Passing the Business on to the Next Generation
By Bill Schoeffler & Catherine Oak, CIC, AAI

At some point, most business owners must decide whether their business will be held for the next
generation or be sold to a third party. Recent statistics indicate that only 35% of family
businesses survive past the first generation of ownership and about 20% survive to the third
generation.

There are many reasons why family businesses do not always successfully pass down through
the generations. Sometimes no family member wants to, or is able to, manage the business. Not
everyone is an entrepreneur capable of running a business successfully.

Typically, however, the next generation cannot afford to handle the buy-out. If the business is
gifted, the tax consequence in gifting may create a large financial burden on the retiring owners.
These problems result from mainly a failure to properly plan rather than from any other reason.

Holding the Business for the Next Generation.
The successful transition of the business for the future generations requires planning. The
founding owners need to plan for their retirement, death or disability. Without a good plan, the
fate of the business is up to the whim of outside influences, such as the courts. Also, the lack of
any plan may create a situation that will drastically lower the equity or value of the firm, thereby
not preserving the family wealth.

Incentives have to be provided for children and family to remain active in the business. A means
to provide liquidity for the estate of the senior generation to pay taxes and expenses relating to
the business must be established. Transfers must be structured in a tax-efficient manner.

Decide Who Will be Next
Treating all the children equally may not necessarily mean treating them all fairly. Ownership
should only be reserved for children active in the business. A non-active owner tends to create
many problems for the active owners. For some people, the lack of day-to-day control is often
asserted by other means, such as not agreeing to a major decision just to show their power.

There are many other issues that need to be investigated and resolved. What rewards should be
given to children already in the business? If there is more than one child, who will own the
company? Should control be given to only one child, and if so, which one? Once the decision is
made to pass the business to the next generation, the next goal is how to do it and to put the plan
in writing.

Pass Control Efficiently
There are several common options for passing the business to the next generation. The three
most common are gifting, stock redemption and stock purchase. The use of "tools" such as
trusts will add to the variations that can be used to transfer business ownership.

Which "tools" are used and how the transfer is structured is based on three things, minimizing
taxes, making sure it is affordable and ensuring that the seller has an adequate income stream.
Each retiring owner needs to perform their own financial planning. Part of the planning should
include their expectations on how much they will get for their business and an idea on the terms
of the pay-out.

For an insurance agency, there are some common techniques that can be used to minimize taxes
and ensure that the pay-out does not break the business. These techniques will require planning
and usually reduce the retiring owner's return on equity. For many owners, however, the end
results of successfully passing the business to the next generation are more desirable than the
amount of the sales price or the pay-out terms.

Gifting the Stock
Individuals may give up to $10,000 to any number of recipients each year without being subject to
federal gift taxes. A spouse may also join in gifting. This allows a husband and wife to give
together up to $20,000 annually to any number of recipients. A child and their spouse can
therefore receive up to $40,000 in stock per year, free of gift taxes. Because the marginal federal
estate tax brackets begin at 37% for estates subject to tax, for every $10,000 given during lifetime,
at least $3,700 of death taxes can be saved.

GRATification
A grantor retained annuity trust ("GRAT") is a trust to which a donor transfers property, retaining
the right to receive annual payments from the trust for a term chosen by the donor. A taxable gift
is made as to the present value of the remainder interest (at the end of the fixed term) in the
property. If the grantor survives the fixed term, the entire value of the property escapes estate tax.

The value of the grantor's annuity interest is subtracted from the value of the trust property in
determining the amount of the taxable gift resulting from the creation of the trust. The transaction
is leveraged in the sense that the gift removes a larger amount from the grantor's gross estate for
estate tax purposes than is subject to the gift tax. Basically, a GRAT allows property to be
transferred to a member of the grantor's family at a reduced transfer tax cost. Payments are
normally deductible for the firm.

Deferred Compensation
Establishing a deferred compensation plan is a tool one can use to lower the value of the firm in
order to make the purchase affordable for the new owners. Deferred compensation is a way of
saying that you are not currently receiving fair compensation for your current work and you plan
to take it out at a later date.

The deferred compensation becomes a liability on the firm's balance sheet since it is a debt that
must be paid. Because it is a liability, the value of the firm is lowered. The retiring owner receives
their equity in two components: the value of their business interest and the deferred
compensation. The drawback is the deferred compensation is taxed as ordinary income (up to
39.6 % plus payroll taxes), whereas, the income from the sale of the business is taxed as capital
gains (usually a 20% rate).

The firm needs to file with the state that it is establishing a deferred compensation plan. This
should be done years in advance of retirement. The plan can be funded or unfunded, however,
for lowering the value of the firm it should not be funded. Since the deferred compensation is
treated as regular compensation, it becomes deductible for the firm.

Book of Business Ownership
Most owners and their offspring are producers. In the insurance industry it is an acceptable
practice for a producer to own their book of business. An axiom in business valuation is that you
cannot sell what you don't own. Therefore, producer owned books of business are usually
excluded in the valuation of an agency.

First, the producer/heir signs a regular producer contract as an employee of the agency. This
contract includes a clause that allows the producer/heir to own the accounts that they produce.
This way the next generation is not paying for their own effort (the book produced) and the cost
of buying the agency is reduced.

The drawback to the retiring owner is that their equity in the business is reduced. On the other
hand, taxes are minimized (due to the lower value), and the buy-out is less likely to cause a drain
on the business. The heirs will also not resent having to pay for their efforts since their books are
excluded from the value of the firm.

A Final Thought
Any succession planning will take time and must include the advice of tax and estate planning
professionals. Keep in mind that these techniques must be done within the context of acceptable
legal limits and must not be used in a manner to avoid taxes.

Most owners would like their business to continue and thrive well after they exit the firm. With
the proper planning, owners can create a structure that will increase the chances that their
business will be passed successfully to the next generation.