Planning for family, employee succession

Although succession planning involves many decisions and alternatives, there is one outcome that is always an either/or option: Ownership of the practice will pass either to a family member or to an outsider.

Although succession planning involves many decisions and alternatives, there is one outcome that is always an either/or option: Ownership of the practice will pass either to a family member or to an outsider.

Let’s discuss both possibilities, and begin by noting that any business succession plan — whether involving family members or employees — should begin with an independent appraisal of the business, with all the required and necessary documentation to support its value.

In a family succession plan, everyone involved should first define what they mean by “family.” For example, how far down the generational ladder does the planner want to spread ownership, and what would happen if the older generation outlives the younger?

What about married children? I have encountered this comment: “I want to leave the business to my son, but I don’t want it to be part of his divorce settlement.”

Then there is the matter of children from a first marriage and those from a second marriage, and other complexities of modern married life.

For all these reasons, determining which family members get voting power or management authority is a key issue.

Take the case of a dad who is a 100% owner of an S corporation.

He has a wife and two adult children and wants to plan for succession. One child is involved with the business; the other isn’t involved and not interested.

Because Dad also wanted to leave something to Mom, he devised a plan involving voting and non-voting stock in the S corporation. He will give or leave the voting stock to the child involved in the business and give or leave non-voting stock to the other child and Mom.

The plan seems sound, as S distributions are made proportionately by stock ownership. But Dad has forgotten that the child with the voting stock could vote himself a salary bonus and eliminate any possible distribution to the other sibling and Mom.

Plan defeated.

In a perfect world, financial advisers would start succession planning at the time the business is formed. This would allow the owner to gift a greater portion of the business when its value is at its lowest point.

In our imperfect world, however, most owners usually gift away a portion of the business after its value has risen beyond the north side of Mars, making gift taxes and transfer taxes a prime, if not determinative, issue.

Making a gift of a valuable business also makes selling more difficult, as basis in the business is typically low and the selling or transfer price is high. This causes problems because huge capital gains are created.

In family successions, transfer taxes are always an issue. Many advisers want to take discounts related to the practice’s marketability or control in order to lower the value of the transfer. But this raises issues of how much control the older generation actually transferred and whether the discounts are really available.

In sum, family succession can be accomplished through a gifting program and attempting to use various discounts to hold down the value for capital gains and estate tax purposes, or by gradually selling shares to the next generation. This can provide the older generation with cash flow and minimizes some capital gain taxes.

Basis for the younger generation may be an issue; gifting gives them ownership at the donor’s basis, while purchasing is likely to give them a higher basis.

Non-family succession can also take two major paths. One is outright sale of the business to employees or third parties.

This creates a capital gain transfer tax. Sales of C corporations (non-personal services) enjoy favorable tax benefits on rates and exclusions.

The second path involves leaving the business to current employees.

This usually occurs when an owner wants to reward employees. This can be done through stock bonus programs, incentive stock options, non-qualified stock compensation plans and employee stock ownership plans.

ESOPs are probably the most expensive to implement and maintain but have the greatest advantage to the transferor by offering lower taxes and transfer costs. The others have some upfront costs, but lower annual costs.

Stock incentive or bonus plans with vesting schedules and change of ownership clauses are less expensive, but involve the sharing of management responsibilities. They do, however, involve the lowest amount of taxes on the transfer of ownership and can have current tax deductibility for the current owners.

Art Auerbach, a certified public accountant, is tax director of Goodman & Co. in McLean, Va.

For archived columns, go to investmentnews.com/successionplanning.