Business Succession Blog
3. FAMILY CONSIDERATIONS; EQUALIZATION
Do you have an equalization plan for children who do not participate in the business?
When children are involved in the business, family involvement can interfere with business ownership decisions. Looking at the Three Spheres of Business Succession independently (Family, Ownership Succession and Management Succession, see post #2) can help the business owner to see what is important within each sphere. If the business owner is fortunate there will not be a conflict between or among the spheres.
For example, a typical Family objective is that upon the death of mom and dad the entire estate is to be divided into equal shares with an equal share going to each child. The successor trustee is charged with valuing the property and allocating cash or property to each child equally. If the estate is made up of all cash or property that is to be sold, this task is very easy. If an asset is not to be sold but is to be owned equally by the children, again, the task is straightforward. The children of Fred and Wilma (see post #2) were all actively involved in the excavating company, therefore, the ownership transition of the business equally to the three sons made sense and further analysis was not necessary.
Years ago, Joe consulted me regarding the succession of his painting business, he was unmarried and he had three children, only one of whom was active in the business. The participant child, Ralph, worked hard at the business and was interested in eventually taking over (as soon as Joe allowed him to or, more likely, when he died). By looking separately at the ownership & management issues, we can easily see that it would be appropriate to provide for management transition to Ralph when Joe died or became incapacitated. The next question Joe asked himself was who should succeed as the ownership of the business. It became apparent that there was a conflict between the Family objective of treating all the children equally and the Business Ownership objective of having Ralph inherit the business.
We considered four methods to equalize the estate.
1. Provide in the estate plan for equal division of the entire estate to the children upon the death of Joe, with the business also divided among the children equally,
2. Provide for equal division of the estate, but allocate the business to the child active in the business and other assets of equal value to the business to the non-participating children,
3. Provide for equal division of all assets, and mandate a purchase by the participating son, Ralph, of business interests allocated to his siblings, and
4. Provide in the estate plan that all the business be specifically allocated to Ralph regardless of its value, with the other assets allocated to the non-participating children in some appropriate manner.
Unfortunately, the most common technique that I have seen employed is alternative number one, maybe because the other approaches are never considered. Alternative one is the likely approach if only the Family sphere is considered. If, independently, we also look at Ownership succession and ask who should ultimately OWN the business, most would agree that it should be Ralph, the son that works in the business. Alternative one is the least likely to succeed and eschewed by most business succession specialists.
In order to assess the relative merits of the alternatives, we have to look at each in a little more depth. Each approach stated above has constraints that may make it unadvisable. If you fail to consider important details of each alternative, you may have more alternatives to consider and decision making may be easier, but with questionable success. The selection of which alternative to implement is frequently directed by preconceived notions either of the attorney, the planner or the business owner.
For example, in assessing the alternatives presented to Joe the painter, we find the following:
1. By dividing the business among the children equally and giving the non-participating children a share of the business, the following problems may be encountered:
The non-participating children may demand income commensurate with the equity value of the business; this may lead to pressure on the participating child to distribute cash and create friction with his siblings.
If the non-participant does not receive distributions her inheritance may not be worth that much to her since she typically she will not be able to sell it, will not receive a salary, and may never receive a distribution.
If the non-participant is guaranteed a reasonable distribution, it may be in excess of what the company is able to comfortably pay without adversely affecting the health of the business.
Therefore, everyone, including the business itself, loses.
2. Problems may also be encountered if equalization is to be accomplished by providing in the estate plan for an equal division of all the property and then allocating the business to the participating child and other assets of equal value to the non-participants.
First, there must be sufficient other assets to be allocated to the non-participants. If there are not sufficient assets, life insurance could be the answer, allocating insurance proceeds to the non-participating children.
If there are sufficient other assets, essentially the non-participants are exchanging their equal share of the business to the participant child for other assets. This may leave a valuation issue and a potential for dispute.
The participant child receiving the business interest will want a lower value for the business so that he will not have to give up as much of the other assets, whereas each non-participant will want a higher value for the business so that he or she will receive more non-business assets.
Arriving at the property value is an expensive and inexact science. What is the value goodwill and whether there should there be a minority or marketability discount in valuing the interest acquired from each non-participant are just two of the issues that must be confronted. This valuation process during the administration of the estate can be accompanied by an effort by one child to manipulate the value or could result in a genuine disagreement as to value, which in turn can lead to resentment, hostility, or even a law suit among the children.
3. Providing in the estate plan for a buy-sell arrangement upon the death of Joe, giving the participating child an option or a mandatory purchase obligation to buy out the other children, has its own set of constraints.
You will have addressed the constraint of there being insufficient other assets because the property to be given to the non-participant will come from cash flow of the business, but the question becomes whether the business has adequate cash flow to make the payments without jeopardizing operations.
In addition, the valuation issue described in number 3, above, is still present.
4. Finally, the following constraints may exist if the plan provides that the business specifically be allocated to the participating child regardless of value, Joe determines the current business value and allocates assets to each of the non-participating children whose current value equals the business value (possibly purchasing insurance to the extent there are insufficient assets).
If specific assets are identified to go to the non-participants, those assets may not be owned by Joe at the time he dies.
The value of the business or assets to be specifically distributed may differ substantially between the date of the plan and the date of distribution after Joe dies causing dramatic disparity among each child’s inheritance.
Certainly legal and tax constraints are uncovered at this level of analysis, which the attorney and CPA will point out, but each approach may also involve a business or family risk that must be understood by the business owner. In the above example, Joe elected to be engaged in this more detailed analysis in order to understand these risks. Joe understood that the decisions that would be made at this more detailed level drove the outcome, and that the choice of alternative would not only affect the lives of his children but also determine the future successes of the business.
Unfortunately, there may not be a simple answer to the equalization puzzle. But, the decision to participate in wrestling with the details would more likely produce a result that would achieve long term viability of the business and a plan that will not cause family tension and resentment.
NEXT: THE DECISION
2. DEFINING OBJECTIVES; THREE SPHERES OF BUSINESS SUCCESSION
Business succession planning can be very complex, the sheer number of potential objectives, issues, and concerns is daunting. They may include:
Who should succeed as owners?
Who should succeed as managers?
What is the continuing cash flow need of the departing owner(s)?
What am I going to do next?
Is there a need to equalize the inheritance among children not participating in the business?
What is the value of the business?
How will employees handle a change in ownership?
What is to happen if the owner becomes incapacitated before the transition is completed?
When should the business owner transfer control?
Is there likely to be estate taxes that will have to be dealt with by the heirs?
How do the children get along, is there likely to be conflict after the parents die?
I find it helpful when defining objectives to look at the three spheres of business succession independently. They are: Family, Ownership Succession, and Management Succession. Sometimes by merely looking at each independently the core concerns become clearer and selecting the appropriate technique for addressing each issue becomes apparent.
If decisions are made in one of the spheres which conflict with a core objective in another, it is probably either not a good decision or the decision making process becomes more complex. I will discuss methods for ascertaining core objectives when the objectives are in conflict in a future post.
So first look at each of the 3 spheres and identify what your concerns are within each sphere.
1. Do you have the financial ability to retire?
2. Where will you receive any needed cash flow?
3. Do you have outside interests?
4. Do you have an equalization plan for children who do not participate in the business? Have you considered the sweat equity of a participating child?
5. Are there any conflicts or communication barriers among family members?
6. Have you completed your basic estate planning?
1. Have you identified a successor, if so, who?
2. Do you have a plan for transfer (inheritance, gift, sell, etc.), if so, what?
3. Do you have a buy-sell agreement to cover the unforeseen event of death or disability? Is it funded?
4. Is the successor prepared to take on the responsibility?
6. Are there potential conflicts among owners, family members and/or possible successors?
1. Has your future role in the business been defined?
2. Have you identified a management successor for business operations?
3. Has there been a clear definition and delegation of authority?
4. Is the successor trained?
5. Are employee incentives in place to ensure retention?
6. Who should control the business if you are unable to with regard to major business decisions?
This is a list of typical concerns of a business owner, but each situation is different. You are lucky if you can readily determine your objectives within each sphere, and there are no conflicts between or among the objectives. Then you can move to implementation of the appropriate technique to address each objective.
Looking at the Family sphere the business owner generally deals an estate planning attorney and a financial consultant. The financial consultant should give advice regarding retirement planning and insurance for liquidity needs upon death. Ownership succession may be directed within the Will or revocable trust or may be governed by a buy-sell agreement. As for Management Succession a business owner with foresight will ensure that if he or she is unable to manage the business, someone is in line to do so.
Years ago I represented Fred who owned an excavating company; his wife Wilma was a strong willed person who was not involved in the business. Their three sons were all actively involved in the business and were successfully managing operations. After meeting with all the parties and probing for information relating to matters such as family dynamics and conflicts, cash flow needs, management roles and style and who the ultimate owners should be, Fred determined that his real issue was management of the business upon his death and ensuring cash flow to Wilma during her life with the business ultimately passing to the children equally.
At first blush there appeared to be a conflict. How could Wilma get the cash flow and a participant child manage the business without the potential of interference from Wilma?
Considering Ownership Succession, Fred decided to leave the business to Wilma in trust if he should die first, and allow distributions to be made to her for her life, then upon her death the business would pass to the children equally.
Management succession would be dealt with by providing in their Revocable Trust that if Fred was unable to manage the business, the oldest son would act as Special Trustee and make all shareholder decisions rather than have the business managed by Wilma. A Special Trustee is named in the revocable trust and has the authority to make only those decisions specifically provided in the trust. Here, the Special Trustee made all shareholder decisions, including who was to be responsible for operational decisions of the business.
Since there were no other concerns that Fred felt needed addressing at that point, we were able to immediately implement the techniques decided upon and were able to keep the process simple. Fred could more clearly see his core objectives by looking at Ownership Succession and Management Succession independently and Family considerations were not in conflict.
If their oldest son was the only child actively involved in the business, however, Fred may desire that the participating son receive the entire business rather than share the business with his siblings. There would then be a conflict between a Family objective of having the children share the estate equally upon the death of Fred and Wilma and the Ownership Succession objective of having the child who was active in the business receive all of the business. My next post will focus on Family considerations and discuss the important concept of equalization among family members.
NEXT: FAMILY CONSIDERATIONS; EQUALIZATION
1. INTRODUCTION TO BUSINESS SUCCESSION PLANNING
Hello, my name is Allen Ratcliffe. I am an attorney in San Ramon, California. I have created The Business Succession Blog to provide information for those of you that are small to medium size business owners and are contemplating your future and the future of your business.
THINK OF THE FUTURE
During these financially stressful and uncertain times, many people do not want to engage in extensive business planning. However, it is times such as these that action is called for, whether that action is defensive in nature or in order to capitalize upon unique opportunities available today.
Consider the following:
· * Increased litigation, oftentimes frivolous, demands looking at business structure and techniques designed to protect your business and your personal assets;
· * If you may be selling your business, or passing it you your children or to your employees, within the next 3-5 years, you need to think ahead in order to maximize your return, minimize taxes and ensure a smooth transition;
· * Even if you are not planning to exit the business within the foreseeable future, unforeseen events, such as death or disability, require precautionary measures;
· * Estate tax savings techniques are more effective if integrated with business planning and implemented well before death;
· * Finally, with low values, low interest rates and availability of minority and marketability discounts provide a unique opportunity to pass interests in the business by gift or sale.
Business succession planning integrates your personal and business objectives, which are likely to include some or all of the above points, in order to develop optimal strategies to meet these objectives.
WHAT IS BUSINESS SUCCESSION PLANNING?
Business succession planning means different things to different people. To the management consultant is relates to management succession or maximizing business value, to an attorney it typically relates to buy-sell agreements, gifting strategies and passing the business upon death, to financial professionals it may relate to funding the acquisition of the business upon death an retirement planning, the CPA is interested in the financial ramifications of the succession, the psychologist with the personal dynamics, and the business appraiser in ascertaining value. All of these professionals have important input, and some may have critical solutions. Your specific situation, however, dictates which of the above referenced disciplines should be engaged and when. The only way for you to maintain control over the outcome is to first identify and prioritize your objectives prior to seeking solutions.
My blog will take your through a business succession process touching on legal, tax, financial, and to some extent psychological considerations. I will discuss the use of trusts, life insurance, employee incentives, business entities, gifting strategies, buy-sell agreements, and tax strategies and issues relating to family conflicts and the fear of letting go. I will give examples and occasionally include specific techniques that I have used successfully.
It goes without saying that you cannot implement all the techniques your hear about, the trick is to identify which are appropriate for you, which need to be implemented now, and which are inappropriate or can wait. Complex succession planning is like a jigsaw puzzle, you can go crazy if the task is tackled haphazardly.
NEXT: DEFINING OBJECTIVES; THREE SPHERES OF BUSINESS SUCCESSION