Those running a family-owned business often confuse the concepts compensation and inheritance, columnist Léon Danco explains.

A profitable business ought to have enough for everybody, but most family-owned businesses just don't have the necessary advice available to work out a system of maximum rewards for everybody. So they get it done by the only systems they know - through salary and, ultimately, through the equity distribution. "Fair" is made to mean "equal," and this is how the founder divides the limited pie up. He usually doesn't know any other way.

I have to keep coming back to the tax laws, because, in many senses, they represent the collective wisdom about what is fair in the general sense. The tax people have some very definite rules about being paid for contribution. They differentiate inheritance from compensation and stick fairly rigidly to their guidelines. The tax laws, and most of our society, see inheritance as a one-time gift bestowed upon an heir out of the generosity and love of the giver. Nothing in the Internal Revenue Code says that an inheritance has to be earned to be acceptable.

Compensation is something else entirely. It's shot through with the notion of "earned," at least in the minds of the people, and it comes under a whole different category of rules. This distinction, however, often is lost on the members of a family owning a business. Instead of looking upon the benefits that come from a successful business as compensation for effort expended and viewing the opportunity and advantage provided by the business as the inheritance, the two are confused in everybody's mind.

Some examples probably would illustrate the point best.

Two Against One

The founder left a major distribution company on the West Coast equally to his three children. I met him briefly about a year before he died in an airplane accident, and he explained to me then that this was the only way he could be sure his children would know they were being treated fairly.

We discussed some of the problems I saw in the arrangement, and he admitted at the time that maybe there was a better solution. But he never found the time to give the subject any thought, much less to talk it over with his heirs.

Now the elder son, who is also the president; a daughter, who is married to a dentist and not involved in the operation of the company; and a second son, who works in the business as one of the company's truck drivers, own the company in equal thirds. The president, a shrewd, aggressive CEO who is well respected in his industry, has won the distributorship of a major national equipment line after a long struggle.

To handle the proposed expansion, the business is going to need all of the earnings it can keep, but the sister and younger brother won't go along with the plan. The source of the conflict is the sister, who - in league with her financially sophisticated husband - realizes that any expansion will only dry up her accustomed dividends, while increasing her president-brother's income. Because the younger brother is single and impressionable, she has been able to convince him that the expansion will only be beneficial for his older brother. Since his short-term objectives are to have more ready cash than his wages could reasonably provide, he has joined forces with her to oppose the expansion.

Together they are the team with all the power, and the president is left frustrated and powerless as a minority owner. Needless to say, these three siblings are no longer on the best of terms.

What is fair in this situation? Who has the valid claim of the benefits from the company?

Resentment in the Ranks

Another second-generation company, a bakery in the Midwest, was left in thirds to a widow and two sons. At the time of the founder's death, the older brother had been president for six months, an arrangement that was acceptable to both brothers and the founder. The older brother had worked in the company for over 10 years, while the younger brother had worked in various marketing jobs at General Foods. When the founder died, the younger man left General Foods and took over the sales department of the family baking company. It soon became apparent that the older brother was in over his head with the president's job, and the younger man automatically took over more and more of the CEO's responsibility.

The founder's widow, however, has never forgotten that her younger son had refused to come to work for his father when he was asked, preferring instead to work for strangers. The older boy was loyal and he was there "when Dad needed him." Besides, "he's been there longer and knows the company better." In her mind, the older boy is the natural choice for president. So he stays on the job at his higher salary, while the younger son carries the load with increasing bitterness. He can't sell his inheritance because the company can't afford to reacquire his stock, and neither can he afford to reacquire his stock. Furthermore, he can't leave and work elsewhere because he is convinced his older brother would destroy the business within two years.

Time Breeds Bitterness

As a final example, consider the case of a car dealership in New Jersey that was left 100 percent to the successor. The two other children - two non-working, married daughters - were given title to the company's real estate holdings, which included the showroom, service garage, body shop and used car lots. In this case, the founder did not try to be equal. He just did what he thought was fair by giving full control of the company to his only working heir, and a source of steady income to his non-working daughters.

Actually, at the time of the founder's death, the real estate far exceeded the book value of the dealership itself, including the inventory, and the working brother seriously considered contesting the will when the estate was going through probate. Instead, he plowed his heart and soul into the business, and in five years, he has expanded to three other locations and opened a growing truck leasing division.

The sisters, who naturally were very happy with their inheritance in the beginning, now have watched the business that was left to their brother almost triple in size, while the property that was left to them steadily depreciates and declines in value because of its central city location. Now they have grown bitter with the feeling that they were short-changed by their father. They refuse to have anything to do with their brother, who they feel has taken advantage of their father and of them.