The Fate of Your Business: When You Want to Keep it in the Family
For a business owner, one of the biggest legacies to leave behind is the company and business that he/she has spent many waking hours building. However, at this time when many may be struggle to keep their businesses afloat, the idea of succession planning may be further down the to-do list. But without a proper succession plan in place, the business one has worked so hard to build may not survive absence of the original business owner, whether it is due to retirement, illness, or even death.
In addition, the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act of 2010 (hereinafter referred to as the Act) may present a unique albeit, temporary (during 2011 and 2012), opportunity for owners of closely held businesses to review their business succession plans and to consider using some or all of their $5 million gift tax exemption to transfer interests in the family business (or family real estate) to their children.
Although thoughtful succession planning should take place any time during the lifetime of a business, now more than ever, there are benefits to helping them come to fruition. Therefore, making a commitment to put together a business succession plan is the very first step in the process.
Keeping it in the Family
Once committed to formulating a plan, the first question that should be asked is whether the business should remain in the family or should it be sold. As simple as this question sounds, most of the time, it remains unanswered until it’s too late because it does require the owner to make an objective assessment of a child or children’s ability to manage the business in one’s absence. The question may also becomes more complicated to answer should the owner have heirs from a previous relationship. All in all, this is an emotional process for all parties involved but a necessity.
If it is decided that the business stay in the family, now is the time to decide whether ownership should be transferred equally among family members or transferred exclusively to those active in the business. Also, the current owner needs to take an objective assessment of the talent and experience required to carry on a successful business. Failure to address this issue may result in a business being kept in the family when perhaps it would be better for the family, as well as for the business, if it were sold and the proceeds distributed to the heirs. But once the decision is made to retain a business within the family and to transfer ownership to those active in the business, three primary objectives need to be addressed in order to have a successful transfer to the next generation.
Transfer Control to the in an Estate and Gift Tax Efficient Manner
The main objective of planning for business continuity for the family business is to transfer the ownership to the active members of the next generation with the least amount of estate transfer costs.
If a successful business owner waits until his or her death to transfer the business, his or her estate may lack sufficient cash to meet these tax obligations, forcing the estate to liquidate the business. This failure to plan could result in an undue financial burden on the business and may jeopardize its future viability.
Transferring the business to the surviving spouse is often thought of as the simplest approach, one being that all estate taxes are deferred until the second death. However, leaving the business to a spouse who has no working knowledge of the business could jeopardize its ongoing success, and even threaten the spouse’s financial well being.
Another problem with this approach is that family friction may arise if the spouse begins to assume a management role formerly performed by the children. Also, the fact that control of the business will not shift until the death of the surviving spouse may act as a disincentive for the children who are active in the business. Even if all of these obstacles are overcome and the business remains successful, the future growth of the business will be included in the surviving spouse’s estate. This will add to the costs of transferring ownership to the next generation.
Equitable Treatment of Inactive Children
It may be hard to accept this suggestion but the business should not be used to equalize the estate with inactive children. Rather, the business should pass to the active children and non-business assets should be used to treat the inactive children equitably.
Equitable does not necessarily mean equal value. It could be argued that a cash gift is worth more than a bequest of an equal value of closely held stock, since the stock carries greater risk and will generally require the child’s active involvement in the business.
In many cases where the business is the primary asset, it may be necessary to purchase life insurance in order to provide additional non-business assets to meet this objective. This insurance could be owned by an irrevocable trust designed for the benefit of the inactive children. The death benefit could remain in the trust and be used to purchase non-business assets from the surviving spouse’s estate and thereby, provide cash to pay estate taxes. In this way, the children active in the business should receive the business interest and the inactive children receive other property of comparable (or at least equitable) value.
Financially Independent of the Business
Owners may often be reluctant to release control of the business all together because their personal attachments and even their financial are so closely aligned with the business. Therefore, an owner who is relying heavily on his/her retirement and financial security on the continued success of the business may not so easily want to relinquish control to their children or their heirs.
Therefore, it is essential that attention be given to planning for the owner’s – in addition to the business and their heirs – financial security separate and apart from the business. For example, business real estate may be held in a limited liability company, outside the business. In addition, greater use of retirement vehicles, qualified and nonqualified, as well as establishment of sound investment programs outside the business would assure a smoother ownership transition when the children are ready to assume control of the business.
Peace of Mind
A business succession plan is a crucial part of any business owner’s estate plan. Properly arranging a smooth transition to the next generation of one’s legacy can eliminate unnecessary conflict, which may result in needless estate transfer costs and painful family discord that may even jeopardize the very survival of the business.
Assuming the business is to remain in the family, the first step is to address the three primary objectives of (1) passing control to the active children; (2) equitably providing for the inactive children; and (3) creating financial independence for the owner and his spouse.
If the transition is to be successful, these issues must be addressed early in the process.
Pursuant to IRS Circular 230, Barnum is providing you with the following notification: The information contained in this document is not intended to (and cannot) be used by anyone to avoid IRS penalties. This document supports the promotion and marketing of insurance products. You should seek advice based on your particular circumstances from an independent tax advisor.
Barnum, its agents, and representatives may not give legal or tax advice. Any discussion of taxes herein or related to this document is for general information purposes only and does not purport to be complete or cover every situation. Tax law is subject to interpretation and legislative change. Tax results and the appropriateness of any product for any specific taxpayer may vary depending on the facts and circumstances. You should consult with and rely on your own independent legal and tax advisers regarding your particular set of facts and circumstances.
A succession strategy may also include a buy-sell agreement funded by life insurance. More than likely, your successor may not have the cash, or the ability, to borrow at the time of successorship. Under such an agreement, the death benefit proceeds of the life insurance can be used to provide the cash necessary for a successor to purchase an owner’s share of stock in the event of his or her untimely death.
In addition, it may be prudent to explore how your unexpected disability could affect not only your plans for successorship, but also your financial well-being. Under a disability buyout arrangement, a disability buyout policy provides a successor with cash to purchase shares in the event of the owner’s untimely disability.
You should consult with your insurance, legal and tax professionals to devise a plan of action that provides security for your business and your family. With proper planning, your objectives for business succession and securing your family’s future can be met.
This article is for general information only and is not intended to provide specific advice or recommendations for any individual. You should consult with your advisor, attorney or accountant with regard to your individual situation.
Pursuant to IRS Circular 230, Barnum is providing you with the following notification:
The information contained in this document is not intended to (and cannot) be used by anyone to avoid IRS penalties. This document supports the promotion and marketing of insurance products. You should seek advice based on your particular circumstances from an independent tax advisor.