Planning for Business Succession on Three Levels

Succession planning is critical to ensuring the continuation of any family-owned business. An effectively developed succession plan provides for a smooth transition in management and ownership with a minimum of transfer taxes. Given the number and complexity of succession options available, effective succession planning requires time, the assistance of outside advisors, the input of family members, and the willingness to address interpersonal conflicts that can arise during the planning process. Once completed, the succession plan will provide peace of mind for the business owner and key employees, personal satisfaction for family members, and new opportunities for the business itself.

LEVEL ONE - MANAGEMENT The business owner must learn to delegate and work on the business, regardless of whether management of the company will be in the hands of the next generation, important staff, or a combination of both. Training the successor management team to take over the company's day-to-day operations can take many years. It might be challenging for many business owners to relinquish such power. All too frequently, business owners disregard the people concerns associated in a business succession plan in favor of focusing more on the ownership and transfer tax difficulties. The future boss of the normal family business is probably going to be one of the owner's kids. If so, action must be made to ensure that the key employees and other family members who own the business support the future leader. A gradual transfer of roles and responsibilities typically provides the successor time to adapt to his or her new role and gives the firm owner time to adjust to his or her shrinking role. Lead time is crucial for a smooth changeover, therefore. Many family-run firms rely on one or two key employees who are essential to its success. During the transition time, it is frequently necessary to manage (or aid in managing) the firm with the help of these essential personnel. Therefore, the succession plan must include measures to ensure that key workers stay with the company after the firm owner passes away, becomes disabled, or retires. Employment agreements, nonqualified deferred compensation agreements, stock option programs, and change of control agreements are a few of the frequently employed strategies for ensuring that important workers stick with the company during the transition phase. LEVEL TWO - OWNERSHIP How to treat each child equally during the business succession process is frequently a top worry for family business owners whose children are involved in the company. When to relinquish management of the company and how to ensure a comfortable retirement are two more issues that the business owner must deal with. For instance, treating all children equally and providing the business owner with retirement income can be achieved by selling (as opposed to donating) the company to the active children. For those business owners who don't plan to retire from their company, They can leave non-business assets to the passive children and give the business to the ones who are actively involved. Create an irrevocable life insurance trust for the benefit of the inactive children if, as a result, they will not receive an equal (or fair) share of the business owner's estate. The new owners should sign a buy-sell agreement concurrently with the gifting and/or sale of business interests. A buy-sell agreement is a legal arrangement providing for the redistribution of shares of the business following the death, disability, retirement or termination of employment (triggering events) of one of the owners. Upon the occurrence of a triggering event, the buy-sell agreement would additionally specify the purchase price formula and payment terms. A buy-sell agreement can give a departing owner a market for what would otherwise be a non-marketable interest in a closely held company, allow the original owners to keep control of the company by preventing the transfer of shares to the departing owner's heirs, and set the value of a deceased owner's shares for estate tax purposes. All of these benefits are possible if the agreement is properly designed and drafted. LEVEL THREE - TRANSFER TAXES Planning for business succession that minimizes gift and estate taxes includes measures to transfer ownership of the company. The effects on gift and estate taxes require extra consideration. Unexpected federal estate taxes may be so high that the company may need to be sold to cover the cost. While the estate and generation-skipping transfer taxes are now inactive, it seems expected that Congress will reinstate both levies at some point this year (perhaps even retroactively). If not, the top estate tax rate (which was 45 percent in 2009) would increase to 55 percent on January 1st and the estate tax exemption, which was $3.5 million in 2009, will decrease to $1 million. A gifting program can be utilized to lower estate taxes for business owners with taxable estates. Nonvoting shares are typically utilized for lifetime gifts or business transactions for two reasons. The first is to accomplish the business owner’s desire to retain control of the business until a later date (i.e., the owner’s death, disability or retirement). The shares' valuation discounts for loss of control and marketability are the second justification for lowering the gift-tax value of the shares. Up to $13,000 ($26,000 for married couples) may be given each year to as many donees as the business owner chooses as gifts of business interests. Inflation adjustments are made to this amount in $1,000 increments. Such gifts take away not only the value of the gifts from the estate of the business owner, but also the income and potential future appreciation on the gifts. The business owner can give away an additional $1 million ($2 million for a married couple) over and beyond the $13,000 yearly gift tax deduction. The revenue and potential future gains on the gifted property are not included in the estate of the business owner, even though using the gift tax exemption reduces the estate tax exemption upon death (dollar for dollar). The gift tax exemption, in contrast to the estate tax exemption, is permanently set at $1 million. Although a business owner can give shares of the company in cash, giving in trust should also be taken into account. Giving to a trust for the benefit of active children has the advantage of shielding the beneficiaries from their incapacity, disabilities, creditors, and predators, such as ex-spouses. Another benefit of making gifts in trust is that the assets in the trust at the children's passing can pass to the business owner's grandchildren estate-tax free (within certain parameters) (and perhaps more remote descendants depending on state law). These are also referred to as dynasty trusts or generation-skipping trusts. There are complex giving options available for business owners with very sizable estates that can be used with little to no gift tax, like installment sales to grantor trusts, private annuities, grantor retained annuity trusts, and self-cancelling installment notes. Additionally, there are statutory provisions like Internal Revenue Code Section 303, which permits a tightly held corporation to utilize its cash tax-free to pay an estate tax for a deceased shareholder, and IRC Section 6166, which enables a business owner to pay estate taxes in installments. A business succession plan frequently includes life insurance as a key component. For instance, some business owners decide to leave all or the majority of their business interests to one or more of their children after they pass away. Life insurance can give the children inheriting the business the funds they need to pay estate taxes if the business owner has a taxable estate. As was already noted, business owners can use life insurance to treat their non-business-related offspring fairly. Last but not least, life insurance is a well-liked method of supplying the money required for the company or the remaining owners to purchase a deceased owner's interest in accordance with the conditions of a buy-sell agreement. In certain cases, the cash surrender value in a life insurance policy can also be utilized tax-free (by surrendering to base and borrowing the excess) to aid in the acquisition of a business owner's interest over their lifetime.