opinion :-)

  • FratMan

    Hey Joshua, if you have self-employed income (say from blogging) and you fully fund a Roth IRA, what’s the next step? This is something I’ve been curious about for awhile. 

    • Joshua Kennon

      It depends on whether or not you make enough money to justify certain costs.  

      If you are making more than six-figures, you could transfer your blog to an LLC and hire yourself, setup a 401(k) plan, pension, or other retirement option and basically save all of your income without paying any taxes to the government.  The rules are complex, and you would need good accountants and attorneys, but you could shield almost all of the income if you were willing to lock it away until you hit 59.5 years old, at the earliest.

      You could also setup a SEP-IRA or another self-employment plan, though again, you’d need to consult with a tax accountant or attorney.  

      Long-story short, a single person should be able to save between $5,000 and $50,000 per year tax-free or tax-deferred by using those types of plans.  A married couple could get that up to $10,000 to $100,000 if they structured everything correctly.  That would be an especially attractive option if you didn’t live off your blogging income and wanted to pour it all into stocks, bonds, real estate, or other investments.

  • Efranz2920

    Would the earnings be pasted to the family members for taxation. Where will they get the funds to pay the taxes.

    • Joshua Kennon

      You can elect to be taxed like a regular c-corporation or pass-through taxation like an s-corporation. In the event you chose the latter, the relatives would either have to come up with the tax payments out of their own pocket or the business would need to make tax distributions. One popular technique is to use the membership agreement to write-in provisions that require the company to distribute enough money to pay the tax rate levied on the highest bracket to prevent the liquidity problems you described.

      If you chose the former, you would pay taxes at the corporate level but then dividends would be taxed, you might be subject to the personal holding company tax rules, and a host of other complexities that would likely increase your overall tax rate but I can’t advise you on any of that; I’m not a tax accountant or attorney and you would need to speak to an adviser. I’m just looking at the broad level possibilities from an investor’s perspective.

  • urbanman2004

    Good reading material for those needing a tax-advantaged way to transfer gifts that cost too much without having to pay the government

  • Kent

    Dear Mr Kennon, Thank you for making many,many points clearer. I am considering a holding company as a vehicle to simplify my portfolio management especially as I divest some of my assets to my children. The huge majority of my assets are in retirement vehicles(IRA,Sep-IRA, 401K) . Is there still a possibility here. Also I am a physician in Florida and liability becomes an enormous concern.