Long Term Business Success is in the Planning

By: Jennifer L. Zegel

Many owners of closely held and family-owned businesses are reluctant to plan for the future of their business or for unexpected events. Business succession planning is the process of deciding the method and timing of the transfer of ownership in a business and the transition and training of the management of the business. Lack of proper planning can be the greatest downfall for an otherwise successful business, which can be entirely avoided or the damages lessened by taking steps to ensure a formal strategy is in place to deal with death, retirement, and unanticipated events.

Frequently, business owners refuse to think about establishing a business succession plan for fear of contemplating their own mortality or giving up control of their business. Business owners often do not want to ponder tough decisions as to who will takeover the business or how to divide their estate, including their business interests, “equally” or “fairly” when several family members are active participants in the business and others are not. Many owners also question the skill, aptitude, and interest of the next generation to continue the family business, which prevents them from finalizing or even creating a plan.

A good business succession plan should be tailored to achieve the owner’s individual and professional goals and desires. A few of the key questions that need to be answered to begin to formulate and implement a plan are: 1. Who will own the business; 2. Should the business be carried on or sold to a third party; 3. Who will manage the business; 4. Will the new owners run the business or will outside managers take control; 5. How and when will ownership and management be transferred; 6. Will the owner transfer the business during life or at death; 7. Does the owner have enough income for retirement; 8. What happens in the event of sudden death or disability of the owner or key management; and, 9. What are the tax consequences of the business transfer and what options are available for tax savings?

According to a 2012 study by the American Institute of CPAs (AICPA), only 46% of all closely held businesses have a succession plan. The fewer full time employees a business has, the lower the percentage is that the business will have a succession plan. In general, small family owned businesses that do not have a succession plan are less likely to succeed when second or later generations take control. In addition to an increased risk of business failure, lack of proper planning often leads to family discord, uncertainty, and turmoil over the fate of the business. Many family owned businesses suffer due to intra-family discord regarding disagreements with respect to the operations and control of the business if a succession plan or the owner’s wishes are not made clear in advance. Furthermore, if a business owner desires his or her children or other family members to take ultimate ownership or managerial control of the business at the owner’s retirement or death, steps should be taken to allow time to train and groom the next generation in order for the successor to have the requisite skills and knowledge to manage the business and to increase the chances of long-term success.

In addition to planning for the transfer of ownership of the business upon the owner’s retirement or death, a well thought out plan should incorporate a strategy to address sudden death or disability (short and long term) of the owner and key management to avoid or minimize confusion and disruption to the business. The purchase of life and disability insurance by the business on owners and key management is one option to ensure that the cash needs of the business are met during periods of unexpected transition. In order to utilize this planning technique, the working capital of the business must be assessed to determine the amount of death and disability insurance required to assist with the immediate cash flow needs of the business. A contingency plan should also be in place with respect to who will assume initial control of the business during any sudden changes.

A thorough plan must also incorporate tax planning to reduce transfer taxes on the transfer of the business during life or at death. Optimizing tax savings and transferring interests in the business can be done slowly over time by utilizing the annual gift tax exclusion ($14,000 for individuals and $28,000 for married couples in 2013) to gift interests of the business to the next generation in small amounts each year. The interests can be gifted outright, in trust, or placed in a family limited partnership or family limited liability company. This technique requires long term planning in order to shield triggering gift tax on the transfer of business interests, but has the advantage of allowing the owner to maintain control of the business and only gift small interests each year over an extended period of time. An appraisal will likely need to be done for the business every few years to ascertain the value of the business interests being transferred in order to ensure the interests transferred will not trigger gift tax, which can be costly and time consuming.

Other options for estate and gift tax saving are to transfer larger interests in the business and to apply to the transfer the owner’s lifetime federal exemption against estate and gift tax, which is $5,250,000 for individuals and $10,500,000 for married couples in 2013. Again, such transfers can be outright or in trust. One such trust option is a grantor trust, where the owner would continue to pay income tax on the income generated in the trust, which if structured properly, results in a further economic benefit to the trust beneficiaries without incurring any gift tax liability. All of the business succession planning techniques require the owner to relinquish some control over the business, but can be structured in a way to minimize the relinquishment of that control.

The most advantageous business succession plans for owners of closely held businesses also incorporate and are a part of the owner’s overall estate plan. The symmetry between a business succession plan and an estate plan is necessary to optimize and achieve the owner’s desire for transferring assets to the next generation and to minimize any estate, inheritance, gift, and income tax on the transfers. Attorneys, accountants, and financial planners should work together as a team to formulate a custom tailored business succession plan that achieves the owner’s goals, preserves wealth, and minimizes tax on the business transfer, while increasing the likelihood of long term business success when the next generation takes control.

For questions, comments or additional information, please contact Jen Zegel, Partner in our Estates & Trusts Group, at jzegel@regerlaw.com or via phone at 215.495.6523.