Legal Commentary

November/December 2008

All in the Family: Successions in Family-Owned Companies

Lack of planning and ignorance of transition issues can jeopardize a family-owned or closely held business and create acrimony

By Eileen Day

Eileen Day Attorney-at-law Eileen Day is a shareholder in the tax, estate planning and probate practice group of Leonard, Street and Deinard, a Minneapolis-based law firm. She practices in the areas of estate and gift planning, business succession planning, probate and trust administration and charitable giving strategies. Website: www.leonard.com

The family-owned or closely held business is often the passion and consuming occupation of its founder. Monthly projections, annual goals and five-year plans may be in place, but often left unaddressed is the long-term plan for the business when the founder is no longer working. Careful succession planning for a family-owned business may be the difference between long-term success or failure.

For Joe and Sandra Brown, a hypothetical typical couple, the issues were too big to think about on their own. Joe founded and runs a multimillion-dollar construction conglomerate in the paving, construction and equipment-leasing business. Joe’s son runs a division of the company, but his two other children are not involved in the business.

With the help of their tax and estate-planning attorney, accountant and a family business consultant, Joe and Sandra have begun to identify the issues and plan for the future in the hope that their children and grandchildren will carry on the business. Joe and Sandra’s advisory team will help them address company and personal issues that include:

> Planning for retirement or disability;
> Maintaining control within the family;
> Treating equitably Joe and Sandra’s children who are not involved in the business;
> Minimizing estate taxes;
> Furthering their goals for family harmony, stewardship of the company for the benefit of employees and community and passing on their values of hard work and good citizenship.

Starting Early

For Joe and Sandra, meeting their goals will take planning and time. It took Joe 25 years to grow the business to the size it is today. Addressing the issues of the business and his family cannot be done in a year or even in five years. The sooner Joe and Sandra begin the process, the sooner they can implement plans to help them achieve their goals.

With the help of their advisers, Joe and Sandra select techniques that will advance their goals. Joe may decide to recapitalize the company into voting and nonvoting stock so that control and equity can be separated among the family members. Children who are not involved in the business may own nonvoting shares, and Joe’s son can hold voting shares or a controlling interest in the voting stock.

Key company executives may be rewarded and encouraged to stay on in the event of Joe’s disability or death by having an ownership interest in the company. The history of dividend payments and fairness of compensation packages must be evaluated so that nonvoting shareholders feel they are being treated equitably.

A buy-sell agreement may be a solution to resolve the inherent conflict of owners of a business in which noncontrolling owners cannot liquidate their investment. If Joe and Sandra’s children who are not in the business wish to cash out, will the firm be able to buy them out, or will they turn to outside investors?

A buy-sell agreement can address these issues, spell out a process and timeline for stock purchases, the process for determining price, the rights of surviving shareholders on the death of a shareholder and buy-back rights in the event stock is transferred into the hands of a divorcing spouse or other outsider.

Buyout Plans

Joe may consider structuring a buyout plan of his own stock over time so that he has a stream of income and the successors earn their ownership over time. This may be combined with a deferred compensation package that guarantees Joe and Sandra retirement income.

For the children who are not active in the business, Joe and Sandra may identify certain assets that provide income and wealth without active management. Leasing equipment and buildings to the primary construction and paving businesses may be one solution that allows the children to work together but in a limited and manageable way. Other assets, like residences, marketable investments and life insurance, can go to children who are not active in the business. Keeping the family informed and involved in the decisions will help preserve harmony, even if the division of value is not equal among the children. If the children are aware of the parents’ values and decisions and allowed to provide feedback while the parents are alive, they may avoid conflict and animosity when the parents are gone.

Over the long term, Joe and Sandra can combine gifting and sale techniques to reduce the size of their estate and minimize estate taxes. With proper estate planning, Joe and Sandra can defer the payment of all estate taxes until both of them have died.

At that time, their estate may qualify for a deferral of estate taxes for ”hardship” reasons, ”reasonable cause” or under tax provisions specifically designed for family businesses that will remain family owned. Deferrals may extend the time for payment up to 15 years.

Life insurance can be structured to cover some or all of the estate tax. A second-to-die policy may be appropriate and can be owned in an Irrevocable Insurance Trust outside the estate so the death benefit is not subject to estate taxes.

Heavy Hit

The federal estate tax currently is a moving target. In 2001, Congress began to phase down the tax from 55%. The rate gradually declined, reaching 45% for calendar years 2007, 2008 and 2009. At the same time, Congress increased the estate threshold to which the tax applies from $1 million in 2002 to $2 million in 2007 and 2008 (per person, for a total of $4 million per married couple) and $3.5 million in 2009. The tax will disappear in 2010 but reappear in 2011 at 55% unless Congress makes the repeal permanent. Many states also impose their own estate tax of 5% to 6% on top of the federal tax.

President-elect Barack Obama’s tax proposals include ”effectively” repealing the estate tax ”for 99.7% of the estates,” according to a campaign fact sheet. For the other 0.3% of estates—those exceeding $7 million per couple—Obama would keep the rate at the current 45%.

These and other issues involved in estate planning and succession planning require time to plan and implement. Achieving family and business goals will require a dedication to the process and competent, trusted advisers. Identifying goals and making a plan are the first steps. Lack of planning and ignorance of the issues may jeopardize a family business and create family acrimony.