There is an ancient saying in our country that “wealth doesn’t last beyond three generations,” and the main reason for this is the issue of nurturing the next generation.
The emergence of the family office (hereinafter referred to as “family office”) not only provides comprehensive wealth management and family services for ultra-high-net-worth individuals, but more importantly, it allows wealth inheritance to transcend generations and break out of the so-called “wealth trap.”
Especially now, as the country is experiencing a wave of “succession,” the role of the family office is even more important.
So, what are the “risks” and “traps” in the inheritance process for families? How can the family office help families to prevent and avoid these “risks”?
China’s high-net-worth families are mainly composed of the “entrepreneur-investor” group. If we start from the perspective of “confusion-risk-responsibility,” they generally have the problem of not distinguishing between family and business during the wealth creation period. These issues mainly exist in personnel, business, assets, finance, and institutions, including:
- Loss of control, mismanagement, unauthorized custody, and improper operation at the business operation level;
- Misallocation, market manipulation, leverage imbalance, and competition among peers at the asset investment level;
- Tax violations, litigation penalties, illegal money laundering, and improper transactions at the compliance construction level;
- Accidents, inheritance disputes, marital disputes, and succession failures at the member relationship level.
Among these risks, we will elaborate on the following types of risks in detail.
First, the risk of unauthorized custody.
Bob (pseudonym) is the actual controller of a company and has already moved overseas with his wife. Influenced by many friends who have arranged for third parties to hold their company equity in order to isolate some shareholder responsibilities and director and senior executive obligations, Bob has also asked his nephew to act as the custodian of the company’s equity and to serve as the company’s legal representative, executive director, and general manager, while he himself manages the company behind the scenes for a long time.
So, are there any unknown risks or hidden dangers in this process?
(1) Risks of Debt for the Nominee: After the outbreak of the COVID-19 pandemic in 2020, Bob was unable to return to his home country due to being stranded overseas for a long time, and his nephew also experienced significant changes due to the impact of the pandemic. Recently, his nephew’s creditor has taken legal action and applied for the preservation of the company’s equity in court.
(2) The Unsympathetic Trustee: Bob divorced his wife, who demanded a division of the company’s equity. However, Bob claimed that the equity belonged to his nephew personally, and he had only provided a loan to help him start his business.
(3) The Unreliable Nominee: Bob suddenly fell ill and passed away overseas. His ex-wife contacted his nephew multiple times, hoping he would return the equity. However, not only did the nephew ignore her, but he also vehemently denied the fact that he was holding the equity on behalf of Bob.
Second, Marital Disputes.
The first generation of entrepreneurs generally hopes that the vast wealth they have accumulated can be enjoyed by their children without being affected by their children’s marriages.
However, according to Chinese law, most of the property acquired during the marriage is considered joint property of the couple, except in specific circumstances. Therefore, if special arrangements are not made in advance, the situation that the first generation is concerned about may occur.
So, how to prevent risks?
It is suggested that the first generation can fully utilize legal provisions and systems to protect themselves and their children in advance through various tools such as prenuptial agreements, trust plans, and gift arrangements.
In addition to these routine risks, due to the multiple legal relationships involved in family wealth inheritance, there are other risks to consider, including:
For example, the family uses the company to pay for family expenses, or the equity is registered in the name of a specific family asset holder in the business;
For example, a large number of transactions between the company and the shareholders, if the company faces a debt dispute, the creditor usually takes legal action to ask the court to determine that the shareholder has abused the limited liability of the shareholder, thereby denying the company’s independent legal person status, and asking the court to rule that the shareholder bears joint and several liability for the company’s debts.
01 Legal risks in family succession
Similarly, in the event of an unexpected incident or breach of commitment by the holder of family assets, there is a high probability that disputes over the division of assets will arise within the family.
In addition, in recent years, the impact of tax compliance on family businesses has been increasing. The additional payments and fines resulting from tax inspections can also have a significant negative impact on family assets.
So, how should families manage the various risks mentioned above?
Wang Jingqian (a pseudonym) had various brother-sister holding phenomena when he started his business. Later, as the first generation aged, their children also established their own families and industrial systems.
With the development of the family, the unclear ownership and relatively complex equity structure left over from the early days also became increasingly prominent.
This has become an urgent problem for Wang Jingqian to solve. At the same time, he is also worried that if he only completes the asset distribution, the family members may no longer be as united and intimate as they were before.
In response to this situation, the service plan recommends that the family build a structure in the form of “family constitution + family office”, and clarify the rights and interests through trust plans, property division agreements and other tools.
The family constitution, in simple terms, is a guiding regulation tailored for the family by the main members of the family based on their own family characteristics, values, and expectations and plans for the future, coupled with family trusts, to implement the content of the family constitution.
Compared with general wealth inheritance tools, the combination of family constitution and family trust can refine the spiritual wealth connotation of the family, which is used to regulate and adjust the behavior of family businesses and members, enhance communication among family members, improve and strengthen family relationships and family cohesion, and clarify the direction for family governance and family inheritance.
For example, take a family that controls a red chip listed company overseas as an example.
The approach involves selecting a trusted professional organization by the main members of the family to clarify the client’s purpose and carry out related legal and tax planning.
The professional organization is responsible for drafting and establishing a family constitution and internal governance rules.
Subsequently, the professional organization assists the client in connecting with a professional trust company to design a family trust management model, review trust legal documents, assist in signing trust documents, issue a letter of intent, and provide follow-up feedback after the trust is established.
In addition to this, the family can also establish a series of family systems centered around the family constitution.
Furthermore, setting up a family committee with the first generation as the core layer is also very necessary. This can coordinate and manage family affairs, including controlling various risks of the family.
Now, the Wang Jingqian family has implemented the above suggestions for three years and has effectively solved the problems encountered by the family.
In summary, if the family office wants to operate efficiently and effectively isolate related risks, it can rely on the following four aspects:
Firstly, establish a suitable equity holding structure.
In addition to holding the family office equity directly by the group company or family members, it can also be held through family trusts and foundations to leverage the advantages of different tools and create a compound effect.
Secondly, improve the governance structure and rules.
For example, set up a family committee and an external advisory committee in the family office, and supplement it with systems such as a family constitution, meeting rules, and a successor training plan to standardize the operation of the family office.
Thirdly, appropriately introduce a professional manager system to optimize and improve the family’s internal management level through external talents.
Now, some professional managers with senior management experience in large financial institutions are becoming “coaches” for family offices, assisting in the training of the family’s next generation.
02 How to isolate risks?
Finally, it is important to emphasize compliance construction.
For example, Archegos, which experienced a major collapse in 2022, was prosecuted by the U.S. Department of Justice. This incident is very worthy of in-depth study by Chinese family offices. We have conducted a lot of research around this case and have formed some research results.
Since a single family office is generally exempted from the financial regulatory requirements of various countries (regions), neglecting internal compliance construction may have a significant adverse impact on family assets.
Therefore, it is recommended that families consider proactive compliance, apply for relevant regulatory licenses, and use external supervision to improve internal compliance. This can not only protect property safety but also explore the transformation into a professional wealth management organization.
Now, the generation of entrepreneurs who have gone through all kinds of hardships in the tide of reform and opening up have reached the age of retirement. However, the issue of “succession” is troubling them:
Is the next generation suitable for succession? At what point should the succession take place? And how to protect and guide after succession? How should equity be distributed among children, and how to continue to exert a certain influence after the distribution is completed? In addition, there are tax issues involved in the distribution process.
How to solve this “succession” problem? It can be considered from three dimensions.
Firstly, high-net-worth individuals need to clearly understand their core and non-core needs for wealth inheritance, and choose the most appropriate tool based on the solution to the core needs.
Secondly, the needs of the beneficiaries of wealth inheritance should be taken into account. After all, the subject of the tool is two-way.
Once again, it is necessary to match the tools that best fit the legal system of the place where wealth is located.
Especially recently, China’s wealth management market has seen a large influx of overseas inheritance tools, but each region has its own social and cultural traditions and legal systems. Tools that are more mature overseas may still need further observation domestically.
Therefore, high-net-worth individuals should still make cautious decisions when choosing tools.
From observations over the past decade, family core members have been more concerned with the issue of family top-level architecture design, such as family trusts, family constitutions, public welfare and charity, family funds, family offices, family property agreements and will arrangements, cross-border wealth inheritance, asset allocation, and so on.
They need to consider the issue of family inheritance from a more macro perspective. When designing the top-level architecture, family core members are often placed in a more important position.
03 How to do a good job of succession and wealth inheritance
Family offices play a crucial role in helping families with planning and succession.
In addition to the above functions, family offices also need to assist with coordinating the family’s daily affairs and avoiding legal and tax risks. Tax issues, in particular, are a common concern among domestic families.
As a mature family office, it must be able to provide professional, comprehensive, and one-stop products and services for ultra-high-net-worth families. The services it can provide should cover various areas, including financial planning, family strategy, family governance, and professional field consulting.
Moreover, compared to a newly established family office, a mature family office can not only achieve material objectives such as asset allocation but also fulfill the purpose of passing on family culture and values.
Under the requirements of the first or second generation of entrepreneurs, family offices often develop a comprehensive system for nurturing the next generation, tailored to the characteristics of different families. This system involves planning for basic academic education, interest cultivation, social activities, and practical activities, allowing the next generation to cultivate personal abilities, moral character, and networking resources simultaneously.
(VERTU reminder: The content and viewpoints are for reference only and do not constitute any investment advice.)
