Succession Planning For Small Business Owners
It is no secret that family businesses are the backbone of the American economy, with a vast majority of all businesses in this country being either family-owned or family-controlled. Those businesses come in all sizes, shapes, and variation, representing all sectors of our dynamic economy. In fact, some one-third of the businesses included in the Fortune 500 are family businesses. However, without intentional succession planning, many family businesses will not survive beyond their founders. At any given time, approximately 40 percent of family businesses are in the process of transferring their ownership. Unfortunately, a significant majority of all initial transfers fail. Of those that do survive, on about one-half will survive a second transfer.
Why Don't Family Businesses Survive?
While there is no single reason for most family business failures, the significant causes include lack of planning, lack of liquidity and taxes. Deliberate planning can help minimize the impact of these causes and provide for a smoother transition to other family members.
Estate Planning for Family Business Owners
The most significant reasons for the transfer of family businesses is the retirement, disability or death of the business owner. How prepared the family is for such an event can determine the success of business succession. Difficult issues must be addressed to give the family business the best chances for survival following the transfer of ownership and control. For example, who will run the business after you? Will it be your spouse, one of your children or a non-family member key employee? If someone other than your spouse or family member will run the business, will your spouse or family be dependent on the business for their financial security? What provisions have you made for your children's inheritance of those children who are not active in the family business? What about the second-generation transfer of your business, what incentives have been made to encourage responsible but entrepreneurial grandchildren?
Estate Tax Uncertainty
While you have undoubtedly heard that Congress has now made "permanent" the estate tax exemption of $5,000,000 (indexed for inflation) and "portability," history tells us that "permanent" means until Congress changes its mind. In addition, several states now impose their own estate taxes, independent of any federal estate taxes. As a result, it is important to be aware of the ongoing political, economic and legal developments that can impact a family business.
Estate and Financial Plan Coordination
Careful coordination of your estate and financial plans is required to ensure there is sufficient cash to fund your legacy objectives. An appropriately-funded estate plan can meet all of your people-planning objectives and provide liquidity for estate taxes (and business debts). In addition, life insurance, owned in the proper amount, type and manner, may be provide the required liquidity to preserve and carryout your Legacy Plan.
A Business Buy-Sell Agreement (BSA)
A BSA is a contract that provides for the transfer of a business interest upon the occurrence of one or more triggering events as defined in the BSA itself, such as retirement, disability or death of the business owner. An interest in any form of business entity can be transferred under a BSA, including a corporation, a partnership or a limited liability company. In addition, a BSA can cover one or more owners of the same family business. A BSA is binding on third parties, including an owner's estate representatives and heirs. This type of arrangement is critical to ensure a smooth transition of complete control and ownership to the party that will keep the business going. Subject to certain Family Attribution Rules under Internal Revenue Code § 318, a BSA can help establish a value for the business that is binding on the IRS for federal estate tax purposes as provided under Internal Revenue Code § 2703.
A BSA can take several different forms: an Entity BSA, a Cross-Purchase BSA or a Wait-And-See BSA. Under an Entity BSA, the business entity itself agrees to purchase the interest of a business owner. Under a Cross-Purchase BSA, however, the business owners agree to purchase one another’s interests. The Wait-And-See BSA gives the entity a first option to purchase the interest before the remaining business owner(s). In addition to these three general formats, a One-Way BSA may be used when there is one business owner and the purchaser is a third party. The selection and use of the appropriate BSA format is critical for a variety of tax and non-tax reasons beyond the scope of this discussion. However, for a BSA to be effective, a proper funding plan must be in place.
Funding a Buy-Sell Agreement
Some common options to fund the purchase obligation under a BSA include the use of personal funds, creating a sinking fund in the business itself, borrowing funds, installment payments and insurance. Of these options, only the insured option can guarantee complete financing of the purchase from the beginning. Accordingly, a proper BSA will include both disability buy-out insurance and life insurance. Since the health of the business owner determines their insurability, any delay in acquiring appropriate coverage could be fatal to the success of the BSA and, with it, the survival of the business itself.
Should I be worried about asset protection?
We spend a lot of time on building and learning how to build our fortunes; unfortunately, we spend very little time and very little is ever taught on the subject of legally protecting our fortunes. Every family should have at least some basic knowledge of how to legally protect your assets.
Your primary line of defense for protecting your assets is and always will be your insurance coverages. But, what if your insurance doesn't cover everything? Properly structured trusts can also provide asset protection to preserve your legacy.
Certain of your assets are protected against creditors by operation of law - these are what we call exempt assets. Each state has different laws regarding protection of your homestead and a certain dollar value of personal property. Federal law exempts ERISA regulated retirement plan contributions. In a few states, like Florida and Texas, not only are life insurance proceeds protected from the creditors of the insured and the beneficiary, but also the cash value of life insurance is protected (with no dollar limit) from claims of creditors of the policy owner.
Your remaining assets are non-exempt assets and have exposure to creditors. These include your bank and brokerage accounts and non-homestead real estate owned in your own name. However, you can legally arrange your non-exempt assets to protect them from the claims of future potential creditors through estate planning and asset protection planning.
Limiting Liability for Professionals & Business Owners
Many entrepreneurs operate their businesses as sole proprietors rather than through a legal entity, such as a corporation or a limited liability company. Whether their business is home-based or in the Fortune 500, these business owners are attracted by the informality of sole proprietorship. They also do not want to incur legal fees to create and maintain a legal entity. However, in addition to other advantages, conducting business through a legal entity may offer substantial risk management benefits.
While lawsuits brought against a sole proprietorship are really lawsuits against the owner's personal assets, lawsuits against a properly created and maintained legal entity are really lawsuits against the entity's assets. Nevertheless, the selection of an appropriate legal entity is critical for managing your risk.
Transferring Risk with Insurance
When was the last time you reviewed the details of your liability insurance program with your insurance professionals? Are your policies current? Are the coverage limits adequate and are the deductibles reasonable? Have you scrutinized the policies for loopholes? Remember: the fundamental philosophy of any insurance coverage is to pay a premium you can afford to transfer a risk you cannot afford. Take time to understand both the risks you have retained and the risks you have transferred.