Studies show that approximately two-thirds of family businesses fail in transition of management to children. One study of family businesses from 1924-1984 reveals that 80% of these businesses had died, 13% were still in the family, 5% were sold to outsiders and 2% went public.
Business succession planning often does not yield immediate benefits and may be difficult to work through. However, time devoted to strategic planning for business succession is vital to the “net net” bottom line.
ELEMENTS OF SUCCESSION PLANNING
A business succession plan is a strategy (preferably written) detailing the systematic transfer of the management and ownership of a business from one individual (or group) to another. It consists of various elements – which are divided into the following six steps.
1. Management Succession
- Entrepreneurs-by their nature-are reluctant to give up control.
- Developing, motivating, training and nurturing successors is vital.
- Dealing with unmotivated children, or children who are not capable of providing needed management may be extremely painful for the business owner to address.
- The business owner must separate personal from business goals.
- Consider utilizing outside directors and advisors to bring objectivity to the process.
- Equitable compensation planning is essential in dealing with management issues. This includes addressing equitable compensation for both family and nonfamily employees as well as for active and inactive shareholders.
- Ultimately, a plan must be developed for delegation of responsibility and authority to successors.
2. Ownership Transfer
The decision of who will own the business is separate from the decision of who will manage the business. The two decisions, however, must be in concert.
The business can be transferred to one of three potential groups: family, insiders and outsiders. Most family business owners desire to continue the business in family hands. However, the owner should carefully consider whether their motivation is in the best interest of the family. If family members are not able to continue the business successfully, the owner may best assure the long term security of the family by planning for a transfer of ownership outside the family. Many family business owners are extremely devoted to non-family insiders. They should also consider what is in the best interest of those insiders.
If an owner decides to transfer the business to outsiders, they should consider and plan for a lifetime transfer of the business. A business should be transferred when it is at its maximum value. A business is usually more valuable before its owner dies. A lifetime sale permits a smooth transition from one owner to the next and avoids the no-win “fire” sale.
Structure of Ownership Transfer
Ownership can be held in various forms. Consider:
- Voting and non-voting interests. Non-voting interests allows greater flexibility for transfers during life.
- Different classes of interests. One class of stock could have limited future appreciation.
- Debt vs. equity interests. Some children may be given debt interests- such as note payments- rather than equity ownership interests.
- Separate assets from the business. For example, real estate used in the business may be left to a family partnership that would predominantly have non-active children as limited partners. Lease payments could supply desired cash flow to non-active family members.
Timing and Mechanics of Ownership Transfer
Will the transfer be made during lifetime or at death? If during lifetime, will the transfer occur by gift or by sale? Will the transferee be a family member or an entity for the benefit of the family member (for example, a trust or a limited partnership)? If the transfer is at death, will the interests be bequeathed to the ultimate successors or be left equally to family members with provisions for transfers to active family members in a buy-sell agreement?
A buy-sell agreement requires careful planning. At a minimum, every family business should have a buy-sell agreement that provides for right of first refusal restrictions on transfers. Sales of business interests under a buy-sell agreement must be planned to avoid a myriad of tax traps.
3. Treating Family Equitably
If all children of the business owner are not actively involved in the business, the owner may not want to leave the ownership of the business equally to all of the children. Even if ownership is equal, management control and compensation may not be equal. Equal ownership among the children may cause family fights when inactive children who do not provide services and therefore do not receive compensation from the business want a return on their ownership in the form of current cash flow. This is especially difficult for a “C” corporation that would have to pay dividends, which are effectively subject to double taxation, to distribute cash flow to the inactive shareholders.
Grappling with this difficult issue may be gut-wrenching and is the primary reason that many business owners “put-off” addressing succession planning. Family pride is associated with the business, and unless the children are aware of the difficult problems that may occur (potentially for all of the children) from equal ownership, hurt feelings may result. Involving all of the children in the decision making process does wonders for long-term relationships.
We often find that determining the realistic value of the business is a necessary first step to effective planning to divide the business owner’s estate equitably among the children.
One common technique is to leave the business interests equally to the children under the business owner’s will, but to have a plan under a buy-sell agreement for either the business or the “actively-involved” owners to purchase the interests of the inactive children.
4. Liquidity Planning
Can the business survive taxes and expenses associated with the death of the owner? Federal and state estate taxes are often about 55% of the total estate. What business do you know of that could survive a 55% mortgage every 25 years without getting any proceeds for the mortgage? In addition to liquidity for paying estate taxes, liquidity planning is also vital if inactive children will be “bought out” at the business owner’s death. Proper liquidity planning is essential to avoid crippling the business.
5. Tax Reduction
The business owner, perhaps more than any other type of client, may be able to achieve enormous estate tax savings with proper planning. Central to these savings programs are gifts, sales and “opportunity transfers.” The primary estate tax problem is not the large amount of estate taxes that is payable on the current value of the business, but the estate taxes that will be payable on the FUTURE GROWTH of the business. Consider this example, a business worth $1,000,000 growing at 12% per year increases in value to approximately $9.6 million in 20 years. Shifting a substantial part of that future growth will result in significant estate tax savings. A variety of estate planning techniques may be used to shift future growth out of a business owner’s estate for estate tax purposes. The key is to act early before significant growth occurs.
Planning for the succession of a family business is not necessarily a difficult or costly experience. In fact, our experience reveals that family business succession planning not only serves to enhance the wealth of the family but can serve as a catalyst to bring a family together.
The most important element of all of the steps in the business succession planning process is TO ACT.
Steve R. Akers, J.D., partner with Ernst & Young U.S. LLP, is the director of the estate and business succession planning practice for the Southwest Area of Ernst & Young. Steve has previously served as chair of the State Bar of Texas Real Estate, Probate and Trust Law Section, and currently serves as assistant secretary of the American Bar Association Real Property, Probate and Trust Law Section. David K. Walser, C.P.A., co-manages the estate and business succession planning practice and has extensive experience in dealing with the complex tax issues facing business owners