Richard W. Kozlowski, Esq.

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Generally

It is estimated that over one in every three family business owners is age sixty or older -- during the next fifteen years, almost 70% of all closely held business will pass to the next generation.  Clearly, as America's population continues to age, many family business owners will face the reality of transitioning their business to children, key employees or to a willing third-party buyer.  The issues involved in such transitions are myriad and unique:  Who will run the business?  Should you give or sell the business to your children?  How do you ensure a secure retirement?  Can estate and gift taxes be reduced or avoided?

Many family business owners employ the "ostrich method," which is to do nothing until it is too late.  Successful business transitioning requires advanced planning, years if not decades before the family business owner has fully retired.  Since we do not normally choose the dates of our deaths, almost every owner should also have a plan for the transition of the family business in the case of a premature death.

The key to forming a successful transition strategy is properly defining the goals of the family business owner.  The following is a list of typical goals expressed by many family business owners:

(1)  Transitioning the business to a child/children involved in the business.

(2)  Equalizing the inheritance of all children, including those not involved in the business.

(3)  Funding the owner's retirement from the business.

(4)  Ensuring competent post-retirement management of the business.

(5)  Reducing estate taxes.

(6)  Providing liquidity for a retirement plan/buyout.

(7)  Receiving fair market value in the event of a buyout.

(8)  Avoiding post-transition disputes.

(9)  Using life insurance to protect against the owner's untimely death.

Transferring the Family Business

Lifetime Transfers
Lifetime transfers can be broken down into two types:  gifts and sales.  A transfer by gift normally involves younger family members -- i.e. children -- often including one or more who are involved in running the business.  A sale can also involve family members; alternatively, the business can be sold to employees or third parties.  There are varying  considerations in each of these types of transfers.

The first step in devising a successful business transition by way of gift is to determine who will ultimately own, operate and control the company.  This is perhaps the hardest decision facing the family business.  For example, if you have three children, one of which is involved in the business and two who are not, you may want  the company to be owned equally by all three, but to give the  one child control (since he or she is involved in running the business).  Dividing ownership and control can, however, lead to disputes between the controlling and noncontrolling owners:  How much should the controlling owner be paid?  When should profits be distributed?  Should the company be sold?  These disputes often become worse after your death, since the parent is often the arbiter of competing interests.

Once the difficult questions of ownership, operation and control are answered, the next step is to devise a strategy for making gifts.  If not for the U.S. gift tax system, transferring the family business by way of gift would be relatively straightforward.  Unfortunately, under current law, gifts over $10,000 per year to any one individual are subject to gift taxation.  Therefore, any transition strategy which involves making gifts to children must address the issue of gift taxes (for a complete discussion of gift taxes, visit the Lifetime Gifts webpage).

A very common method for transferring a family business is to embark on an annual gift program.  Each year, the business owner makes gifts of stock (for corporations) or fractional interests (if a partnership) to children (a family limited partnership is a popular device for this type of transfer strategy) .  The amount of the gift to each child is at or below the annual ($10,000) exclusion amount -- including discounts for minority interest and lack of marketability (see the discussion of discounts at the Family Limited Partnership webpage).  The gifts are made to achieve the owner's goals concerning ownership, operation and control of the business.  Over time, a large portion of the business can be transferred free of any adverse gift or estate tax consequences.

Another method of transferring the family business to family members is through a sale.  The business owner may need the equity in his or her business to fuel retirement goals, but may also want to keep the business in the family, especially where one or more children are involved in its operation. 

In a sale to family members, the business owner faces many of the same considerations discussed above -- who will ultimately own, operate and control the company?  The only added concern is how the purchaser will finance the purchase.  Many businesses are sold to children on the assumption that the cash flow from the business will fuel the purchase.  Depending on the circumstances, the full retirement of the business owner equates to a drop, often dramatic, in the profitability of the business.  In such cases, the business may not be able to support a buyout of the owner's interest.  To guard against this possibility, some business owners choose semi-retirement as a way of easing out of the operation of the business while guarding business operations.

A sale of a family-owned business can take many forms.  The owner's interest can either be redeemed by the business or sold to family members, or a combination of both.  In a family sale, it is important to realize that the sale price may or may not be accepted by the IRS.  If the price is too low, the IRS may recharacterize the "sale" as a partial gift, with potentially adverse transfer (gift) tax implications.

Choosing the form of the sale depends upon the type of entity involved and the tax consequences to the owner and his family.  If the owner's interest is sold to the children, the children will need to have assets to fund the purchase.  If they plan to rely on cash from the business, they will have to pay income tax on distributions made to them.  On the plus side, the children will increase their tax basis in the business by buying the owner/parent's interest directly (which would decrease income realized on a subsequent sale).  In contrast, a redemption avoids the income tax issue for the children, but also does not involve and increase in the children's basis.

Many of the worries that can plague a sale to family members are not present in a transfer to employees or third parties.  Specifically, the concern over who will control the company  is not as much of an issue where no family members are involved.  On this level, a transfer of the business to non-family members is much easier.

A lifetime transfer to employees or a third party is normally structured as a sale.  The sale can be either an all cash (immediate) sale, or can be an installment sale with payments being made over time.  Each of these structures has advantages and disadvantages.  Obviously, if the business is sold for an immediate, all-cash payment, the family business owner has no risk since he or she has received full payment.  The downside is that the owner will recognize all of the gain from the sale in one taxable year - which could result in a significant, virtually immediate tax payment.

Conversely, an installment sale permits the family business owner to defer the payment of taxes.  In return for this benefit, the owner runs the risk of not receiving payment if the company begins to struggle or even fail.  Although the owner can take some precautions, such as maintaining control over the corporation until full payment is received and/or obtaining a security interest in the hard assets of the corporation, an installment sale can be a risky proposition.

Transfers at Death

Virtually every family business owner should have a plan for transition of the business in the event of death.  Such plans are not static -- they should be periodically modified to fit the owner's circumstances.  A plan which made sense for a young business owner with minor children may be totally inappropriate for an owner near retirement.

Many of the issues are the same:  Who should run and/or control the business?  Should the business be sold?  However, many of these issues are magnified since the business owner will not be present to assist in the transition.

Where the owner simply wants to transfer the business to children, the single most important issue is likely to be estate taxation (see below).  The transition plan should address estate taxation, and whether the business and/or the owner's estate has the liquidity needed to pay these taxes.  Often, life insurance is used to guard against an untimely death and to add this necessary liquidity (see Life Insurance, below).

In other circumstances, the owner may expect the business to be purchased.  The proceeds of a sale may be needed to fund a surviving spouse's lifestyle, or to ensure the inheritance for children who are not involved in the business.  If the sale is to children, the issue of liquidity must be addressed.  If the sale is to non-family members, it is critical to identify (if possible) potential purchasers and to arrange for the operation of the business until the sale is complete.

Valuation

The valuation of a family business is critical for a number of reasons.  First, gratuitous transfers of a family business, whether during life (gifts) or at death (bequests) are subject to gift and estate taxation.  The tax is calculated on the fair market value of the interest being transferred; therefore, the valuation of the business will determine the amount of tax paid.  Obviously, in this instance, the business owner (and especially his or her family) wants the valuation to be as low as possible.

Second, a business valuation will often be used to fix a price for the sale of the business, whether to family members, employees or third parties.  In this case, the business owner will want the highest value possible in order to maximize the profit from the sale (the exception being a "bargain sale" to family members (which can create gift tax issues)). 

Third, a valuation can be used to support a loan from a lending institution -- to show that the business has the assets and income to service the loan.  A high valuation is optimal.  Finally, a business valuation will often be used in divorce proceedings as a basis for the division of marital assets.  In a divorce, the owner usually wants a low value placed on the business while his or her spouse wants precisely the opposite.

How is value of a closely-held business determined?  Value is often defined as follows:

    The highest price available in an open and unrestricted market 
    between informed and prudent parties, acting at arm's length and
    under no compulsion to act, expressed in terms of money or 
    money's worth.

While this definition seems to provide some guidance, it simply begs the ultimate question - how do you determine what price would be paid by a  "prudent party"?

Over forty years ago, the IRS issued a ruling which set forth the factors which are to be used in determining value for businesses which are not publicly traded.  These factors are:
 

The nature of the business and the history of the enterprise from its inception.

The economic outlook in general and the condition and outlook of the specific industry in particular.

The book value of the stock and the financial condition of the business.

The earning capacity of the company.

The dividend-paying capacity of the company.

Whether or not the enterprise has goodwill or other intangible value.

Sales of the stock and the size of the block of stock to be valued.

The market price of stocks of corporations engaged in the same or a similar line of business having their stocks actively traded in a free and open market, either on an exchange or over-the- counter.

These factors are discussed in some detail in the ruling issued by teh IRS (read the ruling).  In addition to these factors, the IRS provided guidance as to how these factors should be weighted, how capitalization rates can be used to determine value, and what effect restrictive (stock) agreement might have.

Over the last forty years, a large body of law has developed regarding the valuation of closely-held (family) businesses.  This law can be applied by valuation experts (CPA's, attorneys, etc.) to quantify the value of a business with some degree of accuracy. 

It can be advantageous, for planning purposes, to have your business valued.  Although this involves some expense, it can avoid prevent missteps in the planning process.

Estate Taxation

As mentioned above, the transition of a family business at death can trigger the payment of estate taxation.  The business is taxed at its fair market value (see Valuation, above).  With estate tax rates rising quickly from 37% to 50% and beyond, without proper planning the heirs of a family business may have no choice but to sell the business in order to pay the tax.

The pressure on small business owners has not gone unnoticed in Congress.  Spurred in large part by the plight of small business owners, a movement is currently (July, 2000) afoot to eliminate, or greatly reduce, the estate tax.  This movement faces some political opposition (surprise) and may or may not come to pass.

Several years ago, Congress tried to assist small business owners by enacting an estate "exclusion" which essentially gave small business owners a small estate tax break.  This exclusion was revamped in 1998, and now allows an executor to deduct the value of a "qualified" family-owned business up to $675,000.  Depending on the year of death an the value of the other (non-business) assets in the estate, this deduction can result in sheltering up to $1.3 million dollars of the owner's estate.  These rules are complicated -- if you think your estate might qualify for such a deduction, you should consult your estate planner about revising your estate plan.

Life Insurance

Life insurance can play a key role in the transition of a family business.  Often, the biggest obstacle in transitioning a business is the need to provide for the surviving spouse in the event of a business owner's death.  Life insurance can provided the cash needed (by family members or other co-owners of the business) to buyout the surviving spouse's interest. 

Split dollar life insurance is often suggested as a way to provide life insurance for a small business at a low tax cost.  Split dollar life insurance is really "regular" life insurance which is subject to certain agreements between the employee/owner and the business.  These agreement provide for a division of the proceeds from the policy at the owner's death.   If structured properly, split dollar life insurance can result in significant tax savings to a business owner in the early years of the plan.  However, split dollar plans should never be employed without a full understanding of the tax consequences in the later years of the plan.  You should consult a tax advisor prior to using split dollar life insurance as part of your business transition strategy.