There are essentially three levels to a business succession plan. The first level of a business succession plan is management. It is important to recognize that management and ownership are not the same. The day-to-day management of the business may be left to one child,
while ownership of the business is left to all of the children (whether or not they are active in the business). It is also possible that management may be left in the hands of key employees rather than family members.
The second level of a business succession plan is ownership. Most business owners would prefer to leave their businesses to those children that are active in the business, but would still like to treat all of their children fairly (if not equally). Yet, many business owners lack sufficient non-business assets to allow them to leave their inactive children an equal share of their estate. Thus, a business succession plan must provide a means of transferring wealth to the children who are not interested in, or not qualified for, continuing the business. Business owners must also assess the most effective means of transferring ownership and the most appropriate time for the transfer to occur.
The third level of a business succession plan is transfer taxes. Estate taxes alone can claim up to 45% of the value of the business, frequently resulting in a business having to liquidate or take on debt to keep the business afloat. To avoid a forced liquidation or the need to incur debt to pay estate taxes, there are a number of lifetime gifting strategies that can be implemented by the business owner to minimize (or possibly eliminate) estate taxes.
LEVEL ONE – MANAGEMENT
Whether management of the business will rest in the hands of the next generation, in the hands of key employees, or a combination of both, the business owner must learn to delegate and work on the business. It can take many years to train the successor management team so that the business owner can walk away from day-to-day operations. For many business owners, giving up such control can be difficult.
All too often, business owners focus more on the ownership and transfer tax issues involved in a business succession plan and ignore the people issues. In the typical family business, the future leader is likely to be one of the business owner’s children. If so, steps must be taken to assure that the future leader has the support of the key employees and other family member owners. Generally, a gradual transfer of roles and responsibilities gives the successor time to grow into his/her new position and allows the business owner some time to get use to his/her diminishing role. Thus, lead-time is important for a smooth transition.
Many family businesses are dependent on one or two key employees who are critical to the success of the business. These key employees are often needed to manage the business (or assist in the management of the business) during the transition period. Therefore, the succession plan must address methods to guarantee that key employees remain with the business upon the death, disability or retirement of the business owner. Among the commonly used techniques used to assure that key employees remain with the business during the transition period are employment agreements, nonqualified deferred compensation agreements, stock option plans and change of control agreements.
LEVEL TWO – OWNERSHIP
Often, a major concern for family business owners with children who are active in the business is how to treat all of the children equally in the business succession process. Other concerns for the business owner include when to give up control of the business and how to guarantee sufficient retirement income. For example, selling (as opposed to gifting) the business to the active children results in all children being treated equally and provides the business owner with retirement income. For those business owners that are not reliant on the business for their retirement, they can gift the business to the active children, and leave the inactive children non-business assets. If, as a result, the inactive children will not receive an equal (or fair) portion of the business owner’s estate, make up the difference by establishing an irrevocable life insurance trust for their benefit.
Simultaneous with the gifting and/or selling of business interests, the new owners should enter into a buy-sell agreement. A buy-sell agreement is a legal arrangement providing for the redistribution of shares of the business following the death, disability, retirement or termination of employment (triggering events) of one of the owners. The buy-sell agreement would also set forth the purchase price formula and payment terms upon the happening of a triggering event. If properly designed and drafted, a buy-sell agreement will create for the departing owner a market for what otherwise would be a non-marketable interest in a closely held business; will allow the original owners to maintain control over the business by preventing shares from passing to the departing owner’s heirs; and will fix the value of a deceased owner’s shares for estate-tax purposes.