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Business succession planning is critical to the long-term success
of any closely held company.
By Bennett S. Keller and Scott H. Malin
Immersed
in day-to-day operations, many business owners neglect succession
planning. Although the estate tax is a significant factor in the
collapse of businesses upon the transfer to the next generation,
lack of effective planning is most often the cause of such failures.
The decisions
involved in implementing a succession plan often require considerable
time and thought. There are two distinct areas of concern. The
first involves the psychology of transitioning the business to
the next generation. The second area focuses on the technical
legal and tax rules that impact the process.
In
creating any succession plan, the family patriarch or matriarch
must determine what he or she intends to do with the business.
This is usually a difficult decision. In some cases, one or more
key members of the next generation may be serious candidates.
In other cases, there may be no appropriate family members to
take over the business. Options range from providing for the sale
of the company before or after death, to naming one or more members
of the next generation to run the business.
If the owner decides that one or more family members will run
his business, the next issue is maintaining family harmony. If
some children are receiving stock in the business and others are
not, the business owner must decide how to treat the children
not active in the business in an equitable way. Children not actively
involved in the business can receive non-business assets comparable
to the business interest given to the active children. Another
concern is how to value the business interest for this purpose.
Also, the owner may not have other assets to sufficiently compensate
the children who are not active in the business.
Re-capitalizing the company by creating non-voting and voting
stock is one way to handle that challenge. The non-active children
can receive the non-voting stock and the active children can receive
the voting stock. The disadvantage to this plan is the non-voting
stockholders will still be subject to the decisions of the voting
stockholders, including whether to pay dividends. This can often
lead to discord. Another option is to give stock to all of the
children, whether or not they are active in the business.
Rights and equalization among family members concerning who has
“earned” his or her ownership often creates problems. If a child
has operated a business for many years, it is not necessarily
fair to equalize for the non-active children by relying on a current
value. Also, the Internal Revenue Service will have an opinion
about the valuation of the business for estate tax purposes.
Life insurance proceeds can provide liquidity to level the field
for the children who are not active in the business. However,
life insurance may not always be a viable option, due to insurability
and/or cost.
If business interests are given to family members during the business
owner’s lifetime, an Agreement governing the parties’ respective
rights, duties and obligations is a must. Such an Agreement can
prevent a spouse or other party from acquiring stock held by a
child of the business owner. The Agreement can also prevent the
child from selling his interest if there is a disagreement among
shareholders. The Agreement may include several other provisions,
including a buyout in the event of disability, a right to sell
by the child or purchase by the company at any time, and a formula
for valuing the company at the time of a possible buyout.
Estate tax is inexorably linked to sound succession planning.
The estate tax is a tax on the transfer of all assets owned by
an individual upon his or her death. The highest estate tax rate
is 55 percent. Assets left to a spouse usually qualify for the
marital deduction and are not subject to the estate tax until
the surviving spouse dies. There is an estate tax exemption for
the year 2000 equal to $675,000, and an additional $625,000 of
exemption for a family-owned business that meets certain stringent
qualifications.
To reduce the potential estate tax burden, the business owner
may decide to make lifetime gifts of his business interests to
his children. Each individual is allowed to give up to $10,000
of assets ($20,000 if married) to each of his children or other
individuals. These gifts may be outright to the descendants or
placed in trust. Special trusts are required to own certain types
of interests (S corporation stock).
Gifts of business interests during the business owner’s lifetime
reduce his estate for estate tax purposes. This can provide significant
savings over time. Moreover, minority interests in a business
are valued at less than a majority interest, because of the lack
of control and marketability. Therefore, upon the death of a business
owner who owns 100 percent of the company, there will be no discount
for minority interest.
Another advantage to lifetime gifts is that they freeze the value
of the gifted property. If the company appreciates in value between
the time the gifts are made and the time of the business owner’s
death, the appreciation of the gifted portions is already outside
of the decedent’s estate.
Other sophisticated gifting techniques beyond the scope of this
article include Grantor Retained Annuity Trusts, Installment Sales,
and Family Limited Partnership.
The final issue is how a business owner can maintain the income
and/or control of his company during his lifetime. Methods include
a deferred compensation Agreement, which can provide for a stream
of payments during the business owner’s lifetime, even if the
business interest is given away to his or her children. The business
owner also might obtain an employment agreement providing for
certain consulting agreements and/or severance pay. In some cases,
the sale of the business interest for an installment note is ideal,
since it transfers the interest to the next generation, provides
a stream of payments to the senior generation business owner,
and freezes the value for tax purposes so that any future appreciation
is out of the estate of the senior member.
As with most endeavors, the most difficult aspect of business
succession planning is taking the first step. Once the business
owner’s goals are identified, advisors can suggest various techniques
and alternatives to achieve those goals and reduce taxes. Although
time-consuming and challenging to implement, a solid succession
plan is essential to ensuring the future of any closely held business.
Bennett S. Keller and Scott H. Malin are principals in the
law firm of Rosenblum, Goldenhersh, Silverstein & Zafft, P.C.,
specializing in the areas of estate and business succession planning.
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