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How to Pass Your Family Business to The Next Generation

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You have worked hard for many years building your business.

You have worked for many years building your business to what it is today. While you are proud of what you have accomplished, it’s now time to begin the next chapter in your life. Transferring your business to your children is more complex than people realize. This is true whether you're getting ready for retirement or facing health issues.

Many business owners find it harder to pass their business to their kids than to sell it to someone else. Why? The transfer goes from just being about money to involving family members' feelings and often causing arguments.

To avoid future issues, make a written plan that clearly states your goals and the necessary steps to achieve them. You should create this plan before you leave the business.

Setting Clear Goals for Family Business Transition

When parents retire, they often ask their grown-up children for help in deciding what to do with the business. You must clearly state that you will make the final decision about your future, and your children must understand this. Your financial future is one of the primary goals. Any transfer of ownership and control of the business will not occur until your financial future is secure.

In another article, we discuss how to determine what everyone in the family expects in the exit plan. The article lists common expectations of your spouse, children in the business, and children not involved in daily operations.

We highly recommend that you follow this approach to explore the concerns of all members of your family. It's better to handle these problems now, while you can, instead of leaving them for your heirs to figure out later. This process should eliminate deep-seated resentments from developing later.

Choosing the Right Successor in a Family Business

If you only have one child, who wants to run the business and is qualified to do so, this process is relatively simple. If any one of these factors is not true, the process becomes more complicated.

Preparing for Business Succession Early

Our article discusses the significance of preparing your children early to eventually take over your business. Start this process early. By doing so, your children will be able to assume control of your business in the future. How you talk about your business at home will affect how your children see the business when they grow up.

You should provide them a balanced perspective of the rewards and sacrifices of managing their own business. You can prepare a successful successor by teaching values like honesty, understanding, effort, and taking responsibility. Teach values and skills like communication, organization, planning, team building, negotiation, and compromise.

You can prepare your children early as potential successors. This will provide them with the necessary experiences. Additionally, it will help you determine who genuinely values the company's future.

Starting early may also make you realize that your children may not be capable of managing the business. Even if they want to, they may not have the necessary skills or experience. Assessing their abilities and providing them with proper training and guidance is important. This will help them develop the necessary skills and increase their chances of success in the future.

Having this discussion will be difficult, but it will be less difficult than discussing the business declining or failing. If your child’s decisions put your financial security at risk, guilt and resentments will inevitably happen.

Selecting the management successor

In most family-run businesses, the selection of a successor is an emotionally draining process. As the business owner, you have made efforts to raise your children, ensuring that you treat everyone equally and love them all the same. Now, you must evaluate your children's aptitude and leadership skills and choose one over the others. No wonder business owners are reluctant to begin this process.

Different approaches exist for making the decision on management succession.

  • Some will select a child early and prepare them for management succession. Frequently, it’s the oldest child if he or she demonstrates a passion for the business. This approach may eliminate the most qualified candidate for the position.
  • Other families will have anyone interested in running the business compete against each other. This approach postpones any decision indefinitely and may cause discord among those who are in competition.
  • Another alternative is to establish a Family Executive Council or Board to force siblings to work together. This approach works well when the siblings have different areas of expertise. As an example, one may be interested in financial responsibilities (CFO), another sales management and another manufacturing.
Each situation and its dynamics are different and require a solution that matches the family. If lots of kids want to take over the company when you retire, it's best to sell the business.

Determining the Fair Purchase Price in Business Succession

Wanting to pass your business to a family member poses a major challenge of determining its worth. Many business owners have the majority of their money invested in their company.

They will need to sell their company for a good price to financially support themselves during retirement. At the same time, most children will not have the ability to purchase a company on their own. In addition, any children not involved in the business will want you to get as much as possible for the company.

To pass your business to your kids, seek assistance in determining its fair market value. This will alleviate possible conflict among siblings and will also help establish the value for tax purposes. In ‘How do you value your Business?’ we discuss how a business valuation expert figures out the fair market value of your company.

As previously mentioned, your financial security is one of the primary objectives when transferring your business to your children. You need to support your lifestyle for 20-30 years. As an entrepreneur, you should maximize your business to achieve this. By having an independent valuation done, the price will be fair to both you and your children.

Make the Family Business Affordable for the Next Generation

To pass on the business to your kids, you need to understand the company's value. This understanding will also help support your retirement lifestyle. Unfortunately, exceedingly few children have the ability to purchase a company outright. The following are a few actions you can take to make the purchase more affordable to your children.

Separate building and operating company

If your company owns valuable property, you can create a separate company and rent it to your children. This will significantly reduce the purchase price of the business and increase the pool of potential buyers. You can keep the property as an investment for your retirement or sell it to investors seeking passive income. Nearly everywhere you go there are investors who are looking for rental real estate with tenants in place who are under contract.

Spin the equipment out of the company and lease it back

If most of the company's assets consist of equipment, consider forming a separate company solely for the equipment. This new company can then lease the equipment to the children. Lease taxes are complicated, so consult a certified public accountant before setting them up.

An advantage to this approach is that you own the equipment rather than having a note from the children. If they get into financial difficulty, the equipment will still be there to partially fund your retirement.

This, too, can provide you with passive retirement income, while making the business more affordable to your children.

Create a Supplemental Executive Retirement Plan for the parents

You can make a SERP to get retirement money and lower taxes when passing the business to the next generation. This plan helps you have a stable income in retirement and reduces taxes for your heirs.

Employees can reduce their current taxable income by putting money into non-qualified retirement plans. However, they'll have to pay taxes on these funds when they take them out. These plans, like Supplemental Executive Retirement Plans (SERPs), don't have to include all employees equally. With SERPs, the tax benefits come later, as contributions are only deductible when employees start receiving payments after retiring.

For a business, committing to a SERP means it has to recognize the money it will pay out in the future as a current liability. This can decrease the business's value on paper, which might affect the sale price if the business is sold. However, it also means the business commits to future payments, which can impact the amount of cash it has on hand down the line.

To ensure compliance with IRS rules, it's essential to establish the SERP before selling the business. This timing is crucial for regulatory adherence and financial planning.

Exploring Transfer Methods for Passing on a Family Business

There are many ways to pass your business on to your children, and no single method is best. Since every family is unique, the plan to transfer ownership should take into account your family's specific situation. Often, a mix of different strategies might be the best solution to meet your family's needs.

The following discusses the primary methods to transfer a business to the next generation.

Sell the business to the children

Selling your business to your children is a common way to transfer ownership. However, many children may not have the funds to buy the business outright. In such cases, you might need to finance the sale yourself and allow your children to pay you back over time.

Here’s what to watch out for in this process:

  • Fair Sales Price: The selling price must be realistic. The IRS may not recognize a price between family members as fair market value if it seems too low or high. It's wise to get an independent valuation to set a fair price and to prevent disputes with other children not involved in the purchase.
  • Interest Rates: When you provide the money for the sale, the interest rate you charge must follow IRS rules. The IRS sets minimum rates for loans depending on how long the loan is for. Your interest rate should be at least this IRS-set minimum.
  • Financial Risk: If you're the one financing the business sale, you're relying on the business doing well in the future. Even if you believe in your children's ability to run the business, unexpected problems or mistakes could make it hard for the business to make payments to you.
  • Family Stability: Consider the impact of potential divorces on your children's financial stability and their ability to continue payments.
  • Legal Paperwork: It's important to have a written contract when you sell the business. This contract should spell out the details of the loan, including using the business itself as security. This makes sure everyone knows what they are supposed to do and keeps your investment safe.
  • Tax Costs: When you sell your business at a profit, you get taxed twice. The business first pays tax on its profits. After that, you pay tax on the money you get from the sale. So, the business needs to make a lot more money than what you end up with after all the taxes are paid.
  • Staying in Charge: If you want to keep a hand in running the business, you could sell just part of it to your children. Make sure you keep over half the business (more than 51%) so you can still make the decisions.

Gift the business to the children

Another business transfer method is gifting the company to your children. Most small businesses can be transferred to the next generation and avoid gift taxes. There are two gift tax exclusions that you should be aware of.

  • There is an annual gift tax exclusion of $16,000 per year, jumping to $17,000 in 2023. This means that you and your spouse could give each of your children $32,000 per year and not be required to file a gift tax return.
  • There is also a lifetime gift and estate tax exclusion of $11.58 million, increasing to $12.92 million in 2023. You and your spouse can give up to $23.16 million during your lifetime to all of your children in excess of the annual exclusion. This is more than the value of most small businesses today.

Gifting your company has several distinct advantages and disadvantages.

Giving your business shares to your children can help you avoid income tax, as this kind of transfer isn't taxed. Unlike selling the business, where the company needs to earn much more than what you actually take home due to double taxation, gifting bypasses this.

The main downside of gifting is that you won't get any money for your retirement. Most business owners can't afford to give away their business without receiving something in return for their future needs.

Another advantage of gifting is that if your business increases in value, this growth moves out of your estate and into your children's, potentially escaping estate taxes if your estate is over $23 million.

However, when you gift your shares, your children inherit your original investment cost in the business, not its current value. If they were to inherit through your will instead, they would receive a "step-up" in basis, meaning the value would be reset to its worth at the time of your death, which can be beneficial for future tax purposes.

Gifting shares is typically just one part of a larger strategy that may include various other methods.

Pass the business to your children through your will

Another approach to take is to do nothing now and pass the ownership of the company to your children through your will. While this approach allows you to avoid family conflict now, it may be creating greater conflicts after you are gone.

  • This approach allows you to maintain control of the company, but it may also create problems when you are no longer mentally capable of managing it.
  • This approach will also give your children a step-up in basis to the fair market value at the date of your death. Keep in mind, children are likely to be more diligent about managing the company if they are risking their own money.

Passing the business to your children through a trust

Transferring the business to your children by utilizing a trust is another option. This approach should only be taken with a professional who is familiar with trusts. We recommend that you consult with your legal advisor to gain a thorough understanding of the use of a trust in estate planning.

Transferring a family business to the next generation is complicated. Consult tax advisors and consider your retirement finances carefully.

Planning for the Future: Key Steps in Business Succession Planning

Taking the time to plot your company's future can ensure that you leave on your own terms. It helps you maintain control and maximize profits from your business. Your business is often your most valuable asset. This will provide a stable retirement income.

Not sure where to start? Connect with us! Our experienced Relationship Banking Officers will help Make Great Things Happen for your business, wherever you are in the exit planning process.