Family Business Succession Planning (Non-Tax Aspects) – Part 2

Family Business Succession Planning (Non-Tax Aspects) – Part 2

Part 1 of this series offered an overview of family business succession planning and buy-sell agreements. Part 2 of this series will focus on the business sale as an essential component of any family business succession plan. Regardless of the desired succession plan, statistics show that a majority of family business are sold which makes planning for a business sale an integral part of the plan. Continuing from Part 1:

III. Sale of Business

A.        Preparatory Actions

As with selling a house, the business should be in good order before being put on the market. Preparatory actions include:

• Valuation
  • To facilitate the valuation process, the owner or his/her accountant should submit to the business appraiser:
    • an “adjusted balance sheet” listing the company’s assets at estimated fair market value and eliminating assets and liabilities that will not be transferred (such as cash, any personal vehicles and associated obligations, etc.)
    • a three-year “discretionary income” spreadsheet adding back to the business’ taxable income: compensation paid to the owner(s); depreciation; interest income and expense; expenditures motivated by “tax avoidance” and any other items that are not integral to the business
  • Control expenses – if the most heavily weighted valuation component is the business’ cash flow, each dollar of savings will have a multiplier effect on valuation

• Records
  • Conform financial records to generally accepted accounting principles (GAAP)
  • Obtain a review or audit of the financial statements of the business
  • Bring contracts and other records up-to-date
• Update SWOT analysis and business plan to reflect focus on current opportunities, competitive advantages and improvement of weaknesses (sometimes identifying additional resources for growth attracts buyers who can provide the resources for an immediate ROI increase)
• Create reports showing historical and projected business growth
• Prepare detailed asset schedule and detailed records of completed and pending jobs/sales/transactions
• Enhance business image
  • Update web site and printed marketing materials
  • Clean up facilities – dust inventory storage to reduce appearance of obsolescence, upgrade exterior landscaping, etc.
  • Obtain customer and business partner testimonials

• Information systems (including accounting software) should be “standard” to facilitate buyer utilization
• Reduce excessive concentrations of suppliers and customers
• Groom strong employees and qualified managers to reduce dependence on departing owner(s)
• Negotiate key personnel employment/retention agreements
• Execute noncompetition and confidentiality agreements with all personnel/consultants

• Intellectual property
  • protect trade marks, patents and copyright by registration
  • protect trade secrets by confidentiality agreements and other actions reasonably necessary to preserve secrecy
  • confirm adequacy of licenses for intellectual property used in the business

• Conduct a “sell-side” due diligence review to anticipate buyer issues, avoid buyer “surprises” and maintain buyer trust in seller’s integrity. Due diligence is an in-depth investigation to ascertain matters potentially affecting the business. Typically a buyer will submit a “due diligence” questionnaire covering a broad range of issues to identify areas of concern and to eliminate those of no concern. A sample questionnaire is located here. Seller responses frequently form the basis of the representations and warranties in the purchase agreement.
• review material contracts, leases and loan documents for imminent expiration and for clauses prohibiting assignment, change of control or ownership transfers
• Identify obligations personally guaranteed by selling owner(s) for refinancing or release
• Engage legal counsel and accountant experienced in selling businesses
  • Review business and transaction structures which minimize owner’s exposure to post-sale liabilities
  • Analyze and, if feasible, settle pending litigation by or against the business
  • Analyze potential environmental liabilities
  • Due to conflicts of interest, the same legal counsel should not represent the buyer and the seller.

• Determine optimum tax-advantaged sale structure
  • Although each sale is different, the following generalized rules provide a starting point.
    • Buyers generally prefer to purchase the assets of an appreciated business to increase their basis for tax purposes for recovery through future depreciation and amortization.
    • Owners of a C corporation generally prefer to sell stock since an asset sale may result in taxation at both the corporate and the shareholder levels.
    • If the business is conducted as an S corporation, partnership, or limited liability company taxed as a partnership, complex tax considerations affected by the character of the assets sold generally determine the owner’s tax liability.

• Analyze sale alternatives
  • sale of ownership interests or assets
  • full or partial sale, with or without an auction
  • minority equity investment/recapitalization
  • retained assets or lines of business for post-sale income to selling owner(s)
• Identify and contact potential purchasers through existing contacts or, after your attorney’s review of the contract, engage a business broker or investment banker to market business by auction or negotiated sale
• Analyze potential buyer’s financial and operational capabilities to complete the transaction and to meet required licensing standards
• Discuss potential sale with key employees and obtain agreement to maintain confidentiality (beware of shifting employee loyalties from current owners to the leading purchaser candidate)
• Divide due diligence into phases
  • Phase 1 – summary business information is delivered after the potential buyer has been qualified and a confidentiality agreement has been signed
  • Phase 2 – business information provided after a letter of intent is executed
  • Phase 3 – highly sensitive business information should be made available only after all other buyer closing conditions in the purchase agreement have been satisfied.

Caveat: No confidential business information should be disclosed prior to buyer’s execution of a confidentiality agreement. Even after the confidentiality agreement is signed, extremely sensitive business information should not be disclosed until all other buyer closing conditions are satisfied or waived or verification arrangements are made for independent confidential review by a third party professional. Although a confidentiality agreement provides legal recourse for buyer violations, the remedy may not be satisfactory from a practical perspective. The damage to the business will have already occurred, and litigation is expensive, time consuming and frequently takes years to conclude.

B.  Sales Documentation

• Letter of intent
  • expressly nonbinding major transactional terms for preparation of definitive sales agreements
  • expressly binding provisions for confidentiality of disclosed information, non-solicitation of employees, nondisclosure of negotiations, allocation of costs and dispute resolution.
• Purchase and Sale Agreement (including obligations to refinance or obtain release of seller guaranties; expect the buyer to require a noncompetition agreement with each selling owner)
• Consulting and employment agreements with selling owner(s) for continuity and income
• Security Agreement for deferred payments (including earn-outs)
• Buyer’s promissory note, personal guaranty and security agreement for Seller financing

C.  Sale to Employees

• Preparatory actions are generally same as described in Part III.A except due diligence may be reduced for key employees who have been involved in the business. Depending on degree of owner involvement in the business, the purchasing employees may have superior knowledge about the business requiring the reversal of business information disclosures
• Sales Documentation is generally the same as described in Part III.B except representation and warranties of selling owner(s) may be reduced
• Leveraged buy-out or seller financing may be necessary for purchasing employee(s) to pay the purchase price
• Sale to an employee stock ownership plan (ESOP) – a defined contribution retirement plan designed to provide employees with an opportunity to invest in employer securities. Benefits of ESOPs include pre-tax funding of the stock purchases but, due to regulatory requirements, are not appropriate for all situations.
• If less than all of the ownership interests are sold, new owners should be required to execute the Buy-Sell Agreement.

D.  Sale to Family Members

• Preparatory actions are generally same as described in Part III.A except due diligence may be reduced for active family members.
• Sales Documentation is generally the same as described in Part III.B except representation and warranties of selling owner(s) may be reduced
• Leveraged buy-out or seller financing may be necessary for purchasing family member(s) to pay the purchase price
• If less than all of the ownership interests are sold, new owners should be required to execute the Buy-Sell Agreement.

IV. Transfer to Family Members other than by Sale

A.  Transfer Methods

• Direct and Indirect Gifts
• Redemption of transferring owner’s interest (leaving other owner’s interest outstanding)

B.  Non-Tax Issues

• New owners should be required to execute the Buy-Sell Agreement
• Fairness/equalization issues between active and inactive owners
  • Equal transfers to children are not required by law.
  • Sale of business to active children at fair market value can provide the most equal treatment (but may not be the most tax efficient)
  • Distribution to inactive children of non-business assets in an amount having equal value to the business
    • What is the value of the business – “fair market value” of the business as a whole or the discounted value of the ownership interests? (Ownership interests may be discounted for lack of marketability and control)
    • Supplement the value of non-business assets with insurance proceeds as necessary
    • Real estate used by the business may be transferred to inactive children for leasing to the business. Caveat: The property should be transferred subject to a long-term lease with purchase option to prevent “unreasonable” landlord actions
  • Award equity to active children as reimbursement for previously inadequate compensation
• Protections for selling and inactive owners
  • Retention of Control
    • Limited liability companies and limited partnerships may be used to transfer ownership to children while senior generation retains control
    • Senior generation owns voting shares of a corporation and transfers ownership to children by nonvoting shares
    • Ownership interests may be placed in a trust with voting exercised by a board or committee of trustees
  • Income protection for senior generation and/or inactive owners
    • Issuance of preferred stock with cumulative dividends and/or right to require repurchase by the business on pre-determined terms
    • Installment sale promissory notes
    • Salary continuation, consulting and employment agreements
  • Approval requirements for “major” actions
• Contractual protections and incentives for key employees
• Contractual assurance (via Buy-Sell Agreement) of transfer of control to active children on death/disability of currently controlling owner

V.       Tax Minimization Techniques.

Although beyond the scope of this paper, various methods exist to reduce estate and transfer taxes. Listed below are brief, incomplete summaries of a few techniques for discussion with the tax advisor who is part of the family business succession planning team.

A.  Gifting Ownership Interests

• Annual gifts valued up to the annual gift tax exclusion amount per donor to each of multiple recipients
• Gifts valued up to the lifetime gift tax exclusion
• Gifts of family LLC or family limited partnership interests (discounted values for lack of control and minority ownership permit gifts of greater percentages of the business within the foregoing gift tax exclusions)
• Gifts of ownership interests in trust to children and grandchildren
• Gifts to children and charity with subsequent corporate repurchase from charity

B.  Sales of Ownership Interests

• Installment sale to intentionally defective grantor trust
• Private Annuity
  • Objective – avoid gift and estate tax
  • Structure – ownership interests are sold to active children in exchange for unsecured promise to make payments to seller for the remainder of seller’s life or for the remainder of seller and his/her spouse’s lives
• Self-Canceling Installment Note (SCIN)
  • Objective – avoid gift and estate tax
  • Structure – an installment note in which seller’s death cancels the remaining payments
• Charitable Remainder Trust – seller donates ownership interests to a charitable remainder trust for the benefit of seller (and his/her spouse) followed by a cash sale to the business of the ownership interests; the cash funding of the trust provides retirement income to seller (and his/her spouse) while contemporaneously reducing seller’s ownership interest in the business.
• Grantor Retained Annuity Trust (GRAT) – seller retains the right to receive fixed annuity payments for a term of years or until his death. At the end of the term, the seller receives no additional benefits from the trust, and remaining property (remainder interest) in the trust is either distributed to beneficiaries or held for their benefit. Only the value of the remainder interest is subject to gift tax.

This blog does not establish an attorney-client relationship and does not constitute legal advice. Legal outcomes are based on the particular facts of a situation and the application of the law to those facts.  Anyone with issues described in this blog should hire an attorney for legal advice based on the relevant facts. The firm has no obligation to maintain the confidentiality of any information received by email or comments.