NEW YORK — Most family business owners expect their thriving enterprises to transfer to the younger generation with minimal fuss and bother. Reality, though, can be far different. Absent a carefully designed plan, misunderstandings and disputes can turn any business transition—including ownership of coin laundry stores—into a costly train wreck.
Parents must analyze the skills and proclivities of their children before assigning future management roles. While such assessments can help smooth the transition, even the best of such plans needs the support of legal documents that ensure power flows to the right people and sufficient cash is available to make everything happen on cue.
AVOIDING PROBLEMS
Successful buy-sell agreements include provisions that anticipate and head off common problems. Here are some tips from John J. Scroggin, a partner at the estate planning law firm of Scroggin & Company, Roswell, Ga., who has studied the hidden pitfalls of family business transitions:
Non-Compete Agreements — Suppose one family member desires to exit the business but wants some compensation in return. The buy-sell agreement may include a clause that specifies the value the individual will be paid for his or her shares. That sounds fine on the surface, but it can backfire if the individual then goes out and starts a business pursuing the same customers.
“If an individual is paid a lot of money for their share of the business, but nothing stops the person from competing for the very business that was purchased, why should the amount paid be any more than the value of the hard assets?” poses Scroggin.
The way to avoid this pitfall, says Scroggin, is to include a “non-compete provision” that prohibits the departing family member from engaging in a similar business for a set period of time. The agreement can also specify that the departing owner may not solicit the organization’s current customers or vendors, or utilize any of its trade secrets.
Tax Implications — “Never provide for a business transition without having a tax expert review the documents and the plan,” advises Scroggin. “Proper planning can substantially reduce the tax cost of the transaction.” In many cases, for example, the sale of the business to family members can create substantially more taxes than a gift.
Funding — It’s important to set up vehicles for funding the buyout. Often, life insurance provides funds for buying the shares of an owner who has died. And if the owner is retiring, there can be provisions for installment payments over time.
Exit Strategy — Suppose one child wants to leave the laundry business after some time passes. How much will that individual be paid for his or her shares? This should be spelled out in a legal document that you can think of as a kind of pre-nuptial for business owners. “Two people who own a business together are even more likely to divorce than a husband or wife,” says Scroggin. “There should be an agreement that defines their relationship and obligations and describes how they can exit the relationship.”
Protecting Funds — Suppose your laundry business has accumulated a large amount of money over and beyond the amount required to fund operations in future years. How can these funds be transferred to the member of the next generation? The answer often poses a puzzle: On the one hand, you want to make sure the funds stay in the family. On the other hand, you do not want to give so much money to individuals—particularly very young ones—that they will lack incentive to do anything productive with their lives.
In many cases, the answer to the puzzle is to establish what is called an incentive trust. This vehicle provides for the incremental transfer of funds to the next generation, but only when those individuals have reached specified parameters such as finishing their education.
“Incentive trusts are perfect for liquid assets,” says Wayne Rivers, president of the Family Business Institute. They can be written so that rewards are given for performance in or outside of business. And the reward formulas can be flexible. “Suppose one child decides not to remain in the business,” poses Rivers. “The trust can be written so that it rewards the individual who goes into a public service to be a public defender, a missionary, or similar work.” The trust might pay 40 cents for every dollar earned in such pursuits. Any number of such parameters can be written into the trust document.
STARTING EARLY
Before legal documents are drawn up, the proclivities and skills of new-generation members must be assessed. The process should start with individual interviews, assessing the goals of each family member. Then goals should be incorporated into documents that ensure the smooth process of business and wealth transfer.
Many family business owners hesitate to draw up transition plans because of the current uncertainty in tax laws. Such hesitation is not necessary, says Gregory Herman-Giddens, a board certified specialist in estate planning at the law firm of TrustCounsel, Chapel Hill, N.C. “A qualified attorney can create a flexible plan that anticipates many different tax scenarios. So put a plan in place now and have some peace of mind that you and your family are protected. You can always update your plan in a year or two.”
Indeed, delay can be costly. “Don’t wait until one of the owners is sick or gets ready to retire,” says Herman-Giddens. “There can be an unexpected incapacity or death at any time.”
Information in this article is provided for educational and reference purposes only. It is not intended to provide specific advice or individual recommendations. Consult an attorney or financial adviser for advice regarding your particular situation.
Have a question or comment? E-mail our editor Bruce Beggs at [email protected].