Eight Realities of Family Business Succession

By John J. Scroggin

“…but in this world nothing can be said to be certain, except death and taxes.”
                                                                                                                                  – Ben Franklin

Many entrepreneurs intend to pass the family business to future generations. However, most family businesses fail to survive into the third generation. When considering the passage of a family business, there are eight important realities that need to be understood:

Death and Disability Will Occur

We will all die. However, Paul Simon may have gotten the perspective of many of us correctly: “[I will]…continue to continue to pretend that my life will never end…” Death will happen to all of us – and most of us will suffer at least one period of disability before passing. But estate planning for businesses is not most fundamentally about death and the taxes that occur at death. It is about planning for the legacy you will leave.

This perspective starts with understanding that estate planning does not start with THINGS or the taxes imposed upon them. It starts with PEOPLE: Who you were and are and who your family is and might become. In the last two decades I have observed a significant re-orientation of both clients and advisors from acting as though the preservation of family assets (e.g., minimizing taxes) is the most important goal of estate planning. Increasingly, clients and planners recognize there is often a misplaced emphasis, which focuses on assets rather than family, on structure and complex techniques over perspective, on tax savings in place of family need. When protecting and preserving the family becomes the beginning point of planning, clients first focus on how to leave a positive impact on their family. Both the client and the planner may be forced to deal with difficult family issues (e.g., treating the children as individuals with their own personalities and problems, not as equals), which both the client may have preferred to ignore – to the ultimate detriment of the client’s family. When you deal with this inevitable reality, you can leave a positive LEGACY for family – instead of the bitter legacy of conflict, taxes and legal expenses which so often occurs when an inadequate plan (or no plan) is in place.

Does this mean that taxes can be ignored in the planning process? Absolutely not. But the cost of taxes pales in significance to the cost to family of poor planning or no planning.

Taxes Are Not Going Away

The January 2, 2013 tax legislation provided for substantially higher transfer tax exemptions. These changes will reduce the transfer tax costs for business owners transferring their businesses. However, the change means that much of the tax planning for closely held business owners will shift from transfer tax avoidance to income tax minimization.

Virtually every intra-family transaction that business owners enter into have income tax implications that need to be addressed. For example, gifting S corporation stock to a family Dynasty Trust can terminate the S election for all shareholders if the trust does not contain certain required provisions. Transferring a flow-through business interest (e.g., an LLC, partnership or S corporation) to a family trust must take into account how the cash flow will fund the allocated income tax costs of the trust or its beneficiaries (i.e., just because taxable income is allocated, does not mean a comparable distribution is made from the business).

And even though there has been a significant reduction in the federal estate tax, states are continuing to increase their estate and inheritance taxes to fund their own budgetary shortfalls. Dead people are an easy source of revenue.

Income Taxes Are Going Up

On January 1, 2013, the top federal income tax rate rose to 39.6%. Given the various sources of taxation to small business owners, their top income tax rate is easily approaching 50%. Given the deficit concerns, Congress may raise these rates even higher. Without question, the social security tax burden is also going to increase in coming years to fund the significant shortfalls in the entitlement programs.

If your taxes are going up, start planning now to reduce that future tax burden.

There is No Equity Value to a Family Business

When an entrepreneur wants to pass his or her business to family members, there is no true equity value to the business. Because the equity will not be reduced to cash (i.e., by a sale of the business), it provides no current benefit to the business owner. In fact, the equity value of the business is a liability waiting to happen because of the potential state and federal transfer tax liabilities on the passage of the business.

When the issue is properly addressed, the owner is interested in control of the business and the income and benefits which are derived from that control. Using readily available planning approaches (e.g., deferred compensation, voting rights, partnerships and trusts), the income and control of the business can be separated from equity, and the equity can be passed at a reduced tax cost to family members using various techniques (e.g., minority and lack of marketability adjustments).

The retention of the equity value of the business may create a transfer tax liability, which could have been reduced or even eliminated. By retaining ownership, the entrepreneur loses the ability to not only discount the present value of the business, but also causes the family to pay estate taxes on the appreciation in the business. For example, assume in 2013, a married taxpayer has a $10.0 million company and transfers all of the business to a three separate family trusts for his three children and their descendants. The client dies 15 years later. Such a gift has a number of benefits:

  • If the minority interest, which was transferred to each trust, was discounted at 45% and the donor’s spouse agreed to gift splitting, the couple’s combined gift tax unified credit would cover the entire gift (i.e., $10.0 million discounted at 45% is worth $5.5 million – less than the couple’s combined gift exemptions).
  • Because of valuation adjustments, even if the business did not grow, the immediate estate tax savings would be as much as $1.8 million (i.e., the $4.5 million valuation adjustment times a 40% estate tax rate after 2012).
  • But what if the business grew at a 10% annual rate until the parents died 15 years later? At the end of 15 years, the prior transfer will have moved $42 million out of the donor’s estate, saving the family an additional $12.8 million in estate taxes (i.e., $32 million in appreciation at a 40% estate tax rate in 15 years).
  • Trustees selected by the entrepreneur may control the gifted business interest and decide how trust distributions will be made to family members. With proper drafting, the business owner and/or heirs may retain the ability to remove the trustees, without the trust assets being included in his taxable estate.

With a 40% estate tax potentially due nine months after death, the tax burden may make it financially impossible for an entrepreneur to pass the business to family members. The tax payment of 40% of the value of the business (even when electing estate tax deferral under IRC section 6166) can result in such significant cash drains that the business cannot survive.

Essentially, federal transfer taxes are a voluntary confiscation tax. With proper planning the confiscation can be minimized or eliminated. The key is recognizing that equity is not the same element as control – and control allows the owner to benefit from the income of the business. The thoughtful business owner recognizes this difference and realizes that transferring current equity (and its future appreciation) can reduce the future tax burden on the business, without adversely impacting the owner’s income or control. Contrary to the owner’s intent, the emotional retention of all of the equity ownership can actually destroy the business.

The Inevitable Conflict

Many business owners intend to pass their businesses to one or more designated family members who will run the business after the entrepreneur’s death or retirement. However, because the business is often the largest single asset of the estate, the owner often passes part of the business ownership to other family members who are not involved in the business.

During the owner’s lifetime, the owner may have been able to maintain peace in the family and serve as the “benevolent dictator” of the family business. Unfortunately, this powerful role disappears with the entrepreneur’s death or incapacity. Sibling rivalry, in-law problems, and other issues begin to come forward, particularly between those who operate the business and those who are outside the business.

Almost inevitably, the outsiders feel that the compensation and perks provided to the insiders are “excessive.” Outsiders question the business decisions (e.g., capital expenditures, hiring and firing of employees, expansion plans) of the insiders even when they know little about the business’s needs, operations or competition. Outsiders often believe that the income paid to them should match the compensation paid to the insiders.

Meanwhile, the insiders (who often feel they are working too hard) resent that their sweat is increasing the equity value of the outside family members who are continually asking for more and more income to which they are “not justly entitled.” The insiders often fail to see that the outsiders have a right to a return on their “investment” in the business. Many family businesses have paid huge legal fees because of these conflicts and/or have been forced to sell the business to alleviate the problem.

This conflict is inevitable as each family member attempts to direct his or her own financial destiny and feels increasingly unable to do so because of the common business ownership with other family members. This is not a matter of “good” and “bad” family members. It is a matter of increasingly different life goals – a normal part of life.

The solution lies in setting up a structure in the estate plan which assures that those in the business own and control as much of the business as possible, while giving outsiders other assets so that they can effectively control their own financial destiny. Life insurance is often a necessary element of this “equalization planning.” This planning process is best done during the business owner’s life so the entrepreneur can dictate the terms to family members. Often the entrepreneur will recognize the contribution to the business of those who have had long term involvement by passing a greater part of the business to them.

Heirs May Increase Their Own Burden

A son works in the family business. Over 20-30 years the son helps grow the value of the father’s business – only to share it with his siblings and a not-so-appreciative stepmother. Not only does the development of the parent’s business increase the potential federal and state death taxes, but the son’s helping to foster the growth of the business must be shared with siblings and other family members. By not addressing the issue before the father’s death, the son will have increased his own burden. Even if a business owner is unwilling to address the value of the child’s long term contribution, children in the business should address the issue.

Passing on the Problem 

Many planners view the role of the estate planner as passing as much wealth to the next generation as tax-free as possible. Often a family business is included in the wealth passage. The problem with such an approach is it ignores the inter-generational tax confiscation of wealth that occurs as each generation grows the family’s wealth and then attempts to pass it to the next generation.

Clients need to understand that it is possible to separate the control and income of the family business from its equity value and future appreciation. The equity and future appreciation can be passed across successive generations without incurring a transfer tax, while the control and the income benefits are passed to the appropriate family members who are involved in the business. Dynasty trusts can fulfill this purpose. Flexibility in inter-generational transfers can be maintained by using special powers of appointment and by the manner that successor Trustees are selected and/or removed.

Divorces Will Happen

Almost 50 percent of all marriages end in divorce. Baby boomer divorce rates have doubled in the last two decades. If divorce is such a prevalent issue, why do we so often ignore the possibility in our planning? Planning should include reducing the divorce-driven exposure of a parent’s and an heir’s assets. Buy-sell agreements should be drafted to allow the family to purchase ownership interests which pass to non-blood family members at divorce or death. Trusts can be created which provide long term benefits to family members, but deny such benefits to divorcing spouses or non-blood heirs. Although they are not particularly romantic, clients and their heirs should be strongly encouraged to sign pre-nuptial agreements before marriage.

It is my impression that most small businesses split because either they do too poorly or they are too successful. Small business owners need to draft pre-nuptial (i.e., buy-sell agreements) at the beginning of their business marriages which definitively deal with how the business marriage will be terminated with the least amount of damage to the business. For example, if the remaining owner is buying out the interest of the departing owner based upon a “going-concern-value” of the business, the remaining owner needs to make sure the agreement limits the ability of the departing owner to compete with the business or solicit its customers from an building across the street.


Clients who realize the existence of these eight truths will reduce future heartaches and avoid the potential loss of the family business to estate taxes and family conflicts.

Copyright, 2013. John J. Scroggin, AEP, J.D., LL.M., All Rights Reserved.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s