Providing for Orderly Succession in Multi-Generational Family Businesses
After a lifetime of working towards building successful family businesses, many business owners will look to pass their family business on to their adult children. This raises many issues that must be considered and that may lead to significant, consequential choices on the part of the business owners.
Assessing the Estate
Prior to beginning any discussion on an actual transfer, individuals considering a generational transfer should first have their attorney review their estate documents, assess whether the documents align with or even permit the transfer of interests in the family business, review their options, and make changes where necessary, desired and possible. Only then can the business owners begin to properly address the remaining questions.
Assessing the Adult Children
A good starting point for the business owners is to assess whether the adult children even want to continue the family business at all. In many cases, adult children of successful entrepreneurs will have received excellent college or professional educations. Quite possibly, the adult children may have other professional desires or aspirations in mind or, conversely, may simply want an ordinary 9-5 job with security and benefits and without the responsibility associated with running a business.
Thornier still is when there are multiple adult children, some of whom may want a role in the family business while others may have different aspirations. Still, some may want the family business but, owing to temperament, maturity, or general disposition, may simply not be capable of running an enterprise dependent on their actions and decisions.
Conversely, each of the adult children may want to run the family business, may be capable of running the business and may think themselves better suited than their siblings thus setting up a struggle among them, akin to something straight out of HBO’s series Succession.
Thus, the business owners will need to take a cold, hard assessment of the adult children to determine whether to transfer the family business at all and, if so, how to structure the exact nature of the transfer.
Outright Transfer or Sale
As stated above, the next question should be conceptualizing the exact nature of the transfer. Many business owners in this situation, being parents first and foremost, will have very soft spots in their hearts for their children and may wish to simply gift their ownership interest outright. This is seldom a wise decision.
An outright gift of the family business to adult children might have the negative effect of the adult children not valuing the company as much. Oftentimes people simply do not value that which they do not themselves earn. This may be especially true in cases where the adult children have failed to appreciate the effort their parents put forth to make the business a success.
Further, an outright transfer will raise at least two other issues. First, in the event that some adult children want to stay with the family business, but some prefer to seek other options, the business owners will have benefited some of the adult children but not others. Depending on family dynamics, this might pose a significant issue.
Remedying that disparity might require gifting a similar amount of property to the non-recipient adult children in order to compensate for the gift to the recipients. Business owners in this situation may simply not have assets sufficient to fund such an outright gift, especially if most of their wealth is tied up in the family business itself. They may also need the remainder of their assets in order to fund their retirement.
Second, an outright gift of the family business will likely have federal gift tax consequences. Currently, any grantor may gift up to $16,000 per recipient, per year without federal gift tax consequences or even filing requirements. This figure is set to increase to $17,000 in 2023. Above that figure, grantors are required to file a gift tax return, IRS form 709.
Nonetheless, grantors may gift up to $12.06M in an entire lifetime, double that for married couples. The federal estate tax laws provide that a person can gift up to that amount during their lifetime or die with an estate worth up to $12.06M and not pay any gift or estate taxes. This figure is set to increase to $12.92M in 2023. Consequently, any substantial gift of interest in a profitable, ongoing business may have gift or estate tax consequences, especially if the business owners also feel compelled to gift similar amount of property to the non-recipient adult children to compensate for the gift to the recipient adult children.
Ownership in Trust
Alternatively, business owners may place all the ownership interest in the family business in a revocable trust naming themselves as both the trustees and beneficiaries and their children as contingent beneficiaries. Note, this can include both the adult children who are interested in the business as well as those who are not.
Once the business owners pass, the revocable trust would become irrevocable, and the above structure would become permanent. Adult children interested in running the family business can be compensated by means of employment and bonuses, perhaps with employment contracts, all of which can be stipulated in the trust documents. Those who do not wish to be part of the family business may simply hold their beneficial interests as silent partners and collect dividends and distributions, to the extent such are ever paid.
Use of a trust in this circumstance can work particularly well to ensure inheritance and ownership by all siblings but participation only by those siblings who would welcome an active interest in the family business.
Valuation of the business
Regardless of how a transfer is structured, the founders will need to assign a value to the business. This will likely require that the retention of a business valuation expert to review the business’ books and determine a going concern value, that is, the value of the family business as an operating business. Such an independent valuation will ensure that the sale will be viewed as legitimate by Internal Revenue Service in the event of an audit thus avoiding gift or estate tax consequences.
Structure of the Transaction
In the event of a sale without use of a trust, then the next question is exactly how to structure such a transaction. A transfer can be accomplished in installments or in a complete transfer.
Transferring in installments permits the business owners to secure payment and keep a certain amount of control until the adult children are able to properly manage the company. This can be accomplished by structuring the payments over a period of years and transferring only a certain number of shares per payment, per quarter or upon the meeting of certain milestones.
Alternatively, transferring the entire number of shares would be like a real estate transaction. Once completed, all the shares of the family business would belong to the recipient adult children who would then have full control. A business owner opting for this choice should ensure there are adequate provisions kept in place to secure the sale, including officers and directors’ insurance, and to secure their repayment in the event part of the purchase price is paid over time.
Financing
Depending on the valuation of the company, the sales price and their creditworthiness, the recipient adult children will need to consider financing options. The options are essentially seller-financed or third-party financed.
Seller-financed is exactly as it sounds. Essentially, the recipient adult children will owe the business owners (sellers) some or all the purchase price and pay it back over time. Note, adequate steps would need to be taken to secure payment under these circumstances. Some of these steps are covered in the section above. Also, any financing should contain a due-on-sale clause. Essentially, in the event that the recipient adult children sell shares to a third-party any amounts that they would owe as part of the sale would be due immediately to the sellers. These types of clauses are common in residential real estate mortgages but should be used in this case as well.
Third-party financing relies on outside institutions or persons to finance the purchase. This may be a commercial business loan from a bank, a loan from a private investor or a blend of the two.
Continued Involvement
In sales of family businesses, often the sellers remain on for a period of time as advisors or even in more formal positions. As this article concerns sales by parents to their adult children, the seller-parents would likely remain available anyway regardless of a formal agreement. Nonetheless, sellers would still need to decide how long to remain involved and in what capacities. Further, this involvement can and should be paid above and beyond the purchase price but may simply be included in the purchase price, nonetheless.
Officers’ Insurance
The recipient adult children should also be required to buy and maintain life and disability insurance naming the sellers as beneficiaries in the event that the adult children pass or suffer some debilitating injury or illness that would materially affect their ability to run the family business. The insurance should be sufficient to pay off whatever debt they may owe the sellers after the transaction closes. This consideration applies mostly in cases of seller-financing. In the event of third-party financing, this option may not be necessary.
Closing Remarks
As with so many things in life, passing a family business on to adult children has many more considerations than may at first be apparent. Business owners nearing retirement and wishing to pass their legacy onto their adult children should consult with counsel to determine the best manner in which to structure such a generational transfer.
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This article is provided for informational purposes only and is not intended as legal advice. For further inquiry, please feel free to contact me at the email or telephone listed below.
