Reconciling management and financial objectives in family business succession and estate planning.

Holland, Phyllis G. ; Holland, Michael L.

COMPONENTS OF A SUCCESSFUL TRANSITION

A successful transition involves transfer of managerial control of the business as well as ownership from one generation to the next. Both transfers may not be to the same individual or individuals. The presence of several parties with different, perhaps conflicting objectives complicates the transfer. Frequently, the owner (especially if he or she is the founder) resists initiating the transition process or, having initiated it, sabotages it. (Landsberg, 1988). A critical need is to reduce the difficulty that the owner has in "letting go". A considerable body of wisdom exists concerning how this might be accomplished and this work generally points to a transition time of shared, mentored, or delegated managerial control (Handler and Kram, 1988). The continued participation of the founder in the business reduces anxiety levels of other family members (Rosenblatt, et al, 1985) and provides opportunity for sharing the founder or owner's technical knowledge and contacts.

The financial and property aspects of the transition are labeled "estate planning". The tax burden on the estate is an important consideration on the financial side, but of more immediate concern is the need for withdrawing members of the family business and their spouses to have an adequate stream of income for the remainder of their lives. Also, financial provision must be made for nonmanagerial family members who may have contributed little to the business but are nevertheless heirs of the founder-owner.

A successful transition is one which meets the financial and emotional needs of the family as well as the needs of the business. Family financial needs are for a stream of income for the withdrawing family members and spouses and minimization of tax burdens on the transfer of the business and on the estate. Family emotional needs are for continuing challenges and self-esteem for the founder and anxiety reduction for dependents. Dependents may be alarmed at the prospect of the loss of the expertise and judgement of the founder. The business needs are met if an orderly transition occurs which includes transfer of decision-making power and core business expertise. In addition, the business also requires a contingency plan for an unexpected transition. These needs are shown in Exhibit 1.

FAMILY TRANSFERS

There are several ways to transfer a family business from the older generation to the younger generation, but the federal income taxation impact as well as the transfer tax (both gift and estate) varies among the possible choices. Those with lower tax consequences may not meet other needs of the parties to the transaction. A review of the tax impact on transfers and the steps of various alternatives follow.

EXHIBIT 1

Objectives for Transition Planning

Family Financial Needs
Stream of income for founder and spouse
Minimal tax burden on estate

Family Emotional Needs
Continuing challenges and self-esteem for founder
Anxiety reduction for managers and dependents

Business Requirements
Orderly transition from founder to next CEO
Contingency plan for unexpected transition

The current transfer tax essentially combines gifts and bequests over the lifetime and death of the donor. A graduated or progressive tax applies to the cumulative transfer. The only possibility for tax savings on major transfers is to make them early before the assets appreciate in value since the tax is levied on fair market value (FMV) at transfer date. This issue would be of major concern in a growing and appreciating business. The first marginal transfer tax rate is 18% and applies to the first taxable gifts or transfer above $10,000. The highest marginal rate is 55% and applies to transfers above $3 million. There is also a 5% surtax on transfers above $10 million but not in excess of $21,040,000. In addition, there is a unified transfer tax credit of $192,800 which will allow $600,000 of wealth to be transferred tax free. There is a limited annual gift exclusion of $10,000 per gift recipient or $20,000 per gift recipient if given by husband and wife. This is of little consequence in transferring anything other than extremely small businesses, and even then the gifts would have to begin early. Also gifts in contemplation of death and transfers for less than adequate consideration are pulled into the estate at death and taxed at fair market value at date of death. Essentially, the transfer tax is so high that proper planning is mandatory.

Since divestiture before death is advisable for estate tax purposes and generally can't be done with gifts during life, some other transfer must be arranged. The possibilities are listed in Exhibit 2.

EXHIBIT 2

1) Redemption: A redemption allows the incorporated business to buy back the stock from the older generation. This generally would require the redeemed shareholders to sign a noninvolvement agreement covering a 10 year period. The IRS considers noninvolvement to preclude any association with the business other than as a debtor. A qualifying redemption would allow any gain on the sale of the stock to the corporation to be capital gain. This requires sufficient liquid assets in the corporation, some cash flow if an installment, the younger generation in possession of some stock at the time of the redemption, and a willingness by the older generation to pay income tax on the gain on the stock redemption.

2) Bootstrap: A bootstrap acquisition is a variation on the redemption discussed above. Here corporate debt is used to fund the redemption and then the corporation pays off the debt over time. In this redemption also, the redeeming shareholder of a closely held corporation must sign an agreement with the IRS agreeing to have no contact with the corporation other than as a debtor for ten years.

3) Sale: This is an outright sale of the stock to the younger generation. If the younger generation doesn't have any cash, an installment note could be used. One possibility here with an installment sale is for the lender to forgive $10,000 of principle and interest each year. The lender, however, would still have to claim the interest income.

4) Buy-Sell Contingency: The buy-sell contingency is a written agreement between the senior generation and the younger generation which specifies a price (or a formula for determining price) to be paid by the younger generation to the senior generation. A life insurance policy is taken out to fund the buy-out. The life insurance proceeds are tax-exempt and the amount of the insurance establishes the amount included in the estate even if by the time the agreement might be triggered, it does not represent FVM of the business. The original agreement must have been reasonable in amount at the time it was made.

5) Recapitalization (Type E Reorganization): This is an exchange with the corporation by the senior owners of their common stock for preferred stock. This would leave the younger generation holding the common stock which would have all the future growth potential but relatively little current value. Under this arrangement, it would be possible for the senior generation to gift any remaining common stock held with less transfer tax consequences or to make it cheaper for the younger generation to buy the common stock. The senior generation would collect the preferred dividends and keep future growth in the value of the business out of the estate. Note however, in order to create value in the preferred stock, the stock must receive substantial dividends creating a cash drain on the business. The preferred stock could either be voting or non-voting depending on the needs of the senior generation.

6) A Failed Redemption: If the older generation does not sign the nonparticipation agreement, he or she will be potentially subject to slightly higher tax liability but can stay involved in the business (Internal Revenue Code Sections 302(b)3, 453, 368(a)(1)(E), 302).

ASSESSING THE TRADE OFFS

Exhibit 3 shows the ability of each of these alternatives to meet selected family and business objectives for transition. Obviously, no one technique satisfies all the objectives. Several variables are hypothesized to affect the trade-offs. They represent a planning horizon for the transition, number of family dependents, business financial structure, marginal tax rate of founder, size of estate, and psychological readiness to plan. For estate tax purposes, the earlier the transfer the better because the transfer of the growth is to the next generation. However, the owners must be ready and willing to plan. For business purposes, the continued association of the owner with the business is important, but the continued association makes some of the planning possibilities less attractive. The planning process will be more effective if all three types of objectives (family, estate, and business) are considered together rather than separately.

REFERENCES

Churchill, N.C. & K.J. Hatten (1987). Non-market-based transfers of wealth and power: A research framework for family business. American Journal of Small Business, 11(3), 52.

Handler, W.C. and K.C. Kram (1988). Succession in family firms: The problem of resistance. Family Business Review. 1(4), 375

Internal Revenue Code, 1986.

Landsberg, I. (1988). The succession conspiracy. Family Business Review, 1(2), 124.

Riordan, D.A. & M.P. Riordan (1993). Field theory: An alternative to systems theory in understanding the small family business. Journal of Small Business Management, April, 66-78.

Rosenblatt, P.C., L. deMik, R.M. Anderson and P.A. Johnson (1985). The Family In Business.

San Francisco (Jossey-Bass), 179.

Ward, J.L. (1988). The special role of strategic planning for family businesses. Family Business Review, 1(2), 10.

Phyllis G. Holland and Michael L. Holland

Valdosta State University

EXHIBIT 3
TRADE-OFF ASSESSMENT BETWEEN MANAGERIAL OBJECTIVES AND TAX REALITIES

 Family Financial Needs Family Emotional Needs

Tax Realities Stream of Minimize Continuing Reduce
 income for tax burden challenges anxiety for
 founder and on estate and self- managers
 spouse esteem for and
 founder dependents

Redemption yes yes no no
 (IRC 302(b)3)
Boot-strap yes yes no no
 (IRC 302(b)3)
Sale yes yes yes yes
Reorganization yes yes yes yes
Gift no no yes yes
Redemption yes yes yes yes
 (not under
 IRC)
Buy-sell no maybe no no
 contingency

 Business Needs

Tax Realities Orderly Contingency
 transition plan for
 from unexpected
 founder to transition
 CEO

Redemption no no
 (IRC 302(b)3)
Boot-strap no no
 (IRC 302(b)3)
Sale yes yes
Reorganization yes no
Gift yes no
Redemption yes no
 (not under
 IRC)
Buy-sell yes yes
 contingency