Business Transition Planning

Passing the Torch: Business Succession Planning Basics

4/15/17 | WealthCounsel Quarterly | Daniel B. Capobianco, JD, CPA

Introduction

Why do so many businesses fail after the first generation? Often the owners fail to develop a comprehensive strategic vision to address basic issues of ownership, succession planning (both management and ownership), and estate planning. This article focuses on important non-tax aspects of business succession planning, as well as a summary of the tax aspects to be considered in the preliminary stages of the planning process.

Because the family business is often the largest asset in the client’s estate, almost any estate plan in which a closely held family business is an asset must include a business succession plan. The stakeholders are the key employees, marketers, accounting department, client relationship managers, etc. These stakeholders are the business. Sometimes spouses and children are actively involved in the daily operations of the business. Others are not, either because of age (too young) or disinterest in taking over the business.

Business succession planning is not always estate tax-driven. Managing and preserving the value of a family-owned business is often as critical—if not more critical—than saving taxes. Although saving taxes is important, the best estate plan will have little meaning if future generations are incapable of continuing the business. Primary consideration should be given to the orderly transfer of the family business to family members or sale to a third party (including key employees) if there is no desire (or it is impractical) to keep the business in the family. Management and creditor protection issues still exist, as do income tax issues.

Business succession planning will range from basic considerations such as whether direct heirs are willing and capable managers of the business to tax planning objectives which will require the implementation of complex, integrated tax strategies. As planners, trusted advisors, and practitioners, we must be able to address all aspects of the process.

The primary concern of business succession planning is converting a relatively illiquid asset—a business—into cash when the owner dies, becomes disabled, or retires. This raises issues of who will take over the management of the business. The owner’s role may be assumed by multiple persons—a chief executive officer, an operations manager, a treasurer. Can the heirs assume this responsibility? Do they want to? Are there non-family key employees that must be retained to ensure continued viability of the business?

If an exit strategy is being considered—either during the owner’s lifetime or upon death—then the focus will become: Who will buy it? How will the sale be structured? Is the business held by the proper entity to maximize the after-tax cash flow of the business?

Finally, for a very profitable business—one that is worth over $11 million—there is a critical math problem: How will taxes be paid? The current estate tax rate is 40% of the value of the business. If 80% of the owner’s estate is a closely held family business, then only 20% is liquid. Because estate taxes must be paid within nine months of date of death, there is potentially a liquidity issue. If the owner has a surviving spouse, the marital deduction can defer tax until the subsequent death of the surviving spouse. But what if there is no surviving spouse? Or what if there is a surviving spouse but this is a blended family (in which the owner has children from previous marriages) or a situation where leaving substantial assets to a surviving spouse is not an option?

Common Issues Relative to All Businesses

There are issues common to most, if not all, family-run businesses that must be addressed before strategy design and discussion about succession, regardless of the scope of the engagement. Critical to any discussion of the succession plan is the division of assets among family members. Will ownership be divided equally among all children? Or will the business pass to some and not others? Will the children govern equally or will there be voting vs. non-voting ownership interests?

There is also potential conflict between the future active owners and passive owners. The family members actively running the business may feel (or develop) resentment that they are “doing all the work” but having to share with the non-working family members.

If there is a surviving spouse, he or she will likely want (or need) to continue receiving cash flow from the business. If there is no surviving spouse, or upon the death of the surviving spouse, the heirs may need income. Since there is no ready market to sell the family business if the heirs want to cash in on their inheritance, alternate exit strategies must be discussed and built into the succession plan.

Conflict may also arise over control and management issues. There is potential for friction between working owners and non-working owners. Some family members may see an “entitlement” to participate in the family business even though they have neither the expertise nor interest in the business. The desire to be in charge could lead to disastrous family conflict that could so disrupt the family and the operations of the business that the business fails to make it past the second generation. Unfortunately, this occurs more often than not.

If the business is being transferred to the next generation during the lifetime of the owner, the transferring owners can often maintain an orderly transition and see that the transitional hurdles are overcome. But the succession plan must also account for the death of the owners. In this context, death equals disruption. Ownership may pass to family members not qualified to run the business or to spouses outside of the family. Financial institutions may become uncomfortable without the owner at the helm. Surviving owners may not want heirs of the deceased owner to become involved in the business. This could occur where the surviving owners are not related to the deceased owner, as well as situations where the surviving owners are related (e.g., the siblings of the deceased owner). Conflict can arise where the uncles want their family to participate in the business to the exclusion of their nieces and nephews.

If the business becomes subject to probate, the executor and lawyers (with court permission and oversight) could become the de facto managers of the business. Heirs not previously involved now decide to become involved—or worse—nonparticipating heirs may sell their ownership interests to someone outside the family.

Overview of Succession Planning

Implementing a succession plan will have a tax impact—whether it be gift, estate, or income. Any discussion concerning succession planning will include the techniques of transferring ownership from one generation to another in the most tax-efficient manner possible. These techniques should not be used in isolation but should be integrated to achieve the optimum results. There is no single technique that will achieve succession.

Before delving into the technical tax concepts, the advisor must have several very intimate conversations with the client to develop a comprehensive strategic vision. The business owner must verbalize—or even commit to writing—what his or her hopes, desires, and concerns are for the future of not only the business itself but also the family unit. In short, what is the client trying to accomplish?

Succession planning also requires a team of advisors from various professions—the attorney, the client’s CPA, insurance advisor, management consultant, and even perhaps a family counselor. A family counselor or management coach will be a necessary member of the team where the client is unwilling to take the next step because of family dynamics, fear of losing control, fear of having nothing to do upon retirement, or similar internal feelings which perhaps the client has never expressed to anyone.

The family dynamics must always be considered. Even the best succession plan will fail unless the advisor clearly understands how the family members interact with each other. Do the children get along with other? Are there any troubled marriages in the family? Are there medical issues, creditor issues or other personal issues with a particular heir which would mandate keeping assets out of his or her control? Which children can actually run the business? Are there collateral relatives also involved in the business? The design process cannot proceed without these issues being addressed.

The ultimate goal in any succession plan is to not only retain the value of the family business, but also to increase the value of the business for future generations. The planner must understand the key aspects of the business and its life cycle. The senior generation’s current personal financial situation, lifestyle needs, and future retirement needs must also be built into the succession plan.

The succession plan must accommodate changes in assets, family, and future tax laws. The succession plan cannot just be a pile of paper delivered to the client. It needs to be an organic process that actually works.

Succession of Management

Often the senior generation is managing all aspects of the family business. The identity of the business is synonymous with the identity of the owner, and the business is often an integral part of the owner’s personal life. The challenge in a successful transition to the next generation is identifying the key roles played by the owner and transitioning the role to a successor. No plan will succeed without competent management.

We must identify the key employees as a different category from the general workforce. If not already in place, employee benefit plans must usually be implemented to retain, reward, and motivate all employees, but in particular those employees that are critical to the success of the business. If the owner has been the only key employee, then one or more replacements must be found. The key employees may not necessarily be in the next generation.

Employee benefit plans will assume various forms—from tax-qualified plans to non-qualified plans. The employee benefit planning aspect of the succession plan will most often need to be addressed by a specialist in the field since the rules are technical and complex from a tax perspective.

Preliminary Analysis in the Succession Plan

It is essential to the planning process for the attorney to have a complete understanding of the client’s business and personal financial profile. The road map to a complete financial profile is the client’s tax returns and financial statements. Tax returns will disclose all categories of taxable income, as well as income from any pass-through entities in which the client has any ownership interest. Any qualified business appraiser engaged to provide valuations of the components of the client’s business will also require the tax returns and financial statements. The client’s personal CPA will be essential since the he or she will know the client’s financial affairs.

The individual income tax return (Form 1040) reports the client’s personal income, such as interest, dividends, rental income, salary, capital gains, and income from S corporations and partnerships. Schedule B discloses income from the client’s various stocks and bonds. Schedule E reports income from real estate owned by the client individually and income from partnerships, trusts, and S corporations. The Schedule C is used to report unincorporated businesses and income from single-member limited liability companies (LLCs) owned by the client. An analysis of the client’s Form 1040 will disclose the extent that entity formation or reorganization will be required as a preliminary step before structuring the succession plan.

The three primary business tax returns will be the Form 1120 (for C corporations), the Form 1120S (for S corporations) and Form 1065 (for partnerships and LLCs treated as partnerships). These forms are very detailed but will provide insight into how much income is being generated by the business, as well as how unified or compartmentalized the business is. It is common for the operating business itself to be owned by a corporation (either C or S) and the real estate to be owned by a separate LLC which then leases the real estate to the corporation. From a review of the tax returns, the planner can determine which tax strategy or strategies will perform best for the client.

The term financial statements encompasses four separate components of a complete presentation of a client’s financial profile. Where the client or the client’s business has institutional lenders involved in financing the business activities, these financial statements will either be reviewed or audited. The separate components of the financial statement package are the income statement, balance sheet, statement of changes in cash flow, and the footnotes. Although financial statements are the province of CPAs, the attorney should be familiar with the structure, terms of art, and significance of at least basic accounting concepts. Many continuing legal education courses for lawyers teach how to read financial statements.

Valuation Principles

Although the attorney will not conduct the business valuation, he or she must have a basic understanding of the rules governing the appraisal process. Often in the succession planning context—and in estate planning—the term “valuation discount” is a focal point in the tax-savings discussion. If discounts are claimed, then a proper business appraisal is mandatory from a best practices perspective, if not required for full disclosure on any gift (or estate) tax returns ultimately filed.

“Fair market value” is the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.

Form 706, the estate tax return, reports the size of the taxable estate. Whether a Form 706 must be filed is based on value. Form 709, the Gift Tax Return, requires substantial disclosure, such as an appraisal if the gifted property is a hard-to-value asset, or if a discount is being claimed.

In the context of Buy-Sell Agreements, valuation is a tug-of-war due to the inherent conflict of interest. The buyer would like the purchase price to be as low as possible, while the seller would like the selling price to be high as possible.

The IRS has issued several rulings providing guidance as to what is acceptable methodology for business appraisals. Revenue Ruling 59-60 (and subsequent supplemental Revenue Rulings) provides that in applying the standard of fair market value, the assumption is that:

• The Company (and interest) being valued has been placed on the open market for a reasonable amount of time to allow all potential purchasers to be aware of its availability;

• The hypothetical buyer is prudent but without synergistic benefit;

• A seller is not forced to sell (i.e., accept an offer that represents a distress sale) and a buyer is not compelled to buy (i.e., necessary to earn a living); and

• The business will continue as a going concern and not be liquidated.

The process set forth in Revenue Ruling 59-60 is to simulate what would occur in an actual sale between unrelated parties.

No single method exists for determining the fair market value of the shares of a closely held company. However, there is a generally accepted theoretical foundation to the process of valuing a business enterprise. The most critical assumption is that the value of an interest in a business to an investor is the future benefit that will accrue to it, with the value of the future benefit discounted back to a present value at some appropriate rate which reflects the risks inherent in the business’ operations.

Revenue Ruling 59-60 discusses three valuation approaches: (i) the Income Approach; (ii) the Market Approach, and (iii) the Asset Based Approach. Any business appraisal commissioned by the planning attorney must address these methods and explain how and why they are applied to the valuation being submitted. Accordingly, the attorney must have at least a basic understanding of these principles.

The Internal Revenue Code disregards fair market value, or at least radically alters it, under certain instances. Chapter 14 (§§2701 – 2704) requires that special interests in property or a business, income interests in trusts, and certain types of stock in family corporations, are assigned a zero value for certain gift tax purposes. These rules are complex and there have been volumes written on the intricacies and application of these rules. The Treasury Department has released proposed regulations under section 2704 which substantially curtail or restrict the use of discounts in the valuation of closely held business interests.

Preliminary Stages in the Succession Plan

Before implementing the succession plan, the proper legal structure must be in place. If there is substantial real estate involved and the real estate is owned by the client individually, then the real estate should first be transferred into one or more LLCs. Initially the LLC would be a single-member LLC disregarded for income tax purposes, but will become a multi-member LLC if membership interests are transferred to multiple family members or trusts. If real estate is owned by the same entity that is an active operating business, then a reorganization should be considered. There will be income tax consequences depending on whether the business and real estate are owned by a corporation or a partnership. If the business is owned by a corporation, then consideration must be given to whether the corporation should be taxed as an S corporation or a C corporation. If there are key employees, then an analysis of possible executive benefit plans will be needed. Perhaps implementation of a tax-favored retirement plan will also be warranted.

If the planner determines that the proper legal entities are not being used, or if the succession plan will require the segregation of assets into multiple entities, then the planner must engage co-counsel (unless he or she is also a corporate tax lawyer), to navigate the various rules relative to tax-free reorganizations. The rules are complex and failure to strictly follow them could cause an immediate taxable event causing unnecessary taxes to become due. Although the state corporate, partnership and LLC statutes permit entity conversions with minimal paperwork, one must be careful not to trigger a taxable event by changing the tax classification. For example, a corporation with an S election in place can only convert to an LLC tax-free if the LLC itself makes the election to be treated as an S corporation.

Business Entities—A Summary of Tax Issues

There are many types of business entity and each one has its own unique tax issues. Unless the attorney is also a tax attorney, then it is well advised to engage the client’s CPA at an early stage in the process.

Following is a brief description of the most common business entities. In most family businesses, there are often multiple entities doing business with each other (e.g., a real estate LLC owns a building which leases to an S corporation that is operating a restaurant). The income tax rules for the various entities are varied and complex and a full dissertation is beyond the scope of this article. However, a basic understanding of the definitions and differences is required before the succession plan can be fully implemented.

C Corporation

Unless a corporation makes an election under Subchapter S, it will be taxed on its profits at rates of 15% to 35%, depending on the level of profits (taxable income). There is no preferential capital gains tax rate, so if a C corporation sells an asset for a substantial gain, it will likely be taxed at the maximum corporate rate of 35%, rather than the maximum federal rate of 23.8%. Non-salary payments to shareholders will be treated as non-deductible dividends. The shareholders will then pay a tax of 15% on the amount of dividends received from the corporation. This is commonly referred to as the “double-tax” of a C corporation.

S Corporation

The S corporation is not a distinct legal entity under state law. It is a tax concept. An S corporation is a state-law corporation which has made an election to be taxed under Subchapter S of the Internal Revenue Code. In general, taxable income (or loss) is calculated in the same manner for an S corporation as a C corporation. However, the distinct characteristic of the S corporation is that its income (or loss) is reported directly on the shareholder’s tax return. Except in rare situations, the S corporation pays no tax on its income. The S corporation is a pass-through entity because the income or loss passes through to the shareholder, thereby eliminating one level of tax.

Many operational and ownership rules must be carefully considered before implementing the succession plan where an S corporation is the owner of the family business.

• The S corporation cannot have more than one class of stock, but it can have more than one kind of stock (i.e., voting vs. non-voting is permitted; preferred is not).

• Unlike a partnership, the S corporation cannot have special allocations and cannot use third-party entity debt to create shareholder basis (in order to absorb losses).

• The S corporation cannot be owned by a family limited partnership (FLP) or LLC (unless the LLC owner has also elected to be taxed as an S corporation).

• The S corporation can be owned by any type of grantor trust, whether or not the trust is revocable or irrevocable. If the trust is irrevocable, but is not a grantor trust (e.g., the grantor dies), then the trust and/or the beneficiary must make an election so that the trust is a qualified shareholder. The two elections are the qualified Subchapter S trust (QSST) election, which the beneficiary makes, and the electing small business trust (ESBT) election, which the trustee makes. If a QSST election is made, the beneficiary pays the tax on the trust income. If an ESBT election is made, then the trust itself pays the tax on trust income. In addition to the elections, the trust document must contain language which conforms to the Internal Revenue Code requirements for a valid S corporation shareholder.

Partnership

A partnership is also a pass-through entity, and it operates very similar to an S corporation. Partnerships can either be general or limited. Estate planners are most familiar with this type of entity in the format of an FLP. The operational and basis rules for partnerships and S corporations are very different and a good understanding of these differences is important. However, unlike an S corporation, a partnership can have special allocations and third-party debt can be used to create basis to the partners.

Limited Liability Company

The default rule is that if the LLC is a multi-member LLC, then it will be treated for all purposes of the Internal Revenue Code as a partnership unless an election is made by the members of the LLC to be taxed as either a C corporation or as an S corporation. If there is only one member of the LLC, then by default, it is treated as a disregarded entity for income tax purposes unless elected otherwise by the owner. The LLC is the most flexible of legal entities, but the tax classification of the entity may impose its own restrictions. A multi-member LLC can be taxed as a partnership, or it can elect to be taxed as an S corporation or a C corporation. A single-member LLC can elect to be taxed as an S corporation or a C corporation, but cannot elect to be taxed as a partnership. If the S corporation election is made, then the LLC is treated as an S corporation and the LLC operating agreement cannot contain any provisions that would cause a violation of the S corporation qualification rules.

S Corporation vs. Partnership at Death

One issue that must be addressed in determining the proper business entities to hold and manage the family business is what will occur upon the death of the owner. Under the current estate tax regime, all assets included in the decedent’s gross estate will receive a step-up (or step down) in basis equal to the fair market value of the assets on date of death. With business entities, this means that the ownership interest itself receives the step-up in basis, not the underlying assets owned by the entity.

With a partnership interest, there is a full basis step-up for the deceased partner’s partnership interest (referred to as “outside basis”). However, the tax basis of the assets owned by the partnership (the “inside assets”) will not receive a basis step-up unless an election is made by the partnership by the due date (including extensions) for filing the partnership tax return for the tax year in which the partner dies. This election is referred to as the “754 election.” If the election is not made in a timely manner, then the outside basis of the partnership interest will be greater than the inside basis of the partnership assets, resulting in potential unnecessary tax if the partnership sells its assets.

With respect to S corporations, there will be a full basis step-up for the deceased owner’s stock. However, unlike the partnership rules, there is no mechanism for achieving a basis step-up for the inside assets of the S corporation. There is no S corporation equivalent of a 754 election. This is a major difference between the S corporation regime of taxation and the partnership regime. With substantially appreciated assets owned by an S corporation, there is the potential for double taxation. The assets owned by the S corporation will generate a substantial capital gain even though the basis of the S corporation stock was increased to the date of death value. There are ways of planning around this potential tax catastrophe, but the planner must know of this distinction in recommending or not recommending a particular legal entity or entities in the succession plan.

With an LLC, the above analysis must be considered in determining whether the LLC will be treated as a partnership or as an S corporation.

Conclusion

Business succession planning encompasses more than just document drafting and number crunching to reduce estate taxes. It is a process to ensure the continuity of the family business over multiple generations with minimal erosion of value, either due to mismanagement of the business, family dissension, creditors, or taxes. The focus of this article has been primarily on the non-tax aspects of business succession planning and the tax-oriented techniques for implementing the succession plan have been reserved for a future article.