By: Ed Bowen, CLU®, ChFC®, CIMA®

In many closely-held businesses, the implementation of a business succession plan is often ignored until the company owner is forced to confront the issue, usually as a result of imminent retirement, disability or other unforeseen circumstances. When this occurs, the consequences will likely be unnecessary taxes, the sale of the business at less than fair market value, or operational problems caused by the loss of key employees. According to the Small Business Administration,¹ only 30 percent of family-owned businesses are successfully transitioned to the second generation and less than 15 percent survive into the third generation and beyond. History shows that the primary reason for this is that closely-held business owners tend to have a poor track record when it comes to developing a formal business succession plan.

The primary concerns that cause business owners to procrastinate in their succession planning are: 

·         Fear they will not have adequate income during retirement

·         Reluctance to pay capital gain taxes on the sale of the business

·         Uncertainty of when to bring children into the ownership of the business

·         How to treat children not working in the business in a fair and equitable manner

·         What to do with key employees not in a position to buy into the company

Succession planning for a closely held business can be difficult because it involves an entity that has substantial value but limited marketability. In many cases, this causes the transition of such an asset to become emotionally charged due to conflicting family relationships. Additionally, there are tax issues and non-tax considerations that should be addressed when developing a succession plan. While tax issues often dictate the types of strategies involved, non-tax considerations are among the most important aspects in determining whether a business is successfully transferred or ceases to exist. However, financial advisors have a number of creative, tax-favored solutions available to accomplish the business owner’s objectives in developing a successful business succession plan. 

Unfortunately, the typical business owner lacks the sense of urgency needed to address such matters, which can lead to serious consequences. Business owners must recognize the impact that a planned or unplanned succession of a business will have on the numerous stakeholders. The widow of the business owner is certainly affected as her livelihood will, in many cases, depend upon a successful transition. The decedent’s children will be concerned with their career path or getting their fair share. Key employees will feel at risk unless there is an existing succession plan. The company’s vendors will be concerned about their accounts receivables and the bankers will be concerned with the viability of existing loan agreements. In addition, competitors will start circling overhead like vultures eagerly awaiting their chance to swoop in and make offers at “fire sale” prices to the widow of the business owner who failed to plan. Finally, lurking in the background is the Internal Revenue Service who may have its own plan to assess the decedent’s estate. 

A well designed succession plan should involve a number of different solutions for varying situations if the needs of all stakeholders are to be addressed. These solutions could include:

·         Buy/Sell Agreement funded for both death and disability triggers

·         Qualified plan utilizing age-weighted or new comparability designs

·         Non-qualified executive compensation plan for key employees

·         Key person life insurance plan for owner and key employees

·         Employee Stock Ownership Plan (ESOP)

Additionally, your client should consider the structure of the transaction. The sale may be structured as an asset sale or stock sale. The way in which the sale is structured can affect how the seller is compensated, resulting in significantly different tax consequences that could potentially favor the buyer or seller depending on the structure. Regardless of the terms of the structure, the plan should clearly state who will control and operate the business, how and when the transition to the new owner(s) will occur, and to what extent, if any, the current owner will be involved in the business after the transition occurs.

Whether the business is to be sold to a third-party or transferred to family members, a well-designed succession plan should always include an independent valuation appraisal. It is imperative that the business owner know what the business is truly worth as there can be dramatic differences in what the owner feels is fair value and what the IRS considers fair value for tax purposes. An appraisal from a certified valuation appraiser is recommended since it increases the likelihood that the valuation will be upheld if challenged by the IRS. There are numerous examples of where the IRS has contested business valuations that have taken years to resolve at considerable legal expense to the client. A business valuation also determines the value of the business for estate tax purposes.

If properly designed, business succession can occur under the right circumstances, with the right terms, and at the right time for the departing owner. The process involves complex legal, financial and emotional issues that can be difficult for the business owner and their families to face. It is the responsibility of financial advisors to approach their business clients and initiate the process necessary to avoid the potentially disastrous consequences if this future event is not properly addressed. Don’t allow your business clients to ignore their responsibility to the stakeholders until it’s too late. Remember, business owners don’t plan to fail, they fail to plan.

As manager of 1st Global’s Advanced Case Design group, Ed Bowen coordinates the overall planning and implementation of complex financial strategies involving high net worth individuals and closely held business owners.

¹Source:  Astrachan, J.H. and M.C. Shanker, “Family Businesses’ Contribution to the U.S. Economy: A Closer Look.” Family Business Review September 2003.