Family-owned businesses are the backbone of the U.S. economy, making up 90 percent of all businesses operating today, according to the Small Business Administration. Still, only about 30 percent of these closely held enterprises survive through the second generation.
The problem? Too often, well-meaning founders let family dynamics, emotions and concerns about fairness guide their business decisions, says Baker Crow, senior vice president of Regions Private Wealth Management. While all these factors are important, they can lead business owners to make choices that aren’t always best for their business’s future — or their own financial well-being. “What is in the best interest of the business should be the first priority, because the business may solely be what supports your family and your employees,” Crow says. So you need to carefully weigh the emotional aspects against the best path to business survival and success.
One key decision to make is whether to keep the business family owned and, if so, how to most effectively transfer assets to your successors. This should ideally be decided long in advance, as succession planning can entail years of preparation. Here’s a look at three common options for divesting a business and key considerations:
Give the Business to Family
If there’s a family member interested in running your business, you may like the idea of passing it along as a gift. The Internal Revenue Service requires a third-party valuation by an outside qualified appraiser, and if the business is worth more than $5.34 million — the 2014 individual estate tax exclusion limit — you’ll have to think through additional strategies for a tax-free transfer. One option for married couples is to give a split gift. Each spouse is allowed that $5.34 million, which means that a couple can gift up to $10.68 million tax-free this year.
Another option popular in today’s low-interest-rate environment is to create a grantor retained annuity trust (GRAT). By placing business equity ownership inside a GRAT, the owner will receive an annual annuity for a fixed period of time. At the end of the term, if the business equity ownership has appreciated at a rate higher than the GRAT rate on the annuity, the remaining business equity ownership within the trust will pass on to the beneficiary free of gift and estate taxes. Of course, the IRS has guidelines regarding these trusts, so check with your attorney and accountant first.
Sell the Business to Family
Even if you are ready to retire, you may not have the financial resources you need to just walk away from your business and the income it generates. A happy medium between giving the business to your children and selling it to a third party can be selling it to your children. Family members maintain control while you receive extra cash for retirement.
There are some caveats. First, can they afford to buy it? If not, you could take back a note — essentially an “IOU” — and they could pay you back over time, Crow says. This only works, however, if the business generates enough cash flow to cover that payment and still provides sufficient income to the new owners. “Also, do you want your future security dependent upon their ability to manage the business and pay you back?” Crow asks. If the answer is “no,” they will have to find outside financing, such as a bank loan.
Then there are tax considerations. Selling a business can generate a hefty capital gain. The good news is that federal capital gains taxes are sitting at a historically low 15 percent tax rate. Still, if that’s more than you want to pay, you might consider setting up a charitable remainder trust (CRT). With this strategy, you would transfer the business into the trust, and your children would buy it from there. You and your spouse can draw a lifetime income from the trust, either as a fixed annual amount or as a percentage of its total assets. A possible disadvantage of this strategy is that after you and your spouse pass away, the remainder of the trust goes to a charity, not to your heirs — which is why there are no capital gains taxes owed when the business is sold.
Sell the Business to a Third Party
From a strictly financial perspective, you can often reap the most value by selling your business to a non-family buyer, such as a competitor, private equity investors. or even employees. This is a good option if you don’t have any children interested in taking over, if you have trusted employees who want to buy it or if you simply want to keep peace in the family. “If you have four children and only one of them is working in the business, it is very hard to be equitable because the other children’s interests may not be aligned with those of the business,” Crow says.
The drawback is that your family then loses control of the business you’ve created and can no longer profit from any future growth. So before heading down that road, it’s important to have a good idea of what your business is worth and realistic expectations of your family’s future financial needs. It’s a good time to bring in your attorney, your accountant and your Regions Wealth Advisor, as they can help you determine if you can get what you need out of it, or if you should stay longer and grow the business more.
“This is not an easy decision, or a decision to be made quickly,” Crow cautions. “You should be planning your business succession for many, many years.” Whether you give or sell your business — and whether it stays in the family — can have a significant impact on your family’s long-term financial security. It’s worth having conversations with family members about the future of the business and then weighing each option carefully to determine the best course for your particular situation.
