It’s time to discuss family succession. In Part One of this series we looked at exit strategies that aren’t really available to small businesses, and in Part Two we discussed selling to a third party. Now let’s talk about the issues when transferring to a family member or members.
Which Kids?
When passing the business to family, often the primary issue is inheritance. Small business owners frequently have 50%, 60% or as much as 80% of their personal net worth in their company. There is a temptation to treat the business like any other personal asset, and divide it among all the children.
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“After all,” (the logic goes,) “We built this for our family’s security. It isn’t fair that only the kids who work in the business should benefit.”Sometimes the non-active children have succeeded in lucrative careers, like medicine or law. That may make an asymmetrical legacy easier.
Other times the children outside the business have not been successful at all. They are the ones who most need support, and in fact may be on the payroll already (although not “active” in any meaningful sense.) Parents’ expect the same unconditional love they have for them from their siblings, but it just doesn’t work that way.
Splitting it “Fairly”
When the company is too valuable an asset to balance inheritance with other assets, we recommend passing some to the active children before your death. That can be via sale, bonus or gifting, but it recognizes the active children’s contribution to the business.
Upon death, you can divide the balance of the equity evenly, but with a contract that says the non-active children must immediately sell their shares to the active ones at Fair Market Value. This accomplishes several things:
- The value of the business at the parents’ death is divided “evenly.”
- The non-active kids get the step-up in basis, and should have no tax on the sale.
- The active kids retain 100% of the benefits from their efforts going forward.
Its especially important to get spouse signatures on these agreements. Valuations and agreements between family are fine, but an outsider (especially an ex-spouse) may not be as amenable.
I have a comment that I use with parents who are deciding how to divide ownership among children. “In the long run, you want everyone to still have a nice Thanksgiving together.”
Securing Family Succession
This is the other big issue. The parent wants family ownership to be their legacy, but their child or children aren’t qualified to run it. There is capable management, but none of them have the same last name.
Remember, we are talking about small business in this series. Families named Cargill, Ford or Walton need not be too concerned about non-family management.
But for a small company, you can’t put children in a position where the resignation of a key employee could sink the whole enterprise. That makes the children subject to blackmail. Key operating skills have to be retained with incentives.
You don’t need to make key employees into partners, but they should have a vested interest in growth and profitability. This can be as simple as bonuses for company performance, but long-term retention usually requires non-qualifed deferred compensation (NQDC) plans.
These are tied to the long-term growth and profitability of the business. “Non-qualified” simply means it isn’t an ERISA-qualified benefit (like an IRA or 401K) because it is discriminatory in nature.
There are a number of forms for NQDC, mostly involving virtual equity. Phantom stock, stiock options, stock appreciation rights and warrants are all avenues for such compensation. They allow an employee to amass an increasing nest egg over time, based on tenure and appreciation in the value of the business.
Da Plan! Da Plan!
Whether you are deciding how to apportion the business for your estate, securing continuation of a management team, or just minimizing taxes on the transfer, planning is the key. Determining your goals for family succession and working through your options well in advance (5 years or more before your planned retirement,) is the secret for the successful transfer of a family business.
Without planning, you are putting Thanksgiving at risk.