By Meg Muldoon
A poorly planned succession has the potential to derail a closely held family business. The lack of a well-drafted plan can cause financial hardship on both the business and the family. Letting the estate plan dictate how a business is passed on may cause issues, and there are numerous stories of prominent business empires that have been adversely affected by the lack of a well-designed succession plan.
There are several strategies that small business owners can take to ensure a smooth transition from one generation to the next. Careful planning is needed. Families should be aware of the important role that life insurance can play in smoothing the transition from one generation to the next.
Estate planning is not succession planning
The first thing to keep in mind is that estate planning and succession planning are not the same—they have very different goals. Generally the goal of an estate plan is to primarily provide for the surviving spouse and subsequently provide for children equally. The goal of a business succession plan, however, is to ensure the business passes to the heirs who are active in the business. One of the big challenges involves addressing the needs of children who are active in the business as well as those who are not. Should all the children be treated equally, or should they be treated equitably? Too often, the succession defaults to the owner's estate plan, which usually calls for the estate (including the business) to be divided equally among all children.
As an example of how complicated this can be, consider a business family with two sons, one who works in the family company and one who doesn't. The active son, John, has really built up the business, spending considerable time and effort to grow it. The dad, Mike, stepped aside many years ago, although Mike still owns 60% of the business because he is not yet ready to relinquish control. Of the balance, 30% is owned by John and 10% by his brother, Mark.
John feels that he should get the business, and he's been identified as the heir apparent. In fact, the estate plan says that the business passes to John and all other assets are divided 50:50. Mike's wife, Ann, is upset that Mark's inheritance isn't the same as his brother's. Ann wants everything equal across the board. Succession plans for family businesses can become fraught with all the emotional interplay that occurs in families. Family members must understand that there is a difference between "equal" and "equitable." Equal distribution does not take into account the contributions of the children who are active in the business and contribute to its success. An equitable distribution considers these factors.
There are several strategies that closely held family business owners can use to ensure a smooth transition.
1. Address the needs of both active and inactive children. Those who spend their careers contributing to the company's growth and success should be rewarded for their efforts.
2. Recognize the difference between equal and equitable distribution. Should all the children be treated equally, or should they be treated equitably? Business owners should consider the needs of all family members, including their own needs, when developing a distribution strategy. Not every family member has the same needs or wants. It may be best to leave the family business to the active children and other assets, such as investments and life insurance, to the inactive children.
3. Hold a family meeting. Family business succession planning can get bogged down by emotional complexities. The family should consider holding a family meeting, moderated by trusted professional advisers. A meeting enables family members to talk through the issues and the roles and responsibilities of all family members, both active and inactive.
4. Obtain a valuation of the business. The key to a viable succession plan is a formal valuation of the business. Basing any transfer, during lifetime or upon death, on a proper valuation helps to limit the chances that the IRS will contest the valuation, which would result in additional estate or gift taxes.
5. Commit to a succession plan. Without a well-designed business succession plan, inheritance of the business defaults to the owner's estate plan, which often distributes the estate (including the business) equally among all children. Owners must give careful consideration to how the business should transition to the next generation. When a written plan is created, it should be communicated to all family members.
Once a succession plan is in place, it is important to recognize the efforts of the children who are active in the family business. For example, John, in the situation described earlier, should be rewarded for his efforts in growing the business. Mike should consider gifting additional stock to John, both to reward him and to shift the future appreciation and growth of the family business to John's estate as opposed to Mike's.
If Mike is thinking about gifting an additional 5% stake in the business to John, he should consider using valuation discounts to leverage this gift. For decades, senior-generation family members like Mike have made gifts or sales of minority and non-controlling interests in their family businesses to junior-generation family members. Through proper planning, these business owners have used the lack of marketability and lack of control valuation discounts—generally 20% to 30%—to reduce transfer taxes and increase the amount of wealth transferred over several generations. If he wants to implement this strategy, Mike should act now, as the availability of these discounts in the future is questionable.
The role of life insurance in succession planning
Owners of closely held family businesses should understand the multiple roles that life insurance can play. Since the triggering event in most business successions is death, life insurance can obviously serve as the main funding vehicle for a well-designed succession plan. It can also provide liquidity when it is needed most—not only to transition the business to the next generation, but also as a source of funding to pay federal and/or state estate taxes. Life insurance might be used to fund a buy-sell arrangement for the active children, or it can serve as a wealth-replacement vehicle for inactive children who will not receive an interest in the business. In the previous example, John could own a life insurance policy on his brother Mark's life to help pay Mark's family for the value of the business when he passes away. If John owns a permanent life insurance policy, he might have cash value that he can access for an installment purchase of the business in case Mark wants to be bought out sooner.
Another objective that life insurance can fulfill is equalization between children. For example, Mike, the dad, could purchase an insurance policy on his life (or on him and his spouse) and name Mark (or a trust for his benefit) as the sole beneficiary. John would inherit the business, and Mark would inherit an equivalent amount in life insurance to make the brothers' inheritances equal—just as Ann wants.
Succession planning is a big topic, and this brief overview has barely scratched the surface on many issues, but this should help explain the importance of putting a plan in place. Formulating a succession plan is critical to the continued success of a closely held business over several generations. If the legacy of the business is important to your family, take the time to develop a strategic succession plan.
Meg Muldoon is an assistant vice president of advanced sales with The Penn Mutual Life Insurance Company (www.pennmutual.com). She also has related experience as an attorney in the financial services industry.
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