For the transfer of business ownership and control from parent to child to be deemed successful, a myriad of issues must be considered. Below are a few variables to consider.
Treating Children Equally vs. Fairly
Parents want to treat all of their children fairly. Planning an equal distribution of the family business to all children regardless of their contribution to it is rarely fair. Perhaps one or more of the children have invested time and effort in the family business while others have chosen a different path. In such a case, the child who is more active in the company should not be considered responsible for sustaining and growing the company for the benefit of the other children. One solution might be to leave the business entirely to the business-active child and make equitable distributions of the balance of family assets to the inactive children. At the least, if more than one active child remains in the business, only one should be given control over decision making.
When family business owners rely upon the sale value of their stock for retirement and want to transition out of the business, a common technique is to provide cash bonuses to family members involved in the business. These bonuses are performance-based company payouts awarded with the intent that they be used to purchase stock from the owner. In this strategy, however, the greatest benefactor is the IRS, which takes approximately 50 percent of the bonus money paid out. Often, a more efficient way to transfer stock via company payouts is to discount the value of the stock (based on lack of marketability or majority control) and make up the difference with deferred compensation paid directly to the seller. While taxed at ordinary income rates, deferred compensation is at least tax-deductible to the company when paid.
Some owners who are not reliant on sale of stock for financial well-being decide to gift the stock to their children to transfer ownership, but this method has problems as well. Currently, the IRS allows annual gifts of $14,000 per donee without incurring any gift tax ($28,000 between both spouses), so this technique will often take an impractically long time to transfer the necessary percentage of the business.
Additional complications arise if the shareholder’s death occurs before a significant percentage of ownership has been transferred. It is common for the business to represent a significant percentage of the parent’s net worth, and estate taxes at the death of a shareholder can require tax payment of 40 percent of the estate’s value, after exclusions. In some cases, this will force liquidation in order to pay the bill.
While Washington seems to have settled on an exclusion amount of $5.34 million per spouse, don’t expect this to be their final word on the matter. Considering our unprecedented federal budget deficit and search for potential revenue, this tax source is likely to come up for review. Other techniques exist where parents can gift ownership of the company to a trust at a discounted value and still retain complete voting control, all while removing future appreciation from estate tax inclusion. The point is be mindful of your silent partner, the IRS. You want to minimize their take in your chosen exit strategy.
In order to begin planning a transition, you will need to establish a “defensible” figure of your company’s worth, as required by the IRS. It is important to understand the difference between enterprise value, the maximum market value of the company and discounted value, a lower valuation taking into account lack of marketability or majority control. When selling to a family member with limited capital resources or gifting ability, discounted value can make the difference between success and failure.
Key Employee Incentive and Retention
Key employee retention is important in a family business in which successors are dependent upon continued talent. Employees realize that they are unlikely to share in ownership, so how can important employees participate in the equity they feel they are largely responsible for building? The answer may be in the form of “synthetic” stock. Phantom stock and stock appreciation rights can go a long way toward motivating and retaining talent. With phantom stock, employees receive compensation based on stock value as if they were stock owners, but they do not come into possession of stock. Stock appreciation rights are similar, awarding financial compensation to employees based not on the final value of the stock but rather on the stock’s appreciation. Deferred compensation plans can be designed to incentivize performance. Once the employee achieves financial benchmarks, these plans “self-fund” the benefits paid.
The beauty of most incentive and retention plans is that they do not fall under the scrutiny of the IRS or ERISA. They are considered “non-qualified” benefit plans. This means you can offer them on a selective basis to those employees who have shown the greatest impact to your bottom line. Don’t make the mistake, however, of distributing annual awards outright. Some, or all, of the earned award needs to be deferred in order to achieve retention attributes.
The Backup Plan
For any adverse circumstance that might come into play, have a backup plan. If the business-active parent dies before the transfer to children can be completed, for instance, a buy-sell agreement, which dictates the terms of stock transition or bequest at death, can entitle the active child to assume control. When properly funded, it can also provide the active child the necessary cash to buy stock from the parent’s estate or from non-active siblings.
If the active child becomes disillusioned with the idea of taking control of the company, hiring a temporary CEO from outside the family can buy the owner time to decide what to do. In these and other situations, sale to key employees or a third party may be the best option.