All In The Family

Designing the right plan for the next generation

Running a company is hard enough for most small business owners. Still more challenging for many is parting with the firm–especially when kids are involved.

The hurdles lie not only in the financial aspects of designing and implementing a succession plan. For parent-owners, more fundamental issues can be excruciatingly difficult to face: when to loosen control; how to divide business assets among competing siblings of unequal talent; whether to gift all or part of the business; and how best to fulfill kids’ desires while providing for their own retirement security.

“The ultimate question to ask the client is, ‘What, in a perfect world, do you want to see happen to your business,’” says David Nelson, a financial planner and president of NelsonCorp Wealth Management, Clinton, Iowa. “Often, one party will say what the other wants to hear.

“The greatest value we as advisors bring to the table is getting these wishes out,” he adds. “Anybody can do the numbers.”

Too often, however, no one is doing the numbers. According to the 2005 Phoenix Wealth Survey, 63% of 1,514 respondents–small business owners with a net worth exceeding $1 million–have no business succession plan.

Another 50% do not have a business transfer or continuation plan. And 60% are without life insurance for business-related purposes, such as key person coverage.

Because exit planning touches upon so many hot-button issues–business, personal and end-of-life–small business owners tend to ignore the topic for too long, sources say. Part of the sensitivity stems from a natural squeamishness about addressing succession questions. Parents, Nelson observes, often don’t want to burden their children. And many kids avoid raising the subject for fear of appearing greedy.

Parents avoid the topic for other reasons. David Parthemuller, a financial planner with the Normandy Group, Lakewood, Colo., cites owners’ fear of losing control and the difficulty many have “working on the business” when they’re so engrossed “working in the business.”

Some owners, adds Parthemuller, have trouble justifying hiring a succession planner, believing they can handle the process themselves or aided by an attorney or accountant. But delayed or inadequate exit planning, advisors stress, has a price.

“Everyone will have a plan,” says Nelson. “The only question is whether it’s yours or one that a probate court will create for you after you’re gone.”

To kickstart the process, a growing number of advisors are tapping outside parties (such as clinical psychologists) to help parents and children deal with family dynamics that can hinder a smooth transition. Advisors suggest excluding certain third parties. Among them: in-laws (or, as Nelson describes them, “outlaws”).

The heart-to-heart talk between advisor and family members–experts suggest alone with the parents first, later with the kids–can point up problems that, left unaddressed, might prove fatal to the business or to family harmony.

Example: a son or daughter whose business acumen leaves something to be desired. Pete Wheeler, a financial planner and partner at Wheeler/Frost Associates, San Diego, Calif., cites one client who had to leave retirement to resuscitate a family business that his son proved incapable of managing.

Frequently, too, children take the company helm only to fulfill a parent’s wish to keep the business within the family, though their career interests lay elsewhere. Another of Wheeler’s clients, a man in his early 50s, closed a firm that his parents gifted to him to pursue a lifelong dream: working in hotel management.

Even if a child has the requisite skills and enthusiasm for running affairs, a parent risks losing key employees after transferring control. Conversely, selling to a key employee or third party could alienate children whom the parent deems to be less business savvy.

If a son or daughter is fit to assume control, then parent-owners need to determine whether a sale or gift of the business (or some combination of the two) is in everyone’s interest. In most cases, parents will opt for a sale, say experts. Chief reason: the need to provide for a comfortable retirement.

For most owners–especially those with annual revenues of from $1 million to $5 million–the company is their largest asset. They therefore need cash derived from a whole or partial sale of the business to ensure adequate funding of their retirement.

Also dictating a sale, observers say, is the belief among many business owners and exit planners that children who acquire a parent’s business through a purchase feel a greater sense of responsibility for the company. And they take greater pride in their own efforts.

“Positive self-esteem comes from accomplishment,” says Nelson. “Nobody feels good about being handed something. So we tell clients: ‘Don’t deprive the kid of the opportunity to go through tough times and do what you’ve done.’ That experience is very important psychologically.”

Commonly used for transacting a sale is the installment note, a promissory note that permits children to pay off the business over a period of years. If, as is also typical, the children can’t fund the purchase from their own assets, they can make payments from the profits of the business.

Similar to the installment note is the self-canceling installment note, which has one major difference: The note balance is forgiven if the seller dies before being paid in full. The result is that no taxable value is included in the seller’s gross estate upon his or her death.

Alternatively, owners might opt for a private annuity. With this vehicle, the owner sells the business in exchange for a child’s promise to pay a fixed amount for the rest of the owner’s life. One benefit of the private annuity is that the property sold is not included in the seller’s taxable estate.

If, as in a C or S corporation, an owner sells stock to effectuate the transfer, then Parthemuller recommends minimizing the business valuation so as to reduce the double taxation on ordinary income and capital gains. For example, a business worth $3 million could be valued at $1 million; the remaining $2 million could go into a deferred compensation or other retirement plan for the benefit of the parent.

“The various exit strategies available to business owners ultimately have to be weighed against their tax impact,” says Aubrey Morrow, president of Financial Designs, San Diego, Calif. “With the installment sale, for example, mom and dad will have to pay a capital gain tax as they receive principal payments attributable to the gain. That spreads the tax over a number of years.”

Caveats aside, outright gifting sometimes makes sense. If parents have sufficient retirement assets outside the firm or if a son or daughter lacks the means to fund a buy-out–thus risking a liquidation of the business or its sale to a third party–then gifting may be prudent.

For the donor, giving also has tax advantages. A gift of an ownership interest that grows from $5 million today to $10 million in 15 years shifts that interest from the donor’s estate to the recipient’s.

To the extent the transfer also redirects excess income to the recipient(s), the donor also can save on income taxes. And if the business is placed in trust, beneficiaries (e.g., children) will be subject to reduced estate and gift taxes.

Case-in-point: the grantor-retained annuity trust. An irrevocable split-interest trust, the vehicle pays the owner (or trust maker) an annuity for a period of years. When the term expires, the GRAT distributes the property or holds it in trust for designated family members. Though the business may have appreciated in value during the term, remainder beneficiaries pay no gift or estate tax on the appreciation.

Small business owners can lessen estate and gift taxes as well by leveraging other vehicles. These include the family limited partnership, charitable lead annuity trust, charitable lead unitrust, and the demand trust.

The last may be suitable when, for example, the business owner desires to give each of three children an immediate controlling interest in the business, plus protection from creditors. To that end, the owner can create three trusts, each child acting as both beneficiary and trustee of one of the three.

In addition to enjoying the annual gift tax exclusion, the demand trust also permits, at the owner’s option, a controlling interest in the business. But Wheeler advises against this approach.

“Gifting equally to three or four children is generally a recipe for disaster,” he says. “The children who are growing the business have to share their success with siblings who aren’t involved. And that can generate resentment.”

Wheeler adds that few small business owners with less than $15 million or $20 million in assets use charitable trusts for exit planning. And, whether owners are contemplating a gift or sale, he advises transferring ownership only to children able to run the business.

Other children can be compensated fairly from assets remaining in the owner’s estate at death. David Cahoone, a partner with Esperti, Peterson & Cahoone, Sarasota, Fla., counsels establishing an irrevocable life insurance trust for these non-owner siblings to equalize inheritances.

Irrespective of the technique favored, parent-owners of small businesses need to plan at least three to five years in advance of their exit to produce the best outcome for the next generation, says Parthemuller. He also stresses the importance of assembling a collaborative team of experts.

“Advisors have to communicate the exit strategy in a way the owner and kids can buy into,” he says. “This all requires a group of highly talented advisors, including not only the planner, CPA and attorney, but also a business valuation specialist.”

‘Everyone will have a plan. The only question is whether it’s yours or one that a probate court will create for you after you’re gone’