Remember the family’ in family businss

Proper planning could help preserve wealth — and family harmony

Bernie Palmer

February 1, 2007

You know, there's a method to using the “family” in family business. The perpetuation of ownership and the succession of management are among the most difficult challenges that a privately held business will ever encounter. The decisions surrounding these issues will determine what will become of the organization to which business owners have devoted their lives, and what will be the return on what is likely their most valuable financial asset.

Yet, ironically, these critical – and complex – decisions are among those for which the owner is least prepared, since they may be confronted only once in a lifetime. Owners may have many decades of experience at managing a business, but little or no experience with the monumental task surrounding his exit.

A recent PricewaterhouseCoopers Trendsetter Barometer ^TM survey of more than 300 of the fastest-growing U.S. privately held product and service companies reports that while “Trendsetter” CEOs and their family members tend to own a majority stake in their businesses, few (29 percent) consider theirs a “family business.” More than half of those who consider themselves to be “family businesses” mention sale or transition to next-generation family members as a likely exit plan. In fact, only 20 percent overall mention succession planning as a priority.

It is possible that more of these CEOs do not place a near-term priority on succession planning because they and family members control a majority share. Of concern, 30 percent of these same CEOs do not have an estate plan in place that addresses disposition of the business, and only 5 percent see transition plans, such as positioning the business for a sale or identifying an eventual successor, as “extremely important.”

Enlist outside advisors

Why didn't the boards of these companies pick up on their planning gaps and advise them on transition planning? Most of these “Trendsetter” companies simply didn't have a board: in net, only about 20 percent of these up-and-coming private companies have a formal board with independent members that advise on issues like preparing for a sale or eventual transition at the top.

Businesses should consider enlisting outside advisors who have related experience and a good reputation in the business community to serve as checkpoints for issues that arise. However, they shouldn't be family members in order to allow for some formality to the relationship, such as holding regularly scheduled board meetings and providing sufficient compensation; for example, $1,000 per meeting plus expenses if there is travel. At best, a board can help defuse some emotional issues that could threaten a company's future.

In addition to having an outside advisory board, businesses with a high percentage of family ownership require a team of advisors who can provide legal, tax, financial and investment planning insight. Ideally, they can look to someone who knows the business and industry well to help with transition provisions.

For example, a business should have a buy-sell agreement to govern what happens if someone dies or wants to leave the business. What methodology will the company use to determine the value of an owner's shares?

For example, will the firm get three outside appraisals and take the average? Will it use historical books and records and do a projection? Will it secure third-party monetization, then put the company out to bid and see what those prices come in at? The buy-sell agreement also should provide a plan for buying out a shareholder should he or she become debilitated by an injury or illness and the only provision for sufficient liquidity is based on a life insurance policy.

Develop and review a strategic plan

Having a written strategic plan with financial and personal goals that stakeholders agree upon can save energy by eliminating the finger pointing when one family member decides to expand into unrelated industries. Just like a will or an estate document, a written strategic plan helps clarify the intent of the stakeholders at a point in time, whether that is a desire to expand a market by 20 percent a year or just to break even.

Plan ahead

Considering the emotional hurdles involved with transfer – not just of business ownership – but control from one generation to the next, it is not surprising to find that only about 30 percent of the fast-growth companies surveyed had a succession plan.

Among the benefits of creating a succession plan is an understanding of the long-term effects of certain business structures. Some people seem to risk negative consequences by using the family limited partnership (FLP) or Limited Liability Corporation (LLC) without proper planning and implementation.

For example, if a clause in an LLC agreement indicates that a pro rata amount of income distributions must be made to all LLC members, even those who don't want it or need it at that time, would be obligated to receive the distribution. Instead, it might be advantageous to keep the assets in the partnership and invest them within it rather than have individual family members take the funds and invest them separately.

In addition, if a business opportunity presents itself in the future, the accumulated undistributed earnings would be in the FLP/LLC and available to take advantage of the opportunity. Otherwise, management would need to establish a new partnership for the new investment or request capital contributions from the partners or family members, some of who may not be willing to contribute. Therefore, it might be more beneficial to ensure that the distributions from the partnership are discretionary and based on the decision of the management committee.

Another example is that upon the passing of an individual, his or her estate and gift tax returns are reviewed. If the FLP or LLC has not been operated as a separate business, and the IRS challenges the applicable marketability and minority discounts that were taken for gifts that were made to family members, those family members could find themselves with a significant estate tax bill.

Preserve wealth

Whether a business owner plans to exit by selling to a financial buyer, a strategic buyer or transfer ownership to family members, the sooner that value is transferred out of the owner's estate the better. Vehicles to achieve this transfer include:

Grantor retained annuity trusts (GRATS) – These trusts are used by individuals with wealth to spare. They are necessarily irrevocable trusts because they enable grantors to make a completed gift during their lifetime, and remove assets from their estate at little or no gift tax. The grantor decides on the terms of the trust, the amount of annuity retained, and whether payments will increase by as much as 20 percent per year – or remain fixed and level. For example, someone may choose a two-year GRAT and retain a 55 percent annuity, or a five-year GRAT and retain a 22 percent annuity. Any appreciation in excess of the retained annuity rate goes to the next generation, gift and estate tax free.

Intentionally defective annuity trusts – These are an exceptional way to transfer business interests to future generations, especially in situations in which the business interest has cash flow and is expected to appreciate substantially in value. The transaction is structured as a sale that is not taxable to the seller or the purchaser. The sale is to a trust that is disregarded for tax purposes. The use of an intentionally defective annuity trust will result in freezing the estate value of the business at today's value and permit all future appreciation to pass to the next generation.

Life insurance trust – As discussed, buy-sell agreements can be used to fix the purchase price of a company. Often this obligation is quite onerous as the business has great value. One way to fund the purchase of a business interest by one partner from the other is through the use of life insurance. In order to make certain that the life insurance is not included in the value of the business or in the estate of the owner, a life insurance trust is used. A properly structured trust can result in no current gifts and no inclusion in the estate. Use of outside advisors who are knowledgeable about the rules of these trusts is important to achieve the desired results.

Case and point

Stages of family life and various business circumstances inspire different planning efforts. With some major estate tax law changes scheduled to happen in 2010 and the possibility of new estate legislation in 2007, it is important to understand how your estate plan will hold up along with the strategy for your business. Commitment involves the following steps:

•  Understand that the whole process goes beyond a will

•  Assemble an advisory team to assess appropriate strategies

•  Avoid common mistakes, such as waiting too long to do any planning that will add value

•  Be open to uncommon solutions and approach estate planning as part of a long-term wealth accumulation, management and preservation process

•  Implement – once you finalize the strategy, follow through.

 

Bernie Palmer is the Atlanta leader for the Personal Financial Service group in PricewaterhouseCoopers Private Company Services practice. He has more than 24 years of experience in investment consulting and financial planning. In addition, Palmer is the National Leader of PricewaterhouseCoopers Investment Advisers (PwCIA), a Registered Investment Advisor under the Investment Advisors Act of 1940.

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