By Richard O. Kissel II
Passing the family business to the next generation is likely to be one of the biggest projects of the owner’s lifetime. Family business succession is the process of transitioning the governance and ownership of a closely held business to the next generation. Transfers of family business interests involve issues ranging from taxes (both income and transfer taxes) and management progression to human resources and financing – each of which is important and requires significant consideration.
Ideally, the formulation of a business succession plan should begin early enough to allow ample time for preparation of both the business and of the family members for the transition. The succession plan should take into account the financial and other interests of all family members, not just those involved in the operation of the business on a day-to-day basis.
While many issues are important, the family members and the professional advisers must all be aware that assuring the business’s ongoing financial success is critical to creation of financial security for all family members and to the success of the transition plan.
At the beginning of the succession planning process, the client should plan for the operation of the business both during and after the transition process. In connection with the formation of such a plan, the business owner should thoroughly analyze the current condition of the business, such as its governance, financial condition, relationships with its lenders, and employee performance. Decisions must be made with respect to the decision-making for the business both during and following the transition to new ownership.
The client should prepare for a potentially lengthy transition period in which the next generation is properly groomed to continue the business successfully. Of course it is always advantageous to try to anticipate interfamily disputes, managerial problems and other issues and to determine how to address such conflicts within the succession plan.
In addition, the client should consider formulating a personal plan for involvement in activities other than the business. Given that many business owners are driven, active people, one aspect that often contributes to the transition plan’s success is the former owner’s satisfaction with his or her day-to-day activities following transfer of control of the business.
Other non-tax issues which must be considered while transferring a closely held business include such things as determination of the client’s financial and retirement goals; the level of his or her ongoing involvement in and decision-making authority with respect to the business after the transition; establishment of a timeframe for the transition; and selection of the individuals who will be directly involved in the transition.
In addition to plans for operation of the business and for the former owner, another critical aspect of the transaction is a thorough analysis of its tax consequences. This analysis may be performed by the attorney who is involved in the transition, by other professional advisers or, most frequently, by all members of the transition team. Initially, it will be necessary to consider the income tax issues of the family members and those specific to the type of business entity being transferred. There are income tax issues specific to S corporations, partnerships, and limited liability companies (the most common forms in which family businesses are conducted) that can be traps for the unaware.
The succession plan will also likely involve the client’s gifting, retirement, financial, charitable and other estate planning goals. Often family business succession planning includes gifts of business interests and other property to family members, trusts for their benefit, or both. For example, sales and gifts to one or more grantor trusts, grantor retained annuity trusts, life insurance trusts, dynasty trusts and/or domestic asset-protection trusts for the benefit of family member recipients may be utilized.
If the client has charitable goals, the attorney may recommend various techniques for charitable giving (e.g., charitable remainder trusts, charitable lead trusts, donor advised funds, private foundations and public-supported charitable organizations). There may also be life insurance considerations for the client, such as the funding of premium payments and split dollar agreements. Providing liquidity for the payment of gift and estate taxes will almost certainly be an issue that must be considered.
Operational and, to a lesser extent, tax issues will help determine the type of business interests received by the family members. For example, a business may be split into operational and real estate holding entities. Interests in the operational entity may then be transferred to children who are actively involved in the business while interests in a real estate holding entity (which owns the property where the business is located) may be transferred to children who are not involved. If such a structure is utilized, it is often advantageous to execute long-term, fair market-value leases with respect to the business’s real estate.
It may also be advantageous to implement a buy-sell agreement, redemption agreement or recapitalization in order to transfer business interests. The tax consequences of each of these techniques, and the possible availability of valuation discounts in connection with the transfers, may assist with the selection of the appropriate structure of the transfer.
Regardless of the ultimate decisions with respect to these goals and techniques, the attorney should ensure that the client’s estate planning and other needs are considered when implementing the business succession plan.
In summary, it is both a complex and rewarding experience for the client to successfully achieve the transition of the family business to the next generation. Whether psychologically or financially, a client may find that keeping the business in the family through calculated business succession planning is a gratifying endeavor. With careful planning, a business owner can formulate a succession plan, provide for the financial well-being of the retiring owner(s) as well as the children, and allow the business to successfully continue as the next generation takes control.•
Richard O. Kissel II, partner of Taft Stettinius & Hollister LLP, has practiced law over 29 years and is an Estate Planning and Administration Specialist certified by the Indiana State Bar Association. His practice areas include estate and business succession planning, income tax, retirement and charitable planning, corporate transactions, buy-sell agreements and other matters affecting closely held businesses. The opinions expressed are those of the author.