Avoid the Five Mistakes that Keep Most Businesses from Getting to the Next Generation
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In my work with business owners, I often find that they are unaware of some of the legal, tax, and family pitfalls surrounding planning for the orderly succession of a family business.
In this article, I will point out some of the mistakes to avoid and the issues you should be thinking about if you ever plan to pass your business to your family or to a partner. The potential mistakes can cost you and your beneficiaries a bundle.
Will Creditors and Predators Get Your Business Before You Ever Have a Chance to Transfer it to Your Family?Business owners often ignore the potential of lawsuits and creditors to take them for everything they are worth. The fact is there are over 100 million lawsuits each year, and if you make over $50,000, you have a one-in-four chance of being sued. There are thousands of law firms that make their money by taking these cases on contingency, knowing that if you have deep pockets, you will probably just settle. Many owners we talk to think that by having a corporate entity and having insurance they are protected--this is not the case! Insurance has some serious limitations, and a corporate entity will not protect what is inside it and may not even protect your assets outside it!
Proper asset protection planning involves segregating your safe and risky assets, stripping assets out of your risky enterprises, and controlling rather than owning your assets whenever possible. You cannot prevent lawsuits, but you can become an unattractive target.
Will You Transfer Your Business Intact, BUT Lose Your Family in the Process?You may have made all the financial preparations necessary to pass your business to your family, but have you done the proper planning to make sure your family stays intact? The three main mistakes I see here are failure to determine and train future leadership, giving your spouse the business instead of cash, and failure to equalize your estate.
- Failure to determine and train future leadership. If you have more than one family member in the business, this is a biggie. They might very well have different ideas about who is going to succeed you, and letting them sort it out after you are gone is a potential disaster. Training them to take the lead is also important. Ask yourself the following two questions: 1) How long will it take your successor to learn the business, and 2) What would happen to the business today if you were gone, and they had to take over? If you don't like the answers, you better do some planning.
- Giving your spouse the business instead of cash. Most people plan to leave everything to a surviving spouse. If he/she is not involved in the business, what would they rather have, the business or cash? If you give them the business, who's in charge, who do the employees report to, who makes decisions? A properly structured buy/sell agreement can allow the children to buy out the surviving spouse, giving the children the business and the spouse cash.
- Failure to equalize the estate. Do you have children who work in the business and children who don't? If so, be very careful about what you leave to whom. Many times, business owners just leave everything equally to children. This can cause a phenomenon known as host/parasite, where the host is the child running the business, and the parasite is the child getting the same payment for none of the work. This is another recipe for disaster and family litigation.
Will the IRS Inherit Your Business?
Contrary to popular belief, the estate tax is still alive and well. It is also due in cash within nine months of your death. If your business and non-business assets are worth more than $1 million, you may have an estate tax problem.
There are two main ways to deal with this: Give your assets away before you die and have a pool of money outside your estate to pay the tax.
- Give your assets away. If you have family members in the business, you can start giving them ownership today. Many owners bristle at this because they don't want to give up control. A solution might be to split up the company into voting and non-voting shares and to give your family non-voting shares only. In this way, you get the business out of your name and into theirs, but you don't give up an ounce of control.
- Have a pool of money outside of your estate. Why should the money be outside your estate? Because anything inside your estate will also be subject to tax, so the money you put aside to pay the tax will also be taxed. The best tool to do this is usually life insurance, and if you are going to use life insurance to pay the IRS, why not let them pick up half the tab? How does it work? You can buy the life insurance in your retirement plan with pretax dollars; in effect, the IRS is picking up 40-50% of the cost. Be careful; if you own the insurance, it will be taxable in your estate.
Do You Want To Be in Business with Your Partner's Spouse?Usually when we ask this question, the answer is no, but if one partner dies, this is exactly what would happen. A properly structured buy/sell agreement will take care of this. What is a buy/sell agreement? It is essentially an agreement between two or more partners that if one partner were to die, the remaining partner(s) or the company would buy the deceased partner's shares from his/her family. It is imperative to have an accurate valuation to assure that a partner's family will get fair value for their share.
Without a buy/sell agreement, if one partner were to die, his/her spouse would inherit his/her part of the business and half the profits. This could be a disaster.
How do you structure the agreement? Generally, there are two main ways: Have the company buy back the shares or have the remaining partner(s) buy back the shares. In most cases, it is wiser to have the partner(s) buy back the shares because the surviving partner(s) would get a step up in basis on the value of the deceased partner's shares. The potential capital gains tax savings down the road could be huge.
When It's Time to Retire and Walk Away, Will You Have any Money?You spend years plowing all of your profits back into the business, and now it's time to retire. Where will the money come from?
Traditional retirement plans allow you to save very little, and the money is taxable when you take it out; this won't help your retirement security much, especially if you have some catching up to do on your savings.
There are retirement plans specially designed for mature business owners that have large contribution limits and offer guaranteed retirement income. Deferred compensation plans have no limit as to contributions and benefits, and can be designed to cover who you want them to cover. Or, if the business has adequate cash flow, your children could buy you out using a Private Annuity, which gives you a guaranteed income for life and gives them the business.
In your planning process don't forget to focus on your retirement security needs.
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