Preparing for Retirement

Business Succession and Estate Management Strategies

Orderly business succession requires careful planning. Here’s a look at tools to facilitate profitable corporate ownership--and personal estate--transitions.

By Albert B. Woodward Jr.

Albert B. Woodward Jr. is chairman of the Woodward Financial Group Inc., which has offices in Naples, Fla.; Newport Beach, Calif.; and Denver.

As owners of closely held businesses approach their golden years, many would like to be able to gracefully--and profitably--back away from the day-to-day operation of their companies. To do so, however, they must have a plan.

Ideally, planning for profitable business succession should begin in the formative years of a company. For many, of course, this is water under the bridge, but a late start is better than no start.

No matter when the process is begun, a successful succession plan should include a number of critical strategies, some of which may change over time. These may include developing a team management approach that facilitates continuity, installing and maintaining record systems that document the profitability and worth of the business, establishing a buy-sell agreement that establishes a method for valuing the business, and determining whether family members will be involved in the future management or ownership of the company.

Not only are these factors important to a smooth transition, but they also can have a direct effect on the value of a business at succession time. According to Charles A. Corriere, president of Corriere & Associates Inc. (Denver), a consulting firm that specializes in strategic planning and financing, the value of a mature business developed by a self-made business owner without benefit of a seasoned management team, books and records, a buy-sell agreement, and so forth, is the liquidated value of the company's assets minus its liabilities. On the other hand, says Corriere, the value of a profitable business that has developed a competent management team, good records, and a viable method of determining business value is worth three to10 times its annual cash flow.

The Transfer Techniques

Owners of closely held businesses ready to plan the transfer of ownership and control of their businesses in exchange for money have at their disposal four traditional techniques.

Transfer ownership to family members. Transferring ownership to children or other family members is doable, but fraught with potential complexities that could only be fully appreciated by the manager of a three-ring circus. To keep these difficulties to a minimum and get a better feel for whether this approach will work for your business, it's important to bring those family members into management as early as possible so there's time to judge their compatibility with other members of the management team.If you decide to go this route, there are two methods of transfer available: the "Newco./Oldco." technique and the family partnership.

The Newco./Oldco. method involves the establishment of a new company owned by the family members who will someday take control of the firm and an agreement that provides for the sale of the old company to the new company over a period of time for a certain amount. The agreement typically contains mechanisms for the original owner to maintain control of the business for as long as he chooses, regain control if trouble arises, and assert claims against fixed assets to ensure that the compensation provisions of the agreement are adhered to. This arrangement demands that special attention be paid to managing capital gains.

In the family partnership technique, a partnership is established whereby the original owner becomes the general partner, the family members become limited partners, and the ownership of the business is gradually transferred to the family partnership according to a predetermined plan, with the original owner/general partner initially retaining 100-percent ownership. If the annual transfer of business ownership is within the current gift tax allowances and exemptions, capital gains tax is postponed, and the future appreciation of the business-which is important in controlling federal estate taxes-is passed on to the family members. This method allows the general partner to retain as much control as he wishes during his lifetime and regain once-relinquished control if necessary.

Selling to employees or co-owners. An employee stock ownership plan (ESOP) can be a handy tool in establishing an employee buyout of a closely held business. To do so, your company would adopt an ESOP--a type of qualified plan, normally a profit-sharing plan--which then borrows bank funds to purchase stock in the business from you. The stock contained in the ESOP, or its value in cash, is paid out to participants--employees, co-owners, and/ or key employees--when they leave the employment of the company or retire, whichever comes first, with participation and vesting requirements controlling profiteering by employees. If you transfer your business using this method, you'll have to pay capital gains tax on the profits from the sale of your stock to the ESOP, but you may be able to defer payment indefinitely by reinvesting the proceeds of the sale in another company's stock. In addition, while this kind of plan by design puts ownership in the hands of employees, you can craft an agreement that addresses your compensation and control of the company.

Selling to a third party. A third party, such as a competitor or someone interested in entering the industry, may be a good prospect as a buyer. Selling to a third party may be especially warranted if there is no logical buyer among your family or employees, if your business is so valuable that any buyer would need considerable cash to get the deal going, or if you want to receive a substantial amount of cash at the time of sale, which is not likely to happen if selling to a co-owner, employee, or family members. With this strategy, the keys are finding a willing buyer and agreeing upon a value for the business. If you've maintained good books and records to demonstrate the profitability and the value of fixed assets and equipment in the business, then IRS Revenue Ruling 59-60 will be helpful in establishing a value for the business. And if the company is profitable, finding a buyer should not be difficult.

When selling to a third-party buyer, take care to protect the confidentiality of business information through options contracts, letters of intent, or confidentiality agreements. And before releasing anything but the most general information about the company, assert your right to determine the buyer's ability to purchase the business by requiring financial assurances from any potential buyer.

The fire sale. The least desirable method of business succession is the so-called fire sale-in short, offering the company at the liquidated value of its assets minus its liabilities. Nevertheless, it may be the only option for closely held business owners who have neglected to develop their management teams, business records, and other factors that influence profitability and determine the business value over time. Unfortunately, this method of business succession is all too common, especially in cases of the owner's disability or premature death. With foresight, however, it can often be avoided.

Added Security: Estate Management

So you've planned for the succession of your business. What about your estate--including the proceeds from the business transfer? How will you ensure that these assets will wind up in the hands of those you've chosen following your death or disability? Furthermore, how can you use estate planning techniques to complement your retirement plans? There are several building blocks available.

The will method. The basic will method of estate settlement continues to be very popular and can be a viable strategy as long as it is dated on or after September 1981, when estate tax laws changed. A will consists of written instructions to your county probate court, which would review the document after your death. If the will is in good order and there have been no contests filed against it, the court will permit settlement in accordance with the will's instructions, and the process should be relatively efficient and timely. If, on the other hand, the will is destined to go through judicial probate and require court supervision--check with your attorney--other techniques to manage and provide for the settlement of the estate may be preferable.

The living trust. The living trust method of estate management and settlement, which remains revocable and amendable during your lifetime, is increasingly prevalent. In this strategy, you simply convey assets to a trust that you serve as trustee over, and, thus, you continue to control those assets. If the living trust is properly funded, it offers the advantages of general avoidance of probate and, through the appointment of your children or a bank as successor trustees, confidence that if you become disabled, these successors will be able to maintain continuity of management. Contrary to popular belief, however, the living trust does not provide insulation from personal or business liability of capital gains exposure, nor does it absolve debt. In addition, its most discussed disadvantage is that your creditors (and possibly those of your business) can claim against the trust as long as it exists, whereas if the estate is settled with a will, creditors are prohibited from making any future claims once final settlement has occurred.

Family and marital trusts. These testamentary (to take place at death) trusts are tucked up inside primary estate planning documents such as a will or living trust and provide a mechanism for couples to pass up to $1.2 million of their assets to heirs free of federal estate tax. As such, establishment of family and marital trusts, which are commonly referred to as A/B trusts, seems mandatory for families with assets in excess of $600,000. But because the trust can only be funded by assets titled in the name of the first spouse to pass away, and it is impossible to accurately predict which spouse will survive the other, an additional step must be taken to make this trust option effective: Up to $600,000 in assets must be directly titled in the name of each spouse. This becomes critical with families whose net worth is above $600,000 but something under $2 million or so, and whose assets are mostly stock in a closely held business and retirement plans.

The family partnership. The family partnership, discussed earlier in connection with selling a business, is also becoming a popular estate-management technique. In this case, it pen-nits you, as general partner, to retain control over personal and business assets, freeze the value of appreciating assets-including the business-at today's prices, and gradually transfer business ownership to family members. In some cases, offshore ownership of limited partnership interests may insulate you from judgments.

The wealth replacement trust. In a wealth replacement trust, you would transfer assets to your children and other beneficiaries, irrevocably, through a trust that owns insurance on your life. When you pass away, the insurance payment can then be used to cover the federal estate tax bill. If the estate is large enough, additional assets can be transferred out of the estate for the benefit of your beneficiaries.

The supertrust. The supertrust, commonly known as a charitable trust, accommodates highly appreciated assets that have little or no hope of ever paying out meaningful income. In essence, it's a way for you to establish your own charity, and thus offers a key benefit all legitimate charities enjoy--no income or capital gains tax. Here's an example of how such a trust works: One of our clients retired from IBM with $1 million in company stock with a cost basis of $250,000. He sought to sell the stock to diversify and reinvest the proceeds to support his retirement, but payment of the capital gains tax--a little over a quarter of a million dollar--was not appealing to him. So he established his own charitable trust and donated the IBM stock to it. The stock was then sold inside the charitable trust, free of capital gains tax (this was long before the now-infamous drop in the price of IBM stock), and reinvested in income-producing assets. Because the sale was made by a charity, no capital gains tax was paid at the time of the sale, and the entire $1 million was available for investment. The client also benefited from an annual charitable deduction spread over six years, which was roughly equal to 30 percent of his adjusted annual gross income-a significant savings in itself.

A major disadvantage to using charitable trusts is that when the donor dies, the principal of the trust must pass to charity. But this obstacle can be overcome by establishing a wealth replacement trust in tandem with the charitable trust. The wealth replacement trust would simply own insurance on the donor's life in an amount equal in value to the assets donated to the charitable trust. At the donor's death, the principal of the supertrust would still go to charity, but an equal amount of money from the wealth replacement trust would pass to the beneficiaries free of federal estate tax and free of federal and state income taxes.

The dynasty trust. A dynasty, or generation-skipping, trust allows you to pass wealth down through generations, possibly reducing the burden of your estate taxes on your heirs.

It works by arranging your assets to replace potential estate taxes with gift taxes. Tax legislation passed in 1976 unified gift and estate taxes under one set of rules, which allow you to transfer up to $ 10,000 per person per year, tax-free, to any number of people, up to a lifetime tax-free maximum of $600,000 in asset transfers. With a dynasty trust, you use up that $600,000 exemption during your lifetime by gifting up to $1 million to your heirs through the trust. You would immediately be subject to paying a small gift tax, but will have avoided the estate tax on the $1 million by shifting it to your heirs' heirs. This represents an estate tax deferral of up to 55 percent plus the growth of capital.

The downside to this strategy is that many professionals believe that it is only a matter of time before Congress reduces the $600,000 federal estate tax exemption. If so, it may make sense for you and your spouse to establish a family partnership and use it to immediately transfer $1.2 million in assets to your children, locking in the exemption now.

Getting Professional Advice

Business succession planning and estate management are amazingly complex. And individual and family emotional and psychological hurdles related to succession, plus the everyday press of business, can further complicate things. Thus, successful business/estate strategizing can require the coordination of a dizzying number of experts and factors-the business attorney, the tax attorney, the estate planning attorney, the certified public accountant, the business broker, the business appraiser, the Internal Revenue Service, and even local, state, and federal environmental regulations.

Today's certified financial planners are uniquely positioned to help closely held business owners negotiate the complexities to establish orderly succession and estate management plans. An organization called the Registry of Financial Planning Practitioners sets professional standards of practice for financial planning and can help identify practitioners who meet these standards and specialize in closely held business succession and estate management. For further information, contact the registry's referral service at Two Concourse Parkway, Suite 800, Atlanta, GA 30328; 404/395-1605. •