Retirement Planning For The Family Business Owner
This high failure rate is due, in part, to the failure of business owners to properly plan for the succession of management, the retirement income needs of the owners, and the transfer of ownership to family members.
When business owners and their families address these issues early on, they can greatly improve the chance that the business will survive into succeeding generations and even fund their retirement. Such planning combines an evaluation of the business, the owner’s estate plan, and personal inter-family dynamics, with a review of the interest level and capabilities of family members who are likely successors.
The results of this evaluation will help owners develop plans which may include extracting cash from the business to diversify the assets of the owner, setting up mechanisms to transfer ownership, forming a family council to make decisions about the business and competing interests of family members, or selling it outright.
These plans can be quite simple or complex, depending on the unique facts and circumstances of the family and business. For example, assume the owner of a large business has three children. Two of the children are working in the business and could be likely successors, but the third child has a successful career independent of the family business.
If an owner wishes to divide his estate equally among his children, he may need to devise a plan for transferring ownership to the children interested in the business, while providing an equivalent share of his estate in the form of other assets to the third child. This advance planning becomes even more critical if most of an owner’s wealth is tied up in the family business, and there are not sufficient assets outside of the business to fund that equal share.
The solutions to problems like these take on many forms. Although there is no “one size fits all” plan, family business owners should be familiar with the most common estate planning tools that are frequently a part of plans developed by the attorneys, consultants, and financial planning professionals who advise them. The following is an overview of some of the more common tools.
BUY-SELL AGREEMENTSIn cases where the business owner is not the sole shareholder, a common tool is to draft a buy-sell agreement in which the owner agrees by contract to sell his shares back to the company or a partner when certain events occur. The agreement outlines the timing, price, and funding for the sale.
Common triggering events for the sale of shares are retirement or death. For example, the owners of a company may agree to a mandatory retirement age of 65, upon which the company will purchase outstanding shares from the retiring owner at a price determined in the agreement.
When death is the trigger in a buy-sell agreement, companies will often buy insurance policies on the lives of the individual owners. Upon an owner’s death, the proceeds of the insurance policy are used to fund the purchase of shares from the estate of the owner.
THE FAMILY LIMITED PARTNERSHIPWhen a business owner holds a majority of the shares in the business and wants to transfer ownership without giving up control, a common tool used in estate planning is to create a Family Limited Partnership (FLP) and fund it with shares in the family business. This ownership transfer tool has the added benefit of potential tax savings.
In this type of partnership, the owner usually holds a 1 percent general partnership interest, and retains control over the business. He then creates a limited partnership interest with the remaining 99 percent of the partnership units. The assets held in the partnership are usually shares in the family business. Individual family members can be made limited partners, but the decision-making authority remains with the owner as general partner.
The tax-efficient transfer of ownership is accomplished by gifting limited partnership units to family members. Because holders of limited partnership units are usually restricted from selling units or making decisions regarding management of the assets, the partnership units are worth less than the underlying shares in the business. As a result, the value of a limited partnership share is often discounted between 25 to 40 percent, greatly reducing the tax value of the transfer.
Under federal estate tax law, up to $1 million in assets can be excluded from an owner’s estate when calculating estate taxes. Because the value of a limited partnership share is discounted, the business owner can gift more of the business to family members without exceeding the $1 million estate tax exclusion. (Note: The 2001 Tax Act raises the estate tax exemption gradually to $3.5 million by the year 2009.)
The FLP can also provide an income stream in retirement to the owner. For example, the owner can bill the partnership for reasonable management fees related to his duties as general partner.
General partnership units can be transferred upon retirement, prior to death, or after death by will, usually in accordance with a succession plan.
EMPLOYEE STOCK OPTION PLANSAn Employee Stock Option Plan (ESOP) can be an effective tool for extracting value out of a family-owned business without having to sell the business outright. The cash proceeds from a partial sale of the business to an ESOP sale also can be used to diversify a business owner’s assets into income-producing investments to help fund the owner’s retirement.
In most cases, the company sets up an ESOP trust, and the ESOP then buys a portion of the owner’s interest in the company. If the owner sells 30 percent or more of his outstanding shares in the company, and the proceeds are invested into “qualified replacement property,” no capital gains tax is due until the replacement property is sold. Stocks and bonds of most publicly traded domestic companies are considered qualified replacement property, allowing the owner to take the proceeds from the sale of the shares and diversify his assets.
In addition, if the ESOP uses a bank loan to purchase the shares, the business may receive a tax deduction for payments of the loan’s interest and principal. An ESOP, like other employee benefit plans, can then offer stock to management and employees as part of their compensation.
When used in the right circumstances, ESOPs can provide a tax-efficient way to liquidate a portion of the owner’s interest, while broadening the ownership base to include those most involved in the business.
SUCCESSION PLANNINGWhen developing estate plans for the transfer of ownership in a family business, the owner should give equal consideration to planning for the succession of management. Too often these issues are put off until health problems or the untimely death of the owner-manager creates a crisis situation for both the family and the business.
Management succession planning should begin early if succeeding generations are involved in the business and should be a consideration in the planning for eventual ownership transfer.
These plans include a career track for children interested in the family business so they can develop and demonstrate the necessary business and leadership skills that are required to continue growing the business long after the business owner retires.
Successful businesses that survive into multiple generations of family ownership typically have set up corporate governance procedures to help address the issues of succession planning and business ownership. In many cases, these include adjusting the composition of the board of directors to include independent non-family directors to act as a guardian for the business and buffer between the competing interests of family members. In the case of an owner/CEO’s premature death, the board may hire an interim CEO to help groom the next family successor.
SALE OF THE BUSINESSOften, the business owner may decide to simply sell the business outright to a family member, employees, or an outsider.
If none of the owner’s children have an interest in continuing to own and manage the family business, one option is to sell the business to the company’s management team using a buy-sell agreement, an ESOP, or an outright sale through a leveraged buyout or installment payments.
When selling a business outright, consideration should also be given to the distribution of the cash proceeds. Using an FLP to transfer partial ownership to family members in advance of selling the company may be a tax-efficient estate planning tool. Following the sale, the business owner can still control the distribution of the sale proceeds since he remains general partner.
With careful planning, business owners can increase the likelihood of a smooth succession while also providing for their own retirement needs.
Knapp is a vice president of Personal Financial Planning at the Northern Trust Company in Chicago, IL.
Publication date: 07/29/2002