Mixing up Family Business and Personal Business: Pitfalls to Avoid

In a family-owned business, there may be a fine line between the interests of the business and the personal interests of the individuals who own and control the business.  Family business owner/operators can fall into the trap of thinking that whatever is in their own personal best interest is also in the best interest of the business.  That is not always the case where the business includes multiple family members.

Take, for example, the case of a company we’ll call Friendly Enterprises, Inc., held by members of the Friendly family for 50 years.  Its stock is now owned by Emma Friendly, two of her brothers and one sister.  The brothers and sister are not actively involved in the business.  It has been the habit of Emma as the president, senior member of the family and largest shareholder, to use cash from operations for her daily expenses, including leasing a car and paying for gasoline, buying lunches and dinners with and without customers as guests, maintaining her condominium in Palm Springs, and traveling around the country for both business and vacation purposes.  She has turned over daily operational responsibility to her daughter and son, but she still maintains an office and comes in every day to manage her personal real estate holdings.  Her long-time assistant, Wiley, spends most of his time managing Emma’s personal assets.  When her son and daughter need cash for their living expenses, she recommends that they just remove it from the till to avoid having to draw up loan documents.  She rationalizes that, since the family owns the business, everything that the business earns is there for the family’s use.

So, is there a problem here?  Well, several.  First, there are a number of income tax-related issues that any competent CPA or tax lawyer would recognize and advise the company to correct.  Some of the personal benefits enjoyed by Emma and her daughter and son will likely be considered income or dividends for federal and state tax purposes and must be declared as such on their personal returns.   Friendly Enterprises, Inc. needs a firmer-handed CFO and a competent tax and accounting professional to help it emerge from potential chaos.  There should be financial controls in place so that no one—including family members, can simply remove cash from the till without accounting for it.

There are other issues that relate to the duties that exist among shareholders.  Unless the shareholders have agreed that Emma’s use of company funds is acceptable as either personal compensation or legitimate corporate expenses, Emma may be required to defend herself against claims for self-dealing and breach of her duties as a senior shareholder to the junior shareholders.  The board of directors has the authority to approve compensation to officers of the company, but it must be able to differentiate between compensation or dividends to one officer/shareholder and expenditures for the benefit of the corporation.  And the board must determine whether Emma’s compensation is fair, given the limited scope of the services she provides to the corporation.  The board needs to be aware that there are minority shareholders who may at some time expect a return on their stock ownership, and who may hire a lawyer or accountant to scrutinize Emma’s performance and the company’s expenditures on behalf of Emma.  The board’s performance and process in protecting the corporation’s assets and applying corporate revenues to legitimate corporate purposes will undergo that same scrutiny.

Also, the family needs to ensure that the “corporate veil” remains intact that protects shareholders from liability for the obligations of the corporation.  One of the best ways to eliminate the corporate veil is for shareholders to disregard the corporate entity by utilizing corporate assets for personal purposes.  The loss of the corporate veil may hurt not only Emma, but also other family members who consciously permit corporate assets to be used for personal purposes without accounting for such uses as compensation or dividends.

Few family businesses are as aggressive in their self-dealing as our example of Friendly Enterprises, Inc.  However, in family businesses, as in any other businesses, nothing beats documenting the financial and other relationships between the individuals and the business and ensuring that business revenues are utilized for business-related purposes.  Even for family businesses that are not quite as brazen as the Friendly family, attention has to be paid to these matters.  Those efforts will be rewarded in the event of scrutiny by tax authorities or concerned family members.