by Nichole Crawford, JD, LL.M, CLU, ChFC, CAP, Federated Insurance
By nature, business owners are entrepreneurs. They’re an optimistic breed – comfortable with risk, able to confidently figure things out and skilled at building something significant. Historically, they have seen opportunities and seized the ones that made sense. These same traits can be applied to proper business succession planning as well.
Yet many business owners put succession planning on the back burner. A present-time focus on building and growing the business may be at the expense of the future. The problem with a lack of succession planning is that the future may be here all too soon. The legacy you eventually want to pass on to your loved ones in the “distant” future can be greatly impacted by the long-term provisions you make – or don’t make – now.
Business owners who don’t have a plan in place may be relying on “wishful thinking.” They may think, “My family knows what I want to happen after I’m gone,” or “Everyone will agree, so there’s no need for a formal, written plan.” In some cases, this couldn’t be further from the truth. What if there are children who are involved with the business and others who are not? Did the business owner intend for them to inherit the business equally, even though one or more may not have any intention of contributing to its operation? The answer will most likely vary, depending on which child you ask! Are the key employees on board with working for the business owner’s heirs, or will they move on to other opportunities after the business owner is gone? Will the banks holding notes from the company trust the new owners’ ability to make payments or will the notes be called? Will long-time customers be comfortable with the new ownership?
Many business owners want to pass their business to family members, but haven’t answered the question of “how.” The first step for business owners is to examine their ultimate goals. These may include
- Provide liquidity to meet emergency needs and allow for a smooth transition of the business.
- Minimize estate and gift taxes.
- Pass the business to children active in the business, but treat all children fairly.
- Provide retirement income for themselves.
Once owners have established their view of the bigger picture, they can start working on the details of a plan that will make their vision a reality. In order to get the right pieces in place, it may be helpful to examine some of the common mistakes business owners make when working on their exit strategy.
An individual without a will has an estate plan in place, even without doing a thing. He or she is actually electing to use a state’s intestacy law, which mandates who gets how much and when. Some states distribute 50 percent to the surviving spouse and 50 percent to the children. All states distribute adult children’s inheritances outright and, for minors, when he or she comes of age (18 or 21). A large inheritance received too early may cause great, unexpected damage to the business.
Estate planning documents, including wills and trusts, play an essential role in making sure a business owner’s intentions are carried out. A revocable living trust can avoid probate and hold assets for distribution to heirs until they reach a certain age. It also can help to protect assets from the heirs’ creditors or keep assets in the family in the event of a divorce.
Additionally, trusts are commonly utilized to help minimize estate and gift taxes. After a one-year repeal in 2010, the estate tax has returned in 2011. The amount an individual can pass to his or her heir without incurring estate taxes (the estate tax exemption) is currently $5 million per person ($10 million for a married couple), with a top rate of 35 percent for the estate, gift and generation-skipping transfer taxes. While it may seem that planning for minimizing taxation may be unnecessary with the high exemption amount and reduced tax rate, this is not necessarily the case. These amounts apply for the next two years (2011 and 2012) and are scheduled to return to 2001 levels (a $1 million exception and a 55-percent tax rate) in 2013. No one can predict what Congress will do in future years, but given the long-term fiscal realities of the federal government, it is probably safe to assume that there will continue to be some sort of estate tax in one form or another. The only estate tax law that matters is the one in effect when the business owner passes away, so the prudent course of action is to create a plan with some built-in flexibilities to adapt to future changes in the law.
No Formal Succession Plan
Many business owners have an “understanding” with their intended successor, whether it is a partner, child or children or a key employee, and, therefore, don’t feel they need a written buy- sell agreement. Unfortunately, an informal “understanding” is like having no plan at all. It defers negotiations, decisions and enforceable rights and obligations to a later time. Consider the implications following the unexpected death of an owner if no value has been locked down to bind the IRS, the seller and the buyer; if no buyer has been guaranteed; and if no terms of payment have been laid out to assure income to the family (at a time when earned income from the business will stop). With no buy-sell in place, all terms of a transfer must be negotiated. While alive, negotiations are private and between owners. After death, negotiations are public and must include creditors, franchisors, executors, heirs, the IRS – and a probate judge.
Even with a formal plan in place, another way a business succession plan can fail is when the owner doesn’t share the estate and business transfer plans with the people who will be affected the most – family, employees, franchisors, creditors and customers. Change can be stressful – even good change. How humans react to a “total surprise” change is unpredictable. With no discussion prior to a transfer event, there can be misunderstandings and unnecessary stresses, as well as lasting human and financial repercussions. Discussing future plans also can lead to conversations about how to put the future owners in the best position to succeed. For example, the current owner(s) may want to delegate some authority and “groom” the successors in the time leading up to the owner’s exit.
Successful business owners often have a solid plan in place for transition of their business and estate (wills, trusts, buy-sell agreements, etc.). However, even the best plans almost always need cash to pay debts, settlement costs and possibly estate taxes. An estate plan with no plan for funding will transfer an estate diminished by both settlement costs and the cost of raising cash in a hurry. The same funding flaws may be found in buy-sell agreements.
The buyer has several options for funding a buy-sell agreement. A savings or “sinking” fund could be established, but depending on the time frame involved, may not be sufficient to accumulate funds for a buy-out. An installment sale, through which the new owner pays the purchase price over time to the family or estate of the departing owner, may not provide the owner’s family with the income and security they need. Finally, life insurance can be a cost-effective way to provide the necessary funding to carry out a business owner’s wishes. Life insurance proceeds are available immediately upon a premature death of the insured, when the funds are needed most, and the death benefit received often can be obtained for pennies on the dollar. Depending on the circumstances of the buyer and the seller, a combination of these funding options may be appropriate.
No Expert Advice
If you had a brain tumor, would you go to see the general practitioner at the local clinic? Of course not! You would see a specialist, like a neurologist. Planning for the transition of your estate and business is much the same. Estate and business succession planning is a highly specialized area of the law. While the company’s general corporate attorney may have worked with the business for many years, he or she may not be prepared to handle all the nuances of transition planning. Business owners would be well served to partner with an attorney with specialized knowledge and extensive experience in these areas.
A business owner does not get a second chance to do post-mortem planning. The planning needs to be done right the first time. But planning is not a one time event, where a buy-sell agreement and trust are drafted, signed and put in a drawer until needed some day in the distant future. Laws change. Family dynamics change. The son who was planning to take over the business may have decided to pursue other interests, but a granddaughter who was too young to work in the business then is now showing her management skills. A partner may have unexpectedly passed away, changing the plan for the remaining partners.
Having a plan in place is the first step, but keeping the plan up to date is an ongoing process. Plans should be reviewed periodically to make sure they still reflect the business owners’ intentions and current laws.
If aspects of the business owner’s estate and business succession plans are essentially “no plan,” steps should be taken to correct the defects before they cause a disaster. The control is in the hands of the owner – if he or she chooses to exercise it. He can choose to go to an attorney. She can choose a generalist or estate planning specialist. He can choose to ignore or take advantage of the generous estate tax provisions that exist. She can choose to arrange leveraged, certain and cost-effective funding ahead of time. For successful business owners, business succession planning is a key tool to fulfill their core values and pass on the legacy they desire. Remember, decisions you make today will affect your loved ones tomorrow.
Nichole Crawford is manager and counsel-advanced life sales for Federated Insurance.
This article is intended for general information purposes only and should not be construed as legal, tax or financial advice with respect to specific facts or circumstances. The contents of this article may be subject to regulations and restrictions in your state and are not provided as a substitute for any state standards that may apply. Neither Federated nor any of its employees provide legal, tax or financial advice. You should consult with your independent professional advisors regarding your specific estate planning needs. © 2011 Federated Mutual Insurance Company. All rights reserved.