[Business Issues] Successful Succession Planning

Benjamin Franklin penned in 1789, "But in this world nothing can be said to be certain, except death and taxes." More than 200 years later, this still stands true, but business owners can deal more intelligently with this adage through proper estate and succession planning.

"The fate of any family business hinges on preparation," says Greg Mayes, Esq., of the law firm Greenebaum Doll & McDonald PLLC in Louisville, Ky. Speaking at the National Pest Management Association’s PestWorld 2004 in Honolulu, Hawaii, Mayes stressed that proper planning is crucial for a closely held business’s future.

INITIAL STEPS. In order to begin the process, owners must figuratively step away emotionally from the business regarding two aspects. First, an owner needs to determine a fair and realistic value for the business. Difficulties can arise in this stage, especially since an owner might tend to inflate the real value, based on the sweat equity and personal importance of the business. Two solutions can apply: An accountant can be retained to deliver a fair estimate; or a good faith estimate from a potential purchaser of the business could be used.

Second, an owner "can get caught up in the web of family relationships." Mayes suggests that when planning for the family’s welfare, "equal is not always fair." For instance, a hypothetical business owner has four children. Two children work for the business and the other two do not. One of the children works 12-hour days, six days a week, while the other comes in late and leaves early. Leaving 25 percent of the business to each child may not be fair to any of them. Adequate planning for the entire family may help avoid dissension during the succession.

BUY-SELL AGREEMENT. "This is the most important document that you create for your company," says Mayes. Simply stated, a buy-sell agreement is used by partners in a business to define what will happen if one dies, retires, becomes disabled or wants to sell his or her interest.

A buy-sell agreement also is an excellent vehicle to leverage tax savings. For example, two partners value their company at $3 million, supported by life insurance. After reviewing, the value is adjusted to $1 million. In the first scenario, $1.5 million is the taxable asset amount, and at death, the family would net $750,000 (in a 50 percent marginal estate tax bracket).

In the second scenario, after the adjustment, the taxable assets would be $500,000, providing $250,000 for the family. In addition, the family would gain $1 million from a sheltered life insurance trust, which is tax-exempt. So, the family gains an additional $500,000.

It is important to keep in mind that a buy-sell agreement is very fluid. If a stated value is declared, the agreement should be reviewed periodically to determine if the value is current. Alternatively, the partners could utilize a formula based on assets to state the value of the company.

IMMEDIATE CONCERNS. Even though a company shows great worth on paper, the owner must make sure it has enough liquid assets to pay all estate taxes upon death. The beneficiaries only have nine months to pay all taxes due on the estate. With proper planning, the family would not be forced to sell the business to raise the money.

Another area of concern for planning purposes is a will. Mayes states that only about one-third of the U.S. population has a will. Even those who do have one, may have an outdated version. As in buy-sell agreements, it is very important to keep wills current, adding or changing beneficiaries as necessary. To minimize the tax burden, a simple will should be avoided. In this case, the survivor receives all the assets of the deceased, and the entire amount is subject to tax.

In addition, beneficiaries who are children would benefit from a trust. The children can be named as the trustee and beneficiary, and they would have access to the money and experience tax savings.

Life insurance is another tool which, when used correctly, can leverage tax savings. "There are two basic rules: Don’t own your own life insurance and never go rock climbing with the beneficiary," Mayes jokes. A life insurance policy, if owned, would become part of the estate and subject to tax. The alternative is to acquire a life insurance trust. A spouse or children can be named as trustee or beneficiary, and gain access to the money, but it is not considered part of the estate.

CHARITABLE GIFTS. This is another technique to lower the taxable amount of an estate, and different options can be used. Gifts can be made outright. For example, property can be donated. If the original purchase price was low, but the property appreciation is high, a donor can avoid capital gains tax. Other foundations or trusts can be established for philanthropy, resulting in appreciable tax gains.

ESTATE PLANNING. Currently, only two tax breaks are available: the applicable exclusion amount and annual gift tax exclusions. The federal government sets the applicable exclusion amount; for 2005, it is $1.5 million, but that will rise to $2 million for 2006-2008, and increase to $3.5 million for 2009. Anyone who dies in 2010 will have no estate tax, and in 2011, the exclusion amount returns to $1 million. Mayes does not foresee the amount being on the high side in 2012 and beyond, but remaining at the $1 million level. A contributing factor is the federal budget and deficit.

The cap on annual gift tax exclusions stands at $11,000 per donee and $22,000 for married donees. "With this in mind," says Mayes, "it is crucial to get as much value out of these tax breaks as possible using various leveraging techniques."

One example uses a hypothetical owner of a company worth $1 million. He recaps the 100 shares of stock he owns, so that each is equal to nine non-voting shares. This owner can now give away 90 percent of the company without losing voting control. The non-voting shares receive a valuation discount of 40 percent. If the owner is married, with the valuation discount, the $22,000 gift exclusion per person grows to $36,666 per year, and there is no cap on the total amount per year that can be given away.

PUT INTO ACTION. Working with an estate planner, an owner can begin to address all the issues related to succession planning. Instead of ignoring the situation, an owner must realize there are three scenarios involving the business and succession: the owner will die, the owner will become disabled, or the owner will retire. Good planning protects the business and family members in all scenarios.

Mayes suggests talking to others who have already been through a succession situation. He says that a client of his summed it up this way: "Succession planning should be an evolution, not a revolution."

The author is a Cleveland-based freelance writer who can be reached at dtaylor@giemedia.com