Business Owners Don't Think Enough About Succession Planning
Succession planning is something that is often on business owners' minds, albeit probably in the back of their minds. With everyday worries and immediate issues to resolve, succession planning usually gets categorized into the "I'll get back to it later" file, and then is usually not addressed. With the economy dragging along, perhaps now is the time to be focusing on more long-term issues like succession planning before things start heating up again.
With succession planning, there are three main issues:
- Who will the successors be,
- How will ownership be transferred, and
- How much is the business worth.
Who will the successors be
What issues should owners be thinking about in regards to succession planning? First off, consider "Who might my potential successors be?" If your business is completely family owned, are there children in the business who are, or could be, capable successors that want to be in the business? How about key employees and managers that are not family members? Will you need to solicit a buyer from the outside? Is there consolidation ongoing in the industry, or a manufacturer who may want to vertically integrate and bring a company like yours on board? These are all questions to ponder, explore and think about in these slower times when we can focus on these items.
Succession planning is not a process that happens overnight, where the new leaders of the company show up on your doorstep tomorrow. It is a focused effort to identify where the new leaders may emerge from, and then to assist them in their growth to groom them to eventually take over. In fact, you may already be doing that inadvertently, by delegating certain responsibilities to these people over time. As they show improved capabilities, they are moving closer to being able to someday assume a more prominent role in your company, perhaps even replacing you.
How will ownership be transferred
Once you've identified a potential pool of successors, the next question becomes "How do I get my ownership transferred over to them?" One way is obviously an outright sale, where other shareholders, managers, key employees or outsiders buy your shares from you. Oftentimes, these sales involve a consulting arrangement with the owner to continue on at an increasingly reduced role over a period to help transition the business in a seamless manner to the new owners and maintain customer goodwill and trust while the owner "fades into the sunset." There may also be an earnout provision over a period of a couple of years where part of the purchase price is contingent on continued business with existing customers, with a portion of those profits then paid to the outgoing owner to help maintain the business going forward for the new owners.
If you desire to transition the business to your children, you can give shares of your stock to them each year in the form of gifts. This may help you keep your finger on the pulse of the business while gradually shifting ownership and responsibilities to your children over a period of years. As can be expected, gifts involve tax issues, and gift taxes in particular can be some of the most complicated in the Internal Revenue Code.
As its name implies, a gift is just that, something given to someone else (usually the owner's children) with nothing given back in return. Depending on the size of the gift, you can transfer some ownership each year and not pay any taxes on that gift. How is that possible? The Internal Revenue Code specifies an amount each year that sets a limit on how much can be gifted without paying taxes. For years after 2009, that limit is $13,000. Therefore, if you give a gift with a value more than $13,000, you will pay taxes on the amount in excess of $13,000. However, if you give a gift of less than $13,000, you will incur no tax on that gift. So how to determine if what you want to gift is below that magical $13,000 limit?
How much is the business worth
Of course, in order to figure that out, you will need the assistance of a business appraiser to value your business. In fact, if you're going to make a gift, your CPA or estate attorney may need to assist you in filing a Form 709 (United States Gift and Generation-Skipping Transfer Tax Return) with you annual tax return. You need a good tax accountant, which is a very specialized area, to help you with all the intricacies involved in that process. You also need a good business valuation adviser which is also a very specialized area. As a business appraiser, I can tell you that getting a professional appraisal done is an important part of the process in determining just what the overall value of the business is and what percentage ownership you can gift away each year to fall under that $13,000 taxable threshold.
Business appraisals arenâ€™t cheap (at least good ones aren't), with a fee typically in a broad range of $7,000-$15,000. However, an effective strategy used by businesses is to have the business appraised at or near the calendar year-end. Values change over time, but barring any extreme circumstances ("our company lost our biggest customer at year end"), the value of a business at, say, December 31, 2011 won't change much by January 31, 2012. Thus, by having the business valued at December 31, 2011, an owner can use that value to make a gift in 2011, and then turn around and make another gift in January 2012, in effect making 2 gifts over 2 years using 1 valuation and spreading the costs of that valuation over a 2 year period. Then, when you want to make another gift in 2013, you value the business again at December 31, 2013, and make gifts in 2013 and 2014 using that valuation. In this way, you're maximizing your investment in the business valuation process to help you obtain your goals of transferring the business without paying taxes and also shifting some of your own estate tax burden in the future.
Furthermore, among the significant pieces of the new federal tax law that was passed in December 2010 were very substantial, albeit temporary, increases in the lifetime gift tax exemptions for individuals and couples. For 2011 and 2012, these exemptions have increased five-fold, from $1 million to $5 million for individuals, and from $2 million to $10 million for couples. There will be no gift tax imposed on gifts that do not exceed those totals. The same law reduces the tax rate for gifts above the exemptions to 35% from a scheduled rate of 55%, thus benefiting individuals wealthy enough to make gifts that exceed the exemption levels. Thus, if interests in your business are worth less than the exemption limits, you can transfer interests tax-free for the next 2 years. The gifts are cumulative, meaning that if you gift $10,000 of stock this year and $10,000 next year, you will have accumulated $20,000 against your $1 million lifetime exemption, leaving $980,000 left to gift in the future assuming these levels remain the same going forward.
The Critical Need for a Sound Business Valuation
Finally, a few words about business valuation. No matter how great your company may have been in the past, buyers buy future cash flows and expectations. Many owners want to be compensated for building their company over the years and their sweat equity. If your company is hurting, and prospects aren't overly promising in the future, don't expect a prospective buyer to pay you for 20 years of your hard work when it will take their future endeavors to move the business forward. They wonâ€™t pay you for their future efforts.
Business valuation professionals don't "make value"; they assess and reflect current market conditions and risks to give their opinion of what a prudent buyer might pay in the current marketplace. As you all know, stock values of public companies change every day in response to economic conditions, industry changes, and specific company issues and risks. So you too should expect that your company won't be worth the same a year from now as it is today.
Be aware, however, of potential penalties your appraiser and you may face. Internal Revenue Code Section 6662 provides for penalties against taxpayers for undervaluation of assets on estate and gift tax returns. These penalties are based on the percentage difference between the value reported on the estate or gift tax return and the value finally determined. So when working with your appraiser, be sure to be objective and realistic in your assessment of your situation so as to be able to help your appraiser provide a realistic valuation and not one so low as to primarily avoid taxes.
Every valuation involves an appraiser giving an opinion of what a business is worth, and of course opinions can differ. However, a good appraisal should at least contain enough elements that another appraiser could look at the written report and concur that even though they may not agree with every aspect of the valuation, that the analysis and final result are reasonable and objectively arrived at.
Well, if you've taken the time to read this article to this point, at least you're thinking about succession planning enough that maybe it's time to follow through. Continue on to the next steps of identifying potential successors and how you might transfer your ownership over. Get together with your CPA and estate attorney to discuss issues and then find a good business valuation professional to assess your business' worth. Find a professional with a business valuation certification (CVA, ABV or ASA) to do a credible job on your business. And then follow through on that plan of yours as you proceed toward your exit or retirement, and enjoy the many good years you may have left in your life in whatever endeavor you decide next.
Kevin J. Czerak
KJC Enterprises, LLC
1350 Bent Oak Trail
Aurora, IL 60506
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