For many small business owners, their company is like their child. As such, they invest the majority of their time and resources into ensuring the business stays healthy and has opportunities to grow and maximize its potential. Few focus on preparing for that inevitable moment in the future when they will have to hand their baby over to someone else. This may partially explain why of the 90 percent of 21 million small businesses in the United States that are family-owned, only 30 percent succeed into the second generation and only 15 percent survive into the third.
While succession planning is a critical concern for any organization, it could literally be a matter of life or death for a small business. Family-owned enterprises are particularly vulnerable because business discussions can be complicated or derailed by the emotions involved in addressing such difficult issues such as aging, death and financial affairs.
To ensure that the business you worked so hard to build and nurture continues to thrive after retirement or death, you must develop a succession strategy that
- Enables an orderly transition of both ownership interests and management responsibilities while minimizing complications between heirs of partners
- Provides economic support for all relevant parties involved
- Helps minimize tax liability and erosion of value
Setting a Succession Strategy
While there is no “one size fits all” succession planning solution, and the details will vary according to the distinct dynamics of your situation, the following are key considerations as you embark on developing a succession strategy:
Start early – Ideally, it is best to begin this process as far in advance as possible. This will give you the opportunity to explore all of your options and prevent hasty decision making that can undermine the stability and value of the business.
Identify your successors – This might be the most challenging aspect of this process for small business owners, particularly those whose dream it is to keep the business in the family. Your first born, or other designated relative, may not have the interest or skills to do the job. Therefore, to ensure that you place your business in the best possible hands, we recommend making a rigorous and honest assessment of the relative strengths and weaknesses of all potential heirs – including family members. If you can afford it, succession specialists generally recommend engaging an outside expert to conduct this analysis to help make objective and rational decisions regarding the best future interests of the business and to de-emphasize emotional attachments and family politics.
It is also important to remember that management and ownership are not necessarily one and the same. Thus, it may be in the best interests of the business to appoint an employee, or outsider with the requisite expertise, to take the business to the next level. Even if your children or other relatives are not holding the proverbial reins day-to-day, they can still retain an ownership interest and exercise some level of control via voting shares. Family members who have no desire to be involved can receive their share of the financial benefit through other arrangements such as trusts, cash gifts or retirement accounts. Likewise, if your successor is a non-family member, it may be wise to offer that individual a piece of the pie to keep him/her vested in the business’ success. In cases where you believe appointment of an experienced and necessary third party may create tension with family members, it may be worth considering setting up a mechanism to buy out the relatives.
Determine the right legal structure for transferring your business – There are significant financial implications and tax consequences when ownership of a business is passed on. If this is done with no succession planning, such as when the owner suddenly passes away, taxes can be as high as 50 percent of the total business value. In many situations, this means the termination of the business and sale of the assets to pay the taxes.
There are numerous legal methods for transferring your business. While the best option for you will depend on your individual needs and circumstances, below are examples of some commonly used alternatives. In addition to the information below, we recommend you consult a tax advisor for advice specific to your situation.
- Selling your business interest outright – creates cash flow which can be used to maintain your retirement lifestyle or pay your estate taxes. You choose when to sell–now, at your retirement, at your death, or anytime in between. As long as the sale is for the full fair market value (FMV), generally determined by an appraisal from a certified public accountant (CPA) or by an arbitrary agreement between all partners involved, it is typically not subject to gift tax or estate tax. But, if the sale occurs before your death, it may be subject to capital gains tax.
- Transferring your business interest with a buy-sell agreement – prearranges the sale of your business interest enabling you to maintain control until the occurrence of a triggering event that the agreement specifies, such as retirement, divorce, disability, or death. At this time, the buyer becomes obligated to purchase your interest from you or your estate at the fair market value. Because the terms and price are pre-arranged, buy-sell agreements eliminate the possibility of a fire sale upon illness or death.
- Leveraging private annuities – it may enable you to help manage tax burdens by selling your property in exchange for a promise of payments to you for the remainder of your lifetime. In essence, you would transfer complete ownership of the business to family members or another party (the buyer) in exchange for an unsecured promise to make periodic payments to you for the rest of your life (a single life annuity) or for your life and the life of a second person (a joint and survivor annuity). Since this arrangement qualifies as a sale, and not a gift, it may enable you to remove assets from your estate without incurring a gift or estate tax.
- Establishing a family limited partnership – another mechanism to limit tax estate and inheritance tax liabilities that functions by creating a partnership with both general and limited interests. Once your business is transferred to this partnership, you’d retain the general partnership interest for yourself, allowing you to maintain control over the day-to-day operation of the business, while incrementally gifting the limited partnership interest to family members. The value of the gifts may be eligible for valuation discounts as a minority interest and for lack of marketability. If so, you may successfully transfer much of your business to your heirs at significant transfer tax savings.
Get professional assistance – Though trimming expenses is always a key concern for small businesses, skimping on succession planning today can jeopardize financial security for you and your family and threaten the continued viability of the business you worked so hard to build. As you saw from the brief overview in this article, there are substantive complexities to managing this process. It is strongly recommended that you consult with an attorney and a financial advisor to help you structure a legally sound succession plan that helps you achieve your financial and business goals while helping manage tax exposure. Moreover, once in place, a succession plan should be updated every two to three years or whenever there is a big change in the business, tax code or the owner's personal life such as a marriage or divorce.