Succession Planning:
What if the Business Doesn't Stay in the Family?
If you've put years of effort into building a business, you're deeply concerned about what happens to it after you're gone. You hope that the business will survive you, or at least that your loved ones will enjoy the benefits of your hard work.
Succesion planning often focuses on keeping a family business in the family after the founder's death. There are a variety of techniques for accomplishing this, including family limited partnerships, lifetime gifts of stock to family members, and taking advantage of applicable federal estate tax exemptions. All these techniques assume that there are younger family members who will carry on the business.
Not every business owner has children, however. And even if there are children, they may be too young to take over or they may not be suited for the business. Perhaps they simply want to pursue other goals than working in the "family shop." Regardless of the reasons, the business owner wants his or her heirs to receive the benefits of the family business, even if they won't work in the business.
Successor Employee Planning
The first step is to determine whether any existing employees are willing and able to take over the business. In many cases, several employees will be needed to take over all the functions of an energetic founder, and they need to be identified.
Ideally, the founder and the successors will draw up a business “game plan” for how the business should be run in the event of the founder’s death or disability. Thorough planning will help avoid delay and confusion at the critical time.
In addition to developing a business plan, consult with legal counsel to develop the structure needed to implement the plan. Issues to be addressed include:
- If the employees will buy the business from the founder’s estate, how will the purchase be structured? For a corporation, the successor employees could buy, or receive as compensation, a small number of shares now, leaving the founder with the majority. A buy-sell agreement could be prepared that provides for the purchase of the founder’s shares by either the corporation or the other shareholders. Similar arrangements can be made for limited liability companies or partnerships.
- If a buy-sell agreement is used, how will the purchase price be determined? Several methods are commonly used: (1) agreement by shareholders on an annual basis; (2) valuation by an agreed expert; or (3) an objective value such as book value or a multiplier of annual sales.
- If the corporation or employees will purchase the business, how will they pay for it? Unless the company is very cash rich or has the ability to borrow, it will likely be necessary to provide for an installment purchase or to identify another source of funds. Frequently, insurance on the founder’s life is used. Be sure to consult with legal counsel regarding the purchase of life insurance. The tax consequences vary dramatically depending on who owns and pays for the policy.
- Are the necessary corporate bylaws in place to provide for a smooth takeover by the successor companies?
Sale Planning
If no employees can be identified with the entrepreneurial spirit and skills needed to take over the business, or if financing probably won’t be available, then serious consideration should be given to selling the business. Proper planning for such a sale can maximize the chances of obtaining a good price for one’s heirs, with minimal disruption to the company’s employees and customers.
Laying the foundation now for selling the business is critical, because the founder is uniquely situated to know:
- Who might be interested in purchasing the business.
- Who would have the ability to complete a purchase on short notice.
- Who would offer the fairest price.
- Who would have the ability to finance the purchase.
- Who would be most likely to treat employees and customers fairly.
Once the most likely purchasers are identified, the founder should share this information with the person or persons who will be responsible for liquidating the founder’s interest in the business. Typically, this will be the executor of the founder’s will, the trustee of the founder’s trust, or the founder’s spouse or children.
Because this information can be quite sensitive, the founder may not want to disclose the names, instead simply advising those who need to know that a letter with the information will be included with the founder’s important papers.
Timing
Because life is uncertain, it’s important that succession planning be considered as soon as a business is established enough to have value to the founder’s heirs. The succession plan will naturally change over the years. A founder without children when the business is started may have children able and eager to take over later on. Key employees may leave. Market conditions may change. Accordingly, the succession plan should be reviewed annually, perhaps as a standing agenda item for the annual meeting.
Coordination with Estate Plan
It’s very important the succession plan with the founder’s personal estate plan. If the company won’t stay in the family, for example, the qualified family-owned business deduction won’t be available. (Note, however, that this deduction is scheduled for repeal in 2004.)
Estate taxes may be substantial if the business interest or sale proceeds don’t pass to a surviving spouse. Strategies for addressing potential estate tax liability include:
- An insurance trust to provide funds to pay estate taxes (separate from the insurance used to fund the stock purchase).
- Charitable trusts.
- A lifetime gifting program.
- Preparing for the eventual obligation to pay the taxes.
Keep in mind that under the Economic Growth and Tax Relief Reconciliation Act of 2001, the estate and gift tax system will change significantly over the next several years. Personal estate plans should be reviewed and revised regularly to reflect these changes and to reflect any additional changes Congress makes in the coming years.
