Lasting family businesses have long erm strategies

June 25, 2012
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When transferring a business, there are three important strategies to consider: outside accountability, long-term focus and taxes. First, a board of advisors or a formal outside board of directors will provide fresh ideas for the family and accountability. Second, a long-term strategic plan provides a roadmap for the future of the company’s growth, fiscal responsibility and profitability. These strategies maximize the value of the company either in the second generation or upon a sale. Third, ownership among family members must be addressed through proper planning, which typically involves transferring the value of the company into the hands of the second-generation either directly, through trusts or the use of other vehicles. This can be accomplished through gifts prior to a sale or where the family intends to retain the business for future generations.

A successful business transition aims to maintain and preserve the value of the business while addressing how to best minimize tax erosion resulting from income, estate and gift taxes. Successful plans focus on both of these goals simultaneously with the transition structure being “tweaked” for optimal tax performance. 

For business owners looking to transition their business, 2012 presents a distinct opportunity due to favorable estate and gift tax rules and historically low capital gain rates, all of which are scheduled to expire at the end of this year. Although favorable tax rules should never be the sole driver of a decision to transition your business, the conditions today present a unique opportunity for those who have held off on gifting or selling due to the potential tax costs. Whether Congress extends the current tax laws or allows them to lapse, it is still important to begin the process on transitioning your business so that ample time is available to transfer leadership in a tax-efficient manner.

Difficult decisions need to be made about whether family member(s) will be actively involved in the business or passive investors looking for a targeted investment return. It is entirely possible that non-family members are better suited to be the successor leaders. In that situation, it can be appropriate for those non-family members to have an ownership position. Finding the right ownership mix requires a careful balance between voting control and pure equity ownership.

Another important consideration is whether the successor is passionate about making the business theirs, or are they simply inheriting the responsibility? A blood relationship doesn’t guarantee that the chosen family member will have the same entrepreneurial success you experienced. An honest discussion needs to take place to determine whether a leadership position is what they desire. The process of working through the transition is more important than how the transition is accomplished. After discussions have taken place about the dynamics of control and leadership, an appropriate and effective tax structure can be wrapped around that plan.

A team of advisors can often help identify a successor who not only wants ownership and the responsibilities that coincide, but also will maintain the business culture. Taking the charge on this part of the transition should be an advisor who can help the family become involved in the transition and develop the next generation of leaders. 

It is important to find an advisor who has experience in helping families minimize taxes related to the transition. Many advisors are apt to address the income tax structure of a sale, often overlooking the estate and gift tax impact. While estate and gift tax has a less immediate impact, the impact upon arrival can be devastating when this planning has taken a back seat. Fortunately, adequate long-term planning can minimize the tax costs and help retain as much wealth as possible; and it is never too early to begin forming this plan.

While today’s conditions present a unique opportunity for transition, some strategies (absent any unexpected legislative action) have been available for years and likely will be for years to come. One includes the transfer of ownership through a common but effective method of using the “annual exclusion” to gift ownership of the business without any tax consequence. The annual exclusion allows you to gift $13,000 ($26,000 if you split the gift with your spouse) of value without eating into your “lifetime exemption,” which is the combined amount you can transfer over the course of your life, including at your death, without paying any gift (or estate) taxes.

While employing the transfer strategy of annual exclusion gifts, a non-controlling, non-marketable interest in your business can be very effective in helping you accomplish your wealth transfer goal. A share of stock or ownership interest in a company having these characteristics will generally be worth less than the fair market value of the company assets represented by that portion of ownership. The lack of control discount stems from the reality that owning a minority interest is significantly less valuable than owning a controlling interest, and the market discount is, in part, a recognition of the time, effort and expense required to convert the ownership to cash. 

If you are looking to make a bigger splash in the amount of ownership to be transferred, there is legislation scheduled to expire at the end of the year that provides tremendous opportunity to business owners. The lifetime exemption is $5,120,000 for 2012 but is scheduled to return to $1,000,000 in 2013, meaning over five times the amount of wealth can be transferred gift-tax-free this year than can be transferred next year (assuming Congress does not modify the rules). This transfer of wealth is especially significant for family businesses with high growth potential.

If you opt to transfer your business by sale instead of gift, selling your business by Dec. 31 could provide sizeable tax savings on your gain on sale of the business. The favorable long-term capital gain rates are set to move to 20 percent in 2013 — 5 percent higher than currently. Thus, a sale by year-end would yield a substantially higher after-tax profit than a sale in 2013.

Families that want to preserve their business for future generations or transition it to a third-party buyer need a strategy. Lack of adequate planning can cripple a business, due to the inability to sustain profitable operations resulting from poor leadership or lack of resources to pay estate and gift taxes. In the sale context, lack of planning could reduce the amount of sale proceeds received by the seller due to under performance of the company.

While all transitions should begin with a leadership transition discussion, 2012 provides appealing conditions to save significant taxes for those ready to make a move. A team of advisors can help you navigate the transition to maximize the value and provide a lasting source of wealth to your family.

Bruce Vandermeulen is a senior director and Brian Boer is a tax associate at BDO. They assist families with estate, gift and trust planning needs. They can be reached at (616) 774-7000.

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