Succession Planning for the Closely-Held Business
Category | Briefing Papers
I. Introduction
It is the American dream to start your own business, help it to grow, and leave something behind for your family. According to the United States Small Business Administration, Office of Advocacy, closely-held businesses (businesses owned by a few individuals or families) make up approximately ninety percent of all companies in the United States. It is estimated that only one-third survive into the second generation of ownership. More importantly, only around one out of five closely-held construction companies make it to the next generation. Most experts agree the reason so many profitable closely-held businesses fail is the absence of a succession plan. Succession planning is an often-overlooked but critical part of any business. A soundly executed succession plan implemented early enough can ensure a smooth transition to the next generation as well as provide the owners with peace of mind as they move toward retirement.
II. Understanding the Problem
Succession planning for a business owner consists of more than making a simple will or trust. A business owner has to consider retirement needs, family needs, possible successors, family dynamics and the repercussions on employees and community. All these decisions are daunting at first; that is why a business owner and the family need to have a solid succession plan in place well before retirement or death. A recent study found that almost two-thirds of business owners that plan to retire in the next five years do not have a succession plan in place.
In the construction industry, contractors consider bond credit vital to the future of their business. Bonding companies recognize the importance of the present owners, yet wonder about the strength of the company once they are gone. Not surprisingly, many bond companies require written business plans and succession outlines before issuing credit. Also many bonding companies require the owner to provide personal guarantees for bond credit. The bonding companies must be informed of an owner’s plan and the owner need to know when the bond guaranty will be released.
When asked why construction companies fail, respondents said that it is due to management succession problems. These are worrisome statistics in an industry where knowledgeable management is the key to success.
A succession plan however, is more than just a means to avoid problems. It can be a helpful tool to strengthen the business. When planning for succession and looking at what is vital to the continued success of the business, an owner is able to see the current problems within the business. Identification of problems is necessary in order to correct them and create a stronger business. A financially strong business is in a much better position to withstand a management and ownership change, even if there are a few bumps along the way.
The first step in developing a succession plan is identifying goals and objectives. The next step is to address the change in management and change in ownership. Once the owner is comfortable with a plan, the third step is to work toward implementation. The final step is to continue to review, modify and monitor the plan until it has been successfully implemented. Succession planning is a process, not simply a task.
III. Financial Goals and Objectives of Owners
The cornerstone to a succession plan is an owner’s goals and objectives. Although a succession plan may seem simple on the surface, the process can be challenging. First and foremost, the business owner has to address retirement needs. Currently the average life expectancy of most business owners is at least 80 years old. With inflation and the ever-increasing cost of healthcare coupled with longer life expectancies, business owners can stumble into a precarious financial situation if they do not plan correctly.
One of the most important and difficult questions when looking at retirement is: how much will you need? Questions to ask yourself are: What do you plan on doing after retirement? Where will you live? Will you have multiple residences? Do you want to maintain your current lifestyle (i.e. spending)? These are questions that must be looked at with realistic expectations.
In order to ensure the owner’s economic future is secure, he needs to be independent from the business. That means once the owner retires, his financial future should no longer be tied to the business. This is important for many reasons, but primarily it helps the transition to new management. If the owner’s economic future is based on the continued success of the business, he may be tempted to not give up control. The main issue that an owner faces is that the transfer of a business to a family member or a management team does not assure that the value of the business will be immediately realized. A sale or transfer to any insider involves significant risk that must be addressed.
IV. Management Change
One of the most difficult decisions a business owner can make is to decide who will take control. All too often this is not addressed until the last minute, but by then it is usually too late. The next generation of management will either make or break a business; much thought should go into choosing a successor management team. Typically, if management succession is ignored, a business goes through liquidation and the owner receives only a fraction of the reasonable value of the business.
The most common succession strategy is to place the younger generation of family members in management roles. Proper succession planning involves more than “throwing the keys to the kids.” With hasty planning, however, this is usually what happens.
Even with planning, special care must be taken when considering a family member as the successor. The dynamics of a closely-held business is much different from a publicly-held corporation. Family members view themselves as “stakeholders” because often they have grown up helping out and feel they are part of the business. The challenge is to select one or more children who are competent to successfully run the business while at the same time provide participating roles for other family and management members.
Sometimes the children may not want to participate in the family business, however, or an owner may feel that the children are not able to run the company successfully. In this case, the owner must find someone outside the family to take over management of the business. The most obvious choice is to groom one or more “key employees” into a leadership role. Key employees usually have industry knowledge and know the daily workings of the business. As the saying goes, good managers are not born, they are made. In either case, if family members or key employees are selected, they still need time to build a reputation and grow into the leadership role before the owner retires.
Another option is to hire someone from the outside to run the business. This can be beneficial if the outside manager has industry experience and has built a solid reputation. If key employees feel as though they were passed over they may quit, however, leaving the business in a precarious situation. The decision to bring outside management into a business should be considered carefully and discussed with all the important employees within the business.
Once a successor management team has been chosen, it is important to continue training them. A business owner has a wealth of knowledge that is vital to the continued success of the business. It may take a substantial period of time before a successor is ready for a seamless transition. Once again, early planning provides the best results. A long transition period also is important for employee morale and retention of key employees. As the successor works in the business and gains knowledge, he will also gain the respect of other employees. It is difficult enough when transitioning from the original owner to the successor; it is even more difficult when the employees worry about the ability of future management to run the business.
One quick indicator of a successful transfer of management is the one-month vacation test. If a business owner can take a month vacation and the business functions well without him or her, the succession plan is well on the way to success. If the owner cannot leave for a month, however, there is still a lot of work left to do before retirement.
V. Ownership Change
For a family business, the most seemingly benevolent act can have disastrous results when it comes to family members. A business owner may want to transfer ownership in the business to children; but this is usually not as easy as it sounds. A business owner (or, more commonly, the spouse) may want to be fair to all of their children. Fair does not always mean functional. All the children may receive equal shares in the business, but only one may actively run it. This may result in resentment and family discord. One goal of a good succession plan is to incentivize family members who participate in the success of the business while at the same time providing for the other children.
What if one of the children neither wants to participate nor own stock in the business? Unless provisions in a will or trust and a proper buy-sell agreement are in place, one disgruntled child could cause the sale of the business at a fraction of its value. This demonstrates the need for communication between the owner and the children. If an owner knows one child wants no part of the family business, the owner may bequeath money to the child directly while giving the remaining heirs the business.
Besides family problems, certain industries may present particular issues. Business owners in the construction industry also have to pay special attention to maintaining equity within the business. In a survey of the surety industry, around one out of four contractors’ succession plans were deemed unacceptable because they called for a reduction in the equity in the firm. A construction company must maintain an adequate level of equity relative to its revenue to maintain bond credit. Most businesses are not over-capitalized; any significant reduction in their equity base will cause their bonding limits to be significantly reduced.
Another possible issue in an ownership change in the construction industry is that ninety-two percent of business owners personally guarantee bond credit. Even after an owner leaves the business, he may still be liable for the bond credit. This makes succession planning all the more important unless the bonding company allows the new management to issue the guaranty – if not, and the business fails, the original owner is still financially responsible for debt.
Likewise, minority shareholders in the construction industry are also sometimes asked to personally guarantee loans. Typically, minority shareholders with fifteen percent or more of the ownership are required by bonding companies to provide a personal guaranty. The issue of personal guarantees can be a major impediment in the succession planning process. New shareholders will be leery of signing the guarantees and the older shareholders may be required to continue the personal guarantee until the successor management is proven.
Finally, valuation of the closely-held business must be addressed prior to an ownership change. For industries like the construction industry, there are special considerations that could cause the value of the business to be minimized. Issues like competitive bidding, heavy dependence on only a few customers, the risky nature of the industry causing wide fluctuations in profitability, and the importance placed on the knowledge of the individual rather than the company can cause a construction company to be worth far less than an owner may think. Although this is a good thing when transferring ownership to the family, it can be a bitter pill to swallow when selling the business to key employees or an outside company. Early succession planning can be useful to transfer ownership to children before estate taxes become an issue and it can help an owner groom a successor to lessen the financial impact upon retirement.
VI. Succession Planning Structures
Properly structured, a succession plan can provide the owners with a valuation that exceeds the owner’s expectations while minimizing the risk to the next generation. Depending on the circumstances, it may be desirable from the owner’s perspective to have either a high or a low valuation. Thus, if sold to a child the price may be significantly discounted, reducing potential estate taxes imposed upon the family’s assets. Alternatively, if sold to the management, the price may be substantially increased based upon the risk assumed by the owner. In either case, the owner may be protected through the use of security interests and loan covenants which protect the selling owner from actions the child and/or the management may want to take.
There are many ways to transfer ownership of a business. Because of the nature of the construction industry it is estimated that seventy percent of construction companies are sold or gifted in some form to the owners’ children or employees. Another twenty percent are liquidated, and only ten percent are sold to outside companies.
Despite the uncertainties and risks, with enough time a properly structured succession plan can achieve all of an owner’s goals.
1. Gifts/Annual Exclusion/Unified Credit
One of the simplest methods to transfer ownership interest in a business is through gifting, using the annual exclusion and estate tax credit. These techniques work through the use of lifetime gifts, gifting shares of the business to the next generation using the annual exclusion, and bequeathing the remainder of the shares to the children after death using a will or trust.
Although a gifting program is the simplest and least expensive ownership transfer method, it may not be the best way to achieve the owner’s goals and objectives. First, this method is only effective if the business and decedent’s estate is small enough to avoid gift and estate taxes. Second, there is no exchange of money to help finance retirement needs. Third, once the majority of shares have been gifted, the owner no longer controls or retains any influence in the business. Finally, a gift or transfer of ownership upon death does not ensure adequate training of the next generation of management.
2. Sale to Family or Key Employees
A simple way to minimize gift and estate taxes is to sell the business (usually to family members or key employees) with a buy-sell agreement. These are legally binding agreements that establish how a business will be sold upon the departure of the owner. The agreements can be made between individual shareholders or between the shareholders and the business itself.
Life insurance can be a great tool to help in the transition from one generation to the next, especially if the sale is to family members. This is especially true in the construction industry, where the vast majority of bonding companies require business owners to carry life insurance. Life insurance polices can provide money to the beneficiary to pay estate taxes, pay off debt, fund a buy-sell agreement, buy out non-participating family members, and provide funds to operate the business in difficult times.
When coupled together, a buy-sell agreement and life insurance policy can successfully transition the ownership of a business to family members with minimal financial loss. A life insurance policy can be purchased by an irrevocable trust to shelter the proceeds from estate tax so that the net tax cost to the family is zero. The only costs are the gradual purchase of stock as set forth in the buy-sell agreement and the annual insurance premiums.
Several other options exist for selling the business (self-canceling installment notes, dual entities and use of an LLC for stock or asset sales just to name a few). These techniques are particularly useful when selling the business to the key employees.
3. Leverage Discount
Estate and gift tax is based on fair market value at the time of transfer or death. One way to reduce gift and estate tax is to recapitalize the business to make use of discounts for minority interest and lack of marketability. This substantially decreases the value of the owner’s interest in the business, allowing him to avoid unnecessary taxes.
The family limited partnership is one strategy for the transfer of ownership interests to the next generation. In a family limited partnership, the discount arises because limited partners cannot readily cause the sale of the assets transferred to the partnership. As a result, the limited partnership interests must be valued based solely upon the expected future cash distributions from the partnership, which are usually significantly less than the value of the underlying assets. One benefit, especially for the construction industry, is that the assets are not readily subject to claims of creditors of its individual partners or members. Therefore, creditors cannot force the sale of the family limited partnership in order to satisfy a partner’s debt.
Another strategy for obtaining valuation discounts is the Grantor Retained Annuity Trust, or GRAT. Essentially, this method freezes the value of the business and allows the owner to be paid an annuity for a set number of years. Upon completion of the annuity term, the beneficiaries receive the assets put in the trust, usually shares of stock in the business. Basically, utilizing a GRAT allows a business owner to discount the value of the business for estate and gift tax purposes and transfer all future appreciation to the beneficiaries of the GRAT. Although this is an effective method of transferring stock to the beneficiaries at a reduced tax cost or tax-free, there are risks. If the grantor dies during the term of the GRAT, all or a portion of the business will be included in the grantor’s estate.
Another method of transferring wealth which avoids the owner dying during the term of the GRAT annuity is the installment sale of equity in a business to an intentionally defective grantor trust (an “IDGT”), where the owner establishes the trust for the benefit of his or her children. Because this trust is “defective” for income tax purposes, the owner is not subject to income tax on the sale of the equity of the owner in the business because the trust is disregarded for income tax purposes. Because the trust is “effective” for estate and gift tax purposes, however, only the amount owed to the owner at the time of his or her death is subject to estate tax.
4. Employee Stock Ownership Plan
Employee Stock Ownership Plans (“ESOP”) can be an excellent way to give employees an ownership interest in the business. An ESOP is a qualified retirement plan which is permitted to own stock in the employer corporation. The corporation can transfer stock to an ESOP, or contribute cash which the ESOP can than use to purchase stock or to pay for previously purchased stock. The corporation obtains an income tax deduction for the cash or the fair market value of the stock contributed.
An ESOP can provide an owner of a business an excellent way to sell all or a portion of his or her stock. If the business is organized as a “C’ corporation, it may provide the ability to diversify into an investment portfolio without having to pay an immediate income tax. If the business is organized as an “S” corporation, it can eliminate income taxes on all or a portion of the future corporate income. In most instances, however, ESOPs do not work in construction companies. The ability to implement an ESOP is somewhat related to the size of the payroll of the company. Most employees of construction companies are union members whose payroll will not be considered when implementing an ESOP.
5. Sale to 3rd Party
This is a relatively straightforward option for the sale of a business. The costs to the owner involve expenses in connection with locating a buyer and negotiating and carrying out the terms of the sale. It would also be necessary to understand the tax implications of the method chosen to sell the business, which may be either a sale of the business assets or equity interest (e.g., a stock sale). With a stock sale, the owner would have tax liability at the favorable capital gains rate, but little upside exists for the buyer, who additionally must take the business subject to all liabilities, known or unknown. Conversely, with an asset sale, the buyer obtains an immediate benefit from a new tax basis in the assets purchased and from depreciation deductions, but most liabilities generally remain with the seller and certain assets might be subject to depreciation recapture, resulting in taxation of the seller at the higher ordinary income rate. It is important to consider all of the relevant circumstances before making a determination about the best method of selling.
In addition, with a sale to a third party, the seller might bear some of the risk of the buyer. In cases where the success of the business comes largely from its local reputation, a change of ownership and company name may result in reduced business, which can put future payments owed to the seller in jeopardy unless the buyer has sufficient capital to pay cash for the business at closing.
6. Liquidation
If no successor can be found, the business owner’s final alternative is liquidation. Liquidation of the business has the advantage of simplicity, but involves numerous significant disadvantages. First, even a planned liquidation in the ordinary course of business significantly discounts the fair market value of the disposed assets. Customers will be slow to pay receivables and auctions of equipment do not always bring the best price. Second, creditors of the business (potentially including unknown creditors) are entitled to bring claims against assets of the corporation for up to two years or longer after the corporation elects to dissolve. These claims would have to be defended without the benefit of revenue coming into the corporation from normal business operations. Finally, liquidating your business can have negative implications for your personal estate plan, because the assets distributed to you on winding up will become part of your estate for federal estate tax purposes (potentially resulting in tax on your death at rates approaching 50% under current law) unless substantial tax planning is carried out.
VII. Conclusion
As a business owner looks forward toward retirement he or she should be well on the way to transferring ownership and harvesting the value of the business. There are many issues to address; therefore, early planning usually provides the best results. Retirement is a time to enjoy the fruits of your labor, not worry about economic and family issues.
This discussion is generalized in nature and should not be considered a substitute for professional advice. © FWH&T