Successful Family Transfer of Your Business
Family transfers can cause problems when owners and families hold disparate views about the business and estate.
By Kris Maksimovich, AIF®, CRPC®, CPFA®, CRC®:
Your business plays a large role in supporting your family’s lifestyle and financial security. In fact, many small business owners hope their children will one day become interested in joining. Sole proprietors who have family members working within the business often expect the younger generation to take the reins once they are ready to retire.
Generally, when owners begin thinking about retirement and their business’s succession, they expect the family business to provide:
- Greater financial security for family members than working elsewhere
- Ease in handing the business over to a younger generation who has grown up in the business
- A gradual retirement where they can remain somewhat active in the business and slowly turn over operations and ownership to their heirs
- A sense of family pride in continuing a tradition of business ownership
- The ability to leave a legacy for future generations
While a transfer may seem like a natural progression of running a family business, family transfers do not always occur with ease.
Three Common Types of Family Transfers
Selling your business – While selling the business to children may seem straightforward, they may not have the funds available to provide you with the cash needed for you to retire. Instead, owners may lend family members the money through a sale in exchange for a promissory note. One benefit of this option is that it can provide owners with a steady income stream throughout the loan period. A considerable disadvantage of selling the business to your children is that they could default on the loan and compromise your retirement.
Buy-sell agreement – Such an agreement is useful when a family business owner is not yet ready to step back from the business. Stipulated in a buy-sell agreement is who holds the right to own a stake in the family business, what events would trigger the obligation to buy or sell a stake, and a process for the valuation of shares. The benefit for family businesses is that it can assure that only lineal descendants can inherit, purchase, or own a share in the company. The disadvantages of a buy-sell agreement are that it can restrict your family’s ability to transfer your interest to parties outside of the agreement or leverage your business interest as collateral for outside credit.
Transfer with a living trust – With this option, owners can transfer the family business through a living trust. The business must be transferred to the trust and an intended successor named. While living, the owner would serve as both trustee and beneficiary of the trust. The trust agreement should carefully outline how ownership decisions are made should the owner die or become incapacitated, and depending upon the type of business, tax-oriented provisions may be necessary. Gifting the business to a family member might be a good option since it allows the owner to run the business for as long as they choose. It may also be used as a tool to pass on substantial debt and tax liability to a younger generation that has time to make corrections. The disadvantages of such transfers are that they can cause some business interests to lose marketability and make it more difficult to secure bank debt. With S corporations, it may trigger negative tax consequences.
While these are simplified definitions of the types of transfers available to small businesses, it is recommended that owners seek the assistance of a trusted financial professional.
What is Needed for a Business Family Transfer?
There are several ingredients necessary for a successful transfer. These include:
- Proper planning and communication
- Parental financial security and independence
- A business-active child or children who show a willingness to run the business for a significant period
- Estate planning that provides fairness to all children
- A backup plan, should something go awry
As you plan for your business’s future, you may run into questions about how to treat family members fairly in your plans. This is especially crucial if you have children who work in the business and children who do not.
Case Study: Dwayne’s Dilemma
When planning for your business’s future success, you will need to address how to distribute your assets to children or close family members. As you address this issue, you may realize that what you consider fair is quite different from what your children and family consider fair. Consider the story of small business owner Dwayne Brown:
Meet Dwayne – Dwayne is 67 years old and ready to retire from his business. He worked for over 40 years building a successful recycling business and is ready to step back and let someone else take the lead. For decades, three of his stepchildren worked in the business after they graduated from college. His two biological children chose a different path; rather than join the business after college, they chose other successful careers. Dwayne was proud of all his children’s success, but it seemed natural to transfer ownership of the business to his business-active stepchildren. As he neared retirement, his plan hit a snag.
The expectations – Dwayne’s business was valued at $14 million. He knew this was more than enough to provide his family with financial security. Dwayne planned to split the business ownership evenly between his three stepchildren over the next six years. This would enable him to fully retire at age 74. His plan called for applying a discounted value to his business which would account for the sweat equity his stepchildren had put in. They earned modest salaries and since they started working in the business, cash flow steadily rose. Because of this, Dwayne did not feel it was fair to make them pay full value for the business.
Discussions did not go well – Dwayne discussed his plans with his biological children. He explained that he would provide both with $1MM upon his death, which he believed was fair considering they never worked in the business. His biological children argued that the stepchildren would receive significantly more based on the business’s worth. They were angry that, as blood relatives, they would not gain any benefit until Dwayne passed away, but his stepchildren would gain the benefit of business ownership now.
Dwayne discussed his plans with his stepchildren and asked them if they would rather receive cash after his death. His stepchildren were incensed. They had worked many years in the business and had even turned down many higher-paying jobs, in favor of one day owning the business.
A stalemate – Despite weeks of discussions with both his biological and stepchildren, Dwayne realized that neither side was willing to compromise. He considered selling the business to a third party, but his stepchildren threatened that they would not work for an outsider. Without the ability to retain his key staff, he knew the cash flow and business value would suffer and selling might prove difficult. The turmoil would make the business far less valuable to potential outside buyers.
Risks of Transferring Business Ownership to Family Members
Insider transfers can be risky, especially when family members have little to no money, and their ownership skills have remained untested. As a family business owner, you will be tasked with a variety of decisions when the time comes to exit your business. Considerations may include:
- Parsing your assets between your business-active children and non-business-active children can create resentment, especially for those who have worked hard to build the business
- A transfer can make non-business-active kids feel they are being forced to engage in a business they have no interest in running to receive their share
- Your business’s cash flow can be negatively impacted which could harm your ability to exit your business on your terms
- Transitioning your business to children usually requires owners to wait longer before receiving the full sale value of the business
- Owners often overlook how much time is needed to train their children
- If your children are not ready to run the business without your help, you may find yourself working longer than you anticipated. This could have a snowball effect and prevent you from doing other activities to achieve your succession goals
- You may also need to mediate fights between children about their business roles as you consider asset allocation between business-active children and non-business-active children
- If a child decides to run your business differently than you, it can create discord or amplify existing friction among your family members
- Hard feelings may crop up among in-laws who do not feel their interests are being treated fairly
- Powerplays can ensue, with passive-aggressive behavior and even weaponizing personal relationships to control ownership transfer
One of the largest mistakes business owners make when thinking about transferring a family business is to confuse equality with fairness. Providing equal shares of assets to all children, including those who are not business-active, ignores the sweat equity that family members put into the business. Promises should be backed up by hard facts.
How Dwayne might have avoided conflict. Dwayne should have focused on providing his children with an objective overview of his plans rather than negotiating directly with them and enabling them to take sides. Such an overview might have included:
- The choice of successor(s) and their expected contribution to ensure his business exit goals are met
- A description of which business assets are illiquid
- A breakdown of transferable value, which is the value his company has without him
- A justification of where and how his business-active children effectively paid for their shares and helped increase the business value through hard work and foregoing opportunities to make more money elsewhere
- An outline of the shares of assets loaded with risk, compared to those portions of the family wealth that are much less risky
- An explanation of how the business is dependent upon the business-active children’s continued performance to reap the benefits of ownership versus the immediacy of the non-business-active children’s inheritance
- A summary of the business’s debt and tax consequences that come with business ownership, which would transfer to his business-active children
- The use of advisors to help him explain and implement the family transfer
Steps to Prepare for a Family Business Transfer
When planning for your business’s future transfer to children, fairness is key. The following steps can help you organize your plan and avoid unnecessary discord within the family:
- Establish your objectives for the business
- Identify a timeline for leaving your business
- Define financial independence and what you believe is a fair distribution of family wealth
- Consider a buy-sell agreement, bequeathment through a living trust, or if the business interest should first transfer to a surviving spouse
- Design what the sale and/or gifting of your business interest will look like for the business-active child(ren)
- Obtain a business valuation
- Determine the business value and evaluate contributions of the business-active child(ren) by assessing future growth that is attributed to them
- Increase business value through motivation and incentive planning for the business-active child(ren)
- Create a business continuity plan, should you or the business-active child die before the transfer is complete
- Engage in estate planning that preserves wealth and works to create fairness in the division of assets for all children
While the material presented here is designed to help you work through the process of transferring your family business and steer away from potential family squabbles, the content represents only a few topics you will need to consider. When planning for your business’s future, it is best to seek out the advice of a trusted business advisor.
This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax advisor, or lawyer.
Kris Maksimovich is a financial advisor located at Global Wealth Advisors 4400 State Hwy 121, Ste. 200, Lewisville, TX 75056. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA/SIPC, a Registered Investment Adviser. Financial planning services offered through Global Wealth Advisors are separate and unrelated to Commonwealth. He can be reached at (972) 930-1238 or at firstname.lastname@example.org.
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