This article was published in Family Offices Journal, 17th edition and was co-written by Carly E. Doshi and Michael S. Schwartz.
Architects of large family enterprises may be tempted by the simplicity and clarity of focusing exclusively on tax efficiency, but at what cost?
Recognised areas of global uncertainty, such as political and social unrest, stock market volatility, global pandemics, and an ageing population erode stability and create challenging environments for the general public, but large enterprises may be particularly susceptible. It is frequently suggested that a family’s resilience in the face of adversity is one of the key predictors for their long-term enterprise success.[1] Large global family enterprises and the professionals who oversee them are well-advised to employ creative planning and management tools to create and maximise the characteristics of nimble decision-making and flexibility – and ultimately resilience – which provide the best chance of success during tumultuous times.
In this article, we advocate for the incorporation of resiliency planning into family systems, concurring with other recent scholarship on resiliency as a goal of family governance work. We will expand this further, by mapping family resiliency to a technical application, including components of a legal advisory framework and against recent cases where this has proved relevant.
Today’s challenges and the importance of proper structuring
One of the central roles of family planning is risk management. At no time has this been more apparent, and more critical, than in 2020, given the litany of global challenges which have arisen during a short period. A steady hand in the face of such challenges is one of the hallmarks of effective risk management. Ultimately, resilience is the way that families will be best equipped to weather the current storm.
Scholars have long observed that many wealthy families establish and then lose their wealth within three generations, absent well thought-out planning. While typically losses of wealth are thought of as negative, if wealth decline is planned then it doesn’t have to be. For some families of significant wealth, the ultimate legacy is a large charitable endeavour, not wealthy generations of heirs. Such a view has, in recent years, been made more public via Bill Gates and Warren Buffet’s “The Giving Pledge”.[2] Still, the classic example of a family losing wealth remains – a family growing in members but stagnant or depleting in its resources, combined with a prevailing sense of entitlement among the future generations.3 As subsequent generations continue to hold onto the lavish lifestyle of their ancestors, the pot must get further divided, until it dwindles. The problem is compounded when future generations do not have the same enthusiasm or interest in taking an active role in the family wealth, through participation in operating businesses, board membership or roles within the family structure. In the classic example, by the end of the third generation, the wealth is gone.
Among scholars and advisers who focus on this dynamic, the agreed-upon ‘insurance’ for high-net- worth families seeking to preserve their wealth and achieve their goals across generations is by demonstrating urgency to address this paradigm, and a commitment to developing a well thought-out family governance structure and system.[4] Just as important as the structures themselves are the actors and family members who play a critical role in preserving wealth and managing risk. They steer the ship and are integral in perpetuating the values and vision of the family and making sure that the stated objectives are maintained (or adjusted as needed). And at the heart of the capability of these actors is resilience. Resilience trumps the fear of uncertainty and can lead to protection from an unstable framework and economic loss in turbulent times.[5]
However, the broad ideas of resilience and family governance are not in themselves enough for families to protect their wealth and achieve their goals. Families need to actively cultivate resilience by folding it into the fabric of the family system, including their legal structures. Within these structures, tax efficiency and investment returns are very important, but the success of a family will depend on its ability to cohesively govern itself within the structure. Below are our suggestions for integration of family governance into legal structures.
Recognising the triggers: instability and unpredictability
Although it is impossible to predict what challenges a family may face over time, certain events test a family’s bonds. These triggers are moments that shock the system, are often emotional, and take family members’ focus away from the continuity of the system and their individual, day-to-day roles. It is crucial to identify these potential inflection points, and build in mechanisms to help deal with them when or if they arise.
Some triggers may be easily identifiable by technical family advisers, as a result of their training in tax planning or investment management. However, many triggers involve interpersonal relationships and family dynamics and require an understanding of the various actors and larger social landscape in which they operate. Triggers may be internal to the family members or might be external, coming from the surrounding environment. Internal triggers include births, deaths, illness, incapacity, divorce and retirement. These triggers impact the family system itself – the size and members of participants and/or their ability to fulfil a given role. Whether through the addition of new family members (marriage, births) or subtraction of others (death, divorce), the definition of ‘family’ itself is changed in some way. External triggers include geopolitical events, market volatility resulting in dramatic declines in capital, political or social unrest, and natural disasters. Both types of triggers put strains on the structure and are key drivers in why families need a solid governance with resilient people at the helm. Leaders of family enterprises are wise to be aware of triggers and to have a risk management plan for addressing them in advance.
Changes in global tax compliance and reporting obligations for families is another potential trigger. For example, in June 2020, the US Internal Revenue Service (the IRS) announced the re-formation of the Global High-Net-Worth squad, formed to take a holistic approach in addressing high-net-worth taxpayers and to look at the complete financial picture of high-net-worth individuals and the enterprises they control.6 IRS Commissioner Chuck Rettig once referred to audits by the Global High-Net- Worth squad as being “audits from hell”, and the reviews will include interests in US and foreign partnerships, trusts, subchapter S corporations, C corporations, private foundations, and gifts between family members.[7] Increased regulatory scrutiny demands cohesive and well-functioning governance, where the participants are adhering strictly to the purposes, structure and formalities of the system. As any practitioner who has navigated an IRS audit can attest, the process can be trying for even the most organised of taxpayers. A solid and organised governance structure with intelligent and capable people can help mitigate this risk.
When dealing with triggers, it is often the perception of a risk that increases the stress response.[8] Humans, whether individually or as groups, are not typically at our best when faced with a decision to fight or flight.[9] Without proper training and structure, family members may push for quick and simple solutions, or may act reflexively and impulsively. Decisions made in a moment of stress frequently fail to account for the long-term problems or risks that erode economic fortunes.
A better plan is to prepare when times are not urgent, and equip family members and other relevant actors with the tools and skills to handle triggers effectively. Under calm circumstances and with level heads, a family is best-positioned to build a system for decision making which can be practised over time, and then utilised when triggers appear.
The solution: family governance integration
Family advisers have a variety of tools at their disposal to maximise wealth and provide for efficient transfer across generations. But while traditional advice may prevent some triggering events from taking root or delay the impact of others, it may not adequately prepare a family and its members for dealing with unexpected or inevitable triggers. This is when resilience is required.
Fortunately, the process for developing effective governance can be easily mapped against resilience by applying the three component parts of resilience: shared beliefs, organisation and communication. Professionals can assist in this by counselling families through these decisions based on professional experience, and drawing on known family fortunes that have been squandered. In quick summary:
Beliefs
The first step to forming an effective governance structure is for a family to turn inward and consider its mostly closely held beliefs and values. Helping family members to articulate family values is critical, as it binds individuals together and is the test against which future actions are considered. It is also the bedrock upon which a family will rely when a crisis hits, giving it the resilience it needs.
Organisation
While unpredictable triggers lead to uncertainty, proactive organisation enables efficient and effective decision making. For family enterprises, this involves developing systems for clear management. Which individuals should be involved in key decisions? Do the relevant persons include those with both formal and informal roles within an operating business? How does a group convene, vote and effectuate its decisions? Who receives material benefits, and what benefits should they reasonably expect? A tax-efficient structure that does not contemplate these issues will inevitably lead to problems, and a family mired in bureaucracy will succumb to inaction during a crisis.
Communication
Finally, family resilience demands clear communication with a spirit of collaboration. Family member roles may differ, and indeed in a complex enterprise the level of participation is likely to be varied.[10] But the importance of feeling included and informed cannot be overstated. Failing to communicate with key parties – even those who lack current authority, but whose future interests are nonetheless at stake – is the surest path to family discord, and ultimately to potential litigation. Communication should not wait until a structure is in crisis mode. If possible, it should occur all throughout the planning and operation phases of the structure.
Importantly, the goals, process and organisation are the prelude to the structure. These three elements, and their codification through a family governance deliverable such as a family constitution, may be viewed as sitting ‘above’ trust structures in the organisational chart of a family system. Taken together, they transcend all individuals, operating businesses or other holdings, even tax and legal planning, and provide both stability as well as flexibility.
Design and implementation
Once the family have established their goals, and have a clear articulation of their desired organisation and communication channels, they can then move on to designing and developing the structure. During this phase the estate plan is formulated, including more precise details of the overall structure, its benefits and implications, and the documents to memorialise it. While legal and tax advisers are frequently in the driver’s seat, this should remain a collaborative process between counsel and the family.
Before drafting, advisers charged with setting up or managing a system should:
take the time to understand the symmetry between the family’s personal goals and business goals;
explain various governance structure options to the family (family entities, trust companies, family offices, etc);
consider the family’s own closely held beliefs and long-term goals;
include various roles in the structure, in keeping with the family’s own identified way of organising themselves;
build in opportunities and channels for family communication; and
help the family identify any service providers that will be needed to implement and maintain the structure.
Finally, jurisdiction can be a very important question at this stage with wide-ranging considerations and implications for resiliency. At the highest level, determining foreign or domestic status is critical, but from there the options quickly multiply. Both US states and many countries globally offer compelling and persuasive tax regimes, governance flexibility, privacy and protection of property rights. But others, particularly the older, larger and more structured jurisdictions, are more restrictive. While considering the most important factors to a particular family, convenience should also not be overlooked. Many a family office has struggled to recruit top talent due to their physical location; virtual offices in major hubs may be a sufficient work-around, but add additional complexity and overheads.
Once these considerations have been navigated with care, and appropriate jurisdictions identified, only then does one turn to the legal documents. The legal implementation should be reserved to the end of the process. In other words – measure twice, cut once.
Looking closely at the legal documents
For a resilient system able to withstand a crisis, legal documents are as important as the codification of the family governance plan. Extending the family governance work into the legal documents takes some effort and creativity, but the resulting system is most likely to address a family’s own values, organisation and communication – and therefore provide the greatest chance of resilience.
While a traditional estate planner may focus primarily on a client’s last will and testament, there are other crucial documents that should and often do form part of the plan.
Trusts
In many US family governance structures rooted in estate planning, trust agreements are often the central documents. This is true for many other common law jurisdictions across the globe. A trust, in essence, is an agreement whereby a settlor (the person currently holding wealth) makes an arrangement with a trustee (a competent, experienced, party suitable to oversee wealth) to manage wealth (whether assets or property) for a set group of beneficiaries (often, but not always, descendants of the settlor and charities).
Trusts are ideal documents for family governance. At a high level, the trust instrument clearly defines roles and provides clarity around expectations. This includes setting forth the fiduciaries and beneficiaries. Trusts also clearly define the terms by which future power holders or beneficiaries step into their roles – potentially mentioning specifically the triggering events about which a family is likely to be concerned, such as the death or incapacity of an older generation. While the trust does not prevent the trigger from happening, it does provide clarity and structure so that the individual actors can proceed in an orderly and organised way.
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