By Robert Pagliarini,
Tribune Content Agency
In my financial planning practice, I work with many clients who own closely held, private, companies. As many are nearing their retirement years, a big focus of our work is planning the exit strategy for their family business. While a lot of the discussion is technical (e.g., how to maximize the value, how can we best minimize tax), a good deal of what we discuss, at least initially, is centered on a discussion regarding if they should transfer it to their children and how.
There are numerous questions and issues to consider when thinking about selling or transferring your family business to outsiders or to children. In the interview below, I talk to Todd Angkatavanich, Esq., a partner of the international private client law firm WithersBergman LLP. He is a regional practice group leader of the firm's U.S. Trusts, Estates & Charities group and co-leader of the firm's Family Enterprise Group, which focuses on representing the successful family in business and investing.
Robert Pagliarini: There are a lot of parents who have built successful businesses. They've put in long hours and have sacrificed a great deal. They are now at the point where they want to scale back and retire. Their concern is that they don't know how best to transfer the business to their child or children in such a way as to minimize taxes or disrupt the business. Based on your experience, what are the first things parents should be thinking about?
Todd Angkatavanich: That's a great, and loaded, question!
The best starting point is to start with a "wish list" type of approach to start to frame the discussion: Before getting into the various planning and coordination issues, very broadly start by considering to whom and in what percentages would you like to transfer your interests? Often this is a question that the matriarch or patriarch has considered many times over the course of their children's lifetimes as they have seen them develop and mature (or not). Once the threshold "wish list" question has been answered, then the more complicated issues of 'how to do it' come into play. This stage will typically require a nuanced discussion of the various overlapping issues that need to be harmonized.
Pagliarini: Yes, I've found that it works best when the initial discussion is about what the family ultimately wants. Too often they will jump into wanting to discuss the most tax advantageous transfers or how to structure the financing. I've found it helps to table the "how" and first focus on the "why" and the "what."
In working with several clients -- some who transferred businesses to their children and others who sold to a third party -- I've found clients can quickly be overwhelmed with all the options and decisions they must address. In fact, one phone call stands out.
My client was selling her business -- a business that was in her family for four decades -- to a third party. Although she had children that could take over, she didn't want them to have to run the business. She didn't want them to have the life she had. This was identified early on in the discussion. The "why" for selling was strong and personal.
The deal took many months and it took a lot of work. One afternoon she called me to vent about the buyer and all their due diligence requests. She said she was fed up with them and was going to stop the sale. We find that seller's remorse is common. But I knew what inspired her to consider selling in the first place. I asked her if she wanted her kids to have to sacrifice like she did to run the company. A few moments of silence and then, "I get it." A few weeks later the deal closed and she has never looked back since. The why is what allowed her to think long-term and move the deal forward.
Once they've had the "why" discussion, what questions then should the family be asking if the owner wants to leave the company to his/her child or children?
Angkatavanich: It is important to understand that there is no absolute "right" or "wrong" answer as to the vehicle that should be used and often the business transfer and succession plan is a very bespoke thing. There are however different legal, tax and cash-flow pitfalls that must be carefully navigated regardless of what structure is decided upon; failure to properly navigate these issues can result in unexpected and potentially negative tax and non-tax implications.
Pagliarini: What are some of the vehicles parents of a closely held business might consider when selling or transferring their business to children?
Angkatavanich: Different vehicles are typically considered in order to effectuate the transfer of interests in a family business in a tax efficient manner. These often include Grantor Retained Annuity Trusts (GRATs), sales to grantor trusts, partnerships or limited liability companies, preferred "freeze" partnerships, private annuities and Self-Cancelling Installment Notes (SCINs). Each of these techniques have relative pros and cons and relative risk and reward profiles.
For example, sometimes a particular plan may involve a combination of techniques depending upon the client and appetite for complexity, risk and uncertainty. Regardless of the vehicle or vehicles used to structure the transfer, it is critical that the formalities of a particular transaction be respected after the transaction is closed to give it the best chance of being respected for gift and estate tax purposes.
Making sure that the right structure for the family is selected and is realistic requires consideration of issues that will broadly fall into different themes that should be considered together: legal, tax (both estate/gift and income tax), cash flow needs, control/management and family dynamics/expectations.
Pagliarini: Likewise, what are a few initial questions parents should consider before they sell or transfer a business to their children?
Angkatavanich: Some initial questions that should be considered ideally with the family advisors are:
How much of the business do I want to transfer now? Do I transfer it to or for all of my children, or just some (for instance, only the ones working in the family business)? If not all children are to receive a share, are the non-participating children somehow "made whole" with some other gifts or arrangements? Or does the matriarch/patriarch intend to transfer the business only to those who have put "sweat equity" into the business? This basic architecture can vary dramatically depending upon the intention of the parents - there is no inherent "right" or "wrong" answer and it is very much a personal decision.
If the parent wants to benefit all children but not all are involved in the business, should some distinction between voting and non-voting shares be considered, or some different classes of shares? What are the legal and tax pitfalls to consider?
Should I transfer by shares "outright" to my children or should I create a trust for their benefit? What is the more efficient and effective trusts structure to create? How will a trust be taxed to my children, and is it possible to create trusts to preserve and protect family assets for many generations beyond my children's lives?
Are my children ready to get involved in management? If not, how do I get them introduced to the concept? Can I remain involved in the business and to what extent can I continue to have influence or control?
How can I structure the gift to my children to be most efficient from a tax and protection standpoint?
What are the tax and legal risks and relative pros and cons of different types of structures?
Once the transfer is "closed" am I done? What kind on ongoing requirements/attention is required to make sure the transaction is effective?
How do I determine the value of the target shares? How are they treated for tax purposes? How does this value work with my gift tax exemption? Are valuation discounts or premium applicable in determining the fair market value of the particular interest?
Additionally, it is important to look ahead to make sure that the remaining interests that the parent has continued to own (for instance a percentage interest in the business) is properly coordinated in the event of the parent's subsequent passing while still owning those interests (perhaps by way of a buy-sell agreement) and that a proper funding mechanism is in place and current.
As you can see Robert, the decision to pass the family business to the next generation family members, while a major decision, is just the beginning of the exercise but from that point the real fun begins.
If you have a family business that you want to transfer to your kids, there are many questions and issues to be considered. The takeaway is to not jump too quickly into the "how" -- the highly technical tax, legal, or financial issues -- but first, focus on your "why." It is often the "why" that will then shape mechanics of the exit strategy for the family business and lead to a better outcome for you and your children.
Robert Pagliarini is a CBS MoneyWatch columnist and the author of "The Other 8 Hours: Maximize Your Free Time to Create New Wealth & Purpose" and the national best-seller "The Six Day Financial Makeover." Visit www.other8hours.com.
This was printed in the September 6, 2015 - September 19, 2015 edition.