Succession Planning: Surviving the Second Generation
by Nancy F. Blumberg, CPA
Simon Master & Sidlow, P.A.
As founder and CEO of a prosperous small business you undoubtedly have a keen interest in ensuring its continued viability upon your retirement, disability or death.However, more the 50% of family businesses do not survive beyond the second generation.Consequently, it is important for you to formulate a succession plan that will keep the business going and ensure the security of your heirs.Even if your withdrawal from active involvement in the business is not in the immediate future, formulating a tentative succession plan now is smart business.
If you have younger family members who have both a desire and the necessary expertise to operate the business in your absence, there are several options open to you.The tax law encourages you to begin giving (“gifting”) common stock in the business to family members as soon as possible.The annual exclusion can result in all estate and gift tax liability being eliminated on transfers of up to $10,000 worth of stock each year to each donee ($20,000 per donee if you are married and gift-splitting is elected).If your business is not already incorporated, you can incorporate it tax-free in order to implement the gift program.
Another planning approach is the estate freeze.It calls for you to reorganize the corporation by creating both common and preferred classes of stock.The idea is to attribute the entire value of the business to the preferred stock, which you will retain.The common stock can then be gifted to family members at little or no gift tax cost.In addition, because of its fixed terms, the value of the preferred stock is frozen and all future appreciation in the business’ value is reflected in the value of the common stock.
This approach can substantially reduce your estate tax liability as well as encourage younger generations to promote the continued profitability of the business.However, recent changes in the tax laws have made this strategy costly.Now, in order to effectively attribute the full present value of the business to the preferred stock, a high dividend rate must be provided.
If you are inclined to give equal amounts of your wealth to each of your children whether they are active in the business or not, a buy-sell agreement should be used.The agreement provides for the sale of your stock interest to the other shareholders (cross-purchase type) or to the corporation (entity type) at your retirement, death or disability.The agreement provides that the stock will be exchanged at a specified price or in accordance with a stated valuation method.Consequently, shareholder disputes and a possible dissolution of the business are avoided.The option price specified in the agreement may also fix the estate tax value of the stock.
An additional benefit of a buy-sell agreement is that it draws upon your business expertise to fairly and accurately value the stock and ensure a smooth change of ownership.It can also provide both a ready market for your stock and the funds necessary to buy out those heirs who will not be involved in running the business.
The liquidity needs of a buy-sell agreement are most often met with life insurance, since policy proceeds are not subject to income tax. However, insurance proceeds paid to the corporation in an entity type buy-sell agreement can generate or increase the corporate alternative minimum tax.In addition, the cash value of the insurance is an asset that can be attached by corporate creditors.
If no family members will be succeeding you, potential purchaserssuch as key employees, customers or competitors should be considered.Transferring ownership to employees can be accomplished over time using an employee stock ownership plan (ESOP).This plan takes the tax-deductible contributions made on behalf of employees and invests them in company stock.The ESOP also provides areadymarket for the company stock.The plan ties total employee compensation to company performance and can enhance your ability to retain valued employees.
In a stock sale to an outsider or an employee, installment sale reporting may prove to be beneficial.As in the case of buy-sell agreements, your participation in the valuation process is crucial to ensuring you receive fair value.An installment sale allows you to spread the taxable gain over a number of years and match the tax liability with cash flow from the sale.Your willingness to accept installment payments may also make the business more marketable.
Regardless of the succession plan that you adopt, it must be implemented on a timely basis.Furthermore, once adopted, the plan should be reviewed at least annually and revised as necessary.