More Tax News from Fun with Taxes

Finding a safe pair of hands

According to the Small Business Administration, nearly 90 percent of the 21 million businesses in the United States are family-owned. Only 30 percent of family-run companies make it to the second generation, and it's estimated that no more than 15 percent make it to the third generation.

Businesses don't make the generational leap on their own. In order to pass the baton of a business on to a younger generation, whether that means to the offspring of the owner, or to younger workers who will take over when current management is gone, there must be a succession plan in place to ensure a smooth transition.

the fact that small businesses aren't typically as liquid an investment, so a plan needs to be there in order to capitalize on the investment, as opposed to a publicly traded corporation, where there's an open marketplace for the stock of those companies," said Stautberg.

There are several elements that contribute to an effective succession plan. "The plan has to be comprehensive. There are so many elements to a succession plan that if you miss something, it might not work," explained Tim McDaniel, shareholder and director of the valuation and succession planning practice for New Philadelphia, Ohio-based Rea & Associates.

Not only does a company need to prepare for the people who will take over when current owners leave - there are also significant accounting issues associated with succession planning.

"Taxes are always a concern any time you're talking about shifting assets from one person to another. There are estate and gift tax considerations if you're shifting ownership from one generation to the next without consideration, without payment," explained Stautberg.

Business valuation is another significant factor when dealing with succession planning. The SBA suggested that a valuation should include tangible assets, as well as intangibles such as goodwill, customer base, employee loyalty, manufacturing processes, patents and company reputation. Part of the valuation process involves projecting revenues, asset costs and expenses for the future. Professional valuation companies can perform the valuation, and many accounting firms offer this service as well.

One popular method of transferring ownership is a buy-sell agreement funded by insurance. Two types of buy-sell agreements are frequently used: cross-purchase agreements and redemption agreements. With a cross-purchase agreement, shareholders who remain with the company agree to purchase the ownership stake of the departing owner. With a redemption agreement, the company itself buys the ownership stake of the departing owner; thus the company value increases across the board for the remaining owners. Typically, these agreements are funded by life insurance taken out on the owner by either the other individuals (cross-purchase) or the company (redemption).

Some companies are turning to employee stock ownership plans as part of their succession planning.

"Recently, I've seen more companies that are trying to utilize ESOPs," said Stautberg. "Those allow for the owners to sell their shares to a trust, which is then owned in some part by the employees of the company, so that the employees essentially wind up being the owners of the company."

When choosing individuals as successors, McDaniel recommended looking beyond basic job skills to find people with leadership ability, decision-making ability and a passion for the business.

Start them planning

Business owners might postpone succession planning, thinking they'll get around to it someday, or that the business will take care of itself and a natural leader will emerge to take the reins, or that the business will simply fall into the hands of the owner's child or children with no advance planning necessary. Business owners who have no plans to retire anytime soon might not be willing to face the fact that at any time they could get seriously ill, become disabled, or die.

McDaniel suggested that business owners who are contemplating retirement and who have not yet developed a succession plan should start implementing a plan at least three to five years before retirement. The organization recommended succession planning for business owners who are between the ages of 55 and 65. Other succession planning experts recommend allowing as many as 10 to 15 years before anticipated retirement to create and implement a plan.

The more time a business has to create, fine-tune and embrace a succession plan, the more relaxed and natural the transition will be. The worst thing to do is to wait until it's too late to start thinking about a succession plan.

It's certainly too late if the business owner dies or becomes incapacitated before a plan is in place. But there are other instances that qualify as too late.

For example, if a company makes no strides to inform current family members or talented employees that they are in line to succeed the current owners, those people might search for jobs with a better future and leave the company. Additional unforeseen personal events can occur that can affect the operation of the business, such as the loss of a professional license, divorce and bankruptcy.