A Small Business Could be NO Business Without a Succession Plan

Small businesses are the engines for innovation. They not only account for 75% of all businesses in the U.S., they also provide for over 50% of jobs. It is readily apparent that small businesses are vital to the U.S. economy and help shape our great nation. Yet, a majority of small businesses fail to pass to the next generation. Even worse, only 13% of small businesses survive to the third generation. Why is this? As Benjamin Franklin said, “failure to plan is planning to fail.”

Think of business succession planning as a plan to manage issues that create a smooth transition between you and the future owners of your business. With family businesses, succession planning can be especially complicated because of the relationships and emotions involved - and because most people are not that comfortable discussing topics such as aging, death, and their financial affairs. In most cases, the "killer" is taxes or family discord, both issues that a good family business succession plan will cover.

When considering your business succession plan, it is easiest if you break your planning into three main issues: management, ownership, and taxes. Let’s start with the easy one. Estate taxes. Currently, the Unified Credit (the coupon the federal government gives everyone to pass their assets upon death free from estate tax) is set at $3.5 million. In 2011, it drops to $1 million. Any excess is taxed at approximately 50%. If a person dies owning a successful small business, that business may have to be liquidated to pay the estate tax.

Let’s assume that either the estate tax is not an issue. What other issues may derail all the hard work someone put into growing a business? It could just be family dynamics. Sibling rivalry could hinder the succeeding generation for management. Or the older generation may not wish to let go of management because of the fear of losing their leadership role in the family. Or there may be different expectations and ideas on the direction the business should grow in the future. Consider the sacrifices the founding member made to make the business successful. 80 hour work weeks. Missing baseball games and dance recitals. The younger generation may not understand or appreciate the hard work.

So what can be done? First, ensure that the business is structured properly so that it may be passed easily to the next generation and ease the tax burden if needed. There are many, many ways to do this based upon the goals of the family.

Second, schedule family meetings where business planning such as short and long term strategies are discussed. It is important that the older generation explain the values in which the business was started and grown, while the younger generation decides whether they are willing to manage the business and if so, what direction they envision the business heading. These meetings are also an opportune time to facilitate identifying if, or which child can be groomed to be an heir. Erase the concept that the only fair thing to do is to divide the business equally between your children. While this is a nice idea in theory, it may not be in the best interests of your business. Remember that management and ownership are separate business succession planning issues. It may be fairer for the successor(s) you have chosen to run the business to have a larger share of business ownership than family members not active in the business. Or it may be best to transfer both management and ownership to your chosen successor and make other financial arrangements to benefit your other children. Consider inviting a third party advisor, the business’s CPA or attorney, to identify this protégé.

Finally, it may be that the next generation simply does not want the family business. While that can be disheartening, it is best to address this issue when both the business owner and business is healthy. If you want to pass your family business along to the next generation, putting off business succession planning is the worst thing you can do. By discussing the issues with the family and creating a plan unique to your business and your family you can ensure that you have the funds you need to retire and that the business you have built continues to thrive in the hands of the next generation.

Stephen J. Lacey, JD, LLM-Tax is a partner in the law firm of McClelland, Jones, Lyons, Lacey & Williams, LLC. Mr. Lacey concentrates his practice in the areas of Estate Planning, Asset Protection, Medicaid Planning, Probate and Real Estate. To contact Stephen call (321) 984-2700 or visit www.mjlandl.com.

Silver Lining

Silver Lining

Yes, your business is down. Yes, we may (or may not) be slowly coming out of the recession but the economic climate will not be the same as it was a few years ago. Yes, the value of your business is at its lowest point since you began the business in 1984.

Even in the darkest of times, I always try to find a silver lining. So here it is: this is the perfect time to explore gifting shares of the business to younger family members.

Let’s look at an example: Mr. Gates owns a tech business called Computers R Us, LLC (as you saw in previous article, there are advantages to owning small business as LLC rather than corporation). Mr. Gates owns 80% of Computers R Us, LLC, while his son owns 10% and his daughter owns 10%. In 2007, the business was valued at $3,500,000. It is now worth $2,500,000. Mr. Gates has a meeting with his attorney and realizes that if the Unified Credit drops to $1,000,000 as it is set to do in 2011, significant estate tax will be owed on the value of his business alone at his death. After exploring several tax strategies and planning tools, Mr. Gates decides to transfer 20% of his interest to each of his children. Now, Mr. Gates owns 40% and each of his children own 30%. So what has Mr. Gates achieved?

First, the Internal Revenue Code allows an annual gift of $13,000 to be excluded from tax. Mr. Gates is married so between the two of them, they can pass $26,000 under the annual exclusion. The above-described transfer of business interest is eligible for this gift exclusion. Currently, the marginal estate tax rate is 45%. Therefore, Mr. Gates provided savings to his family of $23,400 ($26,000 x 45% x two children).

Second, the value of the interest transferred to each child is $500,000. If the value of the business returns to 2007 levels, the value of those interests will be $700,000. Yet, Mr. Gates transferred $400,000 free from estate or gift tax because the value of the transfer is frozen at the $500,000 level (value at the time of the gift). Thus Mr. Gates provided additional savings to his family of $180,000 ($200,000 x 45% x two children).

Third, the Internal Revenue Code allows certain valuation discounts due to minority interests and lack of marketability. Often times, these discounts can be 25% or more. Due to the fact that the transfers to the children were minority interests and lacked marketability (unlike shares of stock traded on the Stock Exchange, there is no readily available market to buy interest in Computers R Us, LLC), such gifts may be discounted by 25%. As a result, the gift of $500,000 may be discounted by $125,000 resulting in Mr. Gates’ family saving $112,500 ($125,000 x 45% x two children).

Lastly, at Mr. Gates death, his estate can claim a minority interest and lack of marketability discounts against any remaining interests. Thus, Mr. Gates passes away in 2012 when the value of Computers R Us, LLC is $5,000,000. His estate may be able to claim a minority interest and lack of marketability discounts since Mr. Gates owns 40% of the company at his passing. So Mr. Gates has saved his family an additional $675,000. (45% x ($2,000,000 – $500,000).

So, yes, the economy is terrible. Yes, the value of the company is less than what it used to be. But through proper planning, Mr. Gates saved his family over $990,000 in estate taxes. See, I can always find a silver lining.

WORD OF CAUTION: Currently, there is proposed legislation threatening the viability of lack of marketability and minority interest discounts. With the White House spending into historic deficits, money will need to be raised through taxes. Therefore, please consult with a qualified attorney so that proper planning may be done specific to your factual situation and current laws.

Developing an Estate Planning Checklist

The only thing worse than having a Will or Trust Agreement that is out of date, is having no estate plan at all. Many estate plans become outdated as children grow older and financial conditions change. Because many people don’t fully understand all the legal provisions and “broiler plate” in their Wills or Trust Agreements, the need to update, and/or replace provisions may not be apparent.

Following is a checklist of Estate Planning issues you should discuss with your advisors, whether to establish an estate plan in the first place or update an existing estate plan:

WHO PAYS THE BILLS?

While the primary purpose of most Wills or Trust Agreements is to designate who inherits your property, attention should also be given to who will pay the debts, taxes, expenses of administration, maintenance and repair of property. Where all or some of the heirs maybe under the care of a legal guardian, directions should be provided and arrangements made to reimburse the guardian for each additional expenses, including housing and transportation. Dividing expenses the same way you divide property is not always fair.

WHO GETS THE PERSONAL PROPERTY?

Most family feuds start over division of personal property rather than money. Emotions often run high and in-laws don’t help matters. Florida Law provides a very easy means to leave instructions concerning personal property and which don’t require constant trips back to your lawyer’s office to amend or update your instructions.

WHO IS IN CHARGE?

The appointment of one or more Personal Representative in a Will or Trustees in a Trust Agreement is often a difficult choice. Sometimes the wrong choice is made based on location, business experience or age. More important qualifications may be the abilities to delegate, supervise and communicate. In many circumstances, it may also be appropriate to select or include a third party or professional fiduciary. In preparing or updating your estate plan, be sure and talk to your advisors about the selection of both primary and backup legal representative of Trustees.

ARE THERE ANY TAX ISSUES?

The maximum federal estate tax rate in 2009 is 45%. If real estate is owned outside the State of Florida, separate and additional estate debt taxes may apply. In turn to ignore these taxes in favor of a simple estate plan is the same as listing the government as your favorite heir. While tax exemptions in various other means exist to reduce or avoid these taxes, they do not happen automatically. In addition, changes in the federal estate tax laws could be expected. An even up to date estate plan may require future revisions. Beside possible estate taxes, significant income taxes may arise on individual retirement accounts, pension plans and other forms of deferred compensation. While not easy to avoid, options do exist to defer these income taxes.

IS THERE A BUSINESS TO SELL OR CONTINUE?

Business succession planning will be the subject of future articles. Prevailing the business or professional practice has been the primary source of family support, will often vanish or quickly diminish without careful planning or good management. Where such a business exists, the Will or Trust Agreement should confirm the arrangements for the sale or continuation of that business in the hands of qualified managers.

DOES THE WILL OR TRUST AGREEMENT CONTROL THE ASSETS?

Previous articles have discussed the common estate planning mistake of not letting a Will or Trust Agreement control such substantial assets as life insurance, property, retirement plans, or jointly owned property. Exception in many cases, these types of assets pass outside the terms of a Will or Trust Agreement. It may be distributed:

1. To either the wrong people, or to the right people too early;

2. A Trust Agreement that is not properly funded; or

3. A Will that does not control important assets, is not worth the paper it is written on.

READ AND UNDERSTAND ANY ESTATE PLANNING DOCUMENTS YOU ARE SIGNING

Leases, mortgages and many other types of legal agreements are signed without reading the fine print. While this may be safe if the fine print cover terms you may not intent to violate, both Wills and Trust Agreements are not your usual legal agreements. Broiler plate provisions do exist to avoid court intervention, provide for tax election and confirm the authority of designated Personal Representatives or Trustees. Nonetheless, you should ask for an explanation of any provision that is not clear or its purpose apparent.

Common Mistakes in Physcian Asset Protection Planning

Any Physician named as a Defendant in a malpractice lawsuit can tell you there is a world of difference between the “what if” world of asset planning and the “what now” world of real litigation. While the vast majority of lawsuits are settled before trial and within policy limits, the resolution of one bad experience is no guarantee that another bad experience won’t follow it in the future.

At least some of the stress and concerns about financial security can be relieved by reviewing what asset protection is available and avoiding certain common mistakes.

ASSETS HELD IN MARITIAL JOINT NAMES (Tenancies by the Entirety):

Simply putting of the husband’s and wife’s name on the same asset title does not automatically protect that asset from the creditors of one spouse. The marital status of the owners must be clearly identified on the Deed for account title (e.g. Harry Jones and Sandy Jones his wife or Harry Jones and Sandy Jones Tenants by the Entirety). Common mistakes in this area include certificates of investments in privately held companies entitled to out of state real estate. The mare fact that the owners listed on the title are married does not automatically create marital protection.

Another common mistake occurs after one spouse is faced with an actual lawsuit for potential claim that could exceed insurance coverage. At that point, the spouse “at risk” should ask the questions “what happens to the joint marital property if my spouse dies before or after this lawsuit is over?” The answer in all cases is that the joint marital property loses its’ protection and can then be attached by a judgment creditor. In the face of a real threat, joint marital ownership is no guarantee of asset protection other steps (e.g. spendthrift Trust) must be taken.

HOMESTEAD PROPERTY:

The Florida Constitution provides absolute and unlimited protection against attachment of a “Florida homestead” whether owned in joint marital names or in a singe name. However, this asset protection extents only to one half acre inside a municipality and 160 acres outside the municipality. The lots and many upscale residential areas exceed one half acre and are not protected by the Florida Constitution.

RETIREMENT PLANS AND INDIVIDUAL RETIREMENT ACCOUNTS:

Besides being a good financial and tax planning option, qualified retirement plans and individual retirement accounts are fully exempt from creditors under both state and federal law. The key word in the last sentence is “qualified”. While the IRS may allow you to correct discrepancies in coverage, contribution and permitted investments, a creditor may be able to seize Plan assets due to these technical defects. If asset protection is a concern, use of experienced third party plan administers is a must.

BENEFICIARY DESIGNATIONS AND INHERITANCES:

One of the most common mistakes occurs when an otherwise fully protected position unexpectedly receives life insurance proceeds, retirement plan benefits or an inheritance. While such assets may have been fully protected on the previous name of a spouse or other family member, that protection is lost the minute it is received by the beneficiary or heir. Asset Protection Trust should be used in the case of life insurance, annuities, or retirement plan assets payable to a Physician as beneficiary. In the case of a future inheritance a candid discussion with other family members may be necessary, no matter how difficult.

PRACTICE ASSETS:

A common concern and common mistake is the protection of accounts receivable. Leveraged life insurance “protection” programs are often promoted as a means for both large and small medical groups to shield their accounts receivable. In my opinion, these programs costs too much, provide uncertain protection and may result in IRS tax issues. Simpler and cheaper solutions include: (i) Pledging the accounts receivable toward a revolving line of credit to be used if and when necessary; (ii) Pledging the accounts receivable as additional security toward medical office lease payments (if the medical office is owned by related parties).

MALPRATICE AND OTHER LIABILITY INSURANCE COVERAGE:

The debate will never end whether minimum coverage is enough or extra coverage makes the Physician a “target”. Experienced Plaintiff and Defense attorneys alike can attach a “price” on almost any malpractice lawsuit once the full extent of permanent injury is ascertained. While many “worst case” injuries are still within minimum policy limits, certain procedures on certain patients can have catastrophic results. In my opinion, Physicians who perform high risk-high injury procedures should increase their coverage. The stress and worry of defending the claim for two or three times insurance coverage is a great deal worst that the extra premium expense.

Whether minimum or greater malpractice insurance is purchased, be certain the insurance company is solvent and determine if defense costs are “included” or in addition to the stated coverage amount. The legal fees and expert witness expense to fully defend a lawsuit through the stage of a jury trial can be expected to exceed $75,000.

In the case of other types of lawsuits (e.g., automobile negligence, teenage drivers and parties without adult supervision), every parent and every person with assets worth protecting should have “umbrella” liability insurance of at least $3 million (preferably $5 million).

LIMITED LIABILITY COMPANIES (LLC) AND OTHER GROUP ENTITIES:

LLC’s have become the entity of choice for group ownership of medical offices and substantial practice assets. Because the creditor of an individual member is only to entitled to a “charging order”, a member’s interest cannot be directly attached and the creditor cannot interfere with the operation of the LLC. However, the day will eventually come when the other members of the LLC will want to refinance, sell or otherwise make distributions as a return on their investments. At the time of such distributions, the charging order creditor can attach a member’s share and the asset protection of the LLC is lost.

In the case of a group medical practice, many LLC Operating Agreements are written to allow Physician Ownership only and to provide for forced sale in the event of a member’s bankruptcy or other financial trouble. In the case of all such group investments, the following questions should be asked and answered:

1. Can ownership be held by another protected entity (e.g., spouse or another LLC)?

2. Is the purchase of a distressed member’s interest mandatory or discretionary?

3. Is each member fully liable (jointly and severally) for the debts of the LLC or just their proportion and share?

TRENDS AND TRIBULATIONS:

While the states of Alaska and Nevada has been promoting themselves as asset protection havens, they have yet to be any federal court decisions on the effectiveness of this strategy. For those Physicians facing “last resort” asset protection planning, several offshore jurisdictions still offer the best “and most expensive” options.

As a result of one single Bankruptcy Court decision in Colorado, many advisors have become skeptical of singe member LLC’s. Because Florida law expressly limits creditors of a LLC member to charging order protection only, single member LLC’s remain a valid asset protection option in Florida. Where appropriate, additional LLC members (e.g., other family members eliminate this Bankruptcy Court issue altogether.

Given the recent opportunity to either expand or restrict various asset protections statutes, the Florida Legislature has favored increasing rather than reducing asset protection options.

Business Succession Planning - Part 2

The previous article on business succession planning described why such planning is important and that it is seldom accomplished without outside help. Besides tax, accounting and legal issues involved in any change of ownership, succession planning in a family or closely-held business also involves personal relationships that can both help and hinder the process.

In the minds of many current “senior” owners succession planning is seen as the first step towards retirement and their own morality. These emotions mixed with and often accurate assessment of the abilities of the younger generation results in procrastination, reluctance and even rejection of proposed changes.

In the case of the younger generation, or aspiring new owners, what needs to be said is often left unsaid because the communication between business partners is different than between parents and their children. Rather than expressing disagreement or constructive criticism, both generation, but especially the younger generation, may either remain silent or simply abandon the process.

While any type of business planning will benefit from the “team” approach, committed succession planning may need the added ingredient of family counseling. A few such firms exist and can often salvage a business succession plan that is in danger due to personal conflicts.

The older generation is entitled to keep what they earned, have certain financial security and a post-retirement role to plat if they want it. The younger generation is entitled to respect for their own abilities, a chance to succeed and the right to make a few mistakes. The older generation should remember that they probably made a few mistakes of their own.

In-laws are a “wild card” in every family situation. In-laws can be the best or worst influence and are often both the sounding board for silent frustration and force behind final confrontation. If mom and dad consider themselves a “team”, they should have no less respect for the support showed by a daughter-in-law or son-in-law. A family or a personal relationship that prompts business owners to pursue succession problem create its own set of obstacles. Like obstacles to any objective, they can cause defeat or be dealt with as something to be expected. In the next article we will cover how to spot and develop good successors.

Succession Planning

We can all remember our favorite restaurants or other small business that closed upon the death or retirement of its’ owners. We can also think of a restaurant or other small business that was never quite the same after its owners sold out. Between these two results is what estate planners call the challenging world of “Business Succession Planning.”

In the world of small businesses, more fail than succeed at succession planning and even more fail to even attempt succession planning. While we can all point to automobile dealerships or other examples of successful transition between one generation and the next, these success stories are more the exception than the rule. Looking behind the scenes of these “success stories”, you often find disappointment, hard feelings, and even lawsuits. Having participated myself in a number of both failures and success stories, the two main ingredient of success are good parenting and good advise. While some family businesses can rely on a product or franchise that will succeed on its own, most small business owners face constant challenges of government regulations, competition and taxes. It is no wonder that so many small business owners are both too tired to continue and too busy to quit. A family committed to succession planning and a smooth transition of control between generations face a daunting challenge. Succession planning is not a short term project or a task that many business owners can accomplish without outside help.

Unfortunately, many advisors who provide good legal, accounting, and insurance or investment counsel face succession planning challenges in their own business. While my next few articles will discuss succession planning for a family business many of the points and pitfalls apply to any business or to the passing of wealth between generations. The older generations often needs as much training in their role as the younger generation. In my next article, we will start by speaking to the current owners about how to succeed in succession planning. The children or other perspective new owners will get their turn, including the responsibility they have to look in both directions as the mantle is passed.