by Vance E.
The transition of a family owned or closely-held business
is an important event for families. In a prior article, we covered the issues
that a business owner faces in general in preparing a succession plan. This
article will address specific issues that arise when some but not all of the
owner's children are actively involved in the family business.
Transitioning a Family Business to Children -
Many family business owners are fortunate to have one or
more children work in the business, which provides the opportunity for a
planned transition within the family. This transition can take several forms -
an outright sale, an outright gift, or a part gift/part sale transaction. Each
of the transactional forms presents different challenges and opportunities.
In addition to choosing the right form of the transaction,
family business owners are often faced with potential issues with those family
members who are involved in the business and those who are not. Similarly, the
family business owner may need to address potential issues between different
family members who work in the business.
Form of Business Transition
The family business owner has a number of considerations
in choosing the form of the transition to the next generation. The issues to be
addressed include the ability of the next generation to pay for the business
interests being transferred, tax planning, and the income needs of the owner.
Sale of Business
The outright sale of the business can provide the owner
with immediate liquidity. Ideally, the family member or members will be able to
arrange bank financing for the purchase. The third party financing disconnects
the former owner's financial security from the ongoing success of the business,
which can be beneficial since the owner is no longer involved in the day-to-day
operations of the business. Third party financing is not always available,
however. The sale of the business can take the form of 100% seller financing or
there can be seller financing that is subordinate to any partial third party
financing. In either case, the former owner assumes the risk of the buyer's
potential inability to pay the installment payments.
With any seller financing, the purchaser of the business
will rely on compensation and distributions from the business as the source of
the purchase price payments. The available cash-flow for payments will be the
after-tax funds received from the business. The business owners should give
careful consideration to the terms of any seller financing. For example, the
seller may want to require the purchaser to buy life insurance that is
collaterally assigned to the seller in the event the buyer dies unexpectedly.
Other common issues include (i) the amount of the down payment, if any, (ii)
what collateral will secure repayment, and (iii) what events, such as the sale
of the business or its assets, will cause payment to be due in full.
The risk exists that the buyer of the business will sell
the business to a third party not long after the intra-family sale. Most
intra-family sales have some element of a "good deal" for the buyer.
The transaction documents can provide for an "earn out" to protect
the seller. An "earn out" provides for additional payments to the
seller in the event the business is sold within a specified time period after
closing for an amount in excess of a specified sale price.
Many business owners will own the real estate where the
business operates. The transfer of the real estate needs to be considered in
any transaction. Many owners desire to retain the real estate for the rental
income, particulary if there is gifting of the business. Retaining ownership of
the real estate, however, presents some issues. First, the purchaser of the
business may desire to purchase the real estate. Second, if there is not a
purchase of the real estate, then a long-term lease should be in place to frame
the rights and obligations of the parties. Third, there is some risk involved
with retaining the real estate. If there has been a sale of the business with
seller-financing, then the former owner will have a undiversified investment
portfolio consisting of a promissory note from the buyer and real estate whose
primary (or only) tenant is the owner's former business.
Gift of Business
Certain business owners are able to gift all or part of
the family business. In structuring a gift, consideration should be given to
minimizing the gift tax consequences of the transfer. For example, the business
normally should be recapitalized into voting and non-voting classes of
ownership. The value of the non-voting interests can be discounted for gift tax
purposes based on lack of marketability and lack of control. The gifting of
non-voting interests also allows the owner to retain control through ownership
of voting interests. In some cases the business owner will gift non-voting
interests and sell the voting interests.
An ancillary benefit of non-voting interests is the
possibility of these interests funding trusts that benefit children and other
generations of the family. The funding of generation skipping trusts with
non-voting interests will keep control of the business with individuals who own
the voting interests but allows for equity appreciation to other family members
represented by the non-voting interests. As discussed below, there are
situations where a family has some members who work in the business and some
that do not work in the business. Trusts funded with non-voting interests
present an opportunity for those family members who are not active in the
business to benefit economically while not interfering with the management of
the business. Furthermore, the appreciation in the value of the stock will
occur in trusts that are sheltered from estate tax and generation skipping
transfer tax. Thoughtful, inter-generational planning can therefore mitigate or
even obviate the need for tax-driven planning for future generations. Trusts
may also eliminate the need for pre-nuptial agreements since the business
interests held in trust are not marital property if there is a divorce.
Most family business owners are faced with the situation
of having some children who work in the business (the "Participants")
and children who do not work in the family business (the
"Non-Participants"). A number of issues should be addressed in the
transition of a business to the Participants.
There are many instances of one child being the sole Participant. In
this situation, the business owner must balance the desire to treat the
Non-Participants fairly in his or her planning while at the same time ensuring
a smooth and successful transition of the family business. A common theme is
that the business owner wants to treat his or her children "fairly".
It is important to understand that "fair" and "equal" are
not synonymous terms in succession planning lexicon. It is also important
to acknowledge that some of the value of the business being transferred is
derived from the efforts of the Participant.
A business owner's estate plan can address the disparity
(perceived or real) between how Participants and Non-Participants are treated
in a number of ways. As explained, the Non-Participants may receive non-voting
interests in the business. Although a Non-Participant may receive voting
interests, considerable thought should be given to transferring voting
interests to Non-Participants, particularly if the Non-Participants
collectively will have majority voting control.
A business owner's estate plan may also provide for the
Non-Participants to receive other assets of the business owner's estate. A
business owner could also provide that the Non-Participants be the
beneficiaries of non-probate assets, such as life insurance policies and
The issues of "fair" versus "equal" will continue
to be present if there is more than one Participant so long as there is at
least one Non-Participant. A family business with more than one Participant,
however, faces additional succession planning issues.
At the outset, the business owner must decide which
Participant will succeed the business owner as the lead executive of the
business. There can only be one person in charge, regardless of whether the
Participants each have an equal ownership interest. The task of picking the
next leader is often difficult due to emotional considerations and family
dynamics. It is important that the business owner discuss the leadership roles
of the Participants openly and honestly instead of simply imposing decisions on
the Participants. The owner will need to allow for adequate time to groom the
Participants in their respective leadership roles. The exercise of management
and leadership succession should involve a critical analysis of which
Participant has the skill set required to run the family business. As
important, the business owner should indentify which Participant is most
motivated and engaged to run the business. A Participant that lacks the
necessary drive and motivation likely is not a good choice despite other
Some families will adopt a "family business
constitution". The family business constitution accomplishes a number of
objectives. First, it clearly sets forth the expectations of Participants. For
example, a Participant may be required to have a certain level of education or
be required to work in another business before applying for employment. A
family business constitution often will confirm that the Participant is not
simply expected to meet the requirements of his or particular position in the
business but to exceed those requirements. In addition the constitution can
address nepotism, provide for a dispute resolution, and document mission,
values, and principles.
A buy-sell agreement should be implemented (or hopefully
updated) as part of any succession plan. The buy-sell agreement addresses the
mandatory sale and purchase of business interests among owners. The agreement
should establish a cross-purchase obligation between Participants (or require a
redemption by the business) in the event of death, disability, and perhaps
termination of employment.
The buy-sell agreement may provide certain shareholders
with the right to "drag along" other shareholders with regard to
certain actions. For example, the agreement may provide that a certain
percentage of the voting interests can force the other shareholders to agree to
a particular action, such as an asset sale, stock sale, or merger. Conversely,
the agreement may provide minority and non-voting owners the right to "tag
along" to certain actions, such as a sale or merger, so the voting
minority and non-voting owners are not frozen out of the benefits of a
transaction. Drag along and tag along rights can be important to ensure the
Participants can make certain decisions and to ensure that the Non-Participants
are not excluded from significant opportunities.
In some instances a family business owner will not have a Participant
or will have a Participant that is incapable of managing the business. The lack
of a Participant managing the business does not mean that the family will no
longer realize the benefits of ownership. The Participants and Non-Participants
may still be owners, but careful consideration will need to be given to the
ownership of the voting interests. An ownership structure that results in
conflict could serve to drive out talented managers who are important to the
business. Each non-family manager must be adequately compensated since they
will not have any equity ownership and should have an employment agreement that
confirms compensation, job duties, and provides for a non-competition covenant.
The manager could enjoy "phantom" equity in the form of compensation
tied to the performance of the business. A non-family manager could also run
the family business until other Participants gain more experience and develop
the necessary leadership skills.
A thoughtful succession plan is an outgrowth of a
thoughtful estate plan. Every situation is unique, but a succession plan should
address the "fair" treatment of all family members and other
generations while at the same time ensuring the continued success of the
E. Antonacci is a member of the law firm of McNees
Wallace & Nurick LLC practicing out of the firm's offices in Lancaster and
Harrisburg. For more information on business succession planning, please
contact him at VAntonacci@mwn.com
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