A common issue that arises for many when preparing their estate plan is resolving the struggle between equity vs. equality. Are there certain assets that are passing to some beneficiaries but not others? If so, are those beneficiaries receiving more than the others? If the answer to that question is also yes, then is that result fair to the other beneficiaries?
While there is no legal requirement that the distribution of assets be equal among your chosen beneficiaries, leaving some beneficiaries more assets than others may not be in line with your estate planning goals and may also cause unintended conflict between you and your loved ones.
To explore some of these issues, as well as some potential solutions, let’s use a family running a closely-held family business as an example. Mom and dad are getting ready to pass the business down to the next generation, but only one of the kids is interested in taking over the business.
Option #1: Fairness is not a priority, so Mom and Dad leave the entire business to pass to the “business kid.”
Even though mom and dad have three children, only Child 1 has an interest in continuing to run the business. In addition, Child 1 has been handling many of the day-to-day operations for the last 10 years in an effort to take the burden off mom and dad and help them start to ease into retirement. In light of Child 1’s efforts, mom and dad state in their Will and/or Trust that the entire business goes to Child 1. While they also provide that Child 2 and Child 3 will receive the balance of their assets, the business comprises 90% of their estate, so the value of their other assets is somewhat minimal.
Mom and dad must now address the fairness question. Is this result fair to Child 2 and 3? Or, more to the point, do they care if the result is not fair to Child 2 and 3?
Mom and dad might be perfectly fine with Child 1 receiving a lion’s share of the estate in light of the work he has put into the business. Perhaps they have even had a conversation as a family, and Child 2 and 3 are also on board as they recognize Child 1's effort and agree he should be compensated fairly for it. Another point to consider is that even though Child 1 is receiving more “on paper,” the fair market value of the business will only ever be realized by Child 1 if he sells the business. So long as the business is operating, Child 1 has only inherited a job and not necessarily a financial windfall.
Option #2: Mom and Dad do want to be fair and find a way to provide additional assets to their “non-business kids.”
If mom and dad still want to try to equalize the assets passing to all three children, one option is for them to purchase additional life insurance and name Child 2 and 3 as the sole beneficiaries. Assuming mom and dad are still insurable, this is an easy way to make more liquid assets available to the other children upon their deaths. Be aware, however, that if mom and dad’s estates are close to or over the estate tax exemption, adding more assets to their estate may not be a desirable option for them. In such an event, it may still be possible to obtain the policies but have them purchased by an irrevocable trust of which Child 2 and 3 are the trustees and beneficiaries, or have the policies purchased by Child 2 and 3 directly (with funds gifted to them from mom and dad).
Another option is to allow the business to pass to all three kids under the Will and/or Trust and implement a business Buy-Sell Agreement that would require Child 1 to purchase the business interests passing to Child 2 and 3 upon mom and dad’s deaths. This would still ensure Child 1 ends up with the business while also providing an inheritance to Child 2 and 3. One potential issue with this strategy that must be considered is whether the forced buyout by Child 1 will create an unmanageable financial burden for Child 1 and the business. These buyouts only work well if the business generates sufficient income to fund the buyout, fund the business’ regular operations, and still provide the necessary personal income for Child 1.
One Final Consideration
If mom and dad are trying to equalize distributions among the kids and are doing so, in full or in part, by allowing qualified retirement accounts (401ks, IRAs, etc.) to pass to the non-business children, mom and dad need to be aware that the beneficiaries of those retirement accounts will only receive approximately 70% of the account’s value. This is due to the fact that qualified accounts are funded with pre-income tax dollars. When the beneficiaries take distributions from those accounts, they will be required to pay income taxes on the amounts withdrawn. Taking into account both federal and state income taxes, the end result is the kids only receive approximately 70% of the value of the account. So when trying to calculate how much each kid is going to receive, don’t forget to take into account the income tax consequences that may be associated with each asset.