The majority of family business owners intend to pass on ownership to the next generation, but very few have actually planned for it.
It’s not a process that can be made up as you go. Rather, it must be carefully planned for, especially when it comes to anticipating a number of common challenges that many family businesses encounter.
One of those pitfalls involves funding challenges, which can put a hard stop to successfully transitioning a business from one generation to the next.
Here are some possible funding solutions.
1. Leveraged buy-out
A leveraged buy-out involves the next generation borrowing funds to acquire the business. Business assets are used as collateral and business profits are used to make loan payments.
While this strategy has its advantages, it can create risk for the next generation, as they may find themselves in debt without the business income to pay it off.
2. Installment sale
The sale of the business may be structured as an installment sale with payments made over a term of years with interest.
Business profits are used to make payments on the note; the terms may be more favorable to the buyer than in a leveraged buy-out. However, the primary risk lies with the older generation selling the business, in that they will have a longer time horizon before realizing a full liquidity event.
3. Self-cancelling installment note
When a self-cancelling installment note is in place within an installment sale, the note terminates upon the death of the seller, regardless of whether the note has been paid in full. The buyer agrees to pay a premium in the form of a higher sale price or a higher interest rate.
This is advantageous because the remaining balance will be excluded from the seller’s gross estate for estate tax purposes.
4. Non-qualified deferred compensation
The business can enter into a non-qualified deferred compensation agreement with the business owner; it’s an enforceable promise by the business to pay a certain amount of compensation to the business owner after retirement.
This adds a liability to the books, lowering the value of the business. That being said, there’s a tax advantage to the business as the payments are deductible, while installment sale payments are not.
5. Charitable bailout
The ownership interest can be contributed to a specially designed charitable trust that provides income to the donor and a remainder interest to a named charitable organization. The next generation purchases the interest from the trust, providing the business owner/donor with an income stream.
6. Sale to an intentionally defective trust
Instead of selling the business directly to children, all or a portfolio may be sold to a trust with the children named as beneficiaries. The trust is intentionally drafted to make the parent/business owner responsible for taxes on income generated inside the trust.
The tax payments financially benefit the trust, and therefore the children, but are not considered gifts for tax purposes.
Outside of funding challenges, there are a number of issues that may arise when multiple children are involved as owners, such as:
- When children have different skill sets
- When some children are involved in the business and others are not
- Key employee discontent
Lastly, another key element is the retention and continued dedication of key employees. Business owners should consider strategies to create incentives for key employees, such as:
- Phantom stock and stock appreciation rights plans
- Non-qualified deferred compensation plans
- Restrictive executive bonus arrangements
- Stay bonus plan
Giving up control of your business may be a difficult process, but giving your child an opportunity to be successful and take your business to the next level is something worth planning.