Navigating The Challenges Of Business Succession Planning

Most insurance company training on business succession planning is limited to describing the difference between cross-purchase agreements and redemptions. Thats fine for businesses with more than one owner and where none of the owners children are involved in the business.

But where children are active in the firm, theres a great deal more to consider than stepped-up basis and estate taxes. The following are among the more common pitfalls faced by planners engaged in business continuity planning.

Pitfall 1: Treating children equally frequently results in not treating them fairly.

Take the case of Henry, who owns 100% of D&E Heating. Henry and his wife, Wilma, have two grown sons, Erik and Derek, who do not work well together. Henry gave Erik the first opportunity to manage the business. Erik was very successfulat alienating employees, customers and suppliers.

Derek, to whom Henry then entrusted management, expanded the business multiple-fold. Confident in Dereks work, Henry decided to give Derek ownership of the business and its real estate. We were retained to build up assets of equal value for Erik.

To that end, we devised a plan that incorporates insurance and defined benefit pension plans and presented our case to the parents, children and their advisors. While waiting for our applause, Derek said, “Seems to me that you think these two pots are equal. If so, and this is lets make a deal Ill take door No. 2. Give me the insurance proceeds and the investments and give Erik the business.”

There was a pause, and then Derek said, “because in 6 months, Ill own both.” He realized that his brother could not run the business.

That day, I learned the difference between fair and equal.

In a revised plan, we valued Dereks “sweat equity” (i.e., the years that he has worked in the family business) with a “risk premium” (i.e., because his net worth was concentrated in one asset, with labor problems, competitors and much more, he could also lose everything).

That resulted in Dereks share of the parents estate being numerically greater, but now considered fair by the parents, the sibling and their advisors.

By working hard, Derek could substantially increase his personal net worth. Erik, on the other hand, had a diversified portfolio of assets and the opportunity for his own career, including forming his own private business. He, too, had the opportunity to increase his net worth.

Here is another example of parents who planned to distribute their net worth equally but potentially not fairly. Harry owns 100% of ABC Manufacturing. Harry and his wife, Willa, have two sons and a daughter. One son, Andy, had worked in the business for 15 years. His brother, Bill, worked a few summers and no longer lives in the area. Their sister, Carol, has no interest in the business.

The parents anticipated that their net estate after taxes and costs would be worth $1.5 million. The total includes the business real estate (owned outside of the business), worth $500,000, and the business itself, valued at $1 million.

Harry and Willa told us their plan was to leave the business to the boys 50/50 and the real estate to their daughter. “That way,” according to the parents, “all of our children would receive $500,000 of equal value.” What do you think of that plan?

We asked, “What would be your reaction if you were Andy?” Harry looked at Willa, smiled, and then said, “We have been concerned about leaving only 50% to Andy. After all, he has been working here a long time. What if we give him 51%?”

We smiled back and asked, “Why are you willing to effectively disinherit Bill? What is the value of 49% of a closely-held business?”

We continued by asking, “Who repaired the driveway or fixed the roof of the business building?” Harry said, “What difference does it make? I own both!” We asked, “Who would pay for these improvements if your daughter is the landlord and your sons are the tenant?”

We continued by asking Harry if he ever didnt pay the rent to meet payroll. He told us that he had on more than one occasion. We asked how that would be received by Carol if Andy and Bill couldnt pay the rent. Would that create a conflict between the siblings?

By asking these tough questions, we were able to develop a plan whereby Andy now owns the business and its real estate. Bill and Carol receive other assets (including life insurance proceeds and retirement plan assets that previously were not in place) valued less than the business might be worth based on Andys “sweat equity” involvement over the last 15 years.

Whether the long range value of Andys share will be larger or smaller than Bills and Carols depends on his efforts and the economic environment in his industry. Bills and Carols value will, likewise, depend on what they choose to do with their careers and their inheritance.

Pitfall 2: Failing to coordinate the owners business succession planning with his or her estate planning.

Sam, age 65, is an only child and owns one-third of the business founded by his father, Fred, who is 90. Fred still owns the other two-thirds. During the last 30 years, Sam increased the value of the business almost 20-fold.

When his father dies, the business will be sold to pay estate taxes.

I frequently tell that story to groups of estate planning attorneys. They shake their heads and say, “that would never happen in my practice.”

I ask if they work with any businesses that have one owner with children active. “What is the current estate plan for your clients $5 million business?” I ask. They tell me that there is an A-B trust.

Under current law, the “B” share or Family Trust receives assets that will not be included in the surviving spouses taxable estate. The amount passing to this portion of the trust is designed not to exceed the death tax exemption of $1.5 million in 2004 and 2005.

The balance of the estate passes to the “A” share or Marital Trust). As a result, I ask, “Does that mean that $3.5 million or 70% of the business stock will end up in the Marital Trust which remains in the surviving spouses taxable estate?”

What happens when the surviving spouse dies?

The $3.5 million share in the “A” Trust continues to grow inside the surviving spouses taxable estate. Isnt this the same result as what happened to Fred and his son, Sam? Every year, the son who is still working in the business is helping to increase his mothers taxable estate. He ultimately will be responsible for paying those estate taxes.

What could have been done? Fred wanted to retain control. He could own one voting share. Sam could then own 99 non-voting shares. In fact, by age 65, we would likely have gifted some of Sams non-voting shares to his children. But, its too late to do that now. The cost of gifting the non-voting shares over the last 30 years, however, would have saved this family business.

Pitfall 3: Keeping family businesses alive is a complex process of ownership succession as well as management succession.

Just because an owners child may receive the stock does not necessarily mean that he or she is capable of running the company.

Key employees are loyal to the owner, not to the business. Incentives need to be in place that motivate these players to remain with the business and work with the owners children.

Tax and financial considerations are critical in developing a successful business succession strategy. However, it is frequently the people issues (children and key employees) that are overlooked and result in the founders business dying with the founder.

Herbert K. Daroff, J.D., CFP, is a Registered Investment Advisor, d/b/a Baystate Financial Planning, Boston, Mass. E-mail him at HDaroff@baystatefinancial.com.


Reproduced from National Underwriter Edition, September 9, 2004. Copyright 2004 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.