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Business Management
Managing Succession
Plan now for when you want to retire, or sell your family business.
by David N. Knapp
By now
most business owners are familiar with the statistics: less than
one-third of family businesses survive into the second generation,
and fewer than 13 percent survive into the third generation. But
even less seem to know why this is the case.
This high rate of failure is due, in part, to the failure of business
owners to properly plan for the succession of management, the retirement
income needs of the owners and the transfer of ownership to family
members.
When business owners and their families address these issues early
on, they can greatly improve the chance that their businesses will
survive into succeeding generations and even fund their retirements.
Such planning combines an evaluation of the business, the owner’s
estate plan and personal inter-family dynamics with a review of
the interest level and capabilities of family members who are likely
successors.
These plans can be quite simple or complex depending on the unique
facts and circumstances of the family and the business. For example,
assume the owner of a business has three children. Two of the children
are working in the business and could be likely successors, but
the third child has a successful career independent of the family
business. If an owner wishes to divide his estate equally among
his children, he may need to devise a plan for transferring ownership
to the children interested in the business, while providing an equivalent
share of his estate in the form of other assets to the third child.
This advance planning becomes even more critical if most of an owner’s
wealth is tied up in the family business, and there are not sufficient
assets outside of the business to fund that equal share.
Although there is no “one size fits all” plan, family
business owners should be familiar with the most common estate planning
tools that frequently are a part of the plans developed by the attorneys,
consultants and financial planning professionals who advise them.
The following is an overview of some of the more common tools.
BUY-SELL AGREEMENTS
In cases where the business owner is not the sole shareholder, a
common tool is to draft a buy-sell agreement in which the owner
agrees by contract to sell his shares back to the company or a partner
when certain events occur. The agreement outlines the timing, price
and funding for the sale.
Common triggering events for the sale of shares are retirement or
death. For example, the owners of a company may agree to a mandatory
retirement age of 65, upon which the company will purchase outstanding
shares from the retiring owner at a price determined in the agreement.
When death is the trigger in a buy-sell agreement, companies will
often buy insurance policies on the lives of the individual owners.
Upon an owner’s death, the proceeds of the insurance policy
are used to fund the purchase of shares from the estate of the owner.
THE FAMILY LIMITED PARTNERSHIP
When a business owner holds a majority of the shares in the business
and wants to transfer ownership without giving up control, a common
tool used in estate planning is to create a Family Limited Partnership
(FLP) and fund it with shares in the family business. This ownership
transfer tool has the added benefit of potential tax savings.
In this type of partnership the owner usually holds a one percent
general partnership interest and retains control over the business.
He then creates a limited partnership interest with the remaining
99 percent of the partnership units. The assets held in the partnership
usually are shares in the family business. Individual family members
can be made limited partners, but the decision-making authority
remains with the owner as general partner.
The tax efficient transfer of ownership is accomplished by gifting
limited partnership units to family members. Because holders of
limited partnership units usually are restricted from selling the
units or making decisions regarding management of the assets, the
partnership units are worth less than the underlying shares in the
business. As a result, the value of a limited partnership share
is often discounted between 25 to 40 percent, greatly reducing the
tax value of the transfer.
Under federal estate tax law, up to $1 million in assets can be
excluded from an owner’s estate when calculating estate taxes.
Because the value of a limited partnership share is discounted,
the business owner can gift more of the business to family members
without exceeding the $1 million estate tax exclusion.
EMPLOYEE STOCK OPTION PLANS
An Employee Stock Option Plan (ESOP) can be an effective tool for
extracting value out of a family-owned business without having to
sell the business outright. The cash proceeds from a partial sale
of the business to an ESOP sale also can be used to diversify a
business owner’s assets into income-producing investments to
help fund the owner’s retirement.
In most cases, the company sets up an ESOP trust, and the ESOP then
buys a portion of the owner’s interest in the company. If the
owner sells 30 percent or more of his outstanding shares in the
company, and the proceeds are invested into “qualified replacement
property,” no capital gains tax is due until the replacement
property is sold. Stocks and bonds of most publicly traded domestic
companies are considered qualified replacement property, allowing
the owner to take the proceeds from the sale of the shares and diversify
his assets.
In addition, if the ESOP uses a bank loan to purchase the shares,
the business may receive a tax deduction for payments of the loan’s
interest and principal. An ESOP, like other employee benefit plans,
can then offer stock to management and employees as part of their
compensation.
SUCCESSION PLANNING
When developing estate plans for the transfer of ownership in a
family business, the owner should give equal consideration to planning
for the succession of management. Too often, these issues are put
off until health problems or the untimely death of the owner-manager
creates a crisis situation for both the family and the business.
Management succession planning should begin early if succeeding
generations are involved in the business and should be a consideration
in the planning for eventual ownership transfer. These plans include
a career track for children interested in the family business so
they can develop and demonstrate the necessary business and leadership
skills that are required to continue growing the business.
Successful businesses that survive into multiple generations of
family ownership typically have set up corporate governance procedures
to help address the issues of succession planning and business ownership.
In many cases, these include adjusting the composition of the board
of directors to include independent non-family directors to act
as a guardian for the business and buffer between the competing
interests of family members.
SALE OF THE BUSINESS
Often, the business owner may decide simply to sell the business
outright to a family member, employee or an outsider.
If none of the owner’s children have an interest in continuing
to own and manage the family business, one option is to sell the
business to the company’s management team using a buy-sell
agreement, an ESOP or an outright sale through a leverage-buyout
or installment payments.
When selling a business outright, consideration also should be give
to the distribution of the cash proceeds. Using a Family Limited
Partnership to transfer partial ownership to family members in advance
of selling the company may be a tax-efficient estate planning tool.
Following the sale, the business owner still can control the distribution
of the sale proceeds because he remains general partner.
CONCLUSION
Many pitfalls stand in the way of successfully transferring the
ownership and management of a family business to succeeding generations.
With careful planning, business owners can increase the likelihood
of a smooth succession while providing for their own retirement
needs.
David N. Knapp is a vice president of personal finance planning
at the Northern Trust Company, Chicago, IL. Prior to that, he and
his family managed a financial services company that survived three
generations. He has more than 12 years of industry experience.
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