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Engaging in Business Succession Planning

Columnist: Susan M. Teel
October, 2011 Issue

Susan M. Teel
All articles by columnist

When can a business owner afford to step aside? Or afford not to? What are the alternatives? Considering these questions can be paralyzing, especially given the current economic chaos. Multiple financial and emotional anxieties arise to block even the steeliest entrepreneur from facing realities, particularly as values of premium wineries, real estate and yesterday’s cash cow enterprises are sliding. But today’s total business environment for succession planning is compelling.

This year presents an unprecedented set of tax incentives to encourage family businesses, particularly wineries, to do succession planning. The infamously “unsettled” 2010 Tax Act brought us increased transfer tax exemptions, which shelter gifts from tax during life and at death—letting a person give away $5 million tax-free ($10 million for couples). It also brought portability so couples can use both exemptions at death: If one spouse dies with an estate worth less than $5 million, the unused exemption can be added to the survivor’s exemption to shelter gifts worth a total of $10 million. Finally, it brought annual gift tax exemptions, separate from the lifetime $5 million, remain at $13,000 per person covering an unlimited number of donees; but these provisions are temporary. They expire in 2013, when the pre-2001 exemption ($1 million) and tax rate (55 percent) return, unless Congress enacts a fix.  

Congress’ recent behavior should warn us that temporary legislation is dangerous. It can change or stall, seemingly irrationally, based on political whims and economic firestorms. Thus, the generous options before us are more attractive now than they appeared nine months ago. Why risk waiting until 2012 to use these tools to secure tax savings on gifts, when values of such gifts will likely grow over the long term? Failure to act soon may cost tax dollars in the future.

Succession planning, or planning for ownership changes in the family business, can be messy. But if succession is considered in phases—sequential steps undertaken with active communication between family members and supported and guided by legal and financial counsel—such planning can be therapeutic. Statistically, 90 percent of U.S. businesses are family enterprises. It’s staggering that only 30 percent survive to the second generation, even though the founders intend to pass on a viable business. This number shrinks to a 3 percent survival rate to the fourth generation or beyond. The central destructive force is lack of planning.

Many approaches and formulas are circulated, but they distill into two phases. The up from “Ground Zero” phase begins when business owner(s) face the core issues of control (loss of their own) coupled with competing cash flow needs. How will control and cash flow be managed if the owner retires (voluntarily or involuntarily), dies or is suddenly incapacitated? How would minority family owners fare at a controlling owner’s death? Core estate planning coupled with succession planning anticipates these events.  The “worst event documents”—trusts, wills and durable powers of attorney—provide for how asset ownership, control and management will pass when an owner faces death or incapacity. Trust planning also provides for ownership division, asset protection and financial provisions for survivors; it also includes tax planning.

The protective, “pre-crisis event” documents for business owners usually include a life insurance component. Insurance can provide liquidity for tax payments, cash to pay business debt or cash to finance a family member’s buy-out or ensure non-owning family members can redeem a descendant’s interests and receive cash.  

It’s important that family business owners should also incorporate a buy-sell agreement into their planning—in advance of a crisis event. Using a buy-sell agreement, owners decide how they’ll handle given business decisions during a crisis and how transfer limitations restricting ownership to family members may be imposed. It can also provide a formula, or outline a process, for determining valuation and facilitating purchase arrangements at liquidation or involuntary sale (an owner’s death, incapacity, divorce or bankruptcy).  

An updated, trust-based plan typically includes traditional marital and exemption trusts, so couples can provide for the survivor and other family members and lock in estate tax exemptions to the fullest. An inter-generational trust may be included, and if funded with business interests, it will add a control element to preserve and protect the business interests from premature disposition or improper management. Such planning may help preserve the business for future generations. Trust language can also be incorporated directing the trustee at the first death to fully use the portability options (if available) of a deceased spouse’s unused exemption.

Phase II planning emphasizes risk analysis and targets special assets—like businesses. Typically, planning seeks to reduce valuation risks such as steep increases in value, which will drive taxes up; strengthen creditor protection so debilitating debt won’t erode liquidity and inhibit growth; and shield the business from potential family dissension, which can permanently derail business relationships. Key strategies include accelerated gifting, use of techniques to freeze asset values and lay a foundation for discounting value, and use of split interest gifts to shift enjoyment and further reduce valuation. Options include: the use of grantor-retained annuity trusts (GRATs), limited liability companies (LLCs), intentionally defective irrevocable trusts (IDITs), irrevocable insurance trusts (ILITs) and others. Used with the Phase I fundamentals, these strategies may help preserve a family business’ integrity for generations to come—just ask the Waltons, Fords and numbers of successful local enterprises.


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