Post by Sandy Swartzberg
If you read my last post about Difficult Assets for Real Estate, you know that a lack of planning can lead to disaster. The potential for disaster and family discord is greatest when the owners of a closely held business fail to plan for what happens when they die or become unable to run the business.
People spend a lifetime building a successful closely held business. Often the business is profitable and they do not wish to sell it before they die, they want to keep it in the family, or they hold onto it with the expectation that they will live a little longer and have more time to decide whether to sell it or pass it on.
If you decide to keep the business in the family, there are all sorts of dynamics that need to be considered. First of all, and outside of the scope of this post, is ensuring whoever takes over the business from the family actually has the ability to successfully run it. Sometimes parents place too much faith in the next generation either out of misplaced judgment or misplaced hope. This post will concern itself with the estate planning aspects of closely held business and the challenges that a closely held business holds for an estate plan.
As discussed in my previous post about real estate, there are numerous challenges when drafting an estate plan, which includes closely held business. Below are some of the challenges:
First of all, if the business is held in a trust or there is a corporate trustee, corporate trustees hate closely held businesses and will attempt to sell the business as quickly as possible often getting distinctly below market value. If the business is placed in the hands of an individual trustee or personal representative, they are usually not as quick to sell the business, but may lack the expertise to decide who is going to run the business and evaluate whether it should be sold.
One device that is often used in an estate plan is to have a committee set up to decide what the proper course is with the business, including who should run it. Remember even if the decedent has selected someone to run it, if the business is not sold rather quickly after the death of the decedent that person may not want to run the business and may not be there to run the business. The continuity of a stable decision maker as to what should happen to the business is important.
Another challenge: even if a family member has been picked to carry on the business and is successfully carrying on the business, there is the fact that the business may be the major asset in the estate.
When the business is the major asset in the estate, there are numerous challenges. If, for instance, there are four children, each receiving twenty-five percent of the estate and two children are active in the business and two are not, how do you balance that out?
No matter how well the children get along, the two heirs employed by the business have a different interest than those employed by the business, making equitable division a problem. The children employed by the business want to maximize the return of the business and often, therefore, want to put all of the profits back into the business and/or they usually believe that the profit of the business should go into their compensation. Often, the non-employed children demand that they be paid dividends or that their interest be bought out of the business. If their interest is to be bought out of the business, it is usually bought out over time. In any case, the possibilities for family tension are decidedly multiplied. I have seen successful buyout of the interest of the non-employed children of the business if it is done rather quickly. However, where the non-employed children continue to own an interest in the business and expect to receive dividends in return for their interest, I have never seen this work for any period of time. It almost always ends up in litigation and huge family tension. Also, this could be a situation where there may be a second marriage. Second marriages are particularly troublesome if the widow has an interest as well as the children of the deceased.
In addition to all of the challenges above, you also have the question of the value of the business. Family members retaining the business tend to see the value of the business as distinctly lower than family members that are being bought out.
You can have the business appraised, but there are numerous challenges with appraisals, not the least of which is their accuracy. There is also usually a substantial cost to said appraisals. In any case, more chances for controversy. There are some solutions and they require planning.
First of all, select what the mechanism is going to be for deciding how to manage the business. If you are leaving it to family members and there are non-employed family members that will have an interest in the business, provide a mechanism for them to be paid off as soon as possible or receive assets from the estate that are more liquid.
For the valuation, you can put a valuation formula right into the estate plan or select the evaluator. One solution proposed is to value the business every year. The business owner should know best what the value of the business is and if they look at the value every twelve months and change it according to market conditions, this is usually the most accurate evaluation. Unfortunately, that solution seldom works because the business owner in the press of everyday business seldom updates the valuation of the business. Usually what happens is that the valuation is many years out of date, which leads to controversy. If you do use the method of resetting the valuation every twelve months, then there needs to be a backup method.
The time period for payoff should be short as possible to minimize the chances of friction. As soon as possible, if there are going to be family members continuing to own the business, it should be only family members employed by the business. The only caveat I would suggest would be to make sure that the payoff amount is affordable by the business. You may want to put a mechanism in the payoff that allows the business to decrease payments in the event of financial problems with the business.
If the business is going to be continued for a period of time, but eventually sold, these wishes need to be expressed clearly by the business owner saying that he wants the business to be disposed of, but not at a sacrifice. Knowledgeable people should be put in charge of the process and if there are going to be non-family members running the business, which is usually the case, there needs to be oversight of these persons. A committee or a trusted advisor should be put in place or some combination of both.
One solution for a transfer of the business inside the family is to start that transfer while the older generation is here and can supervise the transition. It is even desirable that the transition be completed while the older generation is still alive.
In any case, whatever the solution, it should be discussed thoroughly with all family members. The discussion should include the reasons and rational for the way the transfer is being handled. The discussion should allow for questions and even for family members to express dissatisfaction. This type of frank discussion leads to less problems and friction later.
I can go on and on discussing the multiple problems and multiple solutions. However, the one thing that isnot a solution is to do nothing and take no action. Often this leads to disaster where the value of the business is lost and family relationships are destroyed. A business which nurtured a family can suddenly poison a family.
As we baby boomers age, we are having more trouble accepting our limitations. We often procrastinate about planning. If a health crisis or a sudden death occurs, it could leave a business adrift and lose its value.
In my law practice, I have sometimes been called to step in and have actually taken over the running of the business or the oversight of the business. While this has worked out in some cases, leaving the fate of a business to chance is not a good idea. Planning, while not always perfect, is a part of a better solution.