Family Business Succession Planning

Jun 18, 2014

Related Practices: Business and Estate Planning & Administration

This post is part two in a three-part series about noteworthy topics regarding entity choice, compensation, and business succession. Part one, "Sweat Equity and Entity Choices," reviews questions to keep in mind when considering entity choices. Part three, "Nonqualified Deferred Compensation for Closely Held Businesses," outlines the requirements of nonqualified deferred compensation plans and the penalties for failing to meet their requirements.

What should you consider when transferring equity of a closely held business to younger generations?

There are several options for how to involve younger generations in the ownership of a closely held business. The best option for any particular family or company will depend largely upon the various factors described below.

Keep in mind that not any single factor is determinative and the importance of each may change depending on your family’s situation.  Unless there are extenuating circumstances, the effective succession of a business involves a proactive process that not only takes time to fully implement, but requires facilitated communication with the entire family.

We generally recommend a planning meeting with your business and an estate planning attorneys to discuss your desired plans and help define your succession goals.  Your attorneys can then assist you with implementing a specific plan of action.  It is important to keep in mind that implementation of any succession plan often involves revising company documents and your core estate planning documents (e.g., your will and powers of attorney).  Integration of your accountant and financial and insurance planning professionals may also be appropriate to create an effective team to assist you.

When contemplating your business succession plan, key factors to evaluate when and how to transition your ownership include:

  • Control.  Consider when and to whom you would like to transition control of your business.  Not everyone in the younger generation may be ready or willing to participate in the business.  If you would like to retain management control of the business for some duration, you may want to consider a lifetime plan for the gifting of equity (either as minority voting interests or as non-voting interests of any amount).  The gifting strategy can be staggered over time and could involve gifting equity to trusts, where the Trustee and not the beneficiary, controls the gifted business interest.  You should also consider a backup plan to phased gifting-based transition in the event that you die unexpectedly and control has not yet been transferred.
  • Cash flow needs.  You should carefully evaluate your financial security and cash flow needs before transferring equity, which will decrease your net worth and cash flow.  The purchase of equity by younger generations with payments over a number of years may be used to help with lifetime cash flow, and life insurance can be utilized to fund the purchase after death to assist with estate liquidity.
  • Timing.  When you are ready to relinquish control of the business, you should ensure that the younger generation is properly trained and engaged in running and maintaining the business you’ve worked so hard to create.  Implementation of a staggered gifting program over time, along with open and honest communication, is often key in ensuring that the younger generations will be successful managers.
  • Taxes and Valuation.  The transfer of business interests can have significant income, gift and estate tax consequences and valuation issues.  Whether stock is being gifted or sold to related parties, it will typically be necessary to obtain an independent appraisal for tax purposes.  In many cases, obtaining the appraisal is the first step in implementing your succession plan. 
  • Creditor protection.  You may want to consider the financial and marital situation of the recipients of your business interests.  If you are concerned about their creditors or a potential bankruptcy or divorce, you may want to transition interests in trust or in another entity structure. You should also make sure that your corporate documents address the impact of these potential problems.