Navigating The Challenges Of Business Succession Planning
Most insurance company training on business succession planning is limited to describing the difference between cross-purchase agreements and redemptions. Thats fine for businesses with more than one owner and where none of the owners children are involved in the business.
But where children are active in the firm, theres a great deal more to consider than stepped-up basis and estate taxes. The following are among the more common pitfalls faced by planners engaged in business continuity planning.
Pitfall 1: Treating children equally frequently results in not treating them fairly.
Take the case of Henry, who owns 100% of D&E Heating. Henry and his wife, Wilma, have two grown sons, Erik and Derek, who do not work well together. Henry gave Erik the first opportunity to manage the business. Erik was very successfulat alienating employees, customers and suppliers.
Derek, to whom Henry then entrusted management, expanded the business multiple-fold. Confident in Dereks work, Henry decided to give Derek ownership of the business and its real estate. We were retained to build up assets of equal value for Erik.
To that end, we devised a plan that incorporates insurance and defined benefit pension plans and presented our case to the parents, children and their advisors. While waiting for our applause, Derek said, "Seems to me that you think these two pots are equal. If so, and this is lets make a deal Ill take door No. 2. Give me the insurance proceeds and the investments and give Erik the business."
There was a pause, and then Derek said, "because in 6 months, Ill own both." He realized that his brother could not run the business.
That day, I learned the difference between fair and equal.
In a revised plan, we valued Dereks "sweat equity" (i.e., the years that he has worked in the family business) with a "risk premium" (i.e., because his net worth was concentrated in one asset, with labor problems, competitors and much more, he could also lose everything).
That resulted in Dereks share of the parents estate being numerically greater, but now considered fair by the parents, the sibling and their advisors.
By working hard, Derek could substantially increase his personal net worth. Erik, on the other hand, had a diversified portfolio of assets and the opportunity for his own career, including forming his own private business. He, too, had the opportunity to increase his net worth.
Here is another example of parents who planned to distribute their net worth equally but potentially not fairly. Harry owns 100% of ABC Manufacturing. Harry and his wife, Willa, have two sons and a daughter. One son, Andy, had worked in the business for 15 years. His brother, Bill, worked a few summers and no longer lives in the area. Their sister, Carol, has no interest in the business.
The parents anticipated that their net estate after taxes and costs would be worth $1.5 million. The total includes the business real estate (owned outside of the business), worth $500,000, and the business itself, valued at $1 million.
Harry and Willa told us their plan was to leave the business to the boys 50/50 and the real estate to their daughter. "That way," according to the parents, "all of our children would receive $500,000 of equal value." What do you think of that plan?
We asked, "What would be your reaction if you were Andy?" Harry looked at Willa, smiled, and then said, "We have been concerned about leaving only 50% to Andy. After all, he has been working here a long time. What if we give him 51%?"
We smiled back and asked, "Why are you willing to effectively disinherit Bill? What is the value of 49% of a closely-held business?"
We continued by asking, "Who repaired the driveway or fixed the roof of the business building?" Harry said, "What difference does it make? I own both!" We asked, "Who would pay for these improvements if your daughter is the landlord and your sons are the tenant?"
