Succession planning for closely held family businesses requires creativity and a collaborative team approach. Advisors must consider a myriad of legal and tax issues while remaining sensitive to complex family dynamics, especially when some members of the next generation are involved in the business, but others aren’t. While many practitioners deal with these issues, clients often fail to address succession planning in a comprehensive way because they’re wedded to preconceived notions of what should be done.
Practitioners advising business owners should consider the following questions:
What are the owner’s goals for the business and for the family? The practitioners ought to assist the client with prioritizing competing objectives, such as maintaining family harmony, equalizing inheritances among children, keeping the business in the family, mitigating estate taxes and securing the owner’s retirement.
Does the owner have an accurate assessment of the capabilities of their children, whether or not involved in the business? In many cases, insightful parents may not be able to assess objectively whether the child designated as successor to the business really has the skills to run the business.
Should interests be equalized among children in the business with those who aren’t? As a corollary, the owner should consider whether business interests should be shared among all children regardless of their involvement in the business or exclusively devised to children in the business to the exclusion of other children. In some circumstances, the best result is when a child purchases the business from the estate for a preferred purchase price so that the cash proceeds from the sale might be used to equalize the inheritances among the owner’s children and avoid interference in business operations by children not otherwise involved in the enterprise.
What happens if the business fails? Regardless of the successor-child’s capabilities, external circumstances may have a dramatic and potentially negative impact on the business. Maybe the company fails because either such child isn’t capable of managing the business or the business itself isn’t structured for a smooth transition. Advisors should help to identify the faults in the succession plan during the planning stage to mitigate the risks.
How might gifts of business interests be structured? Estate planners generally caution clients against making outright transfers, particularly when the goal is for the business to remain in the family for future generations. Consider that the issue of a child not in the business might someday wish to enter the business. Using a dynastic trust to hold interests could enable any descendant of the founder to enjoy the fruits of their labor in the business in a way that outright gifts couldn’t.
Structuring the Plan
Recapitalization. Owners might consider recapitalizing the family business into voting and non-voting interests, so that all children might share equally in business profits while assuring that those not in the business can’t interfere with the successor. Advisors should address with the owner whether additional protections might be needed to prevent the successor from increasing their salary from the business to reduce distributions available to all owners. As part of the recapitalization, the new owners might be required to sign an agreement in which salaries for an owner might need to be approved by a majority of interests or established through a formula.
Bifurcation. Advisors might explore whether it’s possible to separate the operating business from passive property ownership, such as real estate or equipment. The operating business could execute a written lease agreement to use the passive property, with arm’s-length terms. A succession plan could then be structured to allow for a child active in the business to own a greater share of the operating business. When a business is operated in a property that’s owned by the founder, perhaps the operations might be separated out from the real estate. If the real estate isn’t owned in a separate entity, it would likely be advantageous to consult with tax advisors to evaluate whether the property might be spun off into its own limited liability company or other entity.
Life insurance. Life insurance is commonly used to transition a closely held business on the death of the founder. The business could own the insurance policy on the life of the founder so that it might redeem the founder’s ownership on death, leaving the child in the business as the sole owner.1 On redemption, remaining family members would benefit from cash proceeds without entanglement with the child running the business.
Alternatively, the founder’s heir apparent could purchase and pay for life insurance on the founder’s life. Under a cross-purchase agreement, the heir could use the proceeds to purchase the founder’s interests, which would then leave the heir apparent as the sole owner.
Sale to successor-child. A buy-sell agreement could set forth buyout terms after the founder ceases involvement on the occurrence of a specific triggering event, for example, retirement, disability or death. To the extent that an heir is already personally and actively growing the business, as is often the case, a sale before a triggering event might allow the heir to purchase the business before they increase the business value further. A purchase might be reasonably structured to avoid financially stressing the child or the viability of the business, by, for example:
Determining a sales price based on the appraised value as of a specific date when values are somewhat lower due to market conditions or discounts for lack of marketability or control.
Setting up a favorable repayment schedule that both accounts for business cash flow and makes the payments reasonable for the rest of the family.
Structuring the buy-out in tranches, so that if business or personal circumstances change, the founder can adjust future sales of business interests accordingly. For example, the founder could sell 10% of their shares to an heir in one year with an agreement to evaluate additional sales in the future. This structure would ensure that there would still be equity left to sell to other children who may become interested in the business after the initial sale.
Using a grantor trust to effectuate a sale of shares to one or more heirs could avoid taxable gains and also permit equity in the trust to benefit any one or more children, or future heirs, as circumstances warrant.
Private annuities. While sales for a private annuity have traditionally been used as part of estate planning to reduce the value of the estate, it’s a technique that can assure a founder cash flow for life when transitioning the business.
Sale to third party. Practitioners should help owners evaluate whether they might be better off selling their company to a third party rather than entrusting it to their children. At some stage, the founder may not have the interest or the ability to run or sell the business. A comprehensive succession plan should consider that. It may be as simple as naming someone as a successor manager to operate the business to ready it for sale.
Documentation to Support Plan
Whatever the succession goals and whatever plan is adopted, coordination of all relevant documents is critical to the success of the plan. When planning for the succession of the business, the following instruments could avoid unnecessary disruptions to business operations:
Operating or other governing agreement that outlines how decisions related to the functioning of the company should be made, such as payment of expenses, capital contributions and tax elections. Consider how the agreement might protect the interests of family members not involved in the business, while simultaneously mitigating their interference in business operations.
Buy-sell agreement that addresses salary continuation for retiring and disabled owners and purchase or redemption of ownership interests by successors. Such an agreement should clarify how life insurance on the founder or other key person might be used to operate the business or fund a buy-out.
Employment agreements with key employees, which enhance the likelihood of their being engaged for the transition and beyond. Consider the parameters that would permit enforcement of a covenant not to compete or maybe include a “sweetener” in the agreement to entice them to stay, a bonus based on gross revenues in
Year 3 after death, incapacity or retirement of
Vendor, licensing and customer agreements, which secure important relationships with third parties and help to foster continuation of business operations through the transition.
Intellectual property documentation to protect trade names, logos and other intangible rights. It might be necessary to have intellectual property counsel to trademark and copyright appropriate items relating to the business. Advisors should consider whether it’s advantageous to own intellectual property rights in a separate entity, which then licenses it to the operating business.
Employee handbooks and operating manuals, which should be updated and accurate.
For family buy-outs, determining fair market value might be done differently than for an arm’s-length arrangement. The documentation should clarify which factors to consider when determining the price, so that the value is reasonable for all parties. For example, the parties might agree to a fixed discount on the founder’s interests for buy-out purposes, which either protects the founder’s heir apparent or surviving spouse. Review such arrangements against any potential estate tax liability, which will likely require an appraisal report. This could be important to reduce the risk of disputes and protect all parties.
Coordination With Estate Plan
The founder’s durable power of attorney and revocable trust should dovetail the terms of the company’s governing instruments and intended succession goals. To the extent that a trust owns entity interests, the successor child might need to coordinate with a successor trustee. Both the governing instruments of the business and the trust agreements should clarify how business decisions are to be made and how the parties might coordinate following a triggering event.
Succession planning for a family business requires a tailored approach that considers unique family dynamics, goals and needs. Persistent advisors working collaboratively across disciplines must be able to adapt to changing circumstances throughout the planning process that may take years to implement.
1. In Connelly v. Internal Revenue Service, No. 21-3683 (8th Cir. 2023), the value of the insurance death benefit had to be included in the value of the business as reported by the founder’s estate.
On Dec. 13, 2023, the U.S. Supreme Court granted the petition in Estate of Connelly to review the decision of the U.S. Court of Appeals for the Eighth Circuit.