It is no secret the odds are stacked against closely held business owners when it comes to successfully transitioning their businesses from one generation to the next.
Many owners are aware of the odds but find it difficult to start the transition process. This is understandable considering the process can be quite overwhelming: the creation of family constitutions and mission statements, family meetings, employment policies, management succession, incentives for key employees, outside board of directors, prenuptial agreements, buy and sell agreements, life insurance.
The list seems endless, and we have not even addressed transferring ownership.
Although there are many key aspects to a thorough succession plan, often the process should be taken in steps — sometimes small steps.
The first step may be simply to prepare the ownership structure of the business in order to transfer it to the next generation. Business owners are often surprised to hear that ownership of the business does not necessarily go hand-in-hand with control: “You mean we can start to transfer ownership while allowing me to operate and control the company?”
Yes, it is possible. This also allows the business owner to work on the other steps of the succession plan over a time period that is comfortable to the owner.
Ownership of the business is often thought to mean control of the business, but ownership can be separate from control. The first step to separating ownership and control is a corporate reorganization, often referred to as a recapitalization, to change the company’s capital structure.
Corporations as well as limited liability companies can undergo recapitalizations. The original owner — often the patriarch or matriarch as the sole owner — retains all of the ownership, but this ownership is divided between voting and nonvoting shares or membership interests, depending on the corporate form of the company. Often the division is 95 nonvoting interests for every five voting interests, but there is no precise formula.
Subject to certain exceptions, each interest of the company is entitled to an equal distribution of the company’s earnings and profits. The only difference really is control.
The voting interests will elect the board of directors or managers and may decide whether the company makes distributions.
The nonvoting interests have the right to access financial statements, tax return information and other corporate records. Subject to certain limited exceptions, the nonvoting interests have no right to make company decisions.
Once the owner becomes ready to transfer the nonvoting interests, such interests can be transferred through gifts, sales, or other sophisticated techniques that help reduce the transfer taxes attributable to the transfers or that may be applicable at the owner’s death.
Even though we have record-high federal estate and gift tax exemption amounts, many business owners still must anticipate and plan for estate taxes. The current exemption amount is $5.43 million, which is indexed for inflation for future years. The federal estate and gift tax rate is 40 percent.
Transferring nonvoting interests does not necessarily mean these interests go outright to the family members. If the owner would like more structure or lack of direct access to the company, the interests can be transferred to an irrevocable trust for the benefit of the children or other family members. This may be done with lifetime planning or at the death of the owner.
Even though the owner may focus on transferring the nonvoting interests, the owner’s estate plan must address the disposition of the voting interests upon the owner’s death. The voting interests are often left to the surviving spouse or a trust for the surviving spouse.
The ultimate disposition of the voting interests must be integrated into the long-term goals for the company.
For example, should the voting interests pass only to the children who are employed by the company? What happens to the interests if the owner’s estate passes to a private foundation or public charity? Would this be an appropriate party to hold control of the company?
Although a recapitalization of the company highlights these estate-planning issues, it does not create the issues. These are considerations any business owner needs to review, regardless of whether the company is divided between voting and nonvoting interests.
Sometimes the most important decision the patriarch or matriarch can make is simply to start the succession process. Often this process can be done one step at a time to allow the focus to remain on the operations and growth of the business. Starting the process can often be the hardest decision.
Jennifer L. Remondino is a partner with Warner Norcross & Judd LLP and has counseled many family-owned and closely held companies in developing plans for the transfer of ownership and management to the next generations. She can be reached at (616) 396-3243 or firstname.lastname@example.org. To learn more about succession planning, contact Jennifer or any other member of the Trusts & Estates practice group at Warner Norcross & Judd.