Sophisticated Estate Planning with a Personal touch in Pasadena, California

How do you plan for the ultimate disposition of your business, including ownership and control, after you have passed away? Will it be run by your children, your spouse, valued employees? Will the business be sold to family or to outsiders? Will it fail because you are the glue that holds it together? Will your affairs be tied up in probate court indefinitely, leaving the business poorly supervised and in danger of failing?

The issues of planning the succession of ownership and/or management of your business are complex, and will present a continuing challenge for many years to come. You may feel overwhelmed by the choices you have to make, and because the business planning process is ongoing, your may have to revisit your choices as your life unfolds. Business succession planning is not a one-shot event, but requires your commitment to review and revise. Unless you develop and implement a plan, the law and taxes will act on your behalf, usually to the detriment of your heirs.

Recent statistics show that only three in ten businesses survive to the second generation, and only one in ten survives to the third generation. Don't you want your business to be the exception to these discouraging statistics? Where should you begin the process of assuring your legacy is secure?

In virtually every case, the first step in successful planning is to execute a revocable living trust, health care directives, appropriate powers of attorney, and a will (to name guardians of minor children). A business succession plan is the next step.

When you are ready to think about business succession planning, here are some simple questions that should get your mental wheels turning:
• What is my business worth?
• Is there value in good will or contacts that I have made, which might not be there for my successor?
• If my business consists of appreciating assets, when is the last time these were appraised?
• Is the "worth" of my business significantly dependent upon the presence or efforts of one or more "key" employees?
• Do I want and expect my business to continue after I am gone, or should I consider leaving instructions or preparing my heirs to sell or liquidate the business to their maximum advantage?
• I would like to retire but don’t know what to do with my business. My children can’t run it, or don’t want to, and I need cash from my business to fund my retirement. How can I benefit myself and everyone else?
• I envision my business continuing, but whom do I want to manage or control it after I am gone? Is that person(s) trained and able to do this now, or will my plan include grooming my successor?
• Which family members or friends do I wish to benefit from the ongoing or liquidated value of the business after I am gone?

What is my business worth?

Before you consider the other issues related to succession planning, you need to have a good idea of what your business is worth. Remember that what you'd take for the business and what it’s actually worth may be two different figures. An approximation of the market value of your business will figure prominently in your planning, particularly if you are considering sophisticated techniques, such as grantor trusts, limited partnerships, and buy/sell agreements. Speak with your accountant. If necessary, engage an appraiser.

Do I want and expect my business to continue?

This may be the toughest question to answer. You may "want" your business to continue, but it may be unrealistic for you to "expect" it to.

Some of the factors to take into account are:
• Am I such a great personal asset to the success of this business that its operation would be critically negatively affected by my departure?
• Would my creditors, customers and suppliers deal with others?
• Have I wanted or hoped that family members would participate in the business, but been disappointed by their lack of interest or lack of talent or skill?
• Is this a business that may be overtaken by advances in technology, the rise of mega-corporations, or shifts in the habits and customs of consumers?
• If so, is a timed closure of my business a good move for me?
• Notwithstanding my family dynamics, do I know one or more people (possibly employees) who could continue to effectively run my business and would welcome the opportunity to do so?

Who can manage or control my business?

There are a number of possible answers to this question, and we will explore four of them, assuming you do not envision liquidation of your business. Most of the time the people you want controlling the business are the ones you want to benefit from its value, but don’t get locked into this model if it simply does not work in your situation.

Spouse
In all likelihood, if your spouse is competent and has been involved in the business, you will want your spouse to continue managing the business. However, if your spouse does not have your gift for growing the business, has no interest in it, does not get along with or manage the employees well, the "spouse as successor" idea needs careful evaluation. Even if your spouse has worked side-by-side with you, has he or she filled certain roles or functions exclusively? If your spouse has filled a specialized function, can he or she successfully assume all of the responsibilities necessary to run the business? Is it likely that, after your death, you spouse would become newly interested in the business and willing to become educated and active in new ways? If the answer is definitely yes, then your spouse is a good candidate for succession to management. If the answer is no, you need to look elsewhere.
Often your viewpoint about a spouse’s capabilities or interest in the business may be at odds with the thinking of the spouse. No matter how long we have lived with others, we really can’t read their minds. Before making a definitive declaration about your spouse’s willingness or suitability, engage in a structured and substantive discussion with your spouse about these issues. Involve your lawyer, or even a family counselor, if appropriate.

Children
Are your children or other family members (usually younger members of a successor generation) capable of managing the business? Would you have confidence in them? Are they confident in their own abilities, and have they shown the qualities that you most admire: perhaps such qualities are focus, determination, creativity, community involvement, management talent, vision, people skills and there are so many more. The list depends on what you know to be important to the continuing success of the business.
If you don’t feel comfortable turning over the control of your business to your children today, do you believe they could develop the capacity to become good managers and creative entrepreneurs over the next several years? Can they work together, notwithstanding family interplay? Are there spouses of your children who might present special problems or challenges? Is distance a factor? Would a child be required to abandon a dream, goal or other career in order to participate in the management of your business? How would the child and his/her spouse feel about that?
If you have several children, some of whom would not be good candidates to participate in the business, do you feel a need to equalize the benefit provided by the business to provide for the non-participating children, or will they receive other assets, or is inequality of inheritance okay with you?

Employees
Do you have key employees who could effectively and enthusiastically manage the business? Would they be as loyal to the company without your guidance as they are now, and would they be able to stay around after you’re gone? Would you consider a stock ownership incentive plan, or even an outright structured sale of the business to these employees? Normally, employee involvement in business succession is most effective when younger employees are involved. If this is the direction you may want to move in, consider taking steps now to facilitate the employees’ gradual or structured purchase of your business.

Management by Outsiders
Would it be best to bring in an outsider to run the business? If so, should you bring in the outsider well before you retire, in order to teach her the business? Recognize the risks inherent in bringing in a “management employee” who has no ownership stake in the business, and consider an incentive program. If neither you nor family nor current employees are capable of (or desire to) manage the business, and you decidedly do not want it liquidated or sold, you have little choice but to begin planning for outside management. The key to finding the best management may lie in your creative design of incentive and reward features.

Combination
Because every business is unique, maybe some combination of these solutions would be appropriate. The successful choice of a person or team to manage your business is not only a function of ability or training. It’s also very much about personal dynamics, also called personal style, or management style. There’s no value in putting together a team of perfect people, if the people cannot work well together and with their employees. If you are contemplating a combination of family, employees and outsiders, the sooner you create and empower your team, the better.
Once you are satisfied that your team can, indeed, continue without your day-to-day leadership, you have many options: you can remain in your business for as long as you want, you can retire when you want to, take extended leaves of absence, properly attend to a medical disability, follow your dream to pursue other
interests. All the while, your business will continue profitably and without interruption.

Who should benefit from the value of my business?

Most business owners want their spouse and family to be the principal beneficiaries of the value of a business. In effect, this means that the ownership of the business will pass to them. If you have a spouse, or you have children, and you are sure you do not want the value of your business to pass to them, it is critical that you be aware of steps you can take to structure your estate and business planning with this goal in mind, while at the same time not jeopardizing the legal property rights of your spouse or the legitimate support needs of your children. It goes without saying that you do not want the IRS to be the principal beneficiary of your business, so obviously, some planning is necessary in order to prevent the government from becoming the beneficiary or partner of your family business!

If you wish to leave your business (the value of it, if not the management) to your children, do you want to divide the value equally? It’s not uncommon to find that some children are involved in the business, and others are not. Will you leave them equal shares, or will the active participants get a greater proportion? Will you consider individual needs and circumstances in reaching this decision? The answers to these questions lie in knowledge of your personal philosophy and family inter-relationships.

Here is an example of a family dedicated to equal but different inheritances for three children:
A husband and wife own a large business and have one son and three daughters. The son is the only one actively engaged in the business, and has given up educational and social opportunities over the years to assist his parents in the business. The parents want the son to end up with control over the business, but want to divide the value of the business among all three of their children. They decide to transfer the business to their son, and most of their other assets to their daughters. Because the business is located on a valuable piece of real estate, which represents a substantial asset of the estate, the parents will equalize the inheritance by having the children unequally co-own the real estate, while requiring that it be leased by the business (from the three children). Here are some other examples to think about as you contemplate the best solution for your business:

Example 1
You own all of the shares of a corporation. You decide to give stock in the corporation to your two daughters, who are active in the business, and give other assets outside the corporation to your two other children who are not involved in the business. Upon your death, the remaining corporate stock will go to the daughters who are active in the business and your personal assets will go to the non-active children. Because you feel strongly about rewarding the daughter who has worked with you, you are not particularly concerned about disparity in the value of their inheritances, which are all very generous. You may consider giving partial ownership, with no management rights, to the two "outsider" daughters. Techniques which may be useful in a case like this include revocable living trust, with family limited partnerships, grantor trusts, and buy/sell agreements.

Example 2
You allow employees and/or family members to purchase, over a period of time, an increasing percentage of corporate stock (which may be non-voting shares, if you choose to structure or re-structure the classes of stock in this way). The use of grantor trusts and employee stock ownership plans may be a great way to achieve this result.

Example 3
Your children are doing well in their own careers, and your business may never be worth more than it is now. You design a transfer of your business to a charitable organization, through the use of a charitable trust. This gives you an immediate personal tax benefit, income to fund your own retirement or your next business, and is structured to pay generous income to your children, and even your grandchildren, on a tax-advantaged basis.

There are so many options and combinations of techniques that you are well advised to seek the counsel of capable estate planning attorneys, accountants, appraisers, and (if necessary) even a family counselor, to resolve all of your concerns and meet your requirements in a satisfactory and tax-minimizing way.

Developing and implementing your plan

If you’ve dealt with answering the basic questions at the beginning of this article, you should now be ready to clearly state your succession goals. It’s up to your lawyer to translate your thoughts and dreams into appropriate legal documents that will accomplish exactly what you want.

The first step to implementing your plan for succession in your business is to make sure that you have prepared a living trust, a will and appropriate powers of attorney. They are necessary to establish your personal standards for distribution or management of all your assets.

Review the structure of your business

Consider the nature of your business entity. The mechanics of implementing your plan will vary, depending on the organizational structure of your business. If you are doing business as a proprietorship, the transfer of assets upon death is usually addressed by a living trust. While this simplifies your business succession planning, there are disadvantages to operating as a proprietorship. You are personally liable for the debts of the business. After your death, your creditors will seek reimbursement from your estate for both your personal and business debts. Secondly, the odds are that your business may not continue after your death of retirement. Establishing a family limited partnership takes care of some of these problems. It can limit the ability of business creditors to ravage your personal estate. It can provide for orderly continuation of your business, and it can effect a transfer to other family members at minimized tax status.

A sole proprietor might also want to consider changing the organizational structure to a corporation, or a limited liability company, to name only two options. These forms of ownership may give you some liability protection and will increase the likelihood that your business will continue after your death or retirement, or at the least may make your business marketable outside your family.

If you have already entered into any buy/sell agreements or other contracts relating to the disposition of your business, or your share in the business, such agreements should be consistent with your personal estate plan, so that they work hand-in-hand to benefit those whom you seek to provide for.

Determine the value of your business

One of the key issues in planning for the succession of a business is determining the value of your interest. Valuation is also important in the preparation of buy/sell agreements. Such agreements describe the method to be used to determine the value of a retiring, disabled or deceased owner’s interest, which can be established in several ways. The owners may simply agree what the value of the business would be in the event of a buy out. Conceptually, this seems simple, but the value must be updated regularly, and may be subject to IRS scrutiny if it is artificially low. On the other hand, if it is too high, the surviving purchasers may seek to have it revised. Wherever possible, valuations should be done by experienced appraisers.

Remember that an appraisal should accurately reflect the fair market value, but cannot generally take into account future value, the "goodwill" factor, and other subjective considerations. The value of these intangibles must be added to the appraiser’s analysis to achieve fair buy/sell valuation. The best solution may be to obtain an appraisal and then meet with the parties to the buy/sell agreement, and agree on a formula (such as a percentage increase over the appraised value) which takes into consideration factors such as good will, the uniqueness of the product or operation, the value of community recognition and longevity, and so forth.

Prepare a Buy-Sell Agreement

Prepare a buy/sell agreement if you have not already done so. The agreement will specify what will happen to your interest (and to any other owner’s interest), in the event of death, divorce, disability or retirement.. Not only does the agreement provide important estate planning advantages, it prevents the ownership and control of your business from going to others without your approval. Conversely, of course, it protects your interests in the event that a co-owner retires, becomes disabled or dies. Your buy/sell agreement should address (1) the terms of a sale, before death, of an owner’s partial or complete interest, (2) the sale of an interest after an owner's death, divorce, disability or retirement, and (3) the effect of any creditor’s efforts to attach an owner’s interest for payment of a personal or business debt. A buy/sell agreement can also be used to address other issues, which can be structured as "conditions" to a sale, such as the management structure, employee rights, and so forth. The agreement should give the business itself or its owners the right to purchase another owner’s interest before it can be transferred to someone else. This is often called a "right of first refusal." This will protect the remaining owners from having to do business with outsiders, including heirs, unless that is the understanding among the owners or parties to the buy/sell agreement.

Payment of Buy-Out Amount

After you have decided on the terms of the buy/sell agreement, the next issue will be how to fund (pay for) the buy out. Your business, business associates, or participating family members may not have the cash on hand to facilitate the purchase of your interest. Two simple ways to deal with this issue are: - structuring the buy out so that it occurs over a period of time, or; - having each business partner or associate receive the cash benefits from a life insurance policy on the life of the now-deceased owner. (This second suggestion, of course, is of no value if the triggering event is a disability or retirement.)

Other possibilities are use of a private annuity, or exchange of stock, to cite only two examples.
While a buy out may be structured to occur over a period of time, there is a major drawback; the full amount of the business interest (less any discount valuation for lack of marketability) may be included in the taxable estate of the owner, and the resulting estate taxes may be greater than the cash in the estate, which is now the owner of a promissory note, resulting from the buy/sell agreement. Unfortunately, the value of the promissory note will usually be included in the estate tax calculation, even though it is not immediately convertible to cash.

A better solution might be to provide the surviving owners or associates with sufficient cash to buy the entire business interest, thus making the decedent's estate whole, and facilitating the payment of taxes and debts, as well as providing cash to the heirs. The creative use of life insurance can achieve the second objective, if the insurance is owned by the associates, or by the business, itself. If the insurance is in any way associated with ownership by the insured (called "incident of ownership"), then the insurance policy proceeds will be deemed to belong in the insured’s estate, even if they are paid to someone else! If life insurance is to be used to provide cash to fund buy/sell agreements, it must be very carefully structured and managed to avoid serious pitfalls of estate tax inclusion.

Agreements with Key Employees

If your management succession plan depends upon employees who are not also owners, you might consider signing long term employment agreements with them, creating rewards for assisting your successors. If you feel that key employees need or deserve more incentive, or are potential business successor-owners, then creation of an employee stock ownership plan is worth your strong consideration.

Consulting your Attorney

As you've seen in these very few illustrations, there are many factors to be considered in business succession planning. It does not exist in a vacuum, but must be consistent with a personal estate plan. It requires evaluation of a number of factors, which reach beyond numbers, dollars, and contracts. There are potentially significant income and estate tax questions, and there are almost always complex family issues to be resolved.

The "I'm too young" Trap

If you have been avoiding doing business succession planning (or even personal estate planning) because you are relatively young, it is not necessary to adopt the belief that "I might die any day, so I'd better get my estate plan done!" This depressing thought can create paralysis. Perhaps a more palatable attitude would be "I have many years to live, but I know that my planning can be put into effect now, for maximum good results, later. The sooner I take action, the more effective my plan will be."

The information offered in this article is not intended to substitute for competent legal advice, and is informational only. No representation or guarantee is made of its accuracy, and no estate planning should be undertaken without the advice and assistance of an attorney qualified in estate planning.