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From business success to succession

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It’s not surprising that most parents want their adult children to take over the family business. In many ways, it’s the family legacy. Benefits of transferring a business to a family member include keeping the business in the family, reaping more after-tax money than a third party transfer, retaining control until all, or most, of the purchase price is received  and allowing the owner to remain active in the business while gradually reducing day-to-day responsibilities. The problem is that few understand that without adequate financial planning, it’s nearly impossible to accomplish a successful business transfer. Business owners who understand the options available to transfer their ownership interest are more likely to accomplish their objectives and be more satisfied with the results.

The impending expiration of the two-year extension of the Bush tax cuts and the reduction in the lifetime-gift tax exemption amount from $5,120,000 to $1,000,000 could have a dramatic effect on business owners who wish to transfer the family business to their children. Additionally, increases in long-term capital gains rates, qualified dividend rates, gift, estate and generation-skipping transfer (GST) tax rates could also have a significant impact on business owners if the current laws are not changed. Implementing one or more coping strategies before the end of the year may result in short and long-term tax savings.

Succession planning can be evaluated in three phases: exit objectives, devising an exit plan and pinpointing your exit strategy. You should consult with your tax and/or legal professionals to determine which strategy would be advantageous for you. First, here are three questions to ask.

1. Where’s my compass?

Before selling or giving a business to family, the owner must think about what he or she wants to accomplish. Regardless of the intended recipient, all parents have to ponder and answer the following questions to determine their exit objectives:

  • How much wealth do you want to keep?
  • How much wealth do you want the kids to have?
  • How much is too much?
  • What tools minimize the estate and gift tax consequences of transferring wealth?

Once owners establish their financial exit objective, they can design a transfer mechanism that will pass wealth to their children with minimal tax impact. Figuring out one’s wealth transfer objectives tends to be difficult, as family relationships and business objectives become part of the same equation. For example, if an owner wants to transfer the business to a child but retains control and authority over all business decisions, it is doubtful the child will be ready to run the business once the transition is complete.

2. What are the planning elements?

 An exit planning road map includes strategic legal, tax and management decisions of how and when a business owner will transfer his or her interest. Succession planning involves identifying who’ll take over the business. An exit plan encompasses a succession plan, but goes beyond. An essential part of the exit planning road map involves retention of key employees. This is important because key employees might rationalize any number of reasons why they should leave if “Junior” is going to take over the corner office. An owner who plans on transferring his business to a child should consider what if any steps might be necessary to secure the employment of key employees whose departure would detrimentally impact the long-term success of the business. A deferred compensation agreement can make a difference in communicating how valuable an employee is the business.  

Deferred compensation plans range from cash incentive plans, stock appreciation rights, phantom stock plans and restricted executive benefit plans. By incorporating specific performance metrics and a vesting schedule, the plan pays for itself from higher profits or zero is paid out. These types of plans also help protect the company’s intellectual property. The financial benefits available are the carrot used to entice an employee to commit to a non-disclosure, confidentiality or non-compete agreement.

3. Which wealth transfer strategy?

Wealth transfer strategies are complex. Advisors and business owners must work together to pick the right combination of strategies in light of the owner’s objectives and criteria, including parental control and financial security; timing, duration and flexibility of payments; mortality risk, willingness to pay gift or income taxes; willingness to buy life insurance and charitable wishes.

Two popular, but often competing, strategies are the grantor retained annuity trust (GRAT) and an installment sale to a grantor trust.  Both strategies work well when interest rates are low and are designed to freeze the value of an owner’s highly appreciating asset by moving future appreciation to an irrevocable trust designed to benefit family members. Each has advantages and disadvantages, but both work well given properly structured. Both work better when the underlying asset generates a lot of cash and is given time to work.

In conclusion

Business owners work hard to create a successful company, but only one in 10 have a formal plan to exit their business. Now is the time to ensure your business will continue to thrive long after you’ve left.  Discuss the three succession planning phases with your financial advisor and develop a well-planned exit strategy to preserve your wealth for your family and future generations to come.

See also:

How to start the succession planning conversation

Maximize your client’s estate

Succession planning, step-by-step

Opinions expressed are those of the author and do not necessarily reflect those of Key Bank. This article is not intended to provide specific tax or legal advice. Readers should consult with their own advisors concerning their particular situations.


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