Path to business succession is littered with obstacles
Being proactive, however, is the first step.
Family-owned businesses can avert legal headaches and emotional anguish by having a succession plan set in place before it’s needed.
Such plans are particularly significant in West Michigan, where families own an estimated 88.8 percent of businesses, according to the Family Business Alliance, which counts 120 family businesses among its membership.
The key word to effective transition plans is “proactive,” according to Ellie Frey, director of the Family Business Alliance.
“Without a succession plan, there are risks both in management transition and ownership transition,” said Frey. “You can avert, or at least mitigate, those risks. Also, with a succession plan, you can spell out, if you are the owner or CEO of the company, what you want the business to look like in five to 15 years. It’s a way to preserve a legacy you’ve been working to cultivate.”
Succession plans should be in place long before scheduling the boss’s retirement party.
“Our industry tells us succession planning doesn’t happen overnight. It takes five to seven years for a succession plan to be implemented. And that may be conservative. Sometimes it takes longer or shorter,” she said.
“Most entrepreneurs are so caught up in the business of the business, and every market is so competitive today. It takes so much energy to succeed in your given industry that this type of planning often times is neglected, and when it’s neglected, that’s when there’s the biggest resistance to passing on the baton,” saidJim Steffel, a partner with Warner Norcross & Judd LLP.
A well-thought-out succession plan includes: agreed-upon job descriptions for key players involved in the changeover; a determination of who will own the company, and its management structure; providing leadership training to the next generation; bringing alongside a consultant or conferring with the board of directors; and a good estate plan.
Some entrepreneurs who were adept at launching a business and defining its business model are reluctant to establish a transition plan because it means releasing the leadership reins, said Pamela MacDougal, an associate with the Dykema law firm where she concentrates on transactional tax matters.
“They are all action focused and taking risks, and they define themselves by their business and think of the business as their alter ego,” said MacDougal. “Succession planning is about protecting something that exists and handing it off to somebody else. So when you think about that, you understand why succession plans might not be at the top of the list for an entrepreneur.”
Joe Horak agrees. He is founder and co-president of The Relationship Research Institute of Michigan, senior director of leadership and family business consultant for consulting firm DWH, and an adjunct professor at Grand Valley State University’s Seidman College of Business.
“The biggest problem with succession plans is there’s not a plan,” said Horak. “The founder has a controlling personality who makes things happen and has a hard time letting go. They think they’re immortal and they may ‘die-in-the-saddle’ kind of thing.”
If the founder can be convinced a succession plan is in the business’s best interest, Horak recommends taking some specific steps.
“We recommend family business be 10 years out when talking about succession. It includes grooming the next generation of leaders, which sometimes is a non-family member who comes in. Usually we want (the new leaders) to have an education or MBA and we want them to have a minimum five years’ experience outside the business, often acquiring some level of management on their own merits so they’re not ascending to the throne.”
Then there are in-fighting problems that may occur if there’s more than one family member who thinks he or she should be the company’s next president, which a proactive succession plan can often resolve.
“That’s important because people think of family businesses as a financial wealth machine and oftentimes it’s a delicate relationship machine, and parents are more concerned with relationship succession than financial succession,” said Steffel. “The key to a successful plan is coordinating the succession of both management and ownership with the goals of both the business and the family.”
According to Steffel, a strategic family business succession plan needs to separately analyze who will succeed to the management of the business operations and who will succeed to the ownership of the business interests. This dual analysis helps families achieve their business and financial goals through structures that significantly impact multiple levels of both taxation (income, gift, estate, and generation skipping) and asset protection, each of which always apply to the transition of the ownership.
“This is not a one-size-fits-all process because of two things: Every family is different and every business is different,” said Steffel. “For example, the wealth creator of a business, the person who initiated the business in the first place and saw its growth — or I should say, managed its growth — might have no children, or no children who appear to be interested in the family business. That’s a different story than an engineering business that has three kids who graduated from MIT.”
Some families that squabble over who will take the leadership reins may settle on a co-leadership arrangement, said Horak.
“It’s more common today to see co-presidents of siblings if they’re working well,” said Horak. “But oftentimes, it can be a difficult question when people aren’t effective leaders and are lacking in some significant ways. The family may have been avoiding making one of their sons (president) who’s a bully and who assumed he was going to be the leader. It’s pretty brutal to tell somebody they’re not going to be in leadership. Or they get fired, and next week is Thanksgiving dinner.”
Many business succession issues, especially those that are tax-related, can be impacted by the choice of the entity used for business operations, according to Steffel. “This remains true even though we now have checkbox regulations that in many instances give entities the choice of how they would like to be taxed.”
LLCs have significantly increased in popularity over the last two decades and in many cases are the entity of choice, according to Steffel. Like S-corporations, they are attractive to smaller, family-owned businesses that want to avoid the C-corporation’s double taxation, which is a tax on corporate income and a second tax on amounts distributed to shareholders. These “pass-through” entities may also make financial sense if a new business is likely to have an operating loss in its first year. The losses from the business often can be passed through to the individual shareholder's tax return to offset income from similar sources.
Three other important tax practices may apply to business succession planning, added Steffel: the freezing of a family business’s value (for gift and estate tax planning); the fractionalization of ownership interests into minority (less than 50 percent) positions; and the possibility of transferring a “stepped-up basis” at the death of an owner, especially for family businesses with limited exposure to estate taxes, which currently only apply to individuals with assets exceeding $5.25 million or couples with assets exceeding $10.5 million.
“With a 40 percent tax applicable to all estates that are currently valued above $5.25 million, it is easy to see why interest should be gifted or sold before they double or triple in value,” said Steffel. “For example, if a 33 percent interest in a company is worth $5.25 million today and triples in value before the death of the owner 10 years from now, a current gift of that interest would completely avoid the future estate tax of approximately $4 million that will apply if the current tax law does not change.”
Similarly, because the ownership interests in most closely held family businesses have limited marketability, especially when they do not involve controlling interests, those fractional interests commonly receive significant valuation discounts for their lack of control and lack of a market for selling such interest. The combined discounts generally range from 30 to 35 percent.
Finally, for smaller businesses not significantly subject to the current estate tax, caution should be exercised to avoid prematurely transferring interests.
“That’s because gifts of ownership interests transfer a carry-over basis to the recipient, where bequests of ownership interests at death transfer a stepped-up basis to the recipient,” said Steffel.
“For example, if mom and dad originally invested $10,000 into their C-corp that is now worth $10 million and they gift the entire interest today to their daughter, she would get their $10,000 basis. Therefore, if she promptly sold it for $10 million, she would be taxed on $9.9 million of gain. Instead, if mom and dad died today and their daughter received that same interest under their will or trust, she would get a basis that is stepped up to today’s value. Therefore, a future $10 million sale would trigger no gain.”