MANYBillionaires

Ownership creates the biggest fortunes

Salaries, even very high ones, rarely produce fortunes in the billions. The largest fortunes typically come from owning a large share of a company whose value grows enormously, as a founder, an early investor or an heir to a family business.

Much of that wealth is paper wealth: it exists as the market value of shares, not as cash. A fortune tied to one stock can rise or fall by large amounts in a single day, and published figures for prominent people are estimates built from share prices and assumptions about private holdings.

Concentration and the liquidity problem

Turning a large stake into cash is harder than it looks. Selling a big block can push the share price down, founders may be bound by lockup agreements after an initial public offering, and insiders typically trade only in company-approved windows or through prearranged plans under the SEC’s Rule 10b5-1. Trades by officers, directors and large shareholders must also be reported publicly, so big sales can unsettle other investors.

Borrowing against shares is a common answer. A loan secured by stock provides cash without a sale, so no capital gains tax is triggered at that point. The risk is the one every margin borrower faces: if the share price falls far enough, the lender can demand more collateral or sell shares, often at the worst moment. That risk is one reason many public companies limit how much stock their executives may pledge.

Diversifying after a liquidity event

A liquidity event, such as a company sale, a public offering or a large secondary sale of shares, is often the first chance to spread wealth beyond one company. Common tools for reducing concentration gradually include staged sales over several years, hedging strategies such as collars, exchange funds that pool concentrated stock with other investors’ holdings, and gifts of appreciated shares to charity.

Before investing the proceeds, families and their advisers usually work through a short set of questions.

• How much should stay in the original company, and why?
• What taxes are due on the sale, and when?
• How much cash will spending, taxes and commitments require over the next several years?
• Which mix of public markets, private investments and real estate fits the family’s goals and timeline?
• Who will make investment decisions, and who will check them?

Family offices

A family office is a private organization that manages a wealthy family’s affairs: investments, taxes, legal matters, bill paying, insurance, philanthropy and sometimes travel, security and household staff. A single-family office serves one family and is controlled by it, while a multi-family office serves several families and spreads the cost of staff and systems among them.

Because a single-family office carries the full cost of its own professionals, it generally makes sense only for very large fortunes, and families with substantial but smaller wealth often use a multi-family office instead. In the United States, a single-family office that meets the conditions of the SEC’s family office rule falls outside the federal definition of an investment adviser, so it does not register with the SEC as one.

Trusts and estate planning, in general terms

A trust is a legal arrangement in which a trustee holds assets for beneficiaries under written terms. A revocable trust can be changed during the creator’s lifetime and mainly helps avoid probate and plan for incapacity, but it doesn’t reduce estate tax. An irrevocable trust generally can’t be easily changed, and assets moved into it may be removed from the creator’s taxable estate.

The federal estate tax applies to estates above an exemption amount that Congress sets and the IRS adjusts for inflation, transfers that skip a generation can face a separate generation-skipping transfer tax, and some states levy estate or inheritance taxes of their own. Families with very large estates often use lifetime gifts, trusts designed to pass future growth to heirs and long-lasting trusts in states that allow them. The details are technical and change with tax law, which is why estate attorneys and tax advisers build these plans.

Philanthropy vehicles

Large fortunes often fund philanthropy through a handful of structures. Foundations offer control and a lasting family role but come with more rules and administration, while donor-advised funds are simpler and more private but give the donor advisory rights only.

• Private foundations: separate charitable organizations, often controlled by the founding family, which generally must distribute about 5 percent of their investment assets each year and file public tax returns.
• Donor-advised funds: accounts at a sponsoring public charity, where the donor takes a deduction when contributing and recommends grants over time while the sponsor holds legal control.
• Charitable trusts: arrangements such as charitable remainder and charitable lead trusts that split benefits between the family and charity over a period of years.
• Public commitments: pledges such as the Giving Pledge, a public promise by very wealthy people to give the majority of their wealth to charitable causes, which is a moral commitment rather than a legal contract.

Governance and succession

Many family fortunes shrink within a few generations, not only through taxes and spending but through conflict and unprepared heirs. Families that keep wealth together tend to treat it like an enterprise, with clear governance and a plan that is explained to heirs well before it takes effect.

• A family constitution or charter that sets out shared values, decision rules and how disputes are resolved.
• A family council or regular family meetings that give each generation a voice.
• Independent trustees, directors or advisers who are able to say no.
• A succession plan for leading the family business or office, with timelines and backups.
• Education for the next generation in budgeting, investing, philanthropy and the duties of ownership, starting well before any inheritance.