This topic deals with the implications of splitting the Life Insured's Estate (including their interest in the Business) equitably or inequitably between the Children or Beneficiaries.

When are Estate Equalisation Strategies Relevant?

Estate Equalisation Strategies are relevant, if some Children or Beneficiaries are interested in acquiring the Business, but others are not.

Equal Distribution of Business to Children

Many Wills distribute the Estate of the Proprietor to the children in equal shares.

If only some of the children wish to retain ownership of the Business or Property, then there is a risk that one or more of the children might prefer to:

sell their interest in the Business or Property; and
invest the sale proceeds in other investments separately from their siblings.

This will lead to a situation where they require one or more of the other children to buy out their interest.

The purchase would require a loan (which the Purchasers might not be able to fund) and could lead to the sale of the whole of the Business or Property, if a satisfactory agreement can't be reached.

If a sale is eventually required, then the Proprietor has simply passed on to the children a problem that might have been soluble by some of the following strategies.

Unequal Distribution of Business to Children

Many Proprietors faced with this problem elect to treat their children inequitably.

For example, they might gift the Business or Property to the interested children and little of value to the remaining children.

However, this strategy can be defeated by litigation.

For example, a Court might effectively force the interested children to make a payment to the remaining children to equalise the distribution of the Estate, depending on the respective needs of the Beneficiaries.

This payment would have to be funded by a loan against the security of the Business or the Property.

If a loan was not feasible, the litigation might effectively force the sale of the Business or Property to a Third Party.

Most families therefore strive to achieve an Estate Equalisation Strategy.

Estate Equalisation Strategies on Death of Proprietor

Estate Equalisation strategies can be relevant where there are a number of children, only some of whom wish to remain involved in the Business after the death of their parents.

The parents might wish to gift the Equity in the Business to the interested children.

However, this can create a testamentary inequity, if there are no assets of equivalent value to gift to the other children.

It is therefore desirable (if not easy) for Family Business Owners to have a composite or diversified Estate that includes "off-farm assets" and investment strategies outside the Business that will allow the equitable distribution of the Estate between the children.

Example

For example, the parents could gift:

the Business to one child;
the home to the second child; and
superannuation or other investments to the third child (assuming they are equivalent in value).

This type of strategy requires long-term planning, continuity of revenue and profit, and a lot of luck.

Separate Ownership of Business and Property

If there are insufficient assets for this type of Estate Equalisation strategy, some Proprietors consider a strategy that separates the ownership of the Business and the Property (e.g., a Farm).

The Proprietor might gift:

the Business to the interested children; and
the Property or Farm jointly to all of the children.

A variation of the Farm strategy is to gift the Property or Farm to a trust that holds the Property on behalf of the children.

The trust could be either a family trust or a unit trust.

Equal Distribution of Property

The purpose of equal distribution of the Property is to allow all of the children to:

obtain the benefit of the ownership of the land (including the ability to sell it in the future); and
lease the Property to the interested children and derive income from the rent.

Financial Considerations

In the case of a Farm, the substantive Business might not have any recognisable value apart from the Property.

The financial viability of this strategy will therefore depend on:

the level of the rent; and
the ability of the interested children to fund both the rent and their own living expenses out of the income of the Business.

The strategy might not be practical, if the farm income is not high enough or regular enough to commit to a fixed rental cost.

Sale Forced by Low Return on Investment

On the other hand, if the rental is not high enough for the Property owners, ownership of the Property might not generate an adequate return on capital for the Property owners.

Thus, there is a risk that one or more of the children might prefer to:

sell their interest in the Business or Property; and
invest the sale proceeds in other investments separately from their siblings.

This will lead to a situation where they require one or more of the other children to buy out their interest.

The purchase would require a loan (which the Purchasers might not be able to fund) and could lead to the sale of the whole of the Property and the Business, if a satisfactory agreement can't be reached.

If a sale is eventually required, then the Proprietor has simply passed on to the children a problem that might have been soluble during their lifetime by some of the following strategies.

Example

If four children co-owned a Farm where the land was worth $2 million, then each child has an asset worth $500,000.

If this value was invested and earned a return of 10%, it should earn each person $50,000 per annum.

The value of the land in the hands of the children will depend on the return they get for it.

If one child owns the Business that operates on the farm land, then it is arguable that that child should pay rent to the four owners. (This logic applies if the owner of the land is a family trust or a unit trust.)

If the rent was 10% of the value of the land, then the rent would be $200,000 per annum (or $50,000 per annum per owner), before the farming child had earned any profit from the farming activities.

In other words, the farming child would have to earn a profit of $200,000 per annum before they had earned a wage for themselves (subject to their share of the rent).

The rental obligation could be prohibitive in many cases. If you strip out a market rent, then there would be a negligible return on the Business.

If the rent is reduced below an appropriate market level, then each of the other three children would receive a below-market return on their investment in the land and would be tempted to sell their share in order to obtain cash that they can either use or invest for a better return.

Ultimately, there is a risk that the non-farming children will want the cash and will force the farming child to borrow to buy them out.

Worse still, both the Farm and the Business might have to be sold.

This problem can be minimised by the following insurance strategies.

Using Estate Equalisation Insurance to Remedy Inequities

Often where an Estate Equalisation strategy is difficult or only partially successful, insurance is used to remedy the inequity.

This strategy uses insurance to "gross-up" the total value of the Estate, so that:

the interested child receives the Business or Property; and
the remaining children receive Insurance Proceeds equivalent in value to an interest in the Business or Property.

Example

For example, if the Equity in the Business was worth $1 million:

the interested child would inherit the Business worth $1M; and
each other child could receive Insurance Proceeds of $1 million (subject to the value of any other assets they might inherit).

The Estate Equalisation strategy requires a total sum insured of $1 million per child (other than the child who will inherit the Business).

If there are two other children, the sum insured will be $2 million. If there are three other children, the sum insured will be $3 million.

In each case, each child would receive an asset or Insurance Proceeds worth $1 million.

Premium Cost

Because the Premium will increase as the Life Insured ages, this strategy will become increasingly expensive.

However, in the absence of substantial off-farm assets, it might be the only option available to the family.

A less expensive insurance alternative is the Family Buy//Sell Strategy discussed below.

Different CGT Liability

When a Beneficiary of an Estate on-sells an asset, they might incur a Capital Gains Tax liability.

This liability might differ between assets, even though the assets have the same apparent value.

Insurance can be used to compensate a child for receiving an asset that would incur a higher CGT liability in the case of an on-sale than an asset given to another child.

Family Buy/Sell Strategies

A Family Buy/Sell Strategy can reduce the need for Insurance and therefore the premium cost, particularly in larger Families.

Please read here with respect to different Family Buy/Sell Strategies.

Adviser Tip

In the case of Retirement, a Complete Succession Plan can pre-agree the Purchase Price and specify a timeframe for payment.

If you do not have adequate insurance for an Insurable Event, your Succession Plan can specify a timeframe for payment of the shortfall.

See more Adviser Tips

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