Making Family Business Transition Plans A Success

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A plan of business continuity is a crucial element of any business owners estate plan. In our world of uncertainty, it is more important than ever for business owners and their advisors to develop comprehensive plans for passing the business on when death or disability occurs.

This critical planning becomes even more complex when the business in question is family-owned.

When dealing with family-owned businesses, the focus is on minimizing the cost of keeping the business in the family, with one of the principal expenses being the gift and estate tax payable on business interest transfers to family members who have been identified as successor owners.

For many years, small businesses, especially family businesses, lobbied heavily for the repeal of estate taxes to relieve the tax burden when passing the business to their heirs. While the Economic Growth and Tax Relief Reconciliation Act of 2001 did not guarantee the repeal of estate taxes in 2010, it did provide, in general, for an estate tax reduction with some immediate relief and the balance phased in over the next few years.

However, the Act also repealed for estates of decedents dying after Dec. 31, 2003 the qualified family-owned business deduction that was originally enacted as part of the 1997 tax legislation. As a result, estate taxes still need to be addressed to plan for a shorter-term tax liability, while also planning for the possible reappearance of the estate tax in 2011.

Failure to plan for an efficient and effective ownership transition will result in the business having to assume an additional financial burden at a difficult time when it has just lost not only a key employee, but the leader of the organization.

For advisors in the family business planning market, there are 6 key questions that need to be addressed in the planning process.

1. Should the business remain in the family or should it be sold?

Often this question is not asked because it requires the business owner to make an objective assessment of a childs ability to manage the business. This is difficult because of the owners emotional ties to both the family and the business. If this issue is not addressed, however, the result may be a business being retained in the family when it would be better for the family, as well as for the business, if it were sold, with the proceeds distributed to the heirs.

2. What objectives should be part of a business owners estate plan when the business will stay in the family?

The plan should create a synergy among three potentially competing objectives.

One is the desire to pass control of the business to those children active in the business. The second goal is to provide for the financial well-being of the business owner and spouse, separate and apart from the business. Finally, there is an objective to treat fairly the children who are not active in the business.

An advisor and the client will know when a well-prepared plan is in place if it achieves these three objectives.

3. Should the owner leave the business to a surviving spouse to defer federal estate taxes until his or her death?

The marital deduction defers federal estate taxes on assets passing to the surviving spouse or into certain trusts designed to benefit the surviving spouse. These assets will then be subject to federal estate taxes as part of the surviving spouses taxable estate.

It is not uncommon to find a business owner leaving the business to his or her spouse in order to take advantage of this estate tax deferral. Whether this is advisable depends on the degree of involvement the spouse has in the management of the business. Leaving the business interest to a spouse who has no working knowledge of the business could jeopardize its ongoing success and threaten the familys financial well-being.

It could also cause severe discord if the spouse assumes a management role formerly performed by the children or other key employees. Even if these obstacles are overcome, the future growth of the business will be exposed to estate taxes as part of the surviving spouses estate, adding to the cost of transferring the ownership to the next generation.

4. When should control of the business pass to the children active in the business?

In most cases, control should pass directly from the business owner to the children active in the business through gifts during life, through bequests upon death, or by sale pursuant to a buy-sell agreement.

Whether the business should be sold to these active children will depend on whether there are sufficient non-business assets to accomplish the other two major objectives we laid out earlier: (1) provide for the financial well-being of the business owner and spouse; and (2) treat the inactive children fairly.

While a sale may not be the more efficient way to pass control, it becomes necessary when the proceeds are needed to provide financial support and to fund the inactive childrens interest.

Proper planning can avoid this need for a sale by funding the retirement needs of the business owner and spouse through qualified retirement plans, investments outside the business, and non-qualified retirement plans.

5. What if the business owner should die before all the children have had an opportunity to come into the business?

Consideration should be given to transferring control of the business to a trust if all the active children cannot be identified at the time of the business owners death. Trustees can then manage the business until it can be transferred to the active children after all the children have had a chance to come into the business.

This question also highlights the need to have key employees remain with the business upon the business owners death. Their loyalty is key to the ongoing success of the business, but their loyalty is tied to the business owner, not the heirs. A solution is to use fringe benefits that provide a strong incentive for them to stay, such as supplemental retirement packages.

6. Will insurance funding be needed if the business interest is simply going to be gifted or bequeathed to the active children?

Insurance plays a vital role in estate planning for business owners. In fact, insurance on the business owner is the most efficient way for active children to fund the purchase of the business upon death of the business owner through a buy-sell agreement.

However, the need does not disappear if the plan anticipates that the business will be transferred to the active children by gift or bequest.

The flow chart pictured shows that insurance on the life of the business owner may be needed to provide financial support to the surviving spouse, as well as the liquidity needed to pay estate taxes generated by a bequest of the business to the active children. In addition, survivorship insurance covering the lives of both the business owner and the spouse should be considered as a way to provide additional assets needed to fund the inheritance of the children not active in the business.

These policies should be owned outside the owners estate–typically in an irrevocable life insurance trust–which makes the death proceeds available to the family without subjecting them to estate taxes–no matter what the tax environment ends up being.

A business continuity plan should be the starting point for developing a business owners estate plan, but in far too many instances it isnt. It is very often overlooked or ignored because owners focus on building the business, not who will succeed them.

This is true with family businesses where the whole familys financial security is at risk. There always seems to be plenty of time to planuntil it is too late.

Advisors–especially those with insurance expertise–can make a big difference in their business owner clients’ lives by encouraging the planning process and ensuring proper funding of the plan.

, J.D., LL.M., C.P.A., is counsel, business and estate planning for New England Financial, Boston, Mass. You can contact him via e-mail at shoulihan@nef.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, February 11, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.


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