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Statistics suggest that it's one of the greatest threats faced by family-owned companies—and utterly preventable. Here, our wealth strategy professionals offer a road map to the process that may help you protect your wealth and extend your legacy.
A dozen years ago, when the founder of a successful car dealership chain decided to retire, he knew exactly whom he wanted to take control of his company. His son and two daughters were actively involved in the business, and all were well prepared to take the reins. Sure enough, the transition was seamless, and the car dealerships continued to grow. By 2006 the company was worth more than $100 million.
Then, in 2007, the older daughter died suddenly. As part of the transfer of the company from their father, the new owners had a portion of their succession plan in place—a buy-sell agreement that specified how company shares would be transferred if one of the three left the business. There was one problem, says Scott Cooper, managing director of Merrill Lynch’s Wealth Structuring group: The life insurance policies that had been taken out to fund the agreement had been allowed to lapse. When the older daughter passed away—with most of her $50 million estate tied up in the closely held business—her siblings had scant liquidity to cover the 45% federal estate tax in effect at the time (it’s 40% in 2018). “They had to come up with $25 million to pay Uncle Sam,” says Cooper. “To do it, they had to jump through hoops, scraping together cash and taking out a large loan. It could’ve been worse. They could have lost the company.”
When it comes to succession planning, partial measures aren’t enough. Most business owners seem to recognize the importance of having a succession plan, but according to the 2017 U.S. Trust Insights on Wealth and Worth® survey, 4 in 10 baby boomers plan to retire in the next three years, and half of those boomers that will remain in the work force plan to switch jobs and continue working.1 Additionally, the results showed many owners failed to think about the future of their businesses beyond their own lives, with two-thirds of owners failing to have a succession plan in place. Only 16 percent plan to pass the business on to their families, and 64 percent of older business owners (those over 50) have no formal succession plan.2
Why the disconnect? Most entrepreneurs have their hands full planning for the next quarter, let alone trying to think about what will happen to their company when they’re gone. Seeing the larger picture can be difficult, and that can cause issues when planning. There are two levels of essential planning: planning for things that could go wrong—such as an unexpected death—and planning for when things go right. Many families stop their planning at the first level, thinking that wills and trusts designed for when things go wrong are enough for when things go right. That is not always the case. Doing what’s required to help ensure a smooth transition also means tackling a host of delicate issues.
There are two levels of essential planning: planning for things that could go wrong—such as an unexpected death—and planning for when things go right.
Few business owners relish having to pass judgment on which—if any—of their children have what it takes to carry on their work, or deciding how the children outside the business will be compensated. “Often there are no easy answers to these questions,” says Gary Howell, director of Merrill Lynch Family Office Services. Add the pressures of operating during challenging economic times, and it’s easy to understand, says Howell, “why succession planning just falls down the list.”
As the case of the car dealerships shows, there’s financial peril in this land of procrastination. Lack of succession planning is one reason why. According to the same study, 27% of men and 12% of women who own small businesses say it is best for their personal family relationships if the next generation does not work in the business. Those are the sort of sentiments that can easily lead the current generation of owners to delay succession planning. In the absence of a plan, notes Kurt Trimarchi, a partner in the accounting firm McKonly & Asbury, “someone else is going to end up dictating how your company’s assets are transferred.” And it’s a safe assumption that that person will be less invested in the outcome than you are.
Additionally, the demographics of an aging business-owner population point to a large wave of businesses that must transition. The adage “There’s no time like the present” has perhaps never been truer as it relates to securing the future of family-owned businesses. “Now is the time to ask, ‘What is my exit strategy?’ and then take the steps to carry it out,” says Trimarchi. “Even if you decide that the actual transition won’t be for many years, if you have some sense of what you’re building toward, you’re much more likely to get there.”
There’s another reason people put off succession planning: The strategies involved—buy-sell agreements, trusts and other abstruse legal instruments—tend to be complex, timeconsuming and difficult even for lawyers to parse. Business owners know they need to do it, but don’t necessarily embrace it with a huge amount of enthusiasm.
What entrepreneurs often fail to realize, though, is that a thoughtful and thorough succession planning process can actually strengthen their business operations. By thinking through the delicate issues and getting them down on paper, they’re engaging in a rigorous form of long-range planning. Weaknesses in bench strength or capital reserves, which might otherwise have been allowed to slide, bubble to the surface and can be addressed. At a time when many wealthy families are more focused on personal retirement and legacy issues, a business succession plan is also essential for protecting current owners’ visions of their after-work lives. “Owners’ assets are often tied up in their businesses,” says Trimarchi. “Even after they’ve handed off their business to someone, that dream retirement they have in mind may depend on the continued success of that business.” The same goes for philanthropic pursuits and other legacy goals.
The first step, as Trimarchi notes, is to decide on what your exit strategy is going to be and whom you intend to leave in charge. In some companies, a successor will emerge naturally. Other family businesses undergo a more formal process, rotating interested children through various roles inside the company as well as out to gauge their attitudes and aptitudes.
Once a successor, or group of successors, is tapped, the decision process refocuses on how to structure the company to reward the new owners while also providing fair compensation to any children who weren’t drawn to the business. A common solution is simply to divide stock in the business equally among all children but to give voting shares only to those who will run the company. Yet while that approach may seem equitable, it can cause the children who aren’t involved in the business to feel hamstrung in protecting their interests—which, after all, may represent a significant portion of their net worth. “Kids working in the business can give themselves big raises and strip out all of the value of the company,” cautions estate planning attorney Elizabeth Morgan, a partner at Morgan Adler Buxton Jetel. At the same time, operating shareholders may come to resent the fact that siblings outside the company stand to gain from an increase in value they didn’t help create.
A carefully drafted—and properly funded—buy-sell agreement can spell out provisions to account for all these contingencies. The agreement could give the nonvoting family members outside the company the right to force the insiders to buy their shares within a specified period, and give the voting shareholders the same power. “You have to give the children a mechanism with which to pull away from each other,” says Eric Manterfield, an attorney at Indianapolis law firm Krieg DeVault LLP.
The very act of drafting the buy-sell agreement may force business owners to deal with important questions they hadn’t considered before. For example, most agreements stipulate that the price of the shares is based on the value of the business at the time of the sale. “But one key issue is whether the minority, nonvoting interests are going to be discounted for lack of marketability,” says Manterfield. Because few outsiders want to buy a minority stake in a privately held company, the value of such shares may be discounted by 30% to 50%. That can be an advantage to the parents transferring the shares because it minimizes their gift or estate tax liability. On the other hand, it may not sit so well with the children on the receiving end of the reduced-price stock.
And there’s another problem with dividing shares equally: Even voting siblings rarely agree on everything. Unless parents have an odd number of children in the business, deadlocks can occur. That’s why some parents who apportion shares equally among their heirs also choose to retain a small tie-breaking stake for themselves—a Solomon-like approach that has an added advantage of satisfying whatever ambivalence the founders themselves may have about letting go. “That way, even while passing along an economic interest that can benefit the kids and reduce taxes,” says Cooper, “they’re ensuring that it will be a long time before they have to give up control.”
Business owners know they need to do it, but don’t necessarily embrace it with a huge amount of enthusiasm.
Solutions to the question of what is fair are many, but one is to plan to make things go right. According to Cooper, one way to help ensure this is to find ways to structure the family holdings so that those children who are active in the business ultimately own it independently from their inactive siblings. “We look at the entirety of the family’s wealth and consider alternative ways to divide it,” he says. “That includes options such as using life insurance to pass wealth to inactive family members. Siblings may fight as children and many may as adults, but putting some siblings in financial charge of others can create permanent misery for all.”
In preparing a business succession plan, the business owner is essentially protecting his company and his family from two types of taxes that historically have been among the most punitive in the U.S. tax code—the estate tax and the gift tax—as well as increasing income- and long-term capital gains taxes.
Federal legislation in recent years—notably The Patient Protection and Affordable Care Act of 2010, The Health Care and Education Reconciliation Act of 2010 and The American Taxpayer Relief Act of 2012 and the Tax Cuts and Jobs Act of 2017—has introduced changes to income- and transfer-tax rules. For business succession purposes, there are some meaningful changes to rates and exemptions.
While a complete and detailed discussion of the changes is beyond the scope of this paper, we can explain a few items here. Federal income-tax rates have increased: The maximum rate for ordinary income and short-term capital gains is now 40.8%, and the maximum rate for long-term capital gains and qualified dividends is 23.8%. For transfer-tax purposes there are relatively permanent rates and exemptions: In 2013 and beyond, the transfer—estate, gift and generation-skipping—tax rate is 40%. The transfer-tax exemption was set at $5,450,000 for individuals in 2016 and was indexed for inflation so it will continue to grow. For 2018 it is 11.18 million (indexed for inflation), and is set to expire in 2026. State law changes can impact your planning as well, as some states have increased their tax rates. It’s possible that business owners living in high–income-tax states could see combined long-term capital gains rates of over 37%. In the planning community, many advisors are looking closely at trade-offs between transfer-tax savings and a loss of step-up in basis of assets. In a rising income tax environment, basis step-up—the reevaluation of assets during a wealth transfer—is an important consideration.
In any event, any business owner considering selling a business has a strong incentive to begin laying the groundwork now. In the simplest scenario, for example, a husband-and-wife business-owner team might decide to sell their business to their children on an installment basis. Using their combined lifetime gift tax exemption, they could give their children up to $22.36 million of the down payment in 2018, completely tax-free, and then have the kids sign a promissory note for the balance. That would let the children repay the parents gradually out of profits from the company and provide the parents with regular payments for the length of the note.
The only problem with this approach is that the parents would still owe capital gains taxes on the sale, payable over time with each payment that they receive.
Even so, there are other, somewhat more intricate, approaches that may allow them to reduce or eliminate their gift, estate and capital gains tax liabilities. “That’s why we usually encourage owners to consider transferring their wealth in trust,” says Cooper. Depending on the trust, parents can either transfer the company to the trust or sell it to the trust. In an intentionally defective grantor trust (IDGT), for example, they sell it to the trust, the one stipulation being that the trust must be funded with at least 10% of the value of the company it’s purchasing. So if the family business is worth $100 million, the trust would need $10 million in seed capital—all of which a couple could now provide using their combined lifetime gift tax exemption with a little left over. The trust could then buy the stock, usually at a discount for lack of marketability, and agree to repay the parents at a nominal rate of interest set by the IRS (2.87% as of 2018),3 according to the terms of a mid-term note.
While the shares sold to the trust are considered outside their estate, the parents, not the trust or their heirs, will be responsible for the income tax due on the interest payments, as well as the income- or capital gains tax if the shares generate dividends or are ever sold from inside the trust. That’s the “intentionally defective” aspect of an IDGT, says Howell—the defect is desirable, because paying the taxes further reduces the size of the estate outside the trust, while the trust’s proceeds go to the children with no gift or estate taxes due.
In a rising income tax environment, basis stepup— the reevaluation of assets during a wealth transfer—is an important consideration.
Though irrevocable, an IDGT also offers flexibility. When combined with other vehicles, such as a Delaware trust, a limited liability corporation (LLC) or a family limited partnership (FLP), the IDGT can allow parents to maintain day-to-day operational control over the company even as they’re laying a more tax-efficient groundwork for the future. Also, if a family ends up changing course and deciding to sell the business before the trust assets pass to the children, the trust can simply sell its shares, use the proceeds to pay off the note and still transfer the remainder to the children estate-tax-free. That makes it a good option for business owners who might be eager to take advantage of the favorable tax environment but haven’t yet decided whether to keep the company in the family or transfer it to an outsider—whether that be an individual buyer, the public via a stock offering, or employees through an employee stock ownership plan, or ESOP.
As the heirs of the car dealerships learned the hard way, an unexpected death can put even the best-laid succession plans in turmoil. In their case, the problem was failing to fund their buy-sell agreement, but the consequence—having to face the possibility of selling the company to pay estate taxes—can befall any family. One way to guard against that and to further leverage the current tax opportunities is with an irrevocable life insurance trust (ILIT) that designates the children as beneficiaries.
Historically, the challenge with an ILIT was getting enough money into the trust to pay for a large enough policy without triggering substantial gift taxes. For 2018 a husband-and-wife business-owner team has a combined $22.36 million with which to fund a policy while still remaining under the exemption level, or enough to buy some $75 million to $100 million worth of coverage, according to Cooper.
Yet another kind of trust, known as a qualified terminable interest property, or QTIP, can be used in combination with an ILIT or IDGT to further minimize estate taxes while also providing for a surviving spouse. The tax law stipulates that a husband and wife may inherit an unlimited amount from each other without an estate tax liability arising; the tax bill comes due when the second spouse dies. But the QTIP allows a family to at least utilize the estate tax exemptions of both spouses. When the first spouse dies, the individual estate tax exemption can be used to move a certain number of business shares into the trust to provide lifetime income for the surviving spouse. Then, when the second spouse dies, whatever principal remains in the trust goes to the beneficiaries tax-free. And so can assets outside the trust, utilizing the second spouse’s exemption.
Not all succession planning, of course, is done to protect against unfortunate circumstances. It can also be used to increase the windfall from a more propitious event. Although the initial public offering (IPO) market for middle-market companies is nowhere near as active as it was a decade ago, it can still result in a major payday for a well-positioned company in the right sector. That could also spell a big capital gains tax—or far less of one with the appropriate use of a grantor retained annuity trust, or GRAT.
Suppose you intend to take your company public in nine months and expect shares to be priced at about $15, yet an appraisal now puts their worth at only $8 a share. You can choose to set up a GRAT that designates your children as the beneficiaries and pays you a lifetime annuity. At the time you place the shares in the trust you will owe a gift tax, but only on the current valuation of the shares that exceeds your lifetime gift tax exemption. Moreover, the present value of the annuity payments to you reduces the taxable value of the gift for tax purposes. (In fact, when properly structured, the taxable value of the gift to the trust can almost always be reduced to close to zero.) Any growth beyond that amount then accumulates inside the trust until the end of the GRAT term, when it goes to the beneficiaries entirely tax-free.
A succession plan will be worth every ounce of energy you put into it.
Given the alphabet soup of business succession planning strategies—IDGT, LLC, FLP, ILIT, QTIP, GRAT and more—there might be a temptation to put off getting serious about your company’s plan for another time. But you could be making a large, and potentially costly, mistake. “Try not to think about it as one big project,” says Morgan. “You can carve the planning into a series of more manageable stages. The most important thing is to sit down with your advisor, attorneys and accountants now to figure out the best way for you to take advantage of the wealth transfer provisions currently available to you. It takes time to get this right. But a succession plan will be worth every ounce of energy you put into it.”
Your private wealth advisor can help start the process and offer suggestions for how to deal with wide-ranging scenarios. After the two remaining owners of the car dealerships lost their sister and then nearly lost their business, they realized they needed help creating a more robust plan. They also wanted to begin transferring ownership to the next generation in a tax-efficient way. Their advisor reached out to Cooper, who recommended that the siblings set up ILITs and purchase life insurance on each other worth 75% of the value of each sibling’s stock in the company.
The brother then sold $5 million of his nonvoting shares, discounted for lack of marketability, to an IDGT, with his children and grandchildren as beneficiaries. “His stock was highly appreciated, so this avoided what would have been massive capital gains,” says Cooper. And by paying income tax on his payments from the trust, he further reduced the value of his estate—another tax-free gift to his heirs.
Though the siblings don’t know yet which of their children, if any, will take over the business, they have the beginnings of a plan in place. “Now the company is protected,” says Cooper, “and the children and grandchildren are in line to receive the maximum benefit.” That’s the goal of every succession plan, and creating one now, no matter how strong the urge to put it off, will give you the best chance to succeed.
1 2017 U.S. Trust Insights on Wealth and Worth® survey.
2 2015 U.S. Trust Insights on Wealth and Worth® survey. (Latest available data.)
3 The mid-term applicable rate for July 2018.
Neither Merrill Lynch nor any of its affiliates or financial advisors provide legal, tax or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.
The case studies presented are hypothetical and do not reflect specific strategies we may have developed for actual clients. They are for illustrative purposes only and intended to demonstrate the capabilities of Merrill Lynch and/or Bank of America. They are not intended to serve as investment advice since the availability and effectiveness of any strategy is dependent upon your individual facts and circumstances. Results will vary, and no suggestion is made about how any specific solution or strategy performed in reality.