Business Succession Planning

The approach to family business succession planning is based primarily on good business governance.  The core plan is to design business governance that will apply to successor owners and managers and establishing contractual relationships and estate planning mechanisms that are consistent with those business governance structures.  

This approach emphasizes mechanisms for future owner exits that are fair and not disruptive.  Some successor owners, particularly those in the minority, may wish to exit ownership and use the value of their interest for other purposes.  

The approach does not necessarily lead with estate tax planning but makes estate planning much more effective.  The plan is intended to create equitable governance structures and well defined ownership rights that help avoid acrimony among successor owners who may have discordance personalities, incompatible value systems, or conflicting interests and objectives, or just changed circumstances over time.  Under this plan, if successor owners disagree about the business, regardless of the individual emotional or historical causes, they will have equitable means of resolving those disagreements and a structure for co-existing as owners, or t hey may exit ownership on terms that are fair to them and the other owners.  

Transferring family business interests to potential successors in advance of a senior owner's exit can be done well in advance of the senior owners' exit.  Sometimes it is desirable to transfer a minor percentage of ownership units to potential successors which often motivates them even more to work for the business and take a more personal interest in its performance.  

1.  Transfers for Successor Incentive and Involvement 

A plan for business governance after the senior owners' exit can create consistent performance and stability for the business after the senior owner leaves ownership and management.  The business succession plan can allow designated successors to acquire ownership interests consistent with the role they will assume as owners and managers.  

If there is a successor owner who will not be involved in management or governance, a small amount of nonvoting units, in trust or free of trust, can allow them to begin participating in family ownership and better appreciate the business's mission and performance.  If the owners have a family council, the nonvoting owner would likely be encouraged to participate to receive occasional updates on the state of the family business and provide limited input.  

2.  Successor Owners Involved in Management 

Successors who will be involved in governance might be given the opportunity to acquire a small number of voting units, in addition to nonvoting equity, to allow them to attend management or shareholder meetings even if they cannot affect the results of the vote.  

The successor owner can acquire their units by gift from the senior or by purchase from the senior owners or the company, or as a bonus if the successor is an employee.  The form of the transaction should be determined based on the economic needs of the senior owners and the aggregate tax effect among the parties.  

3.  How to Document Sale or Transfer of Ownership 

The successors' ownership units should be held in a buy-sell agreement that allows the company or other owners to reacquire the units for fair value if the succession plan changes.  For example, if a successor owner leaves employment with the business or if a successor owner ceases to participate in ownership.  The buy sell agreement can provide that if an owner ceases to be an employee in the business, the company or other owners may purchase his or her membership units.  If a company is an LLC the operating agreement can give the company or members the right to expel a member.  In a corporation, the shareholders agreement could grant the corporation the right to redeem shareholders.  

4.  Where Uncertain Whether Successor Owners will Participate in Management

One way to control ownership when the succession plan is uncertain, or where successor owners will not participate in management of the business is to transfer the units in trust for the successor as a beneficial owner.  The trust can be established so that the successor owner has nearly all of the same rights of ownership as she would if the units were held free of trust but the decision to continue to hold or sell the units could be assigned to a trustee.  The ownership interests of each successor owner who is not active in the business could be held in a trust and the successor could serve as trustee of the trust but if the trustee determines that the successor's beneficial ownership had become disruptive or counterproductive the trustee could require the trust to sell the shares to the company or other owners for fair value. 

5.  Transfers to Manage The Family Business 

Many times the most effective means of managing the transfer of ownership interest is during the senior owner's lifetime.  Under tax law as of this writing, property passing to a spouse or a qualified trust for a spouse is not subject to federal estate taxes.  Roughly speaking, therefore, a married couple can exclude $22.8 million from federal estate taxes with proper planning.  Current law is schedule to sunset in 2025--these exclusion amounts are scheduled to be reduced by half. 

The federal estate tax exclusion can be applied to lifetime transfers to avoid federal gift taxes.  A similar exclusion applies to transfers during your lifetime.  

Generally, lifetime transfers of family business units to a senior owner's children and grandchildren, or trusts for them, are an effective way to transfer lifetime wealth: 

  • Future income and appreciation of transferred ownership accrues to the transferee and are not included in the senior owner's taxable estate; 
  • Minority interests and nonvoting ownership transferred during lifetime can be valued at a discount for the purpose of applying transfer tax exclusions, even if the senior owner is a controlling owner.  The discount applies because the transferred interest does not carry the benefit of voting control and do not have a ready market for resale.  In contrast, if the senior owner dies while holding a controlling interest, none of his ownership interest will qualify for lack of control discounts for estate tax exclusion. 
  • Some tax efficient mechanisms for transfers of business ownership are available during the senior owner's lifetime, but not at death.  

6.  Lifetime Transfer Techniques 

Some of the more common lifetime transfer techniques are: 

A.  Gift to a successor.  If the senior owner makes a lifetime gift of a minority interest to a successor, the gift should be valued at a discount for purposes of calculating the amount of transfer tax exclusion. 

B.  Installment Sale to a Successor.  If the senior owner sells a minority interest or nonvoting ownership to a successor, the units should be valued at a discount for calculating the amount of the purchase price.  The successor may pay the purchase price in the form of an installment note to the senior owner.  The seller will likely incur capital gains tax on the purchase price, but the seller may elect to recognize the taxable gain over time as the installments are received.  All income and appreciation on the units after the transfer will accrue to the successor except to the extent the successor uses the income from the sale to pay the installments.  

C.  Self cancelling installment note.  A senior owner can sell ownership to a successor in exchange for an installment note that will cancel the unpaid principal upon the senior owner's death.  To justify the self canceling feature, the successor must pay a premium on the interest based on the senior owner's life expectancy. 

D.  Grantor retained annuity trust.  A senior owner can gift ownership to a grantor retained annuity trust (Section 2702 of the Internal Revenue Code.  This type of trust provides an annual payment to the senior owner for a term of years and continues for the benefit of the successor.  

7.  Transfers to an Intentionally Defective Grantor Trust 

A grantor trust is a trust that is treated as though it is owned by the grantor for income tax purposes.  An intentionally defective grantor trust is an irrevocable trust that the grantor creates for the benefit of someone else, usually his children but purposefully including trust provisions that cause the trust to be treated as the grantor's property for income tax purposes but not for estate tax purposes. 

If the grantor's intention is to maximize the amount of wealth that she can transfer to children without incurring transfer taxes, the grantor trust has two special advantages.  First, the grantor can sell property to a grantor trust without triggering a capital gains tax and without recognizing the interest on installment payments as taxable income.  Second, the grantor can pay the income tax each year on income produced by the assets in the trust without treating that additional benefit to the trust as a taxable gift.  

Generally, the transfer of family business ownership to an intentionally defective grantor trust proceeds as follows: 

  • the senior owner establishes an irrevocable grantor trust for his intended successors.  The trust can include the grantor's spouse as beneficiary and thus provide an economic safety net for the spouse in retirement.  The trust can essentially continue in perpetuity and shelter the trust assets from transfer taxes in future generations.  The trust can also provide the senior owner with the power to terminate trust features in case payment of the trust's income taxes becomes an economic burden.  
  • The senior owner makes a gift of a minority interest or nonvoting ownership of the family business to the trust in an amount that will allow the trust to be a credible buyer in a subsequent unit purchase transaction with the grantor.   The gifted units should be valued at a discount. 
  • Next, the senior owner sells additional units to the trust in exchange for a promissory not.  Usually, the installment note runs for nine years, which is the minimum length of a note that can use the mid term safe harbor interest rate for family transactions under Section 1274(d) of the Internal Revenue Code.  Also, it may be possible to use an interest only note or other payment schedule that includes a balloon at the end if cash flow from the trust cannot fund payments on a note that is fully amortized.  
  • If the ownership is in a limited liability company, which is a flow through entity, and if that entity distributes cash to owners to pay their share of income taxes the trust can use that cash flow to make the installment payments to the senior owner because, so long as the trust is a grantor trust it will not be taxed on its income--rather, the senior owner will be.  After the trust has paid off the installment note, it can accumulate and invest the cash flow or purchase additional units from the senior owner. 

8.  Serving Succession Objectives 

Transfer of ownership interests in trust can be particularly well tailored to meeting family business succession objectives even if the transfers are motivated primarily for reasons of mitigating transfer taxes.  This is because the trust instrument can appoint one or more fiduciaries to make decisions about the management and division of ownership units within segregated trust accounts for individual family members.  The fiduciaries can be senior family members or independent parties, or a combination. 

For example, if an individual family member holds ownership units in the family business, then regardless of his or her role in the business or the state of his or her relationship with the family, that individual family members will have all the rights and powers of an owner, perhaps including rights that are disruptive to the business and can be exercised in ignorance or bad faith, such as the right to demand accountings, the right to review books and records, and possibly the right to bring direct or derivative lawsuits against the managers or officers.  In contrast, if ownership units are held in a trust, then the trust fiduciaries hold the legal rights and powers of the owners and make all decisions about how those rights and powers will be exercised, including when to divest ownership in the membership units and on what terms.  

Further, if the trust is funded with a variety of assets, the trustees may allocate family business ownership units to the segregated trust shares of family members who are most committed to the business and can allocate other assets to the segregated shares of family members who are not involved.  With this kind of flexibility, the senior owners can make wealth transfers to mitigate transfer tax liability long before they make final decisions about the specifics of family business successor owners and leaders.  

Please contact me at 307.200.1914 regarding protection and transfer of family business wealth.