In most family owned businesses there will come a time when an owner, usually a parent, will have to sit down and plan for the future of the company in his or her absence. Most owners want to see their business continue and recognize that passing it on to family members may be the most ideal option. This guide will explain why a business owner should consider business succession planning, what the benefits of doing so are, and ways in which to go about setting up a plan to pass along the business.
Why Consider Succession Planning
As an owner there are many reasons why one should consider what is going to happen to the family company after retirement. However, planning should not be limited to those owners nearing retirement. Succession planning should be taken care of early on in ownership, because even young owners are susceptible to emergencies, and in case an unexpected death or disability occurs, the business will be taken care of. Some reasons to consider planning are:
- Know with certainty that the business is going to continue after retirement;
- Supply income for the owner after retirement; and
- To equitably treat children and heirs.
Taking the time to work on a succession plan ahead of time will provide peace of mind, including having the chance to be sure that the successor management will be competent and committed. Planning on certain individuals or family members to take an owner’s spot in management allows for training and time for the successors to get a lay of the land. This may lead to more comfort and security in the business after the owner’s retirement.
Additionally, being able to choose management before an emergency prevents a forced management decision. An owner gets to specifically choose who he wants to take the lead and be the future of the company, rather than management being promoted that the owner would not have chosen otherwise. Similarly, in the absence of a succession plan, and say the death of the owner, the family may have to sell the company in order to compensate for estate taxes, or perhaps the new management might not be capable to handle the finances, and will be forced to sell. Taking the time to plan ahead of time can avoid a forced sale of the family business.
Planning ahead can significantly reduce a large amount of family drama. If there is no specified plan stating which family members will be involved in the business and in which ways, there could be a conflict, especially if some children were involved in the company before the parent’s death and some were not. After the death of the parent owner, some of the children that were not involved in the business may feel entitled to receive some of the income from the business. Business succession planning can set out what exactly the role of each child is going to be and can save a potentially massive headache between the surviving children of the parent owner.
Benefits of Business Succession Planning
A few of the benefits of developing a succession plan were mentioned above, but besides the security and certainty of knowing what is going to happen to the company, succession planning has several benefits.
- Maintain Control: Drafting up a succession plan can allow the parent owner to remain at the company with a certain level of control until he or she feels comfortable with the management and turning it over to a child.
- Income: Planning early on can allow for adequate income after retirement; the money from the sale of the business, for example, can be paid over time, securing an income post-retirement.
- Minimize Taxes: Planning can reduce the cost of estate tax and prevent sale of the company in order to pay estate tax. Additionally, the business can be given as a gift, which removes some or all of the business’s value from the owner’s estate, and therefore decreases the owner’s potential estate tax.
- Flexibility: Allows for the owner to consider options and determine what may be best for the company, and also allows for changes in family dynamics over the years. Succession plans may be altered if circumstances are to change.
Options to Transfer the Family Business to Children
There are a variety of ways in which an owner parent can decide to pass along the family business to a child or to children. The methods tend to get very complex and have various repercussions relating to taxes and income. This will provide a brief overview of possible options, but in no way encapsulates all of the nuances of the transactions. It may be in an owner’s best interest to speak with a business attorney or a tax expert while in the process of business succession planning to understand all of the consequences of a certain option, particularly regarding how any decision affects one’s tax obligations.
- Preferred Stock Freeze: This method of transfer allows the owner to maintain some level of control over the company for some time after passing the company to a family member.
- Basic Estate Freeze: What happens in a basic estate freeze is that the owner exchanges some of his common stock in the business for preferred stock, and then transfers all or some of his remaining common stock to his child or children. Keeping the preferred stock gives the owner some level of control, usually being able to have a shareholder’s vote. The “freeze” occurs because the preferred stock is essentially “frozen,” meaning that shareholders of preferred stock are entitled only to a fixed amount for their shares upon sale of the company. Any sort of appreciation in the value of the company after an owner has exchanged his common stock for preferred stock is shielded from estate tax when the preferred shareholder dies. Because the value of the preferred shareholder’s interest is fixed (meaning it excludes appreciation in the value of the business, which is what the common stock would be worth), any appreciation of the company is excluded from the calculation of the preferred shareholder’s taxable estate on his death.
- For further, detailed information regarding recapitalization and stock freeze techniques see:
- Installment: This is considered one of the simplest methods of transferring over the family business to a child or children. In this situation, the owner parent can sell shares or partnership units to a family member. The benefit of this method is that installments on the sale can be done over time, which would provide an income for the owner after his or her retirement.
- Gift: Giving a company as a gift is restrained by gift taxes, because an owner can only gift a certain amount before incurring an extensive tax on the gift. There are ways, however, to gift a business without having to deal with gift taxes. In most states there is a maximum amount that can be gifted per year before that gift is subject to the gift tax. This is known as the Annual Gift Tax exclusion. In the case of gifting a business, an owner parent may gift some interest in the company to a child each year, eventually gifting the entire ownership interest in the company. In this way, a gift tax is usually avoided and the owner’s estate tax will decrease; however, gifting a company in this way could take a long time.
- Sell Stock: This method is to sell the stock of the company outright to a family member for fair market value. This is no longer a gift, rather a child or children of the owner would have to be able to buy the company’s stock from the owner.
- Place Business Assets in Trust: The business owner may choose to transfer property into a trust. There are two types of trusts applicable, the Grantor Retained Annuity Trust (GRAT) and the Grantor Retained Unitrust (GRUT). In general, these are irrevocable trusts that an owner may transfer his assets into and choose to receive income payments for a specified amount of time. At the end of this established time, or death of the owner, the assets in the trust are passed on to the other trust beneficiaries. At this point the value of the retained income is subtracted from the value of the property that was transferred (meaning the shares of the business). What happens then is if the owner lives past the specified amount of time in which he received income payments, it is possible that the business may be transferred to the next generation at a reduced value for estate or gift tax purposes. It is important to note that the transfer of property into an irrevocable trust is subject to gift tax. GRATs and GRUTs differ substantially from one another regarding advantages and disadvantages, and it is important to know the details about establishing a GRAT or a GRUT in order to make it a successful means to pass along the family company.
- For specific information on these trusts see:
Basic Taxes Involved
As mentioned above, what choice of method that a business owner uses to pass along the family business to a child or to children has implications for the taxes that he or she pays. The following is a brief breakdown of the taxes that may be involved in a transaction:
An estate tax is imposed when a transfer of property is caused by the owner’s death. Not every state imposes estate taxes; however, Minnesota does. There is a $1 million exemption in Minnesota before the value of the estate is calculated. Any gifts in the estate to charity or to the surviving spouse are not included in the total calculation of the estate’s value. Put simply, a taxable estate is the fair market value of the estate on the day of the owner’s death minus any amount of the estate given to charity or to the spouse and minus the $1 million exemption amount. Example: the fair market value of the estate is $2.5 million. A total amount of $500,000 is given to local charities, and $500,000 given to the surviving spouse. That leaves a total of $1.5 million, and $1 million is exempt in Minnesota, therefore the amount of the estate that is taxable is $500,000. The rate of estate tax in Minnesota ranges on a scale from .8% to 16% depending on the value of the estate. Considering a potential estate tax can factor into the business succession planning, because any interest that an owner has in his business is factored into the value of the estate. In the interest of reducing the estate tax and value of the estate, a business owner may want to transfer ownership and interest in the company before death.
The following links are helpful in understanding estate tax in general and estate tax in Minnesota:
- Survey of State Estate, Inheritance, and Gift Taxes on MinnesotaAttorney.com
A gift tax occurs when an owner of property transfers his property to another while he was still living, as a gift, meaning without receiving payment for the property. Gift taxes are in place primarily to prevent owners of property from avoiding tax by making lifetime gifts. Gift tax regulations vary from state to state, but most states include an annual gift tax exclusion, meaning that there is a certain amount an owner may gift to another before a gift tax is imposed. A gift tax is important in regards to business succession planning because a business owner may not be able to just simply give his company as a gift to a child. Doing so could result in incredibly high gift taxes. It is important to understand the gift tax rate and the exclusion rate when considering whether or not and how to give a family business as a gift.
Further information on gift taxes may be found at:
- Survey of State Estate, Inheritance, and Gift Taxes on MinnesotaAttorney.com
There are many factors that should go into an owner’s decision about what to do with the family business upon retirement. The following is a brief list of some of the considerations that an owner should keep in mind:
- How much effort will it take to adequately train the successor? Will it be difficult to share successful business knowledge with the successor? Can the successor function independently of ownership supervision? Does the successor have what it takes to run a business?
- What will other employees think of the decision to transfer the business to family? Will there be any animosity? Is the family member really qualified for the job or will it be seen as favoring? Will employees believe a family member was promoted on his merits and skills, or rather because he is family?
- Will the successor be able to maintain customers and established customer base? A way to help this would be to expose the successor to customers early on so that they are familiar with him when he becomes the owner of the company.
- What happens if you want to pass ownership to one child and not the others who may be less qualified for an ownership position? What if more family members are interested in an ownership position than the company will allow?
- Consider a buy-sell agreement in the event that a child wants to leave the company, this will establish what would happen at that point, especially if the parent owner’s intention is to keep the business in the family.
- Consider insurance and key man insurance. This insurance is owned by the company and would cover specific people designated as important to the company. If anything were to happen to these individuals that would restrict their leadership abilities (death/disability), the insurance coverage would compensate the company the amount necessary to replace them.
- For a concise overview of options and considerations when planning for business succession see:
Business succession planning is all about creating a smooth, successful transition of company ownership when the owner decides to retire. It is by no means a simple process, and the areas that need to be considered are plentiful. There are familial, financial, and personal ramifications for any decisions made that should be dealt with carefully. It is recommended that a business owner in the process of drafting up a business succession plan consult with an attorney or a tax expert to fully understand the options and how best to handle the transfer of the company in a way that is financially acceptable to an owner.
Information and facts in the above article may be largely attributed to the following:
- David Ackermann, Planning for Ownership Succession in the Family Business, Minnesota State Bar Association Continuing Legal Education (Oct. 1999).
- Mary Ceynowa, Mary Dana Korman, Barry J. Newman, Minnesota Business Continuity & Succession Planning, Seminar Materials from Professional Education Systems, Inc. (1998).
- The Business from Cradle to Grave, Minnesota State Bar Association Continuing Legal Education (Nov. 2010).