Intelligent Insights
Diligent Legal Advocacy

Succession Planning for Family Enterprises and Closely Held Businesses

by | Mar 22, 2024 | Estate Planning

Owners of family enterprises or closely held businesses are tasked with making critical decisions that will shape the destiny of their company. These decisions are pivotal because they involve determining what will happen to the business in the long term, beyond the current ownership. Unlike publicly traded corporations, where ownership is dispersed among numerous shareholders, family enterprises and closely held businesses typically have a smaller, more closely connected ownership structure. There are three options they typically consider:

  1. Die While Running the Business:
    • Often leads to the business being disposed of at an estate sale value (discounted).
    • Successors may include family members, key employees, or an ESOP (employee stock ownership plan).
  2. Passing the Business to Successors:
    • Planning should start early to ensure a smooth transition.
    • Successors may be family members, key employees, or a combination.
    • Planning often involves a sale and gift strategy to financially benefit senior owners and successors.
    • Critical to select successors capable of effectively running the business.
  3. Selling the Business:
    • Optimal for owners seeking maximum economic return on their life’s work.
    • Consideration is given to not dying while running the business and uncertainty about successors’ ability to manage effectively.

At the heart of every successful succession plan lies a meticulous examination of three fundamental aspects and a pragmatic evaluation of the enterprise’s future prospects. These ‘nuts and bolts’ are the essential components that ensure a smooth transition and the continued prosperity of the business.

  1. Financial Needs of the Senior Generation: How does the senior generation wish to live in retirement? Perhaps they were savers, made significant pension contributions, or they own the real estate where the business is maintained and will continue to receive rent or a combination of these benefits, which means their retirement does not have to create a cash flow strain on the business. My experience is that the senior generation does not intend to take a pay cut or reduce their lifestyle. This usually translates into some form of continued cash flow requirement from the enterprise.
    • Assess what the senior generation requires for retirement.
    • Continued cash flow from the enterprise may be necessary to maintain their lifestyle.
  2. Business’s Financial Capacity: What can the business afford? The business needs to maintain its resiliency, address its necessary capital improvements, its operating cash flow needs, and reward the successors for their hard work. Ultimately, if the company does not prosper after pulling the trigger, the plan will not work.
    • Determine what the business can afford while maintaining resilience and addressing operational needs.
    • Successors should be rewarded for their contributions.
  3. Fairness to Family Members: What is the business worth? What is fair to members of the family employed in the business, and what is fair to members of the family who are not employed by the enterprise? In numbers 1-2 above, the result is that there is a very low threshold of support that needs to be provided by the family business to the senior generation. Is that fair? For example, if the valuation by a competent appraiser is instructed to determine the fair market value of the business, and it is determined to be $6,000,000. Is the senior generation happy with $3,000.000 paid over ten years at $300,000 annually? Is that fair to the members not employed in the business as they, on paper, at least, miss out on $3,000,000 of inheritance? The corollary also needs to be addressed; the family member running the business and responsible for assuring the $300,000 annually may be in their fifties and started in the family enterprise when they were 25. They claim the business was worth $2,000,000 when they joined, and the sweat equity they have contributed in the past 25 years means they should get a discounted buyout price.
    • Evaluate the business’s worth and impact on family members employed and not employed in the enterprise.
    • Balancing fairness may involve providing alternative assets to non-active family members.

Balancing the fairness quotient is often addressed by providing alternative assets to family members who are not active in the enterprise. The most common solution is an irrevocable life insurance trust, which might insure the parents by one policy known as a “second to die” policy, paying the family members not active in the business with income tax and estate tax-free death benefits instead of a piece of the business. The second to die aspect mirrors the inheritance to be received eventually. The inactive family members would not receive their inheritance until both parents passed. The family member running the business is not a beneficiary of the insurance trust and is at risk because the business could fail.

Parents often feel that each family member should be treated equally/identically. This may be effective estate planning but could be better business succession planning. Family members who don’t work in the business should not own any portion of the enterprise. Suppose they do own a piece of the business. In that case, I suggest to the clients that by giving them a piece of the business or allowing them to inherit ownership, the client has succeeded in only lighting a fuse that will eventually blow up in the survivor’s face. The child working full time for 25 years in the business will not be motivated to grow the business if it only increases their inevitable buyout of their siblings. This is counter-intuitive to the successful operation of a business.

Contact Jim Aussem at 216-621-7860 to guide you through the complexities of succession planning for your family enterprise or closely held business, ensuring a smooth transition and preserving your legacy.

Practice Areas