Family Business Succession Planning

Small businesses comprise a significant portion of our economy. Unfortunately, most small businesses do not survive into the next generation of owners. The hard work and legacy of the current and prior generations can be wasted without proper planning.

Small business owners often feel they have sufficient time to begin making the transition and will delay the necessary steps until some fateful event forces them into acting. This leaves little or no time to prepare the business and the family for the burdens, both financial and managerial, that can be caused by a sudden and unplanned transfer.

If you are currently the owner of a business there will be several questions you will want to consider for your planning:

• Would your family be better off by selling the business or remaining owners?
• Will one or more members of the family desire and be capable of managing the business?
• Do you plan to retire and/or intend for the business to fund your retirement?
• What financial, legal and tax issues do you anticipate?

Once you and your advisor have considered each of these questions, you should be able to take the initial steps necessary to transfer your business.

Family Considerations

Some family-owned businesses cannot be managed by a “hands-off” board of directors and needs one highly-involved person alone at its helm. You will want to consider which members of your family would both desire and be capable of being the manager of the business. In most situations there will be one obvious choice, but do not assume your other children will not either want some control or want to be compensated for their portion of the business. Discussing your plan with your family can be a delicate matter, but you may be able to avoid future conflicts at less opportune times. Some family members will want nothing to do with either earning a salary from the business or being an owner of the business. In addition, it is often the case where a small business produces only enough income to support one owner. Thus, planning to leave the business to one arranging either for compensation or extra bequests to the others can be a practical and necessary step to preserve the business and family unity. If comparable assets are not available to offset a gift to one child, then the business owner will often purchase life insurance that will benefit the other siblings.

Transfer of Management

Once you have determined who or who will not be continuing in the business, you should begin preparing them for their future duties. Most prepare the next generation for their role through their active participation in the business. Through this experience they will become familiar with your business, your contacts, your industry, and the day-to-day tasks that the job entails. Further, there should be an opportunity for the employees and the successor to become familiar with each other. If that prospect seems frightening, then consider sending them to work at a similar business where they will be able to mature and fine-tune their business skills.

Transferring the Business

Determining the method by which the business should be transferred will depend significantly upon the parties’ ability to fund the transfer, the owner’s need for cash, and the legal and tax consequences of the transfer. The factor most likely to affect the transfer is the funding of the transfer. If the business has significant value, then it may be difficult for the child to purchase the business outright and compensate their parents or siblings. If the business is not to be transferred until death, then life insurance can be used to compensate those children who will not be continuing in the business.

If you, as the owner, are not interested in being paid by your children or if the business has little value apart from the people providing labor, then you may be able to simply start gifting interests in the business to your children. Gifting can utilize the annual gift tax exclusion (currently $13,000 to each recipient) to transfer a portion of the business each year, usually based upon the appraised value of the business. To accomplish this annual gifting you will need to assign shares or membership interests each year. And, yes, you will need to go through that formality to have the IRS consider it having been done properly. An additional benefit of annual gifting is that it can be used to reduce your Maryland estate taxes as well. Alternatively, the owner can use their last will and testament or a trust to transfer your business to your children, but you should certainly contact your attorney to see what will be the best method.

If you will be transferring the business and expect some compensation, then you will be able to structure the transfer using similar methods used between unrelated parties. Your ownership interests in the business can be transferred in accordance with a buy-sell agreement whereby your child can purchase interests in the business from your estate. To assist the child with their purchase of the business, you or the child could purchase the child a life insurance policy payable on your death. The proceeds of the insurance policy can be used to purchase the interests from your spouse and provide money for their future use.

Tax Planning

A transfer of a business can involve both income taxes, local transfer taxes, as well as both federal and state estate and gift taxes. Despite the federal estate tax having been raised, here in Maryland, you begin to have state death tax issues once your estate reaches $1,000,000, if transferring to your children. If you are transferring property at your death to someone other than your children, then Maryland death taxes begin with the first dollar transferred; no matter what your total wealth may be. Your tax attorney can assist you with transferring the business in the most tax efficient manner.

If the transfer is structured as a sale, then you should be aware of the income tax consequences. Most assume that the sale of a business always creates capital gains income. This is not always the case, and those items taxed at ordinary income tax rates can create a very large tax bill. One ordinary income item is the taxation of “recapture” income. When a business owner sells property that he earlier depreciated, if the amount realized from the sale is more than the adjusted basis (roughly, what’s left to be depreciated) then the property owner is considered to have recapture income. Essentially, it means you overshot the true depreciation of the asset and the IRS wants its money back, despite the fact you were likely using an IRS-required depreciation formula to calculate it.

Planning for Legal Issues of Your Family

In addition to the obvious tax and legal issues associated with the transfer of a business, the personal and legal issues of you and your family can complicate matters. These issues usually must be considered when structuring the transfer or the consequences can be dire. For instance, you or your children could possibly have debt or spending issues, and transferring the interests to them could suddenly make your business subject to the claims of your child’s creditors. Another possible issue could be your child’s current or future marital status. While gifts and inheritances left to children generally will not be considered marital or community property in most states, the way you structure the transfer of the business to your child or your child having access to income from the business could cause property division and support issues if your child’s marriage takes a turn for the worse.

If your child has potential legal issues that could jeopardize their holding and benefiting from a transferred business interest, you may want to consider some other arrangement. For instance, you may may want to delay giving the business to your child until a later date when your child (or their marriage) matures. Rather than giving an interest in a business directly to your child, you can have the stock held in a trust for the benefit of the child. The trustee can distribute income from the business to the child, but, since the child will not own the stock, it may limit the risk of claims of creditors or divorce attorneys. Once the foreseeable legal issues have passed, you may then have the trust distribute the stock to the child, or even to a grandchild.

Conclusion

Successful succession planning improves the odds that a business will survive into a second generation. We have all seen the consequences of when a child is thrown into the position of being an owner and manager of a business without proper preparation. While the child may be grateful for the opportunity to step into a business, only through proper planning will this gift be a blessing and not a burden.