Legal Corner

Financial and legal aspects of succession
planning for family-owned businesses

• Valuation — No matter who inherits your business, it is critical that you get an accurate valuation of your business. Such a valuation encompasses tangible assets such as real estate and buildings, machinery and equipment, as well as intangibles such as employee loyalty, manufacturing processes, customer base and business reputation, patents on products and new technologies. A business valuation is also a way to predict your company’s future. Using your firm’s historical and financial records and your judgment as owner, work with your valuation firm to calculate whether your business will grow or decline, future inflation rates and anticipated costs and expenses of running the operation.
• Ownership and control — A familyowned business is often held and controlled by husband, wife (or both), or a number of siblings. Other, nonfamily, closely held businesses often have a more complicated system of ownership and control. Along with ownership comes control over compensation, benefits, hiring/firing, management and short- and longterm business goals.
• Management Succession — A family business must be viewed in terms of the way in which management decisions are made for non-family businesses. Non-family businesses make decisions according to performance of their employees and reward them accordingly. Those who are unproductive are terminated.
  However, a family-owned business usually makes decisions based upon the value of family members as people, regardless of whether their performance is satisfactory or not. If “blood is thicker than water,” a concerted effort must then be made to identify and train the appropriate family members to be the successors to manage the business.
  You may also have to consider nonfamily members as successors if they prove to be the key people to ensuring the sustainability of the business. In some cases, short-term successors are appointed while long-term successors complete the necessary training. Overall, the relative strengths and weaknesses of the family members must be carefully considered in determining the management restructuring that must take place.
• Tax Planning — The cash-flow consequences of succession planning are crucial to success. This is an area where the team approach of professionals can really bring value to the process. In the area of estate and gift taxes, questions need to be raised regarding lifetime transfers or transfers at death.
  ° Should there be “carry over” basis (gifting) or “stepped up” basis (transfers at death)? What will be the death tax cost to transfer the business and how will finances be arranged to meet the obligations? In the area of income tax planning, what will the capital gains be if the entity is sold to outside parties? Are there ways that this gain can be deferred or eliminated, perhaps with charitable tax planning? What income will the retiring owners need, and what income levels will successors expect in their new roles?
  ° These questions should be answered by competent legal and accounting professionals who work with estate and tax planning issues.

• The Transfer — If you are a sole proprietor and want to keep your company in the family, you need to think about federal estate and gift taxes. Or, if you plan to sell your company to a family member so you can retire, you need to make provisions through insurance policies to help your successor finance the purchase as well as pay for the ensuing taxes.
  If you are in a partnership, you need to ask yourself whether the percentage of the business would automatically transfer to your spouse or offspring upon your death or, as part of the partnership agreement, is your partner supposed to buy out your shares. If you have chosen the latter arrangement, you need to take out enough life insurance to provide your partner with adequate funds to pay for the purchase.
  In a closely held corporation, stockholders may stipulate that, upon their death, their shares will automatically transfer to their surviving spouse or children. However, if the shareholder’s heirs subsequently want to sell their stock, sufficient provisions should be made so remaining shareholders have enough cash for the buy-out.
  In a cooperative, the bylaws would dictate the agreed-upon transfer terms and requirements for its members to determine how, and to whom, cooperative shares are to be transferred upon the death of a member.
• Put it in writing — With a familyowned business, the family dynamic cannot be understated. If you have children, the issue of who gets what and who runs the business is a major issue to address. If you do not have your wishes in writing, they may be disregarded. Various family members may have an incorrect interpretation of what is supposed to happen with the business. If you have not indicated the plan in writing, it will likely end up being argued in court, with a judge trying to figure it out. The final decision may not reflect your desire. In order to incorporate the terms of your transfer, you may arrange for the transfer via a family limited partnership (FLP).
• Family Limited Partnership — Many estate advisors say the best way to protect your assets while having income tax flexibility is to form an FLP. An FLP allows you to transfer your financial and investment real estate into the partnership in return for 2 percent general partner interests and 98 percent limited partner interests. You would then begin the process of making gifts of the limited partnership units to your children or trusts for their benefit. But because you retain the 2 percent general partnership interest, you are in control.
  By this arrangement, gift and estate taxes may be reduced, which may produce favorable tax results. However, the Internal Revenue Service and the courts are creating fairly specific rules for businesses to follow to avoid any unforeseen tax consequences. The problems usually arise over the issue of whether the creator of the FLP has retained an impermissible level of control over supposedly “gifted” assets. Thus, if the FLP is not correctly designed or administered, or if ownership of the interests is not properly protected, asset protection goals may be jeopardized.

• Lifetime sale: Should the business be sold during the owner’s lifetime?
• Continuance after death: Should the business be continued after the owner’s death?
• Ownership of business: Who will own the business after the succession of the business?
• Control of business: Who will control the business after the change of ownership?
• Treatment of children: Will the owner’s children be treated equally in the distribution of the owner’s estate either before death or after death?
• Treatment of owner: What provisions will be made for the present owner after transfer of the business?

November/December Table of Contents