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Ownership Succession Planning for Family Businesses: A Window of Opportunity Just Opened, But Are You Ready?
Sponsored by Deloitte Tax LLP


Orchestrating the succession of a family business to the next generation involves careful planning and execution.

April 7, 2011

Orchestrating the succession of a family business to the next generation involves careful planning. It's a process of asking questions, setting direction, making plans and then executing them. And there's no single formula. This process is a fluid one and it will be a constant work in progress. It's also surprisingly complex for businesses of all sizes and structures with issues ranging from family to tax planning and from business valuation to goal articulation. Research has shown that only 30 percent of family-owned businesses survive into the second generation, while 12 percent survive into the third. Clearly, solidifying your business's future takes more than the desire to do so.

The Game Has Changed — At least for the Short Term

While there are many considerations and techniques for passing the value of a family-held enterprise efficiently to future generations, a key tool for transferring wealth traditionally has been the federal gift tax exemption — an amount that has, in recent years, been set at $1 million.

On December 17, 2010, President Obama signed into law changes in the tax code for calendar years 2011 and 2012 that increases the federal gift tax exemption to $5 million per person ($10 million for a married couple) through December 31, 2012 — providing business owners with a substantial, but relatively short-term opportunity to expedite wealth transfer to the next generation.

As tempting as this opportunity may be, there are at least four "nontax" essentials that must be in place before moving to pass business-based wealth to the next generation. These include:

  • A willing donor
  • A prepared donee
  • A sound business, with sound management and governance
  • A sense of urgency

Let's look at what each of these means.

A Willing Donor

One of the most important characteristics of a donor ready to pass on the business to future generations is financial independence, i.e., one who is no longer financially dependent on the business. Most business owners say they have the majority of their personal wealth tied up in the businesses they run. When the time comes, it may be difficult to strike a balance between taking wealth out and leaving a healthy operation behind. The various methods for transferring equity — such as sales, gifting and the establishment of trusts — each have different implications for the retirement income they provide, the burdens the new owners assume and the future success of the business.

Planning for the transfer of business value begins with knowing what the business is actually worth — and many entrepreneurs don't have a very good handle on this. But it's an important precursor to calculating the values involved in a gift of ownership. There are different standards by which value can be measured. Book value might be the simplest yardstick, but it's often more arbitrary than accurate. True fair market value of a business, as required for gift-reporting purposes, is influenced by hard-to-specify variables such as current goodwill and must also take into account future growth potential of the business — and that means looking at a host of things ranging from innovation and increased efficiency to expansion into new markets and areas of operation or strategic partnerships. A third-party appraisal certainly can enhance the probability of success in supporting a value for gift purposes and will take into account any discounts for lack of control or marketability appropriate for the circumstance.

Several other factors may also affect readiness to proceed with succession planning. While achieving financial independence is paramount, an owner also must become comfortable with the prospect of sharing — or more significantly, relinquishing — power. For a first-generation business, succession of power is often relatively straightforward and perceived issues can be mitigated through the use of trustees, effective board of directors structures or the use of non-voting stock. When the business is in its second or third generation of ownership, the presence of multiple owners with differing priorities may make it difficult to gain consensus about plans for the future. All of these issues take time to resolve — for some families months or even years. Hence there is an urgency to proceed with planning swiftly

A Prepared Donee

Confidence in the recipients of business-based wealth — and their potential impact on its value and prospects — is also important. There are many factors that may influence an owner's feelings about the next generation's ability to carry out his or her vision of the business — from perceived (or actual) behavioral shortcomings, to fears that increased wealth will have a negative impact on the donees' lives or willingness to work hard to build and grow the business. Various tools, including trusts, enable donors to initiate transfers and lock in today's gift value, while slowing access to wealth. Again, these transfers require careful planning and time to understand and establish.

A prepared donee or group of donees can be effective future steward(s) of the business regardless of their involvement in the day-to-day management. For many potential donees, however, being a steward of a multigenerational family business is not intuitive and must be learned. A donor will consider a donee to be prepared when he or she can visualize this stewardship in the donee. It is the donor's ultimate success to make this happen through training and mentorship. This, again, takes time.

A Sound Business, With Sound Management and Governance

As a matter pride, a donor generally doesn't want to pass on a "bad" business to his or her family. Likewise, most prospective donees probably don't relish the challenges of running a troubled enterprise. As it is in situations involving a sale of the business, it is important to have a solid business foundation — a sound operating model, a timely and well-conceived business plan and products/services that are compelling and differentiated in the marketplace.

Having a strong management team, current and future, is an important consideration and often a stumbling block to efficient transfer of ownership. In fact, owners who are actively involved in the business often confuse the concepts of management and ownership succession. These are — and should be treated as — distinct plans and having a management-succession plan in place is just as vital to the process as the plan for transferring ownership and stewardship in the business.

A majority of family business owners who plan to retire in the next five years say they have not identified a successor. And the top spot isn't the only one that has to be filled — second-tier leadership positions are just as important in maintaining continuity. Before they can step in, successors need to be three things: identified, in place and ready. It's rare to find a company that doesn't have a gap in at least one area. The question is how to close any gaps. That puts a premium not only on planning ahead, but also on recruiting, retention and training.

It is important not only to make a plan, but to discuss it with family and other stakeholders to make sure it's one for which everyone is comfortable and prepared. A business is many things to many people. For a management successor, it may be a career path. For an inactive family member, it can be a source of future financial independence and opportunity. A particular enterprise will lie somewhere on a continuum of priorities — on one end a pure family system managed by blood ties and on the other a pure business system built on profit and management by whoever is most qualified. Most businesses fall somewhere in between these extremes and managing expectations is a balancing act. One way to achieve this balance is to establish a governing structure — such as an outside board of advisors or a formally constituted family council — that separates the "family-ownership activity" from the "business-management activity"

A Sense of Urgency

Transferring a business from one generation to the next involves hard work and difficult decisions. Frankly speaking, it can be easier to sell a business than to make it multigenerational.

Maybe you've built your business from the ground up. Maybe you've been a good steward of something passed on to you. Maybe your success has been based on balancing and serving the demands of private investors. Even if you intend to be the last link in the chain, there's a right and a wrong way to pass on the value of the company. It all starts with a plan.

In any era, it is important is not to wait to plan — but the change in tax law and the potential for a $5 million exemption (or $10 million if combined with a spouse) through the end of 2012 heightens the sense of urgency to plan considerably. Succession lies in the future, but succession planning is a present-day necessity. Every day that passes may reduce the number of options you'll have and even small steps should help keep those options open.

For more information, visit Deloitte Tax LLP.