Look Beyond Taxes and Trusts in Planning for Succession

Look Beyond Taxes and Trusts Northeastern University
in Planning for Succession

Family Business Quarterly
by Gary C. Hayes, CPA
Tofias, Fleishman, Shapiro & Co. P.C.

When the owner of a family business sits down with an accountant to talk about succession planning, most people assume the conversation will center around income and estate taxes, liquidity planning, and other clear-cut financial issues. There may even be the expectation that the succession plan will be forced to follow a certain format because of legal or tax considerations.

Certainly a succession plan may result in the creation of family trusts, the alteration of existing business structures, and certain tax elections.

The End Product

In realty, however, the succession plan should begin with a number of personal decisions. The legal and tax structure are the end product of the process.

In most cases, the personal aspects of succession planning are much more difficult to resolve than a particular tax problem. Some of the personal decisions that a family business owner must face are illustrated by the facts of a recent client engagement.

Case Study

In this case, John Smith, 57, had spent the past thirty years building a successful business. For tax purposes, the business was operated as an S Corporation, with the building and land held in a realty trust.Approximately 90% of John’s net worth is composed of the business and the realty trust.

John has a wife and three children, two of whom work in the business; the third has an outside career.

In planning for the succession of the business, John needed to deal with a number of personal issues first. He decided, first, that he would like to remain active in the business for at least five years, and then enjoy a comfortable retirement. Next, he and his wife decided that they would like somewhat different outcomes when either of them died; in the event of John’s death, he wanted to be sure that his wife has adequate resources for her support. Upon his wife’s death, John would like to see the estate divided equally among the three children.

Thorny Issues

Beyond those basic desires, both John and his children want the business to remain in the family and have no present interest in selling the business. Given the profits from the business, John should be able to meet his current and long-term financial goals with proper planning.

One of the most difficult personal questions that must be resolved is how to divide the estate so that each child is treated fairly. John thought about dividing the estate so that the third child would receive the real estate but none of the stock in the business. In theory, this would leave the other two children free to run the business, which they would receive as part of the estate plan.

Real Estate

While this may be a simple and effective division of property, it could also lead to a number of problems down the road. For example, assume that the business has a short-term lease to use the property. This means that the children will be involved in regular negotiations over the rent. If the negotiations are unsuccessful, the sibling owner of the building may decide to sell the building to a non-family third party, or the two siblings in the business may decide to move to a new location. This could put one side or the other at a financial disadvantage, not to mention the stress it could create within the family.

To avoid problems with rent negotiations, we often advise owners of family businesses to enter into a long-term lease with renewal options based on a cost of living index. While this may be a preferable solution, it is certainly not perfect.Suppose the business either contracts or grows to the point where it needs to consider a new location. This may create a situation where one side can take advantage of the other side. Also, in terms of treating the non-owning child fairly, recent history has shown that it is very difficult to predict the future value of real estate.

For these reasons, John also considered a plan in which the three children would share equally in the business and the real estate. John’s primary concern was whether the third child should be allowed to participate in the management of the business and how the other two children might react to that participation. One option would be for the third child to receive nonvoting stock in the corporation, allowing for an ownership interest in the company but no rights or power in running the business.

Management Issue

One of the most important questions from the point of view of succession planning is who will manage and control the business. In thinking about the future, John tried to decide if one child should be given control of the company or if some form of joint management would work. There was also the question of his role in the company as he begins to phase into retirement.

The answers to these issues are essential to the success of the plan. Clearly, for most family businesses, the technicalities of income and estate tax planning are important, but should only be considered after larger personal and family-related issues are thrashed out. Then it is possible to come up with a well thought out succession plan.

Gary Hayes is a partner of Tofias, Fleishman, Shapiro & Co. P.C., specializing in succession planning issues affecting family businesses.