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Succession planning

Feature, Management | February 1, 2015 | By:

From a financial standpoint, selling or transferring your business requires setting and communicating a clear set of goals and procedures to avoid risk and possible conflict.

Sooner or later, everyone thinks about retirement. For those who own a closely-held or family textile products business, retirement is more than just a matter of deciding not to go to work any more. In addition to ensuring there will be enough money to retire, business owners, shareholders and partners must decide what will happen to the business when they are no longer in control.

For many small business owners, maintaining a positive cash flow and a stable balance sheet can be an ongoing battle that consumes virtually all of their time. Retirement may appear as a distant speck on the horizon, but planning to hand over the business and establishing a sound business succession plan is beneficial for most fabricators and suppliers and can be absolutely necessary for some.

An effective succession plan can involve selling the business to provide a retirement nest egg, or continuing the business with gradual changes in management and/or control to ensure a source of retirement income, or any combination of the two.

Planning basics

At its most basic, a succession plan is a road map to follow in the event of the owner, partner or shareholder’s death, disability or retirement. The plan can include a program for distributing the stock of the business and other assets, retiring the operation’s debt, obtaining life insurance policies, making buy-sell agreements between partners and heirs, dividing responsibilities among successors and any other elements that affect the business or its assets.

The tax component of succession planning addresses the minimization of taxes upon death. The basic estate and gift tax rate structure for estates of decedents and gifts made after December 31, 2012 (with the exception of the rates that apply to taxable transfers in excess of $500,000), have a maximum tax rate of 40 percent. The estate and gift tax exclusion amount is $5 million, which means $5.34 million in 2014 and $5.43 million in 2015, thanks to indexing.

One of the most important aspects of business succession planning is anticipating the financial pitfalls that will follow the death of the business owner. That means answering questions such as: Where will the money come from to pay taxes? Or if the business is a partnership: Where will the money come from to buy out the deceased partner’s share?

Business valuation

There are a number of methods for calculating the value of a business that may or may not reflect the reality of the marketplace or be accepted by the IRS. In general, the value of a business is its fair market value (FMV), which, according to the IRS, is what a willing buyer will pay a willing seller when each is fully informed and under no pressure to act.

While there may be a FMV range, the wider the assigned valuation range, the less reliable the valuation and the more likely it becomes that the valuation will face greater scrutiny from potential buyers or the IRS.

Insurance for the inevitable

Once a dollar value for the business has been determined, usually by a qualified appraiser, life insurance can be purchased on all of those involved in the business. If a partner or shareholder passes away, the insurance proceeds will be used to buy out the deceased partner or shareholder’s interest in the business and distribute it equally among the remaining partners.

Insurance can finance two basic arrangements, known as “cross-purchase agreements” and “entity-purchase agreements.” While both ultimately serve the same purpose, they are used in different situations.

“Cross-Purchase Agreements” are structured so that each partner buys and owns a policy on each of the other partners in the business. Each partner functions as both owner and beneficiary on the same policy, with each other partner being the insured; when one partner dies, the face value of each policy on the deceased partner is paid out to the remaining partners, who will then use the policy proceeds to buy the deceased partner’s share of the business at a previously agreed-upon price.

An “Entity-Purchase Agreement” is less complicated. In this arrangement, the business itself purchases a single policy on each partner and becomes both the policy owner and beneficiary. Upon the death of any partner or owner, the business will use the policy proceeds to purchase the deceased person’s share of the business. The cost of each policy is generally deductible for the business, and the business also “eats” all costs and underwrites the equity between partners.

Giving it away

Giving away or “gifting” an interest in the business can legitimately lower any owner, partner or shareholder’s tax liability. Fortunately, there are several ways to make gifts outright, and all of them serve to reduce the amount of the overall estate.

Annual gift tax exclusions. Currently, gifts up to $14,000 per year per donee (person gifted) may be made without any gift tax consequence.

Other gift tax exclusions. Gifts for the purposes of the donee’s health or education are excluded from gift tax calculations (this is why parents could seemingly pay unlimited amounts for their children’s doctor appointments and, for some of the more fortunate, schooling expenses).

Unfortunately, none of these gifting strategies directly benefits the business. Other strategies for transferring a business do exist, however, and frequently include retaining control.

“Flipping” the business. By controlling the business through a “Family Limited Partnership” (FLP) or a “Family Limited Liability Company” (FLLC), everyone benefits from gifting shares at considerable discounts. An FLP or FLLC can also assist in transferring a business interest to family members.

First, a partnership with both general and limited partnership interests is created. The business is then transferred to this partnership. A general partnership interest is retained for the owner, allowing a continuation of control over the day-to-day operation of the business. Over time, the limited partnership interest is gifted to family members.

Buy/sell agreements. A buy-sell agreement, often called a “business prenup,” is a legal contract that arranges the sale of a business interest between a seller and a willing buyer. A buy-sell agreement allows the seller to keep control of his or her interest until an event specified in the agreement occurs, such as the seller’s retirement, disability or death. Other events—such as divorce—can also be included as triggering events under a buy-sell agreement.

Selling to the employees. An “Employee Stock Ownership Plan” (ESOP) allows the owner of an incorporated textile products business to sell his or her stock to the ESOP and defer the capital gains tax. Ownership can be transferred to the operation’s employees over time, and the business can obtain income tax deductions for contributions to the plan. An ESOP provides a market for the shares of owners who leave the business and a strategy for rewarding and motivating employees, as well as benefitting from available borrowing incentives and acquiring new assets using pre-tax dollars.

An outright sale

To keep income rolling in without having to show up for work every day, a succession plan might look at selling an owner, shareholder or partner’s interest in the business outright. When the business interest is sold, the seller receives cash (or assets that can be converted to cash) that can be used to maintain the seller’s lifestyle or pay his or her estate taxes.

The time to sell is optional—immediately, at retirement, at death, or anytime in between. As long as the sale is for the full fair market value of the business, it is not subject to gift tax or estate tax. (A sale that occurs before the seller’s death may be subject to capital gains tax, however.)

Liquidity strategies=cash. A “liquidity” strategy permits an owner to take cash out of the business in exchange for the transfer of assets to another individual. While liquidity options are most common with third-party sales, they can also be used when the assets are being transferred to family members or business insiders (such as partners or shareholders).

A private annuity involves the sale of property in exchange for a promise to make payments for the rest of the seller’s life. Here, ownership of the business is transferred to family members or another party (the buyer). The buyer makes an unsecured promise to make periodic payments for the rest of the seller’s life (a single life annuity) or for the seller’s life and the life of a second person (a joint and survivor annuity).

Successful succession

Where to begin the succession planning process? The first step involves clearly establishing the owner/shareholder/partner’s goals and objectives, keeping in mind the operation’s current human and financial resources. How much control of the business do you want to maintain? Is someone capable of running the business once you step down? Are there key employees who must be retained? Are there sufficient assets to pay the estate tax, equalize the estate and keep the business? How much money is needed to reach the owner’s financial goals? And don’t forget: Clarifying those goals and wishes is important, but it’s not enough. The business owner also needs to communicate his or her vision with family, business partners and key employees.

Developing a succession plan is a multi-phase process, outlining in detail “who, what, when, why, and how” changes in ownership and management of the business are to be executed. At a minimum, a good plan should help accomplish the following:

  • Transfer control according to the
    wishes of the operation’s owner, shareholder or partner;
  • Carry out the succession of the business in an orderly fashion;
  • Minimize the tax liability of
    all involved; and
  • Provide economic well-being
    after the owner, partner or shareholder steps aside.

Business owners seeking a smooth and equitable transition of their interests should seek competent, experienced advisors to assist them in this process. But no matter how talented and earnest those professional advisors are, their limited specialties should never dictate the choices for the business or the owner, shareholder or partner’s family. Those agreed-upon goals should dictate the path of action.

A tax lawyer can make compelling arguments for strategies that can minimize estate and gift taxes. A CPA can be very convincing when suggesting strategies for controlling income taxes, as can any financial planning and insurance professionals. Tax planning alone should never control any business decision, however.

Succession planning isn’t something that can done once and forgotten. To be complete and effective, a succession plan must be continually revisited, reviewed and updated to reflect changes in the value of the fabric products operation, market conditions, and the owner, shareholder or partner’s health—as well as the abilities and passion of the people to whom the business will be passed.

Mark E. Battersby, based in Ardmore, Pa., writes extensively on business, financial and tax-related topics.

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