Succession, an Attorney's Perspective

Family Business and the Process of Succession

There are various definitions of a "family business."  We are focusing on a business owned or controlled by members of a single family, and in which members of at least two generations work in the business.  The generational shift of leadership as well as ownership requires appropriate succession and estate planning.

The Systems

Three separate systems influence family businesses.  These are ownership, management, and the family.  Each system has its own dynamics and its own set of issues.

Ownership issues are dealt with through legal structures, shareholders agreements, buy-sell agreements, and the like.  Management concerns are dealt with through by-laws and other documents of corporate governance, employment agreements, policy manuals, education, and communication.  Family issues are dealt with through family mission statements, family constitutions, and similar documents that set forth family core values, goals, and rules; as well as the use of family meetings and, perhaps counseling, coaching, or therapy.  When these systems intersect, conflict may arise, and in order to alleviate the problems their history needs to see the light of day.

The problem may involve who in the family is entitled to work in the business or who is entitled to have a proprietary interest.  For example, is obtaining work experience elsewhere a prerequisite to working in the family business?  Alternatively, is ownership a birthright or is it only available to family members who have worked in the business for a certain number of years and have demonstrated the ability to add value?

Succession Planning

Succession planning involves both management and ownership.

Management Succession

Management succession is the most important issue facing family businesses.  With respect to management, succession planning is the deliberative and formal process facilitating the transfer of management control from one family member to another.  The purpose of the process is to ensure continuity and prosperity in the family business.¹

If the family culture requires a member of the family lead the company, there is obviously a smaller talent pool from which to draw.  In addition, sibling and other rivalries may either thwart the selection of the appropriate person to lead, or result in the less effective method of operating the company through power sharing by siblings or cousins.

Professional managers may provide the necessary leadership, either during a transitional phase or on a permanent basis; however, to recognize this and to bring it about usually requires the help of outside advisers.
Typically, leadership of a family business continues in one person for a period much longer than in the case of non-family businesses.  Assuming good health, a family member may lead a company for many decades, whereas other businesses often fix retirement ages and do not have open-ended leadership terms.

Because of complacency, family businesses tend to neglect dealing with management succession.  Having a fixed retirement age forces a company to establish a process or plan to deal with management succession.  Obviously, this process is very helpful in the case of an unexpected death or disability.

A successful management succession plan requires the following:

• The current leader must have the desire to continue management control in the family.  This is important because the leader generally controls the succession process.
• The members of the family are on board with keeping the business in the family.
• The chosen successor has the integrity and ability to lead the business.  That is, the current leader trusts that the successor can do the job.

 Who Should Lead

After many years of study and observation, Peter Drucker believed that effective leaders:²

• Determine what needs to be done for the business.  They tackle no more than two tasks at any one time, and they set priorities and stick to them.  It is a continuing process.
• Determine what is right for the business as opposed to what may be right for its owners, the employees, or the stock price.  "In the successful family company, a relative is promoted only if he or she is measurably superior to all nonrelatives on the same level."³
• Develop an action plan, that is, a statement of intentions, the purpose being to have a flexible plan, which is reviewed often and changed when circumstances dictate.
• Take responsibility for decisions and for communicating them to their superiors, subordinates, and peers.
• Focus on opportunities rather than on problems.  Problems are dealt with, but greater attention is devoted to exploiting opportunities.
• Run productive meetings, sticking to the stated agenda.
• Think in terms of "we" rather than "I", i.e., their attention is on the needs and opportunities of the business rather than on their personal needs and opportunities.

Ownership Succession

As ownership is passed to successive generations, a fundamental issue is whether family members who do not participate in the business are eligible for ownership.

Where the family has established wealth outside of the company, non-participating family members may not receive equity in the business since equivalent value may be available in the form of real estate, marketable securities and other non-business investments, leaving such equity for those family members who work in the business.  Oftentimes, this is not possible because the major family asset is the business itself.

However, it is not uncommon for children working in the business to want to share in the non-business assets as well, since such assets may be income producing or provide needed liquidity. Even in situations where there are substantial assets in addition to the family's interest in the business, it may be part of the family's culture to disperse ownership among family members regardless of participation.  There is no right answer.  This is a decision that each family must make for itself, depending upon its history, philosophy, and custom.

Many successful businesses, especially those that have made it to the fourth and fifth generations, have ownership in the hands of non-participating family members.  Control, however, can be maintained in certain family members through the use of voting and non-voting shares as well as voting trusts and voting provisions in shareholders' agreements.  Again, although not a universal rule, control may be left to those who participate in the business.

Facilitating Ownership Succession Through Estate Planning

Once a family decides upon the rules of the game, the estate planning process can begin.  Certain planning techniques, which can help facilitate the transfer of the family business, are discussed below.

Grantor Retained Annuity Trust

One popular strategy is the grantor retained annuity trust or "GRAT."  Generally, a GRAT provides for an annuity to be paid to the grantor (the creator of the trust) for a stated period and at the end of the period, the remaining property (the remainder interest) either passes outright to the family beneficiaries, or continues to be held in trust for their benefit.

The annuity and remainder interests are valued in accordance with Treasury Regulations.⁴  Since only the remainder interest is being given away, its value is subject to gift tax when the GRAT is created.  However, in Walton v. Commissioner⁵ the U.S. Tax Court decided that it was possible to structure a transaction so that the value of the remainder interest is negligible, if not zero, resulting in no gift tax upon the creation of the GRAT.  In such cases, the payout percentage of the annuity would be approximately 54.70% for a 2-year term and approximately 37.55% for a 3-year term.

Reasons for using a large payout percentage over a short period are to lessen the mortality risk and to transfer future appreciation without any gift tax.  The GRAT is especially useful with property that either produces substantial income or is likely to appreciate within a short time period.  For example, an individual, age 62, owns 100% of the family business valued at $12 million.  In August 2006, she transfers a one-third interest in the business to a GRAT with a two-year term.  Assuming lack of control and marketability discounts of 35%, the one-third interest is valued at $2.6 million ($4 million x 65%).  Further, assume the business has an annual total return of 18%.  At the end of the two-year term, approximately $2.5 million passes free of gift tax to the family beneficiaries, computed as follows

During the term the trust is functioning as a GRAT, it is a "grantor" trust for income tax purposes.  As a result, all trust income including any gain realized on the sale of the interest in the business to a third party will be taxed to the grantor.  The grantor's payment of the tax is a gift tax--free "gift" to the beneficiaries.  If the grantor dies during the trust term, the value of the trust property is includible in the grantor's estate for estate tax purposes.  The grantor may insure against this risk.

Sale to Grantor Trust

The "grantor trust" is unique; it is respected as a viable legal entity apart from its creator for gift and estate tax purposes, yet it is ignored for income tax purposes.  These characteristics provide another opportunity to transfer ownership of the family business to the next generation.

Generally, the grantor creates an irrevocable trust for the benefit of family members.  The trust is structured so that its value is excluded from the grantor's estate for estate tax purposes, but, for income tax purposes, is considered wholly owned by the grantor.⁶  As in the case of the GRAT, the provisions of a grantor trust can be very flexible in providing for the grantor's children or other family members.

The transaction is straightforward.  The trust purchases the stock or other proprietary interest in the business on the installment basis.  The promissory note provides for periodic interest payments at the "applicable federal rate"⁷ with either amortization of principal or a balloon payment at the end of the period.  The result:

• No taxable gain or loss is recognized by the grantor on the sale.
• The grantor is not taxed on the interest payments on the note.
• The grantor bears the income taxes on all of the earnings of the trust.
• The trust is an eligible S corporation shareholder.⁸
• Ownership of the business is transferred free of gift tax.

The trust should have economic significance independent of the sale.  It is generally recommended that the trust be funded with assets such as cash or marketable securities, if available, in order to avoid valuation issues, to the extent of at least 10% of the value of the anticipated transaction.  This contribution will be a gift subject to the gift tax regime.

If the property is sold to the trust for its fair market value, there is no gift because the grantor is receiving adequate consideration.  However, if the consideration is not sufficient, the transaction will be considered a taxable gift to the extent of the bargain.  Thus, an independent appraisal of the property is key.

The sale may be structured with a self-canceling installment note (SCIN).  A SCIN is an installment note, the terms of which include a provision that all amounts coming due after the death of the grantor are canceled upon his or her death.  Thus, the balance due (not including amounts in default) at the time of the grantor's death is not subject to estate tax.  The trust must pay a premium for the self-canceling feature based on the grantor's actual life expectancy.

Generally, property includible in one's gross estate for estate tax purposes receives a "step-up" (or "step down")in basis to the fair market value at the date of death (or alternate valuation date).⁹  As a result of the sale, the interest in the business will not be includible in the grantor's estate, therefore, it will not receive a stepped-up basis.  The business interest will have the same tax basis that it had when owned by the grantor since the sale to the trust is not recognized for income tax purposes.

As long as the trust remains a grantor trust, the grantor will recognize no gain or loss on the installment sale.  Upon the grantor's death, the trust ceases to be a grantor trust and becomes a separate tax-paying entity.  The income tax consequences are unsettled if the grantor dies while the obligation is still outstanding.  Resolution of the issue depends on whether the sale is deemed to take place before or after death.  The problem is avoided altogether if the note is satisfied during life.

A private annuity which is payable for the life of the grantor may be considered as an alternative to the SCIN in a sale to a grantor trust.  On the grantor's death, there is nothing to include in the grantor's estate for estate tax purposes.  The choice between alternatives generally depends upon the age and health of the grantor.

Charitable Lead Trust

A charitable lead trust ("CLT") provides that the "lead" interest be paid to a charitable organization or organizations, and the remainder be payable to family members.  It is, in essence, a mirror image of a charitable remainder trust (see below) where the lead interest is payable to a family member and the remainder passes to charity.

In order to qualify for the income tax and the gift or estate tax charitable deductions, the lead interest must be in the form of either a guaranteed annuity (a specified dollar amount) or a unitrust interest (a specified percentage of the fair market value of the trust property).  The charitable beneficiaries of a CLT may include a family foundation.  At the end of the lead period (which can be for a term of years or over a lifetime or lifetimes) the property remaining in the trust returns to the family.

If the CLT is a grantor trust, the grantor is entitled an immediate income tax charitable deduction equal to the present value of the annuity or unitrust interest.  In such a case, however, the grantor will be taxable on the income subsequently earned by the trust.  Once the trust ceases being a grantor trust, a portion of the charitable deduction must be "recaptured."  This would occur if the grantor dies prior to the expiration of the charitable term.

The amount of the charitable deduction is equal to the present value of the annuity or unitrust interest.  The longer the charitable term, the higher the payout rate and the lower the applicable Treasury rate, the greater the value of the charitable interest and corresponding charitable deduction and the lower the value of the remainder interest and the taxable gift.

The CLT can facilitate the transfer of an interest in a business to the younger generation as well as satisfy philanthropic goals.  Assume Sally, the matriarch of the Simon family, wishes to transfer her interests in Simon Sez, a family business, to the next generation, and fund the Simon Family Foundation as well.  A CLT can fulfill both goals.

If Sally transfers $1 million of Simon Sez stock to a 15-year CLT with a 6% charitable annuity in August, 2006¹⁰, the following will result:

If the business produces a return in excess of 6%, the remainder interest which will pass to Sally's children at the end of the term will be in excess of the actuarially computed $417,268.  Sally's children will receive all of the shares originally transferred to the CLT plus the return in excess of the 6% paid to the charitable beneficiary.  If, however, the CLT failed to produce at least 6%, the principal of the trust would be dissipated to satisfy the charitable annuity.

Unlike a GRAT (discussed above), the grantor need not survive the trust term in order for the CLT to succeed.The CLT can prove especially useful in cases where the grantor is in poor health but not "terminally ill"¹¹, the trust term is for the grantor's life, and the grantor's actual life expectancy is less than his or her actuarial life expectancy.

For example, Sally, who is 62 years old, transfers $1 million of Simon Sez stock to a 6% CLT for her life.  Sally is in poor health, but is expected to survive for at least two years.  The present value of her charitable deduction is $623,706 and the remainder interest, which is subject to gift tax, is $376,294.  If Sally dies shortly after two years, the charity would have received $120,000 ($60,000 annuity for 2 years) and her children would receive the stock in the family business held by the trust free of additional gift or estate taxes.

The CLT is a split-interest trust since it has both charitable and non-charitable interests.  It is subject to the various rules that govern private foundations.¹²  Accordingly, the trust must include provisions which will prevent the violation of certain of such rules, such as prohibitions against:  self-dealing¹³; retaining excess business holdings¹⁴; making so-called jeopardy investments; and making so-called taxable expenditures.

There are important exceptions that apply to holding interests in family businesses.  The restrictions against excess business holdings and jeopardy investments will not apply if:  (i) the value of the charitable deduction does not exceed 60% of the total fair market value of the interest in the business held by the trust; and (ii) all of the CLT's income is devoted exclusively to charitable purposes.¹⁵

Charitable Remainder Trust

The charitable remainder trust ("CRT") may also facilitate the succession plan.  In addition to transferring ownership at a minimum transfer tax cost, a CRT can provide retirement security to the older generation, help satisfy philanthropic goals, and provide an income tax deduction.

Revenue Ruling 78-197¹⁶ provides that the Internal Revenue Service will respect an intra-family leveraged buy-out as long as the CRT has the freedom to opt out of the transaction.  Private Letter Ruling 200230004¹⁷ provides the roadmap.  The authors describe the transaction in a recent article.¹⁸

Conclusion

The ownership of an interest in a successful family business is not only a valuable asset, it represents a legacy as well.  It can provide not only for a family's financial well-being but also for the emotional connection to preceding and subsequent generations.  As a result, a thoughtful and well-defined succession plan is a key to growing the business and sustaining family relationships