Make sure your family business is passed on

If it is true that only 30 percent of family businesses survive into the second generation, then it is important for business owners and their advisers to understand the challenges in passing on the business.

Three recent cases in my practice illustrate the challenge. In each case the business owner was an individual or married couple, and they had successfully navigated the obstacles encountered by entrepreneurs and managers of a successful enterprise.

They have a child working in the business, as well as one or more non-family key employees, all of whom expect to receive an ownership interest in the business after the current leader retires.

The owners also wish to integrate their retirement and estate planning into the succession plan, and may wish to consider a mechanism for preserving health insurance or other employee benefits available on a more cost-effective basis through the company.

In all cases the owner had other children who did not work in the business, but who were to be treated ‘fairly’ in the disposition of the total estate.

The owners had minimal cash investment in the enterprise (a low income tax ‘basis’), and the business had grown tremendously in value, creating capital gains and estate tax issues. The challenge at this point is to provide a structure for an orderly transition of management and ownership.

Consider disability
An often-overlooked obstacle is the potential disability of the owner. Some have estimated that 33 percent of all 35-year-olds will be disabled for 90 days or more before reaching age 65.

In these cases it is important to identify interim leadership and management, determine income needs during periods of disability, and estimate disability insurance needs. This will eventually tie into the issue of management succession within the business.

Appropriate planning will ensure that the goal of the survival and growth of the business will be reached and will preserve family harmony for family-owned businesses. Strong planning will also minimize taxes and facilitate retirement.

Some of the questions that need to be asked here include the following:

• • Have you defined your personal goals and vision for the transfer of ownership and management?
• • Is your successor identified, ready and in place?
• • What is the importance of family involvement in leadership and ownership of the company?
• • Are you currently using techniques to mitigate or eliminate estate taxes?
• • Do you have enough liquidity to avoid the forced sale of your business?
• • Do you have a buy/sell agreement in place?
• • Have you had your business valued recently?
• • Do you have a contingency plan should you become disabled?
• • Have you considered s to help you achieve your succession goals?
• • Are you dependent upon your business to meet your retirement cash flow needs?

Before the financial and tax issues can be addressed, however, it may be helpful to bring in a business adviser to assist with the management issues. In my examples, the question might be how to transfer the day-to-day management of the business to the child and other key employees.

Compensation and benefits, responsibilities and ownership issues would need to be discussed. You also need to know that the expectations of the employees must be consistent with those of the owner.

Conflicts that require attention include who is in/who is out; who does what; who is in charge; who gets what; and who is recognized for what?

In a family context, there may be tension caused by ineffective communication, marital problems, nepotism, inadequate or excessive compensation, inactive family business owners and the issue of how to treat children fairly.

In the estate-planning field it is commonly stated that ‘fair’ does not always necessarily mean equal when dividing up an estate. There can be extreme differences between the business founder’s perspectives and that of the employees or heirs, as well as changing perspectives depending on the growth stage of the business and the amount of sweat equity invested by individuals.

In addition to looking at the management structure, there should be attention given to governance, which includes not only a board of directors, but also quite possibly an advisory board or perhaps a form of professional management.

Taxing issues
Once the management issues have been addressed, then attention can be given to the ownership issues. There are several tax-planning strategies that may be utilized to assist in the transition of ownership.

This could simply be a sale of the business to the succession team or an ESOP (Employee Stock Ownership Plan), or it may involve a gradual shift in ownership by gifts or compensation arrangements, stock options, or purchase of the ownership interests by the business (redemptions).

If transfers are going entirely to family members, then arrangements might be made to minimize the transfer tax (gift and estate tax) cost, as well as the purchase price pressures on the family members.

The business can be sold on an installment basis either to the children or an irrevocable trust, and annual gifts can be made taking advantage of the estate and gift tax exclusions and deductions.

More sophisticated planning might involve an irrevocable transfer to a trust that allows the gift value to be discounted for the deferred gift to the children. Estate planners might also consider a charitable remainder trust, exchange fund, or other sophisticated technique for deferring or minimizing the capital gains tax on the appreciated value.

When planning the succession of a business, whether family-owned or not, the owner needs to make the same physical, financial and emotional investment that was necessary to establish and grow the business.