Protect the passing game

by Erin Hollis

The average business owner spends approximately 10 hours per day, six days per week to get their business to the point where it can provide a measure of security and comfort for their family. At some point, the control of this business will be transferred, and often times to a family member.

It goes without saying that an untimely, unplanned departure of a business owner can be devastating for the company and, even more so, for the owner’s surviving family members. A plan for succession that anticipates timely and untimely triggering events can compensate for that loss, and the business valuation serves as the first step toward taking control of your succession plan. Different methods of ownership transfer exist and many require several years to implement. Some are more difficult to employ than others, and some allow parents to relinquish control over time versus immediately.

Transfer vehicles include:

• Gifting Stock: Gifting is a frequently used transfer method. In 2007, a donor is allowed to gift up to $12,000 tax free to an unlimited number of donees. An advantage for owners with large families is that a significant amount of ownership can be transferred utilizing the $12,000 annual exclusion.
• Lifetime Gift Tax Exemption: An owner many use their allowable lifetime gift tax exemption amount (currently, in 2007, $1 million) to transfer ownership of assets during their lifetime without incurring gift or estate taxes. Gifts utilizing the lifetime gift tax credit can be made in addition to gifts using the $12,000 annual exclusion amount.
• Grantor Retained Annuity Trust (GRAT): A GRAT is an irrevocable trust that pays an annuity to the grantor of the trust for a fixed period of time. After the expiration of the grantor’s retained annuity interest, the trust assets are held in trust for the beneficiaries or paid outright to the remainder beneficiaries. A GRAT is an excellent technique for transferring high-yield or rapidly appreciating assets where the growth rate is expected to exceed the annuity payout.
• Family Limited Partnership (FLP): An FLP provides both tax and non-tax benefits for family members. It is a popular succession planning tool that allows ownership transfer to children without losing control of the business. FLPs also allow parents the benefits of controlling cash flow generated by the partnership as well as restricting children from selling partnership interest. Additionally, it provides a degree of protection from creditors. Large valuation discounts may also be utilized due to the non-controlling, non-marketable value of a pro rata ownership in the partnership. Difficulty, however, exists when senior family members are married and desire an estate plan that will defer all federal and state estate taxes until the death of the surviving spouse.
• Private Annuities: With a private annuity, the transferor (annuitant) transfers complete ownership of property to the transferee (obligor of payments). Traditionally, the transferee promises to pay the transferor for the transferor’s lifetime, or the joint lifetime of the transferor and the transferor’s spouse. (Proposed Regulations released in late 2006 have significantly limited the income tax savings of using Private Annuity contracts. The estate tax advantages are still available, but the decision to use a Private Annuity for estate planning purposes must be considered in light of the revised income tax effect.)
• Self-canceling Installment Notes (SCINs): Similar to a private annuity, the transferor transfers complete ownership of the property to the transferee in exchange for an installment obligation. The SCIN has a fixed term which is less than the life expectancy of the transferor. In addition, the debt instrument contains a provision that automatically voids all future payment obligations at the transferor’s death. Although a SCIN is similar to a private annuity, it differs in terms of the income tax ramifications, basis on the part of the transferee, duration, and security rights in the assets transferred.
• Intentionally Defective Grantor Trusts (IDGTs): The IDGT is a sophisticated estate planning tool that essentially freezes the value of an asset, while effectively transferring funds out of the estate free of gift taxes. Taxpayers who are willing to accept a moderate amount of risk may want to consider an IDGT sale for large value transfers because of the combination of transfer tax and income tax benefits. The potential risk can be reduced if the trust and sale are carefully structured. One of the primary benefits of an IDIT is that the grantor pays the income taxes on income generated from the trust property, thus further reducing the estate and increasing the amount passing to the beneficiary.

Regardless of the transfer channel utilized, a business valuation is the first step toward realizing succession planning goals. For many business owners the proceeds from the sale or transfer of their business interest will serve as the largest source of funds for their retirement. As such, losing control over the business due to insufficient or inadequate plans for maintaining the continuity of operations could potentially devastate an owner’s current and future livelihood and the family’s financial stability. Knowing the value of the business enables effective, proactive plans to be developed and strategies to be put in place thereby assuring a desired result.

According to a 2003 study conducted in part by Loyola University and Kennesaw State University on American family businesses, the leadership of almost 40% of family-owned businesses will change hands within the next five years. More than 56% of CEO’s are expected to retire within 10 years. Of the CEOs expected to retire or semi-retire within five years, only 58% have chosen a successor, and of those CEOs aged 61 or older who are expected to retire within five years, 55% have not chosen a successor. This lack of a chosen successor will define the survivorship of the business – will it live to the next generation and continue the legacy or will it not?

Nearly 90% of business owners report that the family will continue to control the company in five years, and for approximately 80% of owners, the current CEO is related to the controlling family by blood or adoption, and another 14% are connected by marriage. Of those who identified a successor to the CEO, 85% say the successor will be a family member, typically a 40-yearold college graduate.

The Loyola-Kennesaw survey reveals only 37% of U.S. family-owned businesses have a written strategic plan. Of more interest however, those respondents with written strategic plans tend to engage in other types of planning as well: They are more likely to have buy/sell agreements, formal redemption plans and formal company-share valuations. They also employ more workers, tend to have qualification policies for employing family members and are more likely to have selected a successor. In addition, they post higher sales revenues and greater international sales. These findings appear to demonstrate a correlation between the existence of a written strategic plan, including regular business valuations, and taking actions commonly viewed as essential to family business survival.

The core driver for effective succession planning is a professional business valuation. Company owners use the business valuation in conjunction with a strategic plan to either accelerate growth (or continue growth), or to help execute a lucrative shareholder exit.

Therefore, succession planning is necessary to ensure the successful transfer of the owner’s interest during his or her lifetime, or upon death, and protect the integrity of the business and the owner’s wealth. Regular business valuations of the family-owned business, in combination with professional tax-planning strategies, allow transfers to occur with minimal tax consequences. Further, a valuation allows owners to track the potential amount of proceeds that will fund their retirement, which may be acquired from the sale or transfer of their business interest.