5 key questions to make a success of succession
Are you thinking about handing your business to the next generation? The estate planning experts at Schneider Downs are experts in ensuring a smooth transition. They’ve counseled clients in numerous industries predominantly situated in Ohio and Western Pennsylvania, so Traction News asked them what general advice they have for family businesses considering their succession plan.
The team at Schneider Downs identified five of the most frequently raised questions they believe business owners in the tire industry will find relevant to the issues they face in this area.
Here’s what they had to say.
1. How and when do I transfer voting stock (control) to the next generation?
The issue of control is one of the most difficult issues for our clients to navigate. The question of who has control over an entity is generally governed by who possesses the voting stock.
The owners of the voting stock, subject to operating agreement stipulations, generally have the power to:
(i) Govern day-to-day operations,
(ii) Decide salaries,
(iii) Declare distributions, and
(iv) Make decisions regarding dealership expansion or contraction.
Nonvoting stock, on the other hand, possesses no direct power of operations. The rights of nonvoting shareholders are typically limited to the:
(i) Entitlement to dividends if declared,
(ii) Opportunity to inspect books and records,
(iii) Right to transfer ownership, and
(iv) Right to participate, pro rata, in entity liquidation.
While many of our clients are on board with the idea of transferring value to the next generation (to reduce the sizes of their taxable estates), they have a more difficult time transferring control.
In order to address this issue, consider an example: Jen owns 100 shares of stock in her business, which represents 100 percent of the issued and outstanding common stock. Jen wants to start gifting the business to her only child, Sam, to reduce the size of her estate but wants to retain control over the operations. To address this, Jen recapitalizes the equity of the entity (note that recapitalization is generally a rather simple process) so that Jen owns one share of voting stock and 99 shares of nonvoting stock. Now, Jen can gift 99 shares of nonvoting stock, or 99 percent of the company, to Sam. While Jen is only left with one percent of the company, she has 100 percent of the voting powers — thus retaining complete control over the business operations.
In planning for the transition of control, our discussions typically address both voluntary transfers of control (that is, gifts of voting stock made by older generations during their lifetime and at their discretion, as illustrated above in the example with Jen and Sam) and involuntary transfers for control (that is, control transition through death, divorce, bankruptcy, etc.).
This discussion is unique to each family setting, and we have advised many different structures, including:
(i) Gifts of voting stock outright to the younger generation,
(ii) Gifts of voting stock in trust to be controlled by a trustee, and
(iii) The implementation of voting trusts.
Regardless of the plan that is implemented, it is essential that the parties use diligence in both:
(i) Ensuring that their estate planning documents and buy-sell agreements properly implement the plan and
(ii) That the plan is revisited at least annually to prevent it from going stale.
2. How and when do I transfer nonvoting stock to the next generation?
Assume that your entity’s equity structure mirrors that of the example above (one percent voting and 99 percent nonvoting). After counseling our clients on the attributes of nonvoting stock (such as no control over the daily business operations and the timing and amounts of the advances or distributions made to the shareholders), they find very little “value” in retaining it.
In what may come as a surprise, we find that those dealers that retain the majority of their nonvoting interests tend to require more complex estate and insurance plans to address liquidity issues upon death. As a result, we have found that a comprehensive estate plan for most of our clients interested in an eventual transition to the next generation typically involves transfers of nonvoting stock, either outright or in trust, to the next generation before death.
To accomplish this, we have counseled clients through various strategies, some of which include:
(i) Leveraging their gift exclusion amounts (currently $5,450,000 per individual for 2016),
(ii) Selling nonvoting interests to trusts that benefit the next generation, and
(iii) Implementing one, or a series of, grantor retained annuity trusts.
3. How do I balance children in the business with children not in the business?
This issue can most easily be illustrated through an example. Assume Casey, the 100 percent owner of a dealership, has four children (Joe, Mary, Ben and Pam). Joe and Mary work in the business (the “Operators”), while Ben and Pam are teachers (the “Teachers”). The business has a fair market value $40 million. Casey wants to treat each child “equally.” What should/could Casey do?
There are many sub-issues we counsel our clients through in making these decisions, a few of which include:
• What is considered equal?
o Do the Operators each receive $20 million in stock and the Teachers each receive $20 million of cash? Many may argue that $20 million in cash is a better inheritance than $20 million in stock of a closely held business.
o Do the Operators each receive $20 million in stock and the Teachers each receive $10 million in cash? Under this logic, if the Teachers had in fact been Operators, they would have received one-fourth of an entity valued at $40 million, or $10 million worth of stock.
• If you want to give cash to the Teachers, where does the cash come from? Do you purchase life insurance? Sell a franchise? Require the Operators to buy-out the Teachers?
• What if each child receives a 25 percent interest in the business, with the Operators having the voting interests? Under this scenario, what are the Teachers really receiving? The Operators may never make distributions to the Teachers. Also, what if the Operators grow the value of the business from $40 million to $400 million and the dealerships are sold? Is it ‘fair’ that the Teachers receive $200 million, or one-half, of the proceeds?
4. What does estate liquidity mean?
Assume Sam owns 100 percent of a business and related real estate with a fair market value of $45 million. His estate plan provides for 100 percent of the entity to pass to his sole child, Julie. Sam’s other assets consist of $5 million in cash/marketable securities, a $2 million primary residence, and a $3 million secondary residence. Sam’s death generates a $20 million estate tax liability. Even if Julie sells both residences, she still must generate an additional $10 million to satisfy the estate tax liability. What does Julie do? Is she now forced to sell the business as soon as possible to generate cash?
This hypothetical has become reality for many business owners who have failed to engage in proper succession planning as it relates to liquidity needs. We encourage you to explore conducting an appropriate analysis, on an annual basis, to monitor this issue. Generally, plans to address liquidity involve one or more of:
(i) Life insurance,
(ii) Ensuring availability of other asset sources and offsetting against liability exposures, and
(iii) Utilizing certain elections available on the federal estate tax return for payment of taxes over a period of time.
5. How do the manufacturers react to estate plans?
We understand that, in many industries, the relationship between a manufacturer and a distributer can be tense at times. Therefore, many of our clients are hesitant about diving into a comprehensive estate plan for fear of placing even more strain on the relationship.
However, in our experience, not only have both sides been cooperative when it comes to incorporating a succession plan, some have been the biggest proponents of the process.
Consider succession planning from a manufacturer’s perspective: if your dealership is moving tires with acceptable levels of customer satisfaction, you are a great asset to the manufacturer’s business and going concern. If they were to engage in a S.W.O.T. analysis (Strengths, Weaknesses, Opportunities, Threats) with respect to the distributor, a “threat” would likely center around the current generation’s death, incapacity, retirement, etc.
When they learn of the steps the distributors are taking in planning for the transition of the business from one generation to the next, one of their threats is being addressed, and it serves them well to be cooperative, if not encouraging, in the process. The reverse is also generally true when a distributor learns that its supplier is taking action to place the entity in the best position to survive an ownership transition.
Get onto your succession plan today
Whether you think it’s years before you need to worry about succession planning, or if it’s something you’re already actively considering, it’s worth talking to your family and your advisors and getting the best possible plan for you and your situation in place.
You can reach out to the team at Schneider Downs through their website.