Keeping the Business in the Family

By Jennifer Mailhes, Managing Director, Doeren Mayhew Capital Advisors

Transferring a family business to the next generation requires a delicate balancing act. Estate and succession planning strategies are not always compatible, and the older and younger generations often have conflicting interests. However, by starting early and planning carefully, it is possible to resolve these conflicts and strategically transfer the business in a manner that is aligned with the goals for all family members, whether involved or uninvolved in the business, and in a tax-efficient manner. 

Ownership Versus Management Succession

One reason transferring a family business is a challenge is the distinction between ownership and management succession. When a business is sold to a third party, these two processes typically occur simultaneously. However, in the family business context, there may be reasons to separate the two. 

From an estate planning perspective, transferring assets to the younger generation early on allows you to remove future appreciation from your estate, minimizing estate taxes. There have been many proposed changes to the estate tax and planning both from a legislative standpoint and through the Internal Revenue Service (IRS)’s interpretations of current rules, so taxpayers should act soon. 

On the other hand, some business owners may not be ready to hand over the reins of their business or feel the next generation is not quite prepared to take over. There are several strategies owners can use to transfer ownership without immediately giving up control, including: 

  • Placing business interests in a trust, family limited partnership (FLP) or other vehicle that allows the owner to transfer substantial ownership interests to the younger generation while retaining management control, 
  • Transferring ownership to the next generation in the form of nonvoting stock, or 
  • Establishing an employee stock ownership plan. 

Another reason to separate ownership and management succession is to deal with family members who aren’t involved in the business. It’s not unusual for a family business owner to have substantially all their wealth tied into the business. Providing heirs outside the business with non-voting stock or other equity interests that do not confer control can be an effective way to share the wealth, while allowing those in the business to take over management. However, giving too much ownership to children not involved in the company can potentially destroy the business and family dynamic. 

Despite statistics to the contrary, the involved heirs working toward growing the business could potentially develop the idea that they are also building value for the uninvolved heirs, which could lead to frustration on their part and result in them acting in their best interest, or even starting a separate business. This is part of the reason why second-generation businesses do not always flourish – the owner failed to establish a strategic plan that accommodates everyone. 

While the current generation thinks they are being fair to all their children, it also is not ideal for the uninvolved heirs either, as they are essentially holding ownership in a closely held business where management is not focused on maximizing company value. The most optimal planning focuses on giving ownership based on earning it versus birthright, but balancing the desire to be fair to all heirs. 

Splitting Heirs

Most M&A advisors usually recommend first transferring ownership in other assets, such as business-occupied real estate or assets outside of the company. While this approach is the most optimal, it may create some conflict. 

A few keys to optimal planning include: 

  • Providing open and direct communication to all heirs. It is always better if the plan is not a surprise, leaving them wondering who got what and why, which creates resentment. 
  • Offering clarity on how a buyout can happen. Make it easy and structured for the involved heirs to buyout the uninvolved ones. There are occasions where an owner does not want to “dictate from the grave,” but it is in the best interest of involved heirs to have control and receive the benefits of the work they do to grow the business, and for the uninvolved heirs to have assets that they can control. However, you do not want to require them to buyout the uninvolved heirs unless the liquidity is there to do so. 
  • Giving control of the business to the involved heirs but avoid creating inherent/known conflicts both from a financial and family perspective. For example, if there are two heirs who do not get along, steer clear of putting them in a situation where they are both partners in an active business.  Avoid tying their ownership to working in the business, but instead to being a key person that has earned ownership. Give each heir a base interest (10% or less) and tie the rest to them earning it. 
  • Working with a tax advisor to maximize tax savings.We assisted a family-owned business with a father and son who each had 50% ownership. The father pulled a significant amount of cash from the business for an investment disproportionate to their ownership. The investment lost money, resulting in the father having losses on his tax return and no cash to repay the funds loaned by the business. With our help, they considered the redemption of his stock as repayment for the loan by the company, which facilitated the transfer of ownership to the son and provided the father with a consulting agreement to ensure he had the income needed. The income from the consulting earnings was offset by the losses, but the son received a deduction for the consulting payments in the business. This type of planning is very specific to each situation, but there can be some mutually beneficial options if everyone is clear in their intent and goals. 

Conflicting Financial Needs

Another unique challenge in family businesses is when the older and younger generations have conflicting financial needs. For example, a business owner may be relying on the value of the business to fund his or her retirement, while his or her children might hope to acquire the business without a significant investment on their part. 

Fortunately, several strategies are available to generate cash flow for the owner while minimizing the burden on the next generation. 

  • An installment sale of the business to children or other family members.This provides liquidity for the owners while easing the burden on the younger generation and improving the chances that the purchase can be funded by cash flows from the business. Plus, so long as the price and terms are comparable to arm’s-length transactions between unrelated parties, the sale shouldn’t trigger gift or estate taxes. However, it is important to conduct a valuation to support the transaction between family members. 
  • A grantor retained annuity trust (GRAT).By transferring business interests to a GRAT, owners obtain a variety of gift and estate tax benefits (provided they survive the trust term) while enjoying a fixed income stream for a period of years. At the end of the term, the business is transferred to the owners’ children or other beneficiaries. GRATs are typically designed to be gift-tax-free. 
  • An installment sale to an intentionally defective grantor trust (IDGT). This is a somewhat complex transaction, but essentially a properly structured IDGT allows an owner to sell the business on a tax-advantaged basis while enjoying an income stream and retaining control during the trust term. Once the installment payments are complete, the business passes to the owner’s beneficiaries free of gift taxes. 

Because each family business is different, it is important to work with an advisor to identify appropriate strategies with your objectives and resources in mind. For assistance or more information, contact Doeren Mayhew Capital Advisors today.

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