Clik here to view.
Many of us have heard the family business statistics before, but they’re worth repeating. Approximately 90% of U.S. businesses are family firms.1 They range in size from small “mom-n-pop” businesses to the likes of Walmart, Ford and Marriott. There are more than 24.2 million family businesses in the United States, representing 64% of gross domestic product and employing 62% of the U.S. workforce.2 Thirty-five percent of the businesses that make up the S&P 500 are family controlled.3 Family businesses are also more successful than non-family businesses, with an annual return on assets that’s 6.65% higher than the annual return on assets of non-family firms.4 Unfortunately, only a little more than 30% of family businesses survive through the second generation,5 even though 70% would like to keep the business in the family.6 By the end of the third generation, only 12% of family businesses will be family-controlled, shrinking to 3% through the fourth generation and beyond.7
The disconnect between what 70% of families desire and the far bleaker reality can primarily be attributed to the failure to plan for the three big issues of family business succession planning:
(1) family dynamics;8 (2) management succession; and (3) ownership succession through effective estate planning. Dealing with these three complex issues can seem overwhelming in the best of circumstances. It’s no wonder that in the 2007 American Family Business survey, of the top 10 challenges facing family-owned businesses, succession was number one.9
The complexity of estate planning for family business succession and the sometimes hidden objections to ownership transfer decisions can result in a kind of analysis paralysis for business owners where nothing gets executed. The result of not planning can be tragic, at best leaving the next generation to clean up the mess and at worst resulting in a fire sale of the business to pay estate taxes. Over the years, I’ve found that by breaking down the succession process into bite-sized pieces and identifying and overcoming certain key personal concerns of business owners, even the most controlling business owner will take steps to do at least basic succession planning. Here are the key elements of the process.
Take It in Phases
Estate planning for the family business owner can involve virtually all of the tools in the estate planner’s toolkit, including testamentary planning, advanced gifting strategies, liquidity planning for estate taxes and philanthropy. If we attempt to address all of these issues at once, it can be overwhelming, and we run the risk that little or no estate planning gets done. Our experience has shown that planning is more effective if we break it into two phases.
Phase 1. Estate planning for the business owner is basically “‘what if I get hit by a bus’ planning.” Have I done enough to provide for my family in a tax-efficient manner, and do I have the liquidity to pay estate taxes so that the business can continue without the burden of a crushing debt to pay estate taxes? It also deals with making sure that any irrevocable trusts that hold common stock, established at the death of the business owner for future generations, are structured to protect against creditors of the beneficiaries and divorcing spouses of the beneficiaries. Typically, Phase 1 planning includes wills, revocable living trusts, durable powers of attorney and living wills and appointment of health care agents. These documents are revocable and don’t require any lifetime transfer of control by the business owner. When properly drafted and combined with a buy-sell agreement that’s adequately funded with life insurance and ensures proper next-generation control of the business, a Phase 1 plan can be highly effective for succession planning. Typically, Phase 1 planning can be accomplished over a period of weeks or months at a cost that won’t shock the business owner.
Phase 2. Once the business owner has completed Phase 1 planning, typically they’ve become much more comfortable with the estate-planning process and are willing to begin the discussion of gifting some of the business interests to trusts for the family during their lifetime to mitigate estate taxes. If the issues of cash flow and control (discussed below) can be overcome, effective use of dynasty trusts and installment sales to avoid estate taxes for potentially multiple generations on the business interests can be completed. This thoughtful planning can take significant stress off of the next generation involved in the family business by removing the pressure of paying estate taxes at each generation. Phase 2 planning typically evolves over a period of months or years.
Maintaining Control
The desire of the senior generation to maintain control over the family business is commonly a significant obstacle to effective family business estate and succession planning. Family business owners tend to fall into one of two categories when it comes to control. The “Monarch” seeks to maintain control even if it’s at the expense of a successful succession plan. The less common “Steward” seeks to nurture the business and willingly cedes control to the next generation. Unfortunately, there are far more Monarchs out there than Stewards in the family business world. Particularly if the senior generation founded the business, there’s a tendency to want to maintain control even to the grave.
I’ve found that even Monarchs can do effective succession planning if we recapitalize the business into voting and nonvoting ownership interests. This can be done for partnerships, limited liability companies and corporations. Even S corporations (S corps) can have voting and nonvoting stocks without violating the rule that S corps aren’t permitted to have two classes of stock.
For example, assume that a Monarch business owner owns 100% of an S corp and is willing to do succession planning as long as they don’t have to give up any voting control. Further assume that we recapitalize the corporation into voting shares equal to 10% of the value of the corporation and nonvoting shares equal to 90% of the value of the corporation. The business owner keeps all of the voting shares, so that they completely control the corporation. But they’re willing to use most of the nonvoting shares to do estate planning to reduce the taxable estate. If we gift the nonvoting shares to the children, either outright or in some type of irrevocable trust, we’ve frozen the value of the shares for gift tax purposes, and any income and appreciation on the gifted nonvoting shares won’t be included in the business owner’s estate. If the business owner leaves the voting shares to the children active in the business at the owner’s death, we’ve done effective succession planning.
If, however, there are children who are active in the business who get the voting shares and non-active children who only own nonvoting shares, we’re setting up a possible conflict. The children with nonvoting shares who aren’t active in the business will typically seek distributions, while the active children would prefer to reinvest in the business or take distributions in the form of compensation that doesn’t have to be shared with the non-active children. In this case, I recommend that the estate plan be structured in such a way (perhaps through a buy-sell agreement) whereby active children can buy out the non-active children at a fair value payable over a period of years that wouldn’t cripple the business.
The Importance of Cash Flow
According to the 2007 Laird Norton Tyree Family Business Survey,10 an astonishing 93% of family businesses depend on the business as their primary source of income. This statistic has far-ranging ramifications for the success or failure of family business succession. A family business owner’s dependency on the business for cash flow is often an unspoken obstacle to beginning a healthy succession process. Why would a business owner transfer management and ownership of the family business to the next generation without being certain about their own retirement security and that of their spouse?
Advisors to family businesses have seen clients who fit the following description: an entrepreneurial business owner with a very valuable business and business real estate, a large principal residence and vacation home, but little money in a brokerage account or retirement plan. This business owner supports their lifestyle by taking distributions from the business. Aside from the lack of investment diversification, this approach is all well and good until the business owner begins thinking about passing ownership of the business to the next generation with a minimum of transfer taxes.
Phase 1 of the estate-planning process that leads to discussions of ownership succession is sometimes the first time that a business owner contemplates how they’ll maintain their lifestyle when the children own the business. This can be a frightening process for anyone, particularly in the context of having to deal with the loss of control that comes with transferring ownership of a business that they may have spent a lifetime building. Many times, however, the cash flow concern remains unspoken, as many advisors are more concerned with (or interested in) the tax-efficient transfer of shares to the next generation than they are with taking time to discuss the cash flow needs of the business owner. But the business owner often realizes that once ownership is transferred, access to the business as a “personal piggybank” may be over. Failing to solve the cash flow problem can result in the business succession process effectively ending before it even begins.
This is where thoughtful advisors can help. They can show the business owner that there are many ways to replace some or all of the necessary cash flow from sources other than the ownership of the business. Addressing the cash flow needs of the business owner and their spouse is the first step in a successful family business succession plan.
A frank analysis of the owner’s and spouse’s cash flow needs through cash flow-based finance planning helps to frame the issue. Once the advisor determines annual cash flow needs, they can propose alternatives to satisfy those needs. It’s likely that the family business will remain the best way of satisfying the business owner’s cash flow needs. But with a succession plan in place, how the business will satisfy those needs will change. Historically, the business owner’s cash flow has come from what’s been described by Michael D. Allen as “control assured income.”11 While the business owner controls the business, cash flow comes from control assured income such as salary, bonuses, C corporation dividends and S corp and partnership distributions. Before a business owner transfers control to the next generation, Allen recommends that the business owner replace “control assured income” with what he refers to as “contract assured income,” such as rents from business real estate, deferred compensation, salary continuation agreements, buy-out payments and income from such estate-planning vehicles as grantor retained annuity trusts and installment sales to intentionally defective grantor trusts (or simple sales directly to family members). Following the business owner’s death, life insurance on their life may supplement or replace income from these other sources for the surviving spouse.
Once the business owner’s cash flow and financial security issues are resolved, the business owner frequently becomes more amenable to discussing transfers of ownership and control to the next generation. By reducing dependence on the business for cash flow, the business owner frees themself to focus on effective succession planning.
— This information is provided for educational and discussion purposes only and are not intended to be fiduciary or best interest investment advice or a recommendation that you take a particular course of action (including to roll out, distribute or transfer retirement plan assets to UBS). UBS does not intend (or agree) to act in a fiduciary capacity under ERISA or the Code when providing this educational information. UBS Financial Services Inc., its affiliates and its employees do not provide tax or legal advice. You should consult with your personal tax and/or legal advisors regarding your particular situation.
Endnotes
1. J.H. Astrachan and M.C. Shanker, “Family Businesses’ Contribution to the U.S. Economy: A Closer Look,” Family Business Review (September 2003).
2. Ibid.
3. Family Business Alliance, “Cited Stats,” www.fbagr.org/resources/cited-stats/.
4. Ibid.
5. Conway Center for Family Business, “Family Business Facts,” www.familybusinesscenter.com/resources/family-business-facts/.
6. Ibid.
7. Ibid.
8. David T. Leibell, “Succession Planning,” Trusts & Estates (March 2011).
9. See supra note 3.
10. www.businesswealthsolutions.net.
11. Michael D. Allen, “Representing the Patriarch in Family Business Succession,” Ali-Aba Course of Study Materials, Estate Planning for the Closely Held Business Owner (July 2006).