Beating the Odds: Estate Planning and Business Succession

[alert title=”Editor’s Note:” “default”]We’re lucky to have trust and estate attorney Matt Glover join us for our Exit Planning month.  Matt discusses some of the most pressing issues when it comes to planning for a succession – oftentimes the issues we see in our valuation litigation practice when they haven’t been addressed.   -ed.[/alert]

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Statistics vary, but it is safe to say that only a small minority of family owned businesses survive to the second generation. Roughly 30% make it. Even fewer make it to the third generation. To beat the odds, business owners need to plan ahead. Business succession issues should play a central role in their overall estate planning.

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Coming to Terms with the Human Dynamics

The cash flow needs of a surviving spouse, long-submerged sibling rivalries, and tensions occasioned by blended families or second marriages can all threaten the viability of a closely held business when the original owner passes away. This means that the success of an estate plan will frequently depend on the willingness of a business owner to confront and make emotionally difficult decisions about family dynamics. The good news is that once made, these decisions usually leave everyone better off with fewer surprises on the death of the original owner.

Lack of adequate planning can leave a surviving spouse in dire straits, particularly where husband and wife formerly relied on income from the business to support their lifestyle. A surviving spouse may be in need of cash flow without a career to fall back on. If not planned for, this can put the needs of the surviving spouse in conflict with the interests of the next generation.

Business owners who intend to leave their business to the next generation also have to make some tough calls about control.

Business owners who intend to leave their business to the next generation also have to make some tough calls about control. Owners in this position sometimes consider dividing control over business assets. For example, one child might be given control over business operations, while another controls the real estate in which the business operates. This is a mistake. While giving an appearance of fairness, divided control often lays the groundwork for family conflict that could tear the business apart.

Alternatively, when some members of the next generation work in the business and others do not, it may be tempting to give control to the first group and non-voting, beneficial interests to the other. This too is usually a mistake.  The children who are not in control will likely feel themselves and their legacies at the mercy of their siblings, and the children who have control may chafe under the burden of carrying on business operations with an eye to protecting their sibling’s fortunes.

One viable solution to these difficulties would give both the controlling and non-controlling children the right to compel the transfer of non-voting interests on pre-established terms. The purchase price (set by appraisal or formula) could be paid with proceeds from the business over several years. This approach removes an ongoing source of potential conflict, while allowing both groups benefit from value built up in the business.

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Balancing Estate and Income Tax Considerations

By now, most people contemplating estate planning are aware of the drastic changes that recently took place in the federal estate tax system. While increasing flexibility, these changes have not necessarily reduced complexity. Under the old system, avoidance of estate tax was frequently the singular planning imperative, but it is now possible to balance estate tax and income tax considerations. While estate tax considerations may still win out, business owners and their planners may now need to consider whether it is desirable to sacrifices some estate tax efficiency to secure certain income tax benefits, such as a step-up in basis on highly appreciated assets.

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Providing Asset Protection for Beneficiaries

It usually makes sense to leave assets, including business interests, in trust for beneficiaries. These trusts provide creditor and divorce protection. They can also include incentives and distribution guidelines to encourage socially desirable behavior and ward off affluenza in the second generation. Far from being unwelcome burdens, asset protected trusts should be seen by informed beneficiaries as adding substantial value to their inheritance.

Even beneficiaries who will be charged with control of an ongoing business may receive their interests in trust. The modern approach to trust drafting can give a beneficiary control of trust assets for all practical purposes, while preserving the asset protection features that make trusts so attractive in the first place.

Establishing a Dynasty

With advance planning, a business owner stands a good chance of preserving family wealth for generations. There are two primary impediments to this sort of multi-generational wealth preservation: the Generation Skipping Transfer Tax, which penalizes transfers of wealth to grandchildren and great grandchildren, and state law, which frequently sets the maximum duration of a trust. Both of these impediments are manageable with some forethought. A well-drafted trust can persist from generation to generation, protecting family wealth and establishing a true dynasty.

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Liquidity Matters 

Even with the best transition plan, a closely held business may still be torn apart on the rocky shores of an illiquid estate. At the death of the original owner, liquidity will be needed to pay taxes, provide cash flow to support a surviving spouse, fund legacies, and pay the outstanding balance on any installment notes created as part of a business succession plan.

Without adequate liquidity, beneficiaries may be forced into a fire sale of business assets, or their competing interests may slowly tear the business apart. Life insurance, pre-established dividend policies, and deferred compensation plans are some of the tools available to sidestep these problems. All require advance planning.

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Maintaining Control during the Transition

Some business owners put off succession planning because they perceive it as threatening their control. Good succession planning, however, serves to maintain an owner’s control over business assets while he or she shepherds them to the next generation(s). Failure to plan ahead represents a far greater threat to control and puts hard won family wealth at risk.

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