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Family Business Transfers: The Most Hazardous Exit Path

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In this article we discuss the indispensable requirement of successful transfers:  financial security for the owners/parents.  That requirement is too often threatened by a hazard common to this exit path:  transferring control to successors (in this case children) before the owners (parents) attain financial security.

All of us have watched parents transfer control, too soon, to children who subsequently prove incapable of, or unwilling to maintain the success of the business.  As children fail, the parents are helpless to intervene.  The business, the parents’ financial security, and usually the hoped-for family legacy are destroyed.

Parental Financial Security

Unless an exit path leads to the owner’s financial security, it isn’t an exit path:  it is a cliff.  The definition of financial security and how it is achieved, however, depends, in large measure, upon an owner’s unique situation. 

Some owners are fortunate enough to enjoy financial security independent of the business.  Typically this occurs when, over years, an owner invests excess earnings outside of the business.

Some owners can reach financial security by leasing personally owned assets back to the business for its use.  These assets usually consist of equipment or office, warehouse or manufacturing facilities used in the business.  Keeping ownership of these types of assets outside the business and its transfer:

  1. Provides ongoing, consistent income for the owner.
  2. Lowers the value of the business and reduces transfer (gift or estate) taxes thereby easing the transfer of a business to a business-active child.
  3. Makes assets (or wealth) available for transfer to non-business-active children (NBAC).
  4. Protects assets from future creditors of the business after the parent exits.
     

The difference between owners who look to leasing income and the owner whose financial independence does not rely on the business is that the first owner likely needs the business to continue to generate rental income.

Most owners, however, must achieve financial security through ongoing income from their businesses.  This is the major reason why a business owner should not consider–even for a moment–transferring control (operational or ownership) before achieving financial security.

In the transfer of ownership to a child then, there are two competing issues:

  1. Owners must attain financial independence before they transfer ownership and control to their business-active children (or BAC).
  2. The best tax-avoidance ownership-transfer strategies involve gifting, not selling, ownership to children.  This means, of course, that when owners transfer their controlling interest, they get nothing (or at least no cash!) in return.
     

Jumping the Gun

If an owner tells you that she wishes to transfer her business to a child before she has attained financial independence, that announcement should raise a giant red flag.

Of course the owner trusts her child, but events outside the child’s control can cause the child to lose control of the business or affect its cash flow, e.g. the child’s premature death or (far, far more likely) divorce.  Also, children can make poor business and personal decisions that destroy business value and cash flow.

To protect owners, yet give children the assurance that they will one day own the business, BEI Members take the following actions:

  1. Amend the parent’s estate plan to provide for a transfer of ownership to the child at the parent’s death;
  2. Create a written Exit Plan describing the steps in which the child receives ownership as the parent attains financial security.  The plan design is based on the business attaining annual financial benchmarks, an approach we often use in insider transfers.
     

If the BAC insists on controlling the business immediately, we recommend that the child obtain financing in order to pay cash for the parent’s ownership interest–if that financing will provide the parent with financial security.  Of course this sale structure means the family does not avoid the double tax:  first on the parent’s gain from the sale, and then on the child’s income used to pay for the parent’s ownership.

Also, banks are unlikely to lend money to successor owners unless they make a large down payment (20 to 40 percent of the purchase price), or (and this is a big “or”) they already own a large percentage of the business–say 30 to 40 percent.  This means the buying children must receive significant ownership before acquiring the balance of the company for cash via bank financing.

Finally, if the business fails to perform as required, or the child leaves the business during the buy-out period, you must have the right to re-acquire the ownership already transferred.  This enables owners to execute their backup plan to transfer the business and obtain financial security via a sale to management or an outside party.

Whether an owner chooses a third-party sale, sale to management, or transfer to children, the owner/client’s financial wellbeing must be achieved.  With family business transfers, the biggest risk to that financial wellbeing is transferring business control too soon.  A premature transfer of control is unnecessary and dangerous.  Instead consider using the design and techniques (some of which we’ve outlined in this article), to provide assurance to the children that they will own the company and to your clients that they will attain financial security.

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