It has been estimated that approximately 90% of the businesses in the United States are closely held. According to statistics published by the Small Business Administration (SBA), “seven out of 10 new employer establishments survive at least 2 years and 51% survive at least 5 years.” Unfortunately, many of these businesses will fail as they attempt the next hurdle of transferring their business to either the next generation or to a loyal employee.
An article titled “A Transfer Tsunami for Family Biz” dated July 25, 2006 indicated that “Over the next 20 years, nearly $4.8 trillion of wealth is set to be transferred to the next generation of heirs. Much of that wealth will consist of the assets of family businesses, about 40% of which are due to hand the reins to the next generation during the current decade alone. However, most family businesses are not adequately prepared to handle the tidal-wave transfer of wealth. In fact, the majority of family businesses have made few or no provisions for turning the business over to the next generation.”
The successful transition of a closely held business is unique and in many cases can be problematic. Often the primary business owner has been key to the success of the business and has much of the critical management information in their head.
A successful transition of a business should begin with fundamental planning years in advance. Processes and procedures should be systemized and documented. Training is critical for those who will be in line to purchase and run the business. Transition of management responsibilities and contact with both key vendors and clients should be considered.
A sound succession plan should consider:
- How to transfer the control and ownership including choosing, grooming and training of the management successor.
- How the owner is paid for the business in order to afford a retirement income and/or provide for the surviving spouse.
- At what age the owner will be willing to begin a transition and make a complete transfer of the responsibilities.
- If the plan needs to address estate planning concerns relative to the transfer.
- If the transition is to a family member, does the plan address the other members of the family?
The financial aspect of a succession plan is of paramount importance to both the business owner and the successor, because in a majority of cases the business portion of the buy out will be paid out over time including:
- Receiving a down payment and then carrying a note for the balance.
- Agreeing to a smaller purchase price and receiving either some form of deferred compensation or payment for continued consulting services.
In many cases, the sale of the business is the primary source for the retirement of the business owner. There is a need for balance between the economic value of the business and the retirement desires/needs of the owner. Additionally, consideration is due to other family members who are not active in the business and may not be receiving any of the future income from the business.
Among the items to consider is whether there are assets in the business that can be distributed to the owner that would reduce the purchase price, including transferring ownership in the real estate to a separate entity whereby the owner and/or other family members would be receiving rent income. Perhaps, the same could be done with the equipment. Additionally, consider reducing the more liquid type assets whether they are cash or brokerage accounts.
If the business owner plans to transfer the business to a family member, then the use of a qualified plan to fund a large portion of the desired retirement is a very attractive option. Another alternative is the use of a nonqualified deferred compensation plan to facilitate the sale of the business. The value of the owner’s deferred compensation affords a method of getting cash to the owner from the future profits vs. the prior funding in a retirement plan while also decreasing the purchase price of the business. Using deferred compensation should afford the owner a deferred tax liability. However, there is an inherent risk of nonpayment to the owner if the business fails.
An alternative used by some to balance the interest of the children who will purchase and take over the business at a reduced value is to carry a life insurance policy payable to the children who will not be active in the business.
If one follows Steven Covey’s advice “to begin with the end in mind”, the business owner should lay out a plan decades before they plan to turn the business over to lay the foundation from organizational and financial aspects.
Jerry Love, CPA, is the sole owner of Jerry Love CPA, LLC in Abilene, TX. Contact him at
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