(by Jennifer Mailhes, Managing Director, Doeren Mayhew Capital Advisors, written for Doeren Mayhew, CPAs and Advisors)
Transferring a family business to the next generation requires a delicate balancing act. Estate and succession planning strategies aren’t always compatible, and the older and younger generations often have conflicting interests. By starting early and planning carefully, however, it’s possible to resolve these conflicts and strategically transfer the business in a manner that is aligned with the goals for all family members, whether involved or uninvolved in the business, and in a tax-efficient manner.
Ownership versus Management Succession
One reason transferring a family business is such a challenge is the distinction between ownership and management succession. When a business is sold to a third party, these two processes typically occur simultaneously. However, in the family business context, there may be reasons to separate the two.
From an estate planning perspective, transferring assets to the younger generation as early as possible allows you to remove future appreciation from your estate, minimizing estate taxes. The recently passed Tax Cuts and Jobs Acts also provides an additional estate tax savings, as the exemption level has doubled from $5 million to $10 million.
On the other hand, some business owners may not be ready to hand over the reins of their business or feel the next generation isn’t quite prepared to take over. There are several strategies owners can use to transfer ownership without immediately giving up control, including:
- Placing business interests in a trust, family limited partnership (FLP) or other vehicle that allows the owner to transfer substantial ownership interests to the younger generation while retaining management control,
- Transferring ownership to the next generation in the form of nonvoting stock, or
- Establishing an employee stock ownership plan.
Another reason to separate ownership and management succession is to deal with family members who aren’t involved in the business. It’s not unusual for a family business owner to have substantially all of his or her wealth tied up in the business. Providing heirs outside the business with nonvoting stock or other equity interests that don’t confer control can be an effective way to share the wealth while allowing those who work in the business to take over management. However, giving too much ownership to children not involved in the company can potentially destroy the business and family dynamic.
Despite statistics to the contrary, the involved heirs working toward growing the business could potentially develop the idea that they are also building value for the uninvolved heirs, which could lead to frustration on their part and result in them acting in their best interest, not the company’s, or even starting a separate business. This is part of the reason why second-generation businesses don’t always flourish – the owner failed to establish a strategic plan that accommodates all heirs.
While the current generation thinks they are being fair to all their children, it also is not ideal for the uninvolved heirs either, as they are essentially holding ownership in a closely held business where management is not focused on maximizing company value. In my experience, giving ownership of more than 10 percent to each uninvolved heir and/or 25 percent of the total ownership seems to be the tipping point creating a negative dynamic. The most optimal planning focuses on giving ownership based on earning it versus birthright, but balancing the desire to be fair to all heirs.
Most M&A advisors, like those at Doeren Mayhew Capital Advisors, usually recommend first transferring ownership in other assets, such as business-occupied real estate or assets outside of the company. While this approach is the most optimal, it may create some conflict.
For example, a client gifted ownership in the business-occupied real estate to the uninvolved heirs and the majority of the business to the involved family members. However, the real estate rapidly appreciated after estate planning, making the original gift now disproportionate and leaving the business in a position where it needed to relocate, but the respective owners of the business and real estate had conflicting goals.
Another strategy is to purchase life insurance to create liquidity for family members not involved in the business.
A few keys to optimal planning include:
- Providing open and direct communication to all heirs. It is always better if the plan isn’t a surprise, leaving them wondering who got what and why, which creates resentment.
- Offering clarity on how a buyout can happen. Make it easy and structured for the involved heirs to buyout the uninvolved ones. There are occasions where an owner doesn’t want to “dictate from the grave,” but it is in the best interest of involved heirs to have control and receive the benefits of the work they do to grow the business, and for the uninvolved heirs to have assets that they can control. However, you don’t want to require them to buyout the uninvolved heirs unless the liquidity is there to do so.
- Giving control of the business to the involved heirs, but avoid creating inherent/known conflicts both from a financial and family perspective. For example, if there are two heirs who don’t get along, steer clear of putting them in a situation where they are both partners in an active business. Avoid tying their ownership to working in the business, but instead to being a key person that has earned ownership. Give each heir a base interest (10 percent or less) and tie the rest to them earning it.
- Working with a tax advisor to maximize tax savings. We assisted a family owned business that included a father and son who both had a 50 percent ownership. The father pulled a significant amount of cash from the business for an investment that was disproportionate to their ownership. The investment lost money, resulting in the father having losses on his tax return and no cash to repay the funds loaned by the business. With assistance from our CPA and advisory affiliate Doeren Mayhew, they were able to consider the redemption of his stock as repayment for the loan by the company, which facilitated the transfer of ownership to the son and provided the father with a consulting agreement to ensure he had the income he needed. The income from the consulting earnings was offset by the losses, but the son received a deduction for the consulting payments in the business. This type of planning is very specific to each situation, but there can be some mutually beneficial options if everyone is clear in their intent and goals.
Conflicting Financial Needs
Another unique challenge presented by family businesses is that the older and younger generations may have conflicting financial needs. For example, a business owner may be relying on the value of the business to fund his or her retirement, while his or her children might hope to acquire the business without a significant investment on their part.
Fortunately, several strategies are available to generate cash flow for the owner while minimizing the burden on the next generation.
- An installment sale of the business to children or other family members. This provides liquidity for the owners while easing the burden on the younger generation and improving the chances that the purchase can be funded by cash flows from the business. Plus, so long as the price and terms are comparable to arm’s-length transactions between unrelated parties, the sale shouldn’t trigger gift or estate taxes. However, it is important to conduct a valuation with an Internal Revenue Service approach to support the transaction between family members.
- A grantor retained annuity trust (GRAT). By transferring business interests to a GRAT, owners obtain a variety of gift and estate tax benefits (provided they survive the trust term) while enjoying a fixed income stream for a period of years. At the end of the term, the business is transferred to the owners’ children or other beneficiaries. GRATs are typically designed to be gift-tax-free.
- An installment sale to an intentionally defective grantor trust (IDGT). This is a somewhat complex transaction, but essentially a properly structured IDGT allows an owner to sell the business on a tax-advantaged basis while enjoying an income stream and retaining control during the trust term. Once the installment payments are complete, the business passes to the owner’s beneficiaries free of gift taxes.