According to the U.S. Small Business Administration over 99% of the businesses in America are small and privately-owned, often by members of a family, and employ well over 50% of all working Americans. These same small businesses, which are credited with creating a large share of the wealth in this country since World War II, are controlled by an aging generation of entrepreneurs. It is estimated that over the next 25 years some $6 to $10 trillion dollars in business wealth will pass from one generation to the next. Yet, less than one-third of closely-held business owners have a definite plan to transfer ownership of their business if they retire, or suddenly become disabled or die.
An often repeated statistic states that 70% of family businesses fail to continue to the second generation and 88% fail to continue to the third generation. When it comes to creating a business succession plan (also known as a “exit strategy”) for their business, many owners are lost in the wilderness without a trusted advisor to guide them through the dense thicket of rules that have significant tax, business, financial, and estate/probate consequences to their surviving loved ones. Faced with this daunting task and left alone to their own devices, it is no wonder that many business owners become overwhelmed and never know where to start and simply procrastinate to their own detriment instead of effectuating effective wealth transfer planning.
The team of business succession attorneys at Einhorn Harris offers an integrated and multi-disciplinary approach to identify and resolve your unique business challenges involving business formation, ownership, governance, compensation, employment, management, acquisition, merger, and ownership transition and succession. For the closely-held business owner, the business interest is likely to be the largest single asset in the estate. Our team of business succession attorneys also has deep experience in trusts and estates, taxes, employee benefits, real estate, and family law, to help you coordinate your estate planning with your business succession planning to avoid conflicts. Einhorn Harris will help you focus on your tax and non-tax estate and business planning goals for the transition and work with you to develop and implement a viable plan to achieve those goals.
First Step: Develop A Mission Statement For The Business And The Owner
The most likely reason for the failure of most family businesses to continue beyond the second generation, as indicated above, is not the estate or inheritance taxes imposed or the lack of adequate capital, but the reluctance of business owners to make a concrete succession plan with the help of an advisory team. Without preparation, thought and careful planning, the ownership change will not succeed. One simple way to begin the process is to develop a mission statement that outlines the owner’s long-term goals for the business and the owner’s personal financial goals. In other words, the mission statement should capture the owner’s vision of the future. It would address such issues as whether the owner should sell or continue the business upon the owner’s retirement, disability or death; whether to sell the business to outside third parties in a tax-free or taxable disposition; whether to have a binding agreement now to transfer ownership to existing employees or younger family members while the owner has leverage over them or wait until after death when the employees can threaten to leave the business; whether to give ownership interests with management and voting rights only to family members who work in the business and non-voting ownership interests to family members who don’t without creating or exacerbating rivalries among the owner’s children; whether the business will generate enough cash flow to support the owner during his or her retirement or disability; and how to eliminate or minimize income and transfer taxes as a result of the transition. Understanding the owner’s business and personal financial goals is necessary for the advisory team to design strategies for tax and estate planning, retirement planning, and business succession planning consistent with those goals and to fashion a plan to ensure the owner’s personal financial security. In essence, the advisory team should compare the owner’s goals and objectives with the current business circumstances to determine if those goals are realistic and achievable and plan accordingly.
Second Step: Identify And Develop The Future Management Team
The next step in business succession planning involves identifying and developing the future management team, whether it consists of family members, non-family key employees or a combination of both. Most business owners find giving up control or delegating decision-making responsibility difficult to accept after being in charge for many years. A lot of professional advisors neglect this step by instead concentrating on the income and transfer tax issues arising from a change in ownership and paying little attention to advising the owner to take time to coach or mentor the next generation of business managers. The owner must be careful to select a future manager who has the respect, support and loyalty of the key employees and other family members who own the business. The owner must take the time to groom his chosen successor to allow him to adapt to his or her new position as the owner gradually withdraws from the business. During this transition period, the business owner must have in place several methods to ensure that the chosen management team remains employed by the business such as an employment agreement with a provision for a bonus or some form of incentive compensation, stock or grant options to allow the employee to purchase an interest in the business, a deferred compensation agreement, or a change of control agreement that guarantees the employee’s compensation if the business is sold to a third party during the transition phase.
Third Step: Transfer Ownership
The next step for the business owner is to decide who will be the new owner and the most effective means for transferring the business interest. Some options for the business owner to consider in transferring ownership of the business or “exiting the business” include selling the business to a third party such as a competitor or other outside party and structuring the deal as a tax-free reorganization or taxable asset sale or taxable stock sale; selling to the business employees by having a binding agreement during the owner’s life instead of waiting after the owner’s death or disability and having the family negotiate with the employees who may have the upper hand by threatening to leave the business; or leaving the business to family members at death or selling or gifting the business interest to them during the owner’s lifetime. For a business owner who has some children working in the business and other children not working in the business, this last scenario raises the problem of how to treat all of the children equally when dividing up the assets in the owner’s estate, especially if the business owner has insufficient other assets to give to the non-working children. There are various techniques available for transferring ownership of a closely-held business with each having its own advantages and disadvantages depending on the facts and circumstances of each situation including whether the business is operated as a sole proprietorship, partnership (including a limited liability company taxed as a partnership), S corporation, or C corporation. Each of these situations has its own tax and non-tax consequences.
The tax strategies for eliminating or reducing the taxes of each of these methods of transfer will be discussed in the next issue of this newsletter.
 Except where otherwise indicated, “family-owned business” will be used in this article to include any closely-held business owned by unrelated individuals.