Business Succession Planning and Transfers

The succession of a closely held family owned business to the next generation presents a complex challenge. Historically, family owned businesses have not fared well through the generations; a fact that underscores the need for careful and comprehensive business succession planning. To maximize the effectiveness of a succession plan, attention should be given to both the financial and nonfinancial aspects. Financial aspects include considerations of tax, finance and law. The nonfinancial aspects are concerned with the relationships, expectations and desires of the family members. This article gives an overview of some major points in the area of business succession planning.

Keywords Business succession plan; Buy-sell agreement; Estate planning; Family owned business; Business Transfers

Business Law > Business Succession Planning & Transfers

Overview

Family owned businesses are important to the United States' economy as well as the growth of the nation, as measured by gross national product (GNP) to family owned business. They are also significant creators of new jobs, generating an estimated nine out of every ten new jobs (White, Krinke & Geller, 2004). The entrepreneurs that own and operate these businesses are often fully engaged in the day to day operations of their enterprises. They must increase revenue, limit costs, secure adequate staff, and meet financial obligations; these activities leave little time to consider the future of their businesses. Only about one third of the businesses survive until the second generation and only ten to twenty percent make it until the third generation. This difficulty can be largely attributed to the lack of trained and capable successors to run a business. That problem can largely be overcome by a clear and well designed business succession plan (White, Krinke & Geller, 2004).

Business succession planning is the process of creating and implementing a strategy to turn over control and ownership of a family business as a going concern. It is the owner's exit strategy that seeks to achieve the owner's financial and family objectives. Ownership of a business typically represents a substantial portion of the owner's overall estate and warrants careful consideration. Unlike other parts of a person's estate, which can be handled with the familiar estate planning tools including wills and trusts, a business succession plan presents a separate challenge that typically involves more complex issues, related to the difficulty of maintaining successful operations.

The business succession plan, as part of an individual estate plan, is the topic of this article. Accordingly, the primary object of a business succession plan is the closely held family business. A closely held business refers to a business, usually a corporation, whose stock is not freely traded and held by a few shareholders. The succession of the business can be to either family members or non family members, depending on the owner's goals and particular family situation. Either way, the process involves complex legal, tax, financial and management planning issues that can extend over a lengthy period of time. The planning process must also involve many people, including; family members, professional advisors, shareholders, partners, and key employees. To ensure the maximum result, it is preferable to begin succession planning earlier rather than later. An unexpected death of a business owner can cause extreme emotional and financial problems for a family. And without proper planning, the sudden lack of leadership and management can cause a business to suffer and ultimately contribute to the failure of the business. Moreover, unmitigated tax consequences of an unexpected death can be disastrous and can cripple the financial condition of the business and the family member who inherits it.

Separating Ownership from Control

A common initial step before a specific technique is employed to transfer the ownership of a business is to separate the ownership from control. Typically, in a closely held business, stock or units (in the case of an LLC) have voting rights and therefore ownership of a majority of the stock results in control of the business. Ownership and control are unified. Ownership and control can be separated by recapitalizing the company into voting and non-voting shares. Recapitalizing means to alter the way in which the financial interests of a company are held. For a simple example, a company with one class of shares would be said to recapitalize if an additional class of non-voting stock were created in addition to voting stock. As a general matter, a corporate structure vests the authority to manage a company in a board of directors and the board of directors appoints officers to manage the daily operations of a company. The shareholders, by voting their shares, elect the board of directors. By use of votes, the shareholders in the corporate structure ultimately control the company, despite being a couple steps removed. In the case of a closely held family corporation, a single person or a few people tend to have multiple roles and the loss of control can manifest more quickly and directly than in a large publically held corporation. An owner may be the chair of the board of directors, the president and a significant stockholder. With a single class of voting stock, transfer of the stock would also cause the loss of control by the owner. By separating the stock into voting and non-voting stock, the owner can retain control over operations during life and begin to transfer ownership of the company to others in the form of nonvoting shares.

Alternatively, a family limited partnership could be set up with control settled in the general partnership interest and only ownership settled in the limited partner interests. This method is the same concept as in the case of a corporation. As a general matter, a limited partnership is a partnership between a general partner and any number of limited partners. Similar to the owner of voting shares in a corporation, the general partner has control over operations, and like nonvoting shares in the corporation, the limited partners have only a financial interest in the business. The limited partners have limited legal liability and limited involvement in the business. The general partner has unlimited liability and ultimate control and responsibility for the management of the business. Under either method, after the restructuring, the primary owners will have both controlling and non-controlling interests in the business and can begin to transfer the business by giving away the non-controlling interests to family members (White, Krinke, & Geller, 2004).

Transferring Interest to Family Members

There are several options for a business owner who wishes to transfer an interest in a business to family members. As a general matter, there are four ways to transfer ownership, by gift during life, by gift at death, by sale during life and by sale at death. Gifts of stock during life can be made tax free to the extent provided by the IRS ($12,000 per year per recipient at the time of writing). Each gift reduces the size of the owner's estate and reduces the potential for estate tax liability at death. However, to qualify for tax free treatment, the gifts must be complete and the owner loses control of the stock once gifted. Gifting is a method that can be effectively employed over time and is a relatively simple transaction. However, a critical part of the choice for a vehicle to transfer a business is tax planning and tax planning is a highly specialized field of endeavor. Tax professionals including accountants and lawyers may use several particular measures according to current state of the appropriate tax law. The important point to remember is that tax considerations are very important to the process and should be considered carefully by a competent professional.

Buy-Sell Agreements

The buy-sell agreement is a very important succession planning tool that transfers ownership to another generation and may often be combined with gifting to accomplish the desired transfer. A buy-sell agreement is an arrangement between owners of a business to buy or sell interests in the business at a determinate price when a particular event occurs. These agreements are useful to restrict the transfer of a business interests to unwanted third parties; to provide for the method of funding a buy-out of a withdrawing or deceased owner's interest; to prevent delay of the administration of a deceased shareholder's estate because details of the transfer had been addressed in advance; and to prevent the disputes between a surviving spouse and children of a deceased owner and remaining owners. Some of the common events that trigger buy-sell agreements are death, divorce, third-party purchase offers, retirement, and bankruptcy. Key issues addressed in a buy-sell agreement are the types of events that trigger the agreement, the method for establishing the value of the business, guaranteeing adequate funding will be available for purchase of the stock or interests when a triggering event occurs, and the tax implications of the transaction.

Types of Buy-Sell Agreements

Generally, there are three main types of buy-sell agreements: cross-purchase, stock redemption, and hybrid (Birch, 2006). In the cross-purchase agreement, each remaining business owner becomes personally responsible for buying the departing owner's interest upon the happening of a specified event. In the case of death as a triggering event, each owner would be beneficiary of a life insurance policy taken on each of the other owners. For example, a company with four owners would have twelve insurance policies; each owner would own three policies, one for each of the other owners. The stock redemption plan obligates the business to repurchase an owners interest in the business upon the happening of a specified event. If insurance is used to fund the purchase obligation, the business would be the beneficiary of a policy taken on each owner. Once an obligation under a buy-sell agreement has been triggered, it may be funded from a number of sources. However, as indicated, life insurance is a particularly important option because it removes the difficulty inherent in generating large amounts of cash at a single time. In the event that a cross-purchase agreement is in place, each owner will own a policy on each of the other owners so that in the event of death, the proceeds of the life insurance policy will be available fund the obligation under the buy-sell agreement. If a stock redemption plan is in place, the business will own the insurance policy on each owner to fund the corresponding obligation. As the name suggests, the hybrid plan may have features of both plans and other mechanisms appropriate to the situation.

A Business' Continued Success

In addition to the specific plan for transferring ownership, presumably, the majority owner wishes the business to continue to be a success. Often, a business's continued success depends not only upon the family members that assume control, but also upon the key employees. The owner should be sure to identify the important employees that serve critical and perhaps unique functions vital to the ongoing operations. Identifying and understanding their position on certain issues is important to continued success and to provide options for its transfer. Whether a key employee will remain with the company under new ownership is a critical question. Does a particular employee have the expertise to run the business? Are the employees willing and able to run or buy the company? Answers to these questions can help prepare the business for the eventual change in ownership by ensuring that proper personnel are available. Moreover, depending on the answers to these questions, a majority owner can consider the sale of the business or accommodate heirs that do not wish to be involved in management.

Application

Business, Financial & Tax Related Matters vs. Emotional Matters

In reality, a business succession plan has two components: the business, financial and tax related matters and the emotional or people matters. Beyond the legal, financial, and tax implications and considerations of a business succession plan are serious family and relational issues. Traditional succession plans tend to focus on legal strategies that seek to avoid taxes and transfer control to the next generation. While those considerations are important, an overwhelming majority of second and third generation family businesses fail, leading some to argue that more is required to effectively transfer a business. Values, morals and matters of the heart may be a vital and often overlooked component of the business succession planning process. For businesses that do thrive, either intentionally or inadvertently, younger generations have embraced family traits that lead the family to business success in the first place (Harris, 2007).

Closely held family business succession plans involve parties with longstanding relationships, and interests that can complicate the process of a management turnover to a younger generation. Families can reach an impasse in the process of drafting a buy-sell agreement and otherwise making plans to pass a family business to the next generation unless emotional and relational issues are addressed. Problems can arise from the emotional impact of the sale of a business interest and the perceived impact the transfer could have on family members' lives. To avoid potentially bitter conflicts during the planning and drafting process, the goals of the majority owner should be clearly defined. The majority owner should carefully consider questions and develop a clear vision of the future of the business. The majority owner may consider whether the proportion of ownership will differ between children. An owner may consider differing interests for children involved in the business and those not employed by the business. Whether the owner wants the children to have outright ownership or ownership through an entity, like a trust, is another important question that includes a host of situation specific facts. The owner may also want to develop a clear idea as to whether ownership in the business should be exclusively for family members or whether it may pass to outsiders. A related question is regarding the projected role of future owners in the business and how they will deal with co-owners. Another consideration is whether or not the majority owners wish to use the business as a device to keep the family connected to one another. Finally, the owner should make clear any wishes regarding the sale of the business. These questions are typically answered by the majority owner with reference to personal and family beliefs and values. The decisions, usually reached after several rounds of conversations, should be made as family decisions, and not simply business decisions. Accordingly, the majority owner should include family members in the process as appropriate (White, 2007).

The owner's spouse is a particularly important family member to consider in an effort to avoid potential problems. If the spouse's interests in the family unit are ignored, there may be significant difficulty forging an agreement acceptable to all parties. Spouses often have different goals for a buy-sell agreement than the owner and are often more concerned with fairness among children and harmony within the family. Likewise, the interests of the next generation should be considered. Often majority owners assume that a child wants to continue a business when many children may prefer to receive monetary benefits and the freedom to pursue their own career direction. There is also pressure for a succeeding family member to honor the wishes of the parents or grandparents and maintain the company to support other family members who have a financial stake but who are not involved in management. Moreover, when a larger benefit is provided for managing children, non-managing children may perceive favoritism or inequality. These potential issues and others should be investigated and addressed to ensure that a business succession plan goes smoothly (White, 2007).

Conclusion

In comparison to large publically traded companies, the succession of closely held family owned business presents a far more complex challenge, due to the close family relationships, and the mixture of ownership and management. Historically, family owned businesses have not fared well through the generations. This fact underscores the need for careful and comprehensive succession planning. To maximize the effectiveness of a succession plan, attention should be given to both the business aspects and the relational aspects. The business aspects include considerations of tax, finance and law. The tax consequences of a business transfer can be great and, if not adequately planned for, can cause a significant financial burden. Improper financing of an agreement to buy or sell a business can also generate such hardship. The need to generate significant amounts of cash to meet those obligations can jeopardize the business itself as a viable entity. The relational aspects deal with the relationships, expectations and desires of the family members and are critically important to the continued success of a family business.

This article has merely touched upon some major points in the area of business succession planning and is only intended to provide a basic foundation from which to begin acquiring other information. The issues are complex and any person seeking to transfer a business should engage the appropriate professionals, including lawyers, accountants, insurance professionals and appropriate business consultants.

IRS Circular 230 Notice:  To guarantee compliance with requirements established by the IRS, we advise you that any U.S. tax information provided within this article is not intended to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

Terms & Concepts

Business Succession Planning: The process of creating and implementing a strategy to turn over control and ownership of a family business as a going concern.

Buy-sell Agreement: An arrangement between owners of a business to buy or sell interests in the business at a determinate price when a specific event occurs.

Cross-Purchase: A type of buy-sell agreement whereby each remaining business owner becomes personally responsible for buying the departing owner’s interest upon the happening of a specified event.

Stock Redemption Plan: A type of buy-sell agreement that obligates a business to repurchase an owners interest in the business upon the happening of a specified event.

Bibliography

Berg, D. (2010). SMB succession planning. Saskbusiness, 31, 43. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=57234862&site=ehost-live

Butler, J., Phan, P., Saxberg, B., & Lee, S. (2001). Entrepreneurial succession, firm growth and performance. Journal of Enterprising Culture, 9, 407. Retrieved May 02, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=7597573&site=ehost-live

Daley, J. (2011). Family affair. Entrepreneur, 39, 97-105. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=67414890&site=ehost-live

Eddleston, K.A., Kellermanns, F.W., Floyd, S.W., Crittenden, V.L., & Crittenden, W.F. (2013). Planning for growth: Life stage differences in family firms. Entrepreneurship: Theory & Practice, 37, 1177-1202. Retrieved November 15, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=90146308&site=ehost-live

Harris, J. (2007). Business succession strategies that work. Practical Accountant, 40, 20-21. Retrieved May 02, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=24623189&site=ehost-live

White, P. (2007). Hidden dragons: Handling family conflicts in buy-sell agreements for business succession. Journal of Financial Planning, 20, 70-76. Retrieved May 02, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=23722774&site=ehost-live

White, W., Krinke, T., & Geller, D. (2004). Family business succession planning: Devising an overall strategy. Journal of Financial Service Professionals, 58, 67-86. Retrieved May 02, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=13048818&site=ehost-live

Suggested Reading

Birch, R. (2006). Preparing for the handover: Getting business succession planning right. Pennsylvania CPA Journal, 77, 1-4. Retrieved May 02, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=22251121&site=ehost-live

Family business succession checklist. (1992). Journal of Accountancy, 174, 24. Retrieved May 02, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=17643582&site=ehost-live

Giarmarco J. (2007). Life insurance in business succession. Advisor Today, 102, 20-22. Retrieved May 2, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=24262545&site=ehost-live

Morrow, E. (2001). Your business succession plan: Are you going barefoot? Journal of Financial Planning, 14, 52-54. Retrieved May 02, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=4459930&site=ehost-live

Powell, L., & Venturella, J. (2006). Succession planning two ways: Business items and emotional items. Production Machining, 6, 22-24. Retrieved May 02, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=20816890&site=ehost-live

Radloff, P. (2007). Now's the time to discuss business succession planning with clients. National Underwriter / Life & Health Financial Services, 111, 22-29. Retrieved May 02, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=24521674&site=ehost-live

Reardon, D. (2005). Life insurance funding strategies for buy-sell agreements. Journal of Financial Service Professionals, 59, 10-12. Retrieved May 08, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=15590583&site=ehost-live

Widland, J. (2006). Small business succession planning: Making the most of the family's golden goose. New Mexico Business Journal, 30, 24-24. Retrieved May 02, 2007, from EBSCO Online Database Regional Business News. http://search.ebscohost.com/login.aspx?direct=true&db=bwh&AN=23395790&site=ehost-live