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The Spectrum of Succession Planning

Corporate transition planning is quickly becoming one of the critical topics of our time. Baby boomer business owners are reaching retirement age at an ever-increasing rate. Their children are not nearly as eager to take over the family business as the boomers were when they took over the business from their parents, the World War II generation.

Complicating this dynamic are the emerging and changing credit, estate tax and global economic markets. Combining all these factors make transitioning the ownership of a privately-held business an uncertain proposition at best and a scary one at worst.

A successful business transition must be done in a way that best accomplishes a number of goals. They include: meeting the owner’s personal motives, allowing the owner to have a clear understanding of their future management role, and providing a reasonable replacement income from reinvestment of the selling proceeds, even if those proceeds are received over time.

At the beginning of any retirement or estate tax planning discussion with a business owner, the issue of value inevitably will come up. Rarely will clients be content to “take a salary for life” and leave the business equally to their children at death. Business owners often will do this because they believe there is no other option. Even if this is the case, we all have seen the unintended estate tax and ownership transfer consequences that this option brings.

What many business owners intuitively know, but spend little time contemplating, is that their company has many values on the same day. For example, the business may have:

  • Orderly liquidation value: sell the assets, pay the liabilities and close the doors.
  • Investment value: the value a non-working owner will pay to own a company that is part of a portfolio of companies.
  • Fair market value: based on valuation rules put forth by the Internal Revenue Service for charitable, gift and estate tax transfers.
  • Market value: the value a private equity firm or competitor might pay for the company.
  • Synergistic value: the value a publicly traded company might pay in order to take advantage of market synergies or vertical integration.

Business owners should understand that they choose the value world in which their business will trade, and that choice is based primarily on their motives. The business transfer spectrum depicted in the accompanying chart shows the many options that exist when transferring the equity interests from one generation to the next. At the top of the chart, we see the business owner’s motives. This represents the first and most important decision that the business owner has to make.

Attempting to make a recommendation of a transfer method without determining the business owner’s motives often will result in a breakdown of the overall planning process. Ultimately, this will lead to a breakdown in trust toward the advisor who made that recommendation. It also is important for the business owner to know that the value conclusion reached will generate cash flow sufficient to meet his or her personal financial goals and objectives.

Business owners might be willing to transfer 100 percent of the ownership interest to a family member at a minority price. But, without a proper valuation and illustration as to how the business owners will be paid, they likely will take no action.

On the other hand, business owners’ motives might make selling to management or to an employee stock ownership plan (ESOP) a very attractive option. But owners likely will take no action unless they know how much the ESOP is legally able and willing to pay, what they will receive in cash at closing and over time, and how they will remain in control of the business at least until the company’s financial obligation to them has been satisfied. These are just some of the reasons that business planning and personal planning must take place concurrently.

Other than business owners’ motives, what drives value? As previously mentioned, the transfer channel drives value within a reasonable range as it relates to the rules used in calculating the value of the stock. But ultimately, regardless of the transfer method chosen, cash flow is the largest value driver. Therefore, it is critical that the value conclusion reached, regardless of the transfer method chosen, is reasonable to both the buyer and the seller from a financial point of view.

For example, if the value conclusion reached can be realized only with a 20-year note, at 2 percent interest, assuming a 5 percent compound annual growth rate of the company’s net cash flow, something is not right and the value is likely too high. That value conclusion may make the seller happy but even the most devout family member will see the exercise as futile and unrealizable, causing him or her to be less than enthusiastic about the process.

Conversely, a value conclusion that is less than two times last year’s earnings (earnings before interest, taxes, depreciation and amortization), when the company has a proven profit growth rate of 9 percent for the current year, may make the buyer happy, but the seller will normally not agree to such a price. At the end of the day, every business pays for itself through its cash flow.

During the entire process, the seller’s value expectation must be managed through proper explanation and illustration. Likewise, the buyer needs to know that the company’s net cash flow will be sufficient to service the purchase price debt over a reasonable period of time without bankrupting the company.

Generally speaking, business owners will not transfer the ownership of their largest asset without understanding what they will receive and what their role in the company will be. Also, employees are unlikely to be willing to work for below-market wages for an extended period just to satisfy the note payments for the purchase price of the company’s stock.

In the end, regardless of the transfer method ultimately chosen, the transition of a privately-held business is complex. It requires a collaborative effort. It is a process, not an event. It requires that the financial planner and the estate tax attorney understand the business owners’ motives.

A successful transition requires a business valuation professional who can calculate the value of a privately-held business under one or more of the likely transfer methods. It requires the company’s certified public accountant or tax accountant to determine the estimated taxes under one or more of the likely transfer methods, using the value conclusions provided by the valuator in order to reach a net after-tax, after-transaction cost value. Lastly, those net value conclusions need to be used in order to develop a comprehensive personal retirement and estate tax plan that will alleviate the business owner’s concerns about post-retirement income.

After the business transition planning strategy has been decided, the next step is to review the business owner’s personal estate plan.

The American Taxpayer Relief Act of 2012 (ATRA) made most of the Bush tax cuts permanent. We now have an annual exclusion amount for 2013 of $14,000. In addition, we have a lifetime gift tax exemption of $5.25 million and a generation-skipping tax exemption also of $5.25 million. These numbers are all indexed and subject to change each year. How “permanent” these numbers are remains to be seen.

ATRA also appears to have made portability here to stay. Portability provides a spousal carryover of the applicable exemption amount of a deceased spouse unused exemption amount (DSUEA). Working collaboratively, the client’s advisory team can create the plan that will best fit the client’s legacy goals and objectives.

This new tax law provides tremendous collaborative planning opportunities for us, along with the client’s entire advisory team, to assist business owner clients by transitioning to their estate planning. The two planning opportunities go hand in hand. Because the business often represents the largest single most illiquid asset in the client’s estate, it follows that the personal estate plan needs to be updated accordingly. Lastly, this will lead the business owner directly into retirement planning.

The planning opportunities of gifting certainly are enhanced and, according to most industry sources, the “claw back” provision really is not a great risk for the client. If the client needs the value of the business to sustain retirement income, selling the business interest in an intra-family sale and having the cash distributions of the business pay the note payments to the owner will provide retirement income as needed. Of course, these types of strategies are collaborative in nature. If created and managed properly, a recapitalization of an S corporation or a limited liability company (LLC), or a family limited partnership for a C corporation, can provide even more leverage for the business owner while allowing the owner to remain in control, if that is the client’s objective.

Life insurance, properly owned, is the product of choice in completing nearly all of these planning scenarios. By working closely with the multiple disciplines of the clients’ wealth planning teams, we can provide peace of mind for business owners. We can ensure that their years of creating and building their businesses will provide them and their loved ones with the income to enjoy their retirement years as well as plan a legacy for their families. 

Dennis M. Axman, CLU, ChFC, AEP, CFP, is managing partner of Advanced Market Resources, LLC. He can be reached at [email protected].

Sam G. Torolopoulos, CPA/ABV, ASA, is president of ATI Capital Group. Sam can be reached at [email protected].

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