Family Business Succession Planning

In 2016, a Family Business Survey by the National Bureau of Economic Research Family Business Alliance found that 43% of family-owned businesses don’t have a succession plan in place! When we consider the amount of planning, time, effort, risks and sacrifices it takes to develop a successful business, it goes without saying that it is mutually beneficial to all owners’ that there is a succession plan in place. This is even more important when considering family business succession planning. For many, family businesses are more than tools for wealth generation, they are a legacy to be  passed on. Unlike the mortal humans that come together to form family businesses, the business entity itself has the potential to be immortal, passing on the symbol of hard work and wealth from generation to generation.

The mortality of a family owned business depends on a successful succession plan. Family members who establish and operate their business, spend many hours ensuring that things operate according to plan – allocating additional time and resources to planning for triggering events such as another family member owner becoming disabled or passing, seems to be something that can be put on the back-burner. I mean the other controlling partners or co-owners are most likely brothers, sisters, parents or uncles right? So why should they concern themselves with what happens if one of them passes or becomes disabled? This thought process is understandable and is precisely why half of family-owned businesses do not have a succession plan in place; But when you delve into things a little deeper, you realize that it comes down to the fact that no one is truly educating the family businesses on the importance of succession planning and what’s truly at stake!

The truth is, there are many variables a family business needs to consider when it comes to succession planning. For instance, one may assume that if your brother who owns a controlling part of the business passes, everyone in the family business will come together and figure things out… but most of the time it is not that simple! For example, one of the family owners may get along just fine with a co-owner’s spouse, which may very well be an in-law, but would this owner be OK with becoming business partners with the spouse? Without a succession plan in place, if one of the co-owners passes then his/her business ownership will be passed to the deceased co-owner’s estate. This means that the new partner will be the beneficiaries of the estate, which most likely will include the spouse and possibly the children or step-children of the deceased owner. If the deceased owner did not leave many assets or life insurance proceeds for the family, then the spouse and other inheritors of the estate may rely on the business income and feel obligated to jump right in.

Even if the beneficiaries of the deceased owner’s estate decided on selling the business ownership back to the other co-owners, there may be issues when valuing it: Issues that can lead to expensive legal proceedings. Furthermore, when considering the possibility that relationships may not be as tight with the spouse or other beneficiaries and the co-owners that remain, matters are only further complicated. It is much better to have business values and plans set up before an event like this occurs. Buy/Sell agreements with life insurance funded with life insurance can solve these issues and create a ready market for the business or business owners to buy the deceased owner’s business interest from the estate at a value that is determined before a triggering event such as death of an owner occurs. This is in the best interest of all owner’s and owner family members involved!

This is where we at East Coast Financial can help! We hope that the business owners who are lacking in the succession planning department find success through our communications and eventually through working with us! In a 2019 Forbes article, it is stated by David Neubert, managing director of SunTrust Business Transition Advisory Group, “Generally, most family business owners find themselves so involved in the day-to-day operations, they’re not thinking of what’s next for them personally or for their family and how that intersects with the business.”

Assume we have Joe who is age 60 and owns an S Corp valued at $3 million per a third-party valuation that was recently completed. This business is part of Joe’s gross estate of $5 million. Joe is married to Mary age 57, who relies on the income from this business to continue their (and in turn her) accustomed lifestyle. Mary and Joe have two adult children Michael 34 and David 32, who have worked for the family business for many years.

Joe executes a unilateral buy-sell agreement with Michael and David, in which both Michael and David agree to buy their father’s S Corp ownership shares for $3 million from his estate at death. Michael and David are listed as equal beneficiaries of a $3 million life insurance policy on Joe’s life from a competitive carrier, such as Lincoln Life or Ameritas. The S Corp advances tax-deductible Section 162 bonuses to Michael and David in order to pay for the premiums. It is important to note that Michael and David must report the bonuses as taxable earned income, which is also subject to FICA taxes. Michael and David’s father, Joe, also executes the usual pour-over will and revocable trust for the surviving spouse and family to provide portfolio asset management after Joe’s death.

At Joe’s death, Michael and David receive $3 million of income-tax-free proceeds, which they use to buy equal shares of the S. Corp from Joe’s state. Joe’s estate now has $3 million in cash to distribute to the revocable trust via Joe’s pour-over will. This trust automatically becomes irrevocable at Joe’s death. The surviving spouse has unlimited access to the income and principal of the trust for life to satisfy lifestyle needs. In this example, ownership was passed to the adult children, Michael and David and the spouse who never worked in the business can continue their lifestyle, so everyone is taken care of.