“Small businesses,” that is, those that have less than 500 employees,
comprise 99.9 percent of all businesses in the United States. The
owners of these businesses will, someday, exit their businesses due to
retirement, incapacity or death. But most are so busy working that they
don’t slow down and think about business succession and estate planning
issues. That is one of the primary reasons that less than one-third of
family businesses survive to the second generation; 65% of those fail to
survive the second generation; and 90% of family businesses fail to
survive the founder’s grandchildren.
The owners of small businesses often have multiple advisors, but rarely
are the advisors consulted as a team with coordinated input. The team
approach, however, is what produces the best results.
In this issue of The Wealth Counselor, we will explore the role
of advisors in helping business owner clients plan for what is usually
their client’s largest asset, their business. This issue will also
explain what business succession/exit planning entails and how this
planning can be coordinated with a business owner’s personal estate
planning.
Introduction
Too often a business owner is so busy “working the job” that he neglects
“building the business.” A business owner may occasionally wonder if he
can ever retire, who could possibly take over his business, if he can
get retirement income without going out of business, and what would
happen to his business (and family) should he prematurely die or become
incapacitated. But most do not seriously think about these things until
they are ready to retire. That’s when they realize they could have
achieved better results if they had only done more to build their
business and prepare for its succession.
The advisory team can help the owner change his focus from how much he
is making today to the future rewards he can be building for his family
and his retirement.
Two Concepts to Start the Process
Quite often, the business accountant or CPA is the advisor most closely
involved with the business on a regular basis and can most effectively
start the business owner on the path to planning. Two tools that are
often not used by business owners can be most helpful:
* The Year-End Review: This lets the business owner see how
the business has performed over the last 10-11 months, review business
profitability, and see the tax situation for the year. Often a lead-in
to a year-end review is considering ways to reduce taxes in the coming
year. It also provides an opportunity to discuss future risk mitigation.
* The Legal Audit: This is a review of all legal documents of
the business, including organizational documents, employment agreements,
leases, loan documents and guarantees, and buy/sell agreements. It
provides another opportunity to look for tax savings and a way to
identify potential gaps or liabilities.
Providing the data for these two reports and reviewing them with the
advisory team will help force the owner to back up to examine business
growth and profitability and talk about continuity issues.
Planning Tip: The
business accountant/CPA has much to gain by introducing this planning
process. Instead of just filing tax returns, the accountant here shows a
real interest in helping the owner grow his business. There will also
be additional work for the CPA/accountant, such as preparation of
financial statements, budgets, projections and valuations, tax planning
and business process and efficiency planning. If new business entities
are created, additional tax returns will likely be needed, too.
How the Team Approach Can Help
No one professional has all the answers, and diverse skills and talents
are necessary for the best results. The team approach also minimizes
time and costs. Members of the advisory team may include the
accountant/CPA, financial planner, insurance advisor(s) (property,
casualty, umbrella and life), investment advisor, business attorney,
estate planning attorney, valuation specialist and a business broker if
an imminent sale of the business is part of the strategy.
Planning Tip: All members of the advisory team should be involved so the planning can be coordinated.
Planning Tip:
Advisory team members should consider keeping their fees for the
initial consultation low, or even free, as there likely will be
additional paid work for them as the planning progresses.
Step One: Identify Motivation and Goals
As Dr. Laurence J. Peter, the man who established the famous “Peter
Principle” said, “If you don't know where you're going, you will
probably end up somewhere else.” In order for the business owner client
to avoid ending up “somewhere else,” he must establish goals for himself
and his business.
Learning what motivates the business owner (income, wealth, identity,
challenge, stimulation, satisfaction and/or pride) will help the
advisory team work better with him. Also, helping the owner verbalize
his goals will help him clarify priorities, avoid quick fixes, move
forward by identifying a desired outcome, and focus energy on the most
urgent concerns.
Typical business owner goals include the following:
- Create and preserve the value of the business
- Exchange that value for money with the least amount in taxes
- Meet personal and family needs by providing security and continuity of the business in case of the owner’s premature departure
- Leave a legacy
- Give money to charity
- Shift wealth to children
- Reward key employees
- Receive full value for the business
- Keep the business (or sell it) at his exit
- Take the business to the next level
Step Two: Value the Business
Most owners have no idea what their business is worth, but the value
will be needed for a third party buyer if a sale is anticipated. In the
meantime, knowing what the business is worth will help in projecting
cash flow, estate and gift tax planning, knowing how much insurance to
purchase for buy/sell agreements, compensation planning, knowing
available collateral for financing, and retirement planning. It also
allows the advisory team and the owner to monitor progress toward the
owner’s stated objectives.
Step Three: Plan for Business Continuity
The business owner’s overall planning objective for what will happen
when he retires, becomes incapacitated, dies or sells the business most
often includes that the business will continue despite such an event.
Most commonly, the business owner will want the business to survive with
whoever he chooses receiving the value of his ownership interest.
Likewise, if one owner “departs,” for whatever reasons, the remaining
owner(s) usually will want to retain ownership and control and not to be
in business with the departed owner’s creditors, surviving spouse
and/or heirs.
Step Four: Plan for Personal Wealth Preservation and Succession (Estate Planning) and Asset Protection
Universal client objectives are to preserve wealth and minimize taxes
using both lifetime and death planning tools. Where a family business is
involved, this requires integrating lifetime succession and business
objectives with the estate plan. Estate planning thus becomes part of
business planning.
The advisory team should be aware that a business owner will often want
to address the business planning first. (They most commonly suffer under
the delusion of immortality.) Once the advisory team has assisted the
owner to clarify his goals and developed a plan for his business,
however, the business owner will see that his estate plan has already
begun to take shape.
Considerations for the business owner’s estate plan include the growth
of non-business assets; how to be “fair” to children both inside and
outside of the business; minimizing and having the cash to pay estate
tax; asset protection during the owner’s life and for his heirs; probate
avoidance; planning for long term health care costs; and sometimes
special considerations, such as a child or parent with special needs.
Step Five: Grow and Protect Business Value
From the owner’s perspective, growing the business and protecting its
value will maximize the amount realized on the sale of the business,
protect assets from potential business and personal creditors, create
the ability to sell the business, and can motivate and keep key
employees and family members in the business.
Promoting its value will include increasing cash flow; developing
operating systems (so that the system, not the owner, who will
eventually be gone, becomes the solution); documenting sustainability of
earnings (if the owner is taking all the cash out of the business, it
will be harder to sell); improving company performance as measured by
industry metrics; and paying down debt.
To grow the business and protect its value, it may be necessary to
restructure the organization, solidify and diversify the customer base,
implement strategies to grow the company, develop and protect
proprietary technology, build a solid management team, and groom a
successor.
It may also be worthwhile to examine and possibly change the corporate
structure (S and C corporations, LLCs and partnerships). The advisory
team can help the owner consider tax pros and cons, ease of operation
and asset protection features of current and potential entities.
Planning Tip: Most
business owners don’t think about asset protection until a claim
arises. But the best time to plan, of course, is before the protection
is needed. Consider discussing asset protection for both business and
personal assets early in the planning process.
Planning Tip: An
umbrella policy is often overlooked by business owners and is an
inexpensive start toward the need for asset protection of both business
and personal assets.
Step Six: Ownership Transfer
The ability to sell and the value of the business are both affected by
intrinsic factors (e.g., how the business has grown); extrinsic factors
(e.g., the local and general state of the economy); and the
effectiveness of the sale process.
There are only two basic types of ownership transfers - to those who are
in the business and to outsiders. Each has special characteristics.
Sale to Outside Buyers (Third Parties): The benefits to the
owner of a sale to an outside buyer can include cash at closing, no
owner financing (which eliminates financial risk), no family succession
issues and the speed with which the exit can occur. However, everything
must come together just right to successfully complete the sale of a
small business. Far more often than not (often as a consequence of
failure to plan properly), no buyer can be found who is willing to pay
the owner’s price. About 20% of businesses are offered for sale, but
only one in four of those actually sells. The probability of effecting a
successful sale changes with the size of the business. About a third of
offered businesses with annual sales of $10 million or less sell while
about half of offered businesses with annual sales over $10 million
sell.
Planning Tip: It can often take seven to ten years of proactive planning to successfully prepare a business for a sale to an outside party.
Sale to Children or Key Employees
The owner’s succession objective may be selling the business to his
children and/or key employees. This can motivate and help retain key
employees and family involvement in the business. Money for that kind of
sale usually has to come from the ongoing business, so planning is
critical to help reduce risk of buyer default and to increase the amount
of money received by the owner.
Conclusion
Depending on the health of the business and the objectives of the
business owner, it can take several years of planning and action to
implement a business succession plan and get the other planning in
place. A forward thinking advisory team that initiates the planning
process years before an anticipated succession event, monitors the
progress, and helps keep the owner on track will provide a great service
to the business owner, his family and his business—and a happy client
will tell others.
To comply with the U.S. Treasury regulations, we must inform you
that (i) any U.S. federal tax advice contained in this newsletter was
not intended or written to be used, and cannot be used, by any person
for the purpose of avoiding U.S. federal tax penalties that may be
imposed on such person and (ii) each taxpayer should seek advice from
their tax adviser based on the taxpayer's particular circumstances