Many family businesses don’t last beyond the first generation, and it is even more difficult to prosper beyond the second and third generations. Among the many issues to address are successor management, providing retirement income for senior owners, developing a role for family members who are not active in the business, and, for larger businesses, coming to grips with death taxes. These issues arise with every generational shift, but every generation is unique, so the succession plans need to respond to the people and assets involved.

Our trust & investment planning professionals can help you plan for the future.

If you want the business to survive – Identify future leaders inside and outside the family

Good leaders don’t develop overnight, so mentorship may go a long way toward positioning the business for a successful transition. Answer questions such as:

  • Are there family members who will or will not participate in the business, and who will eventually take command?
  • Will key employees be in a position to acquire the business and have the skills needed to support continued prosperity after the current owners leave?
  • How will these individuals be trained to prepare for their future responsibilities?
  • If the successor taking over is young and inexperienced, should interim management be arranged?

How to juggle interests by multiple family members

A typical succession plan will have three goals — to find and motivate talented successor management, to treat all children (including those who don’t participate in the business) equally or fairly, and to keep death taxes to a minimum. How can these potentially conflicting goals be reconciled? Here are three hypothetical situations to consider:

Situation: A daughter is working hard in the family business and has the talent to take it over in a few years. Her brother is a busy doctor and likes to offer occasional suggestions but won’t materially participate in the business operations. The “business child” doesn’t want to build up the value of the business only to have to share that value equally with her brother after the parents die. A secondary problem is that the estate tax will be due on the full value of the business at the parents’ deaths, even though much of the value is attributable to the daughter’s efforts.

Possible solution: The daughter purchases a 50% interest in the business today, giving the parents an interest-bearing installment note, which provides the parents with a retirement income. Following the parents’ death, the note passes to the son. Thus, each child is treated equally.

The remaining 50% of the business can be given to the daughter, her husband and their two children. By regularly using the “annual exclusion” ($17,000 for 2023) from the gift tax every year and splitting their gifts, the parents may be able to give the daughter and her family most or all of her share of business equity with relatively little gift tax cost.

Estate tax result: The value of the business will be removed from the estate if the gifting plan is complete before the parents’ death. The value of the note will be taxed, but this value will not increase over time, which effectively “freezes” the estate tax exposure.

Situation: Two sons work for the family business, but they don’t get along. Someone needs to be the sole boss, but the parents are afraid of the potential for abuse of authority. If one son obtains control, he might adjust his salary and control the business so as to eliminate profits to share with his brother. On the other hand, a son with a minority interest might use lawsuits to challenge business decisions, which could paralyze and perhaps destroy the business itself.

Possible solution: This is an especially difficult problem, but the best result all around might be for the parents to give the entire business to one son and purchase a life insurance policy on their own lives to create a comparable inheritance for the other child. The child being forced out of the business, or a properly drafted trust for the child’s benefit, should be the owner and beneficiary of the insurance to shield the proceeds from estate tax.

Situation: Two daughters will inherit a business as equal partners, and they get along well. However, the parents do not want any portion of the business to ever fall into the hands of a son-in-law—they don’t want the business to be vulnerable to a son-in-law’s creditors, or the business to be impacted by a possible future divorce.

Possible solution: Create a living trust to own the business, naming the parents as co-trustees and family members as beneficiaries. As long as they are alive, the parents will run the business as before. At their deaths, a corporate fiduciary (such as Arvest) would take over, managing the shares for the benefit of both families.

Every solution requires putting a value on the business

Before the succession or estate planning questions can be addressed, an accurate valuation is needed. The higher the business value, the greater the tax exposure, the greater the possible offset needed to keep children equal, and the more important the estate planning steps.

Business valuation is as much an art as it is a science. The process begins with the following set of fundamental factors the IRS looks at:

  • the history of the business
  • the current outlook for the economy and the industry segment
  • book value
  • the company’s earning capacity
  • the company’s capacity to pay dividends
  • goodwill and intangible assets
  • prior sales of company stock
  • sales of comparable companies

That’s just the starting point. Valuation discounts may also apply to the transfer of interests in a small business. Discounts for lack of marketability and for having a minority interest, for example, have become routine. IRS has experts in this area, so it is important for the business owner to rely on experts of his or her own. A business valuation must be completed with great care and without bias for it to be effective in tax litigation.

Utilizing a trust in succession planning

Another idea to explore is the use of a trust to manage the ownership of the business. This can provide for great flexibility, while protecting the business assets from claims by creditors of the heirs. The trust document will outline the hopes and expectations of the trust creator, regarding both the operation of the business and the rights of the beneficiaries. The trustee may be given considerable discretion, if appropriate, and a corporate trustee will be required by law through their fiduciary duty to provide a non-biased approach that may preserve family harmony.

A trust officer, such as those at Arvest, could help with that part. However, given the evolving tax environment and the inherent complexity and unfamiliarity of estate planning, owners of a family business should consult a team of specialists to create and implement the business succession plan. Such a team should include an accountant, estate planning attorney, insurance agent, and banker, all of whom can work together alongside family members to enact a plan that can be executed successfully.

Creating this team can be the first active step in developing a practical succession plan. Let us know if you’d like to get the process started.

This content has been prepared by The Merrill Anderson Company and is intended as a general guideline.

© 2023 M.A. Co. All rights reserved.

Arvest Wealth Management does not offer tax or legal advice – consult licensed professionals for advice.