Succession Planning — Survival Tactics for the Family Business


Lisa S. Hunter, Esq.

Proper succession planning may make all of the difference as to whether a family business passes smoothly and intact from one generation to the next, or must be liquidated to help pay estate taxes. According to a national study, the vast majority of American businesses are either family owned or controlled, and Long Island businesses are no exception. The cost of not addressing succession planning issues can be devastating: statistics indicate that less than 30% of family businesses survive into the second generation and less than 10% survive into the third generation. Given this poor survival track record, we are continually surprised at how many Long Island family business owners have not adequately dealt with these concerns.

The reluctance to establish a succession plan stems from numerous factors, including:

  • The succession planning process itself often elicits emotional conflicts among family members.
  • The older generation may be unwilling to give up control of a business which they have spent years building and maintaining.
  • The older generation may also have concerns regarding the ability of younger family members to successfully operate the business, and fears as to the loss of their own personal financial security, particularly if they will be relying on continuing payments from the business as a significant source of their income.
  • Business owners are often stymied by difficult problems encountered in the planning process, such as how to leave the business to children who have been participants in it, and still treat other children who are not involved in the business fairly.

Numerous techniques are available to insure that the transition of the family business from one generation to the next will take place in an orderly fashion after death. A buy-sell agreement is one such technique that is often utilized, which is essentially a contract between the business owner and the family members who will be succeeding to the business interest. Typically, it provides for a transfer of the business owner?s interest to the next generation in the event of the death, disability or retirement of the owner, and either establishes a value for the business interest, or a formula or methodology for determining that value. Often, such an arrangement is funded by life and disability insurance policies, to provide liquidity to make the payments required under the agreement.

From an estate tax and gift standpoint, the goal is to transfer the family business from the older generation to the younger one in such a way that the value of the business interest is discounted for gift or estate tax purposes. Again, there is an array of possible planning approaches designed to achieve those results, including the use of a family limited partnership, grantor retained annuity trust (GRAT), or a gift or sale of minority interests in the business to younger family members or trusts for their benefit.

Recently, however, the law involving transfers of interests in family businesses has become particularly volatile. The IRS has become more zealous in its attack of these types of transactions and has been successful in some of its challenges in cases involving transfers of closely held business interests. As a result of the new IRS posture, there is often less certainty as to the transfer tax effect of such transactions than there was prior to these recent developments, and the degree of control which the older generation business owner can safely retain with respect to a business in which an interest is transferred may be more restricted.

It is very possible that there will be further developments in the case law in this area as it continues to evolve. As noted, liquidity to pay estate taxes (which are typically due nine months after the date of death) is a key issue in the succession planning process, which is often solved with the use of life insurance. However, even where limited cash flow to pay insurance premiums or uninsurability due to health problems is an issue, other planning options exist to insure that the family business need not be liquidated to pay estate taxes. One such option is to rely on the provision of the Internal Revenue Code which allows for deferred payment of estate tax in installments (at extremely favorable interest rates) over a period of years, if the family business interest is worth at least 35% of the estate and other detailed requirements are satisfied.

It is considered likely that there will be more permanent estate tax reform in the next several years, but the uncertainty as to what that reform will be unfortunately contributes to the complexity of establishing a continuation plan for a family business. Even if the Federal estate tax is repealed or the Federal estate tax exemption is substantially increased, the need for business succession planning will not be eliminated because:

  • The New York State estate tax (which has a maximum rate of 16%) will still be a concern.
  • If there is repeal of the Federal estate tax, it will likely be replaced by new ramifications in the form of capital gains taxes that would be incurred on the sale of a family business following death.
  • The non-tax issues as to control of the family business as it passes from one generation to the next would still be present. Thus, Long Island business owners would be well advised not to be lulled into a false sense of security by reports of the possible repeal or reform of the Federal estate tax, as effective business succession planning will still remain critical to the long-term survival of their family business.