Family Business Succession Planning
Family owned businesses are the engine of our economy, employing 60% of our workforce and contributing 64% to our total GDP (KPMG, 2013). Return on assets is greater in family businesses, averaging 6.65% more return than non-family owned businesses (University of Vermont Family Business Facts). And yet, the average lifespan of a family business is a mere 24 years (KPMG). About 70% of family owned businesses fail or are sold before being passed to the next generation (Harvard Business Review, 2012). For many such families, the old saying, “T-shirt to T-shirt in three generations” holds true.
Why do so many family owned businesses barely survive a generation? One major reason is that owners either have no succession plan (beyond a simple will) or have not clearly thought out what a successful plan would entail. Passing a family business from one generation to the next, or planning for the disposition of an ongoing business to benefit heirs, can be a challenging estate planning problem. Therefore it is critical to the survival of a family business that the owner begin the planning process early with the assistance of an experienced estate and business planning attorney. An experienced attorney can insure that a business passes seamlessly to the heirs in a timely manner, subject to a minimum amount of estate taxes and other estate settlement costs.
One reason passing a family business to the next generation can be so complex is that family relationships are complex. Parents may expect too much or too little of their children. There may be sibling competition, or at the other extreme, apathy about the business. In some ways, a good estate planner is also a mediator, negotiating a fair arrangement to satisfy all family members and insure the success of the business.
Take the hypothetical example of Arizona Balloon Company, a successful 25-year-old business founded and run by John Smith. He employs his wife and three daughters, as well as 20 other employees. He has two younger children who are not involved in the business. One day, John dies suddenly of a heart attack. His business is worth $12,000,000. His wife, daughters and employees are left to fight over their disparate visions for the business. They also argue over their respective interests in and responsibilities for the company. In the end, after spending hundreds of thousands of dollars in legal fees, with the business floundering, the only path forward is liquidation.
How can these problems be avoided? One option is to place the family business (whether in LLC, partnership or corporate form) into a revocable trust designating the business owner as grantor and trustee. The grantor funds the trust with business assets, and as trustee, retains control over the assets. Upon certain events (such as death or disability of the owner), the trust distributes the assets to the beneficiaries. The business owner can also determine other distribution triggering event(s) such as a beneficiary reaching a certain age or obtaining certain goals. The business owner can also decide who controls the trust after his or her death by naming alternate trustees. Two distinct advantages of a trust include avoiding the cost of probate (as high as 10% in some states) and avoiding delays in the transfer and control of business assets to beneficiaries. Another advantage of a trust is that if members of the next generation are too young or inexperienced to take on the responsibility of running a business, the power to control the business assets can be given to a trustee until the heirs are a certain age and experienced enough to take control.
There are also tax advantages of placing a family business into a trust. Estate taxes can be mitigated by employing certain planning techniques. Irrevocable trusts are often used in an asset ‘freeze.’ Business assets placed into an irrevocable trust can shelter appreciation from estate taxes. For example, if you were to create and gift to an irrevocable trust with privately held shares of $5.43 million (the current estate / gift lifetime tax exemption) and the trust assets grow to $6.43 million, the $1 million appreciation is estate tax free (along with the initial $5.43 million lifetime exemption gift). This technique is especially effective when healthy future growth of a business is expected. A gift of $5.43 million into an irrevocable trust now can keep future appreciation and the income generated by that gifted interest out of a taxable estate.
Another tool to consider is the Family Limited Partnership. The partnership is created by the business owner(s) who makes a transfer of the business interest to the partnership while retaining control over the business. The other members of the partnership, as limited partners, now have an interest in the business and appreciation and income is divided proportionally. This form of partnership can have significant estate tax benefits because the transfer of assets reduces the size of the business owner’s taxable estate. It is also a way to solve the problem of giving a child who is active in the business more ownership and control while providing income for other non-working children.
Returning to the example of Arizona Balloon Company, let’s say John Smith also had an equal partner, Joe Brown. Joe is essential to the success of the business, and without him, the business will fail. Joe will only continue on at ABC if he is able to buy out the interest of the rest of the family, whom he never really got along with. But who determines a fair price? Again, expensive litigation ensues. One way to avoid such a dispute is to have a buy-sell agreement in place, specifying what happens in the event either partner dies or becomes disabled. Additionally, life insurance for both partners could cover the cost of a buy-out.
Perhaps Joe decides to retire, too. The family cannot run the business in the absence of the two key partners. There is no extra money to hire a qualified manager to run the business. Again, the only option is to sell ABC. A way to avoid this scenario would be for the owners to have a business succession plan in place to address this contingency.
These techniques are only some of the ways to plan for the successful, seamless transfer of a family owned business. An experienced estate and business planning attorney should always be retained in order to determine what tools will help ensure the continued success of a family owned business. Here is a helpful checklist of nine questions all family business owners should consider when planning for succession:
- If you die unexpectedly, can your family continue to run your business? If your family cannot run your business, who can?
- If you die unexpectedly, will your family have sufficient liquid resources to hire someone to replace you? If your family cannot run your business without you, you should consider their liquidity needs. If there is no money to hire someone to run the business, perhaps life insurance is needed.
- If you die unexpectedly, and have partners, will they pay your family a fair price for your business?
- How do you protect your family in the event of your early death? The most effective form of protection for your family, or you, if you survive to retirement, is a well prepared buy-sell agreement.
- Do you have a management succession plan in place?
- Does your succession plan accommodate siblings/children with different skill levels or interest in the business?
- Have you considered the impact of estate taxes on your family business?
- Are you willing to make gifts of interests in the family business to your children, or trusts for their benefit, if you can maintain management control?
- Are you and your spouse in agreement as to the ultimate disposition of the family business?