Reference Library -
Succession
   Reference Library -
Succession

 

 

 

The 10% Solution or the 90% Problem

 What percentage of business owners die while running their business?  What percentage retire?  R. David Wentz, president of Tax Favored Benefits, Inc., posed these questions to dealers during his session titled, “The 10% Solution or the 90% Problem.”

“You know the 10% solution – a buy/sell agreement and life insurance,” Wentz told dealers.  “While that’s a very important 10%, do you know how to solve the rest of it…the 90% problem?”

Wentz offered five ways to transition a business:

  1. Sell, Gift or Leave to a Family Member
  2. Liquidate for Book Value
  3. Sell to Employees at a Discount
  4. Sell to Employees at Market (ESOP)
  5. Sell to an Outside Buyer

He also stressed the importance of developing a strong retirement plan to:

Wentz emphasized that proper plan design remains very important, since no one plan type can meet the needs of all situations and employer needs differ.  “The recommendation should be based on the client’s best interest – not just one size fits all,” he added. 

Wentz explained the different plan types available, including:

Pay-Based Profit Sharing Plans – In this defined contribution plan, the employer agrees to make variable contributions for the benefit of its employees.  Benefits are the value of each participant’s account at retirement or termination of employment.  Businesses with young key persons remain the best prospects for this plan.

Age-Based Profit Sharing Plans – In this defined contribution plan, the employer agrees to make variable contributions for the benefit of its employees.  Contributions are determined by calculating the present value of an annuity for life equal to 1% of pay beginning at age 65.  Best prospects for this plan are businesses with older key persons.

Comparability Plans – In this defined contribution plan, the employer agrees to make variable contributions for the benefit of its employees.  The employees are grouped according to some determining factor and the structure of the group must be defined in the plan document.  Businesses in which lower-paid or non-key employees represent a significant percentage of the total work force remain best prospects for this plan type.

401(k) Plans – This profit sharing plan permits employees to make pre-tax salary contributions.  In addition, the employer can make matching contributions or discretionary profit sharing contributions.  Benefits are the value of each participant’s account at retirement or termination of employment.

SIMPLE Matching 401(k) Plans – This 401(k) plan is available for employers with 100 or fewer employees.   No other kind of qualified plan is allowed and participants remain 100% vested in all accounts.

Safe Harbor 401(k) Plans – In this 401(k) plan, an employer is not required to perform nondiscrimination testing of elective contributions or matching contributions.  This plan must meet certain employer contribution requirements and must provide for 100% immediate vesting of these contributions. 

Money Purchase Pension Plans – In this defined contribution plan, the employer’s contributions are mandatory and based on each participant’s compensation.  Benefits are the value of each participant’s account at retirement.

Defined Benefit Pension Plans – This plan is designed to provide plan participants with a definite benefit at retirement.  Contributions are based on the benefit provided and the actuarial assumptions and cost method determined by the plan’s enrolled actuary.

R. David Wentz is the founder and president of Tax Favored Benefits, Inc., a pension employee benefits administration and brokerage firm with more than 700 corporate clients throughout the Midwest.  Tax Favored Benefits, Inc. is an Association-recommended product. For further information on retirement planning or succession planning, please contact the Association.

 

Passing the Torch-Succession Planning

Picture this…  A dealer (father) is in his mid-60s and has been in business for 25-years as a single-store operation.  A key employee (son) in his middle-30s has been in the business for 10 years and shows great promise.  The major supplier informs the dealer that he will either be a buyer or a seller of the business in the next five years.  The dealer remains in good health, has two other children, is considering retirement and has confidence in his son.  

Sound familiar?  If so, read on.  Samuel Kreamer, J.D., C.P.A. of Dreher, Simpson & Jensen, P.C. offered numerous tips and suggestions on succession planning during his session titled, “Passing the Torch.”

Keys to Success

First, Kreamer stressed the importance of assembling a proper team.  This team should include the dealer and an advisory team made up of his/her attorney, accountant, bankers/financial advisors, family therapist/counselor and I-NEDA.

Kreamer encouraged dealers to make advance preparations and lay the groundwork.  He recommended they:

Kreamer also discussed the general concepts of retirement/deferred compensation and the use of life insurance to fund deferred compensation.  He also covered the tax considerations and mechanics involved.

 The “Art” of the Deal

Once a dealer identifies external and internal candidates, it’s time to put together the deal.  Kreamer reminded dealers that the deal is a process, not an event.  The normal steps in a deal include: 

Gain Exclusion Rules and the Family Business Deduction

Kreamer detailed gain exclusion rules (section 1202) for non-corporate taxpayers and the family business deduction (Internal Revenue Code Section 2057).  Gain exclusion rules stipulate that half of the gain on stock is excluded; the stock must have been issued after August 10, 1993 and held for more than five years; and it must be a “small business stock.”

On the other hand, the family business deduction:

Samuel Kreamer is a practicing attorney and CPA with the firm Dreher, Simpson & Jensen, P.C. of Des Moines, IA

 

Valuing Your Business
Source: Federated Life Insurance Company, 1996

One of the most important and sometimes most difficult thing to do is to determine the value of a business. This is especially true for family-owned businesses where there is no ready market for the shares.

The valuation of a business determines what others will pay for the business upon the death, disability or retirement of the owner. It may also affect the amount of federal estate and gift taxes that may be owed. Therefore, when buy-sell agreements are put in place, it is important that an accurate value is placed on the business. It’s also important to review your buy-sell agreements periodically.

Prior to October 9, 1990, a legally binding buy-sell agreement could fix the value of a business for federal estate tax purposes. Upon the death of a business owner, the IRS would generally accept the value set forth in the buy-sell agreement as the value of the business. However, as of October 9, 1990, special valuation rules were put into place.

Current Valuation Rules
Generally, under current rules, a buy-sell agreement entered into on or after October 9, 1990, carries no weight in setting the value of a business for estate or gift tax purposes. However, there is an exception to this general rule. The IRS and courts will uphold the value set forth in a buy-sell agreement if the following requirements are met:

  1. The agreement must be part of a bona fide business arrangement.
  2. The agreement must not be a device to transfer the business interest to members of a descendent’s family for less than full and adequate consideration.
  3. Terms of the agreement must be comparable to similar arrangements entered into by persons in arm’s length transactions.

These three tests must be independently satisfied.

The above requirements are presumed to be met if more than 50 percent of the value of a business is owned by individuals who are not members of the transferor’s family.

Planning Considerations
Because of the present rules, it is extremely important for business owners to review their buy-sell agreements. If your agreement was put in place prior to October 9, 1990, it will not be subject to the above three requirements. However, if you "substantially modify" your agreement on or after October 9, 1990, you may be subject to these rules.

Substantial modifications are defined as those that result in other than minor changes to the quality, value, or timing of the rights or restrictions in a buy-sell agreement. Modifying an existing buy-sell agreement or adding a new family member shareholder or partner are all considered a substantial modification. On the other hand, a provision to revalue the business periodically so that it more closely reflects the true fair market value, is not considered a substantial modification. If you must modify your agreement, ask the IRS to review your changes to see if they would be considered substantial modifications.

If you are in the process of drafting a new agreement or have one which was effective on or after October 9, 1990, you will want to make sure your agreement conforms to the present business valuation rules. The services of an independent appraiser may be used at the time of drafting the agreement to provide an accurate business valuation.

Determining the value of a family-owned business may be more difficult than in the past. But by complying with the present business valuation rules, you may protect your family and your estate from increased federal estate and gift taxes and avoid estate settlement delays.

 

All In the Family
By Mike Henning

SUCCESSION & TRANSFER TIPS FOR THE PRIVATELY-OWNED BUSINESS

Seasons and Cycles of a Man's Life

One of the major challenges we face working with families in business is helping members of the junior generation to identify, develop and live their career dreams. Many questions arise, for example, should a teenager work part-time in the family's company? Is it best for the 21-year-old to go directly from college to the family business versus working elsewhere? Why do sons in their 30s and fathers in their late 50s have trouble getting along? What is the best age for a person to take over and run a company -- 26? 33? How does a young person know that leading the family company is truly his or her dream in life? How can a parent know their child's dream is to run the company and how best to prepare them? When is the most opportune time for a business owner to retire from the family firm? What happens if a 38-year-old, committed to running the company, discovers his life's structure is in direct opposition to his dream? The questions are many and the studies are few. However, we will explore some research that has helped us to coach families through some of these difficult cycles.

 

 

Age Equals Predictable Value Change
Stage: I II III
Age:

17-25

27-33

34 - 44
Heirs:
  • Self-identify
  • Break with tradition & parents
  • Explore career choices
  • Seek role model
  • Independence
  • Poor relationship with mentors
  • Risk/recognition
Age:

40-50

50-65

60-65
Fathers:
  • Expand business
  • Power/control
  • Less competitive
  • Teacher
  • Tolerant
  • Conservative
  • Loyalty/stability
  • Retain Control

In 1982, John Davis, a Harvard University professor, (now principal at the Owner-Managed Institute at Santa Barbara, CA) studied 200 father-son business teams and discovered that parents and their children tend to differ significantly because of their differences in ages; consequently, predictable patterns of behavior emerge. Davis discovered that conflict between parent and children can often be explained by their respective stages in life. For example, fathers age 60 to 65, become very conservative, retain their power position and responsibilities, and emphasize loyalty and stability. While their sons, age 33 to 40, seek independence, recognition and areas of greater risk, thus creating a stormy relationship with father/mentor. Fathers between 50 and 57 normally have great relationships with sons 27 to 33. But when the son is 20 to 26 or in his forties and fathers are 40 to 50 or 60 to 65, poor relationships are the norm.

The late psychologist Daniel J. Levinson, researched and wrote a classic book in 1978, The Seasons of a Man's Life. Levinson based his study on in-depth interviews with 40 men. He describes the critical part career dreams play during the different stages in male adult development and concludes: "Many young men have a dream of the kind of life they want to lead as adults.

Whatever the nature of his dream, a young man has the developmental task of giving it greater definition and finding ways to live it out. It makes a great difference in his growth whether his initial life structure is congruent with and infused by the dream, or opposed to it. Those who betray the dream in their twenties will have to deal later with the consequences."

What Does This Mean to Families in Business?
In our work as family business advisors, we have interviewed well over one thousand people both active and nonactive in the family business. We have listened to the 25-year-old complain with impatience his idea of leading the company within the next two years, triple his income and gain power and control over his siblings. Nothing is said about the pleasure of working in the industry, the joy of working with his family, or the responsibility of giving back to the community, employees or his family.

We've heard the cry of the 38-year-old divorced, alcoholic who had been bored with the family business since age 29, given much responsibility with little authority. He wanted to change careers, but found he could not get hired on the open market for the income he was used to receiving. The economic "trap" had sprung and he was a victim.

Once a 51 year old told me he was in the business because upon his graduation from high school his father explained he was needed, but he really wanted to follow his dream of being an engineer and build bridges and highways. He burst into tears as he explained how his parents insisted he stay with the family business. He was never able to explore career options, and he will always wonder what life could have been like on the other side of the fence, or what he could have achieved on his own without the support of family and an on-going profitable company.

Those who betray their dreams must deal later with the consequences of frustrations, "I wonder if's", boredom, burnout, unanswered questions, incomplete stage of life and the unfilled dream. They wonder, why am I so miserable.?

We learn that one stage of adult development must be completed before we can successfully move on to the next. (For example, take the twenty-year-old who is coerced into the family business after formal education without the opportunity to explore optional careers. For him, closure on that stage of development will likely not occur until the focus of that stage is complete.) Studies show Americans between ages 22 and 30 will experience 3 or 7 career options on their way to reaching one final career. If a person is to eventually lead their family firm, in our experience it becomes vital to develop a vision for their work and a fire in their belly to accomplish the vision.

As families work together, they tend to assume that others are at the same operating stage of development as they are, even though most would know differently if they thought it through. Our purpose is to give understanding, encouragement, and growth to those people who are struggling to comprehend this implicit concept. Or, to answer the questions, why am I so frustrated if I have been chosen the next president of our family company? If I have a bank full of money, am 64 years old, economically successful children, healthy grandchildren and a loving spouse and have been the president of our family's company for the last 35 years, why do I feel so empty and alone? An individual in a family business will look at any given situation from their own perspective based upon their own stage in life plus the added family dynamics that always play a major role.

This article appeared in Mike Henning's Family Firm Advisor ncwslcttcr. For more information about becoming a subscriber to the newsletter, please write to Henning Family Business Centcr, 1006 N. Pembroke Ct., Effingham. IL 62401 or call 217-342-3728.

 Mike Henning is a nationally respected consultant and speaker on family business issues. For more information, write HFBC 1006 N. Pcmbroke Ct., Effingham, IL 62401, or call 217-342-3728. 

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