By: Randall A. Denha, J.D., LL.M.
Family business owners understand the difficulties of running a business as well as managing, forecasting and dealing with the day to day ups and down of the business. However, when it comes to affecting an orderly and efficient transfer or succession of the business while still providing for the future needs of the owner and his/her spouse, there is a sort of interruption in the generally smooth decision making ability of this same business owner. As such, this key component to the survivability of the business lingers. It is said that the failure to properly plan for succession during the owner’s lifetime can not only result in monetary loss but also the business itself. In fact it is estimated that more than 70% of family owned businesses do not survive the transition from founder to second generation! The following is a summary of key items to consider (and by no means exhaustive) in transitioning the family business and items which should be considered when making a decision.
Transitioning a Family Business to Children – Overview
Many family business owners are fortunate to have one or more children work in the business, which provides the opportunity for a planned transition within the family. This transition can take several forms – an outright sale, an outright gift, or a part gift/part sale transaction. Each of the transactional forms presents different challenges and opportunities. In addition to choosing the right form of the transaction, family business owners are often faced with potential issues with those family members who are involved in the business and those who are not. Similarly, the family business owner may need to address potential issues between different family members who work in the business.
Form of Business Transition
The family business owner has a number of considerations in choosing the form of the transition to the next generation. The issues to be addressed include the ability of the next generation to pay for the business interests being transferred, tax planning, and the income needs of the owner.
Sale of Business
The outright sale of the business can provide the owner with immediate liquidity. Ideally, the family member or members will be able to arrange bank financing for the purchase. The third party financing disconnects the former owner’s financial security from the ongoing success of the business, which can be beneficial since the owner is no longer involved in the day-to-day operations of the business. Third party financing is not always available, however. The sale of the business can take the form of 100% seller financing or there can be seller financing that is subordinate to any partial third party financing. In either case, the former owner assumes the risk of the buyer’s potential inability to pay the installment payments.
With any seller financing, the purchaser of the business will rely on compensation and distributions from the business as the source of the purchase price payments. The available cash-flow for payments will be the after-tax funds received from the business. The business owners should give careful consideration to the terms of any seller financing. For example, the seller may want to require the purchaser to buy life insurance that is collaterally assigned to the seller in the event the buyer dies unexpectedly. Other common issues include (i) the amount of the down payment, if any, (ii) what collateral will secure repayment, and (iii) what default events, such as the sale of the business or its assets, will cause payment to be due in full.
The risk exists that the buyer of the business will sell the business to a third party not long after the intra-family sale. Most intra-family sales have some element of a “good deal” for the buyer. The transaction documents can provide for an “earn out” to protect the seller. An “earn out” provides for additional payments to the seller in the event the business is sold within a specified time period after closing for an amount in excess of a specified sale price.
Many business owners will own the real estate where the business operates. The transfer of the real estate needs to be considered in any transaction. Many owners desire to retain the real estate for the rental income, particularly if there is gifting of the business. Retaining ownership of the real estate, however, presents some issues. First, the purchaser of the business may desire to purchase the real estate. Second, if there is not a purchase of the real estate, then a long-term lease should be in place to frame the rights and obligations of the parties. Third, there is some risk involved with retaining the real estate. If there has been a sale of the business with seller-financing, then the former owner will have a undiversified investment portfolio consisting of a promissory note from the buyer and real estate whose primary (or only) tenant is the owner’s former business.
Gift of Business
Certain business owners are able to gift all or part of the family business. In structuring a gift, consideration should be given to minimizing the gift tax consequences of the transfer. Luckily, in 2013 the gift tax exemption is $5,250,000 (per spouse) so this permits a large amount of gifting to take place. For example, the business normally should be recapitalized into voting and non-voting classes of ownership. The value of the non-voting interests can be discounted for gift tax purposes based on lack of marketability and lack of control. The gifting of non-voting interests also allows the owner to retain control through ownership of voting interests. In some cases the business owner will gift non-voting interests and sell the voting interests.
An ancillary benefit of non-voting interests is the possibility of these interests funding trusts that benefit children and other generations of the family. The funding of generation skipping trusts with non-voting interests will keep control of the business with individuals who own the voting interests but allows for equity appreciation to other family members represented by the non-voting interests. As discussed below, there are situations where a family has some members who work in the business and some that do not work in the business. Trusts funded with non-voting interests present an opportunity for those family members who are not active in the business to benefit economically while not interfering with the management of the business. Furthermore, the appreciation in the value of the stock will occur in trusts that are sheltered from estate tax and generation skipping transfer tax. Thoughtful, inter-generational planning can therefore mitigate or even obviate the need for tax-driven planning for future generations. Trusts may also eliminate the need for pre-nuptial agreements since the business interests held in trust are not marital property if there is a divorce.
“Participants” and “Non-Participants”
Most family business owners are faced with the situation of having some children who work in the business (the “Participants”) and children who do not work in the family business (the “Non-Participants”). A number of issues should be addressed in the transition of a business to the Participants.
There are many instances of one child being the sole Participant. In this situation, the business owner must balance the desire to treat the Non-Participants fairly in his or her planning while at the same time ensuring a smooth and successful transition of the family business. A common theme is that the business owner wants to treat his or her children “fairly”. Remember that treating the children “fairly does not always mean treating them equally.” It is also important to acknowledge that some of the value of the business being transferred is derived from the efforts of the Participant.
A business owner’s estate plan can address the disparity (perceived or real) between how Participants and Non-Participants are treated in a number of ways. As explained, the Non-Participants may receive non-voting interests in the business. Although a Non-Participant may receive voting interests, considerable thought should be given to transferring voting interests to Non-Participants, particularly if the Non-Participants collectively will have majority voting control.
A business owner’s estate plan may also provide for the Non-Participants to receive other assets of the business owner’s estate. A business owner could also provide that the Non-Participants be the beneficiaries of non-probate assets, such as life insurance policies and retirement accounts. Life insurance can always be the great equalizer if planned for correctly and timely.
The issues of “fair” versus “equal” will continue to be present if there is more than one Participant so long as there is at least one Non-Participant. A family business with more than one Participant, however, faces additional succession planning issues.
At the outset, the business owner must decide which Participant will succeed the business owner as the lead executive of the business. There can only be one person in charge, regardless of whether the Participants each have an equal ownership interest. The task of picking the next leader is often difficult due to emotional considerations and family dynamics. It is important that the business owner discuss the leadership roles of the Participants openly and honestly instead of simply imposing decisions on the Participants. The owner will need to allow for adequate time to groom the Participants in their respective leadership roles. The exercise of management and leadership succession should involve a critical analysis of which Participant has the skill set required to run the family business. As important, the business owner should indentify which Participant is most motivated and engaged to run the business. A Participant that lacks the necessary drive and motivation likely is not a good choice despite other favorable characteristics.
Some families will adopt a “family business constitution”. The family business constitution accomplishes a number of objectives. First, it clearly sets forth the expectations of Participants. For example, a Participant may be required to have a certain level of education or be required to work in another business before applying for employment. A family business constitution often will confirm that the Participant is not simply expected to meet the requirements of his or particular position in the business but to exceed those requirements. In addition the constitution can address nepotism, provide for a dispute resolution, and document mission, values, and principles.
A buy-sell agreement should be implemented (or at least updated) as part of any succession plan. The buy-sell agreement addresses the mandatory sale and purchase of business interests among owners. The agreement should establish a cross-purchase obligation between Participants (or require a redemption by the business) in the event of death, disability, and perhaps termination of employment.
The buy-sell agreement may provide certain shareholders with the right to “drag along” other shareholders with regard to certain actions. For example, the agreement may provide that a certain percentage of the voting interests can force the other shareholders to agree to a particular action, such as an asset sale, stock sale, or merger. Conversely, the agreement may provide minority and non-voting owners the right to “tag along” to certain actions, such as a sale or merger, so the voting minority and non-voting owners are not frozen out of the benefits of a transaction. Drag along and tag along rights can be important to ensure the Participants can make certain decisions and to ensure that the Non-Participants are not excluded from significant opportunities.
In some instances a family business owner will not have a Participant or will have a Participant that is incapable of managing the business. The lack of a Participant managing the business does not mean that the family will no longer realize the benefits of ownership. The Participants and Non-Participants may still be owners, but careful consideration will need to be given to the ownership of the voting interests. An ownership structure that results in conflict could serve to drive out talented managers who are important to the business. Each non-family manager must be adequately compensated since they will not have any equity ownership and should have an employment agreement that confirms compensation, job duties, and provides for a non-competition covenant. The manager could enjoy “phantom” equity in the form of compensation tied to the performance of the business. A non-family manager could also run the family business until other Participants gain more experience and develop the necessary leadership skills.
Always remember that planning is an active process. A well thought out succession plan is an outgrowth of a thoughtful estate plan. Each family, business and situation is unique, but a succession plan should address the “fair” treatment of all family members and other generations while at the same time ensuring the continued success of the business.
THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT INTENDED AS LEGAL OR TAX ADVICE AND TAXPAYERS SHOULD CONSULT THEIR OWN LEGAL AND TAX ADVISORS AS TO THEIR SPECIFIC SITUATION.