As you finish off the last of the leftover turkey sandwiches, you might take the New Year as an opportunity for reflecting upon the successes and challenges of 2015, while thinking about how to improve for 2016. The introspection can be even more comprehensive for business owners—particularly those of closely held family businesses—approaching retirement age. Unfortunately, for some business owners thinking about succession planning, the person equipped to lead the business into the next generation might not be sitting around the holiday table. Whether the next generation lacks the skills necessary to lead the company or simply has interests and passions that take them along different paths, there are alternatives outside of standard sale transactions that will ensure a successful transition. Some of the following approaches will allow the family’s second generation to benefit from the hard work of the owner, while identifying and rewarding the team tasked with leading the business forward.
Sharing profits with family, without responsibility
If a business owner wants to provide income to second generation family members, but the second generation will not be active in the business, there are options available to facilitate such an arrangement depending on the structure of the business. The use of preferred shares with preferred dividend returns is a well-established method for those businesses organized as C corporations. Under the LLC umbrella, there are also profits interests that can be gifted or sold to children not actively participating in the future business. Caution should be taken in conveying more general ownership interests, as passive-activity loss rules might limit the benefit of any losses incurred should the business decline in future years.
Passing responsibility to future managers, with more limited ownership
If a business owner is moving his business into the second generation, but his family won’t be actively participating in the business management, that business owner would need to identify and incentivize the next generation of business leaders. While minority shares of a corporation or minority interest in a partnership might be the most obvious solution, there are other alternatives that might do a better job capturing the value those new leaders bring to the organization. Corporate organizations have done this for a long time, and usually through stock options or other forms of stock-based compensation. Stock-based compensation allows option holders to participate in future growth of the company, but use of more sophisticated vehicles like Restricted Stock Units or Stock Appreciation Rights might be more effective incentives with less significant impact on core ownership. For partnerships, using capital interest coupled with the profits interests mentioned above can yield similar results. Typically, much of the appreciation of the capital interest will hinge on the drafting of the partnership agreement, which would include provisions for allocation, distribution, and liquidation preferences. Careful drafting of the agreement can ensure that historical owners of the business continue to reap the benefits of their labor, while giving the next generation of leaders the opportunity to leverage their efforts into more significant investments over time.
The S-corporation dilemma
The S-corporation entity choice is an increasingly popular alternative in recent years, so by extension, a large number of business transitions will involve S corporations going forward. Several of the preferential ownership alternatives mentioned above will not be available to S-corporation shareholders due to the limits that are in place related to multiple classes of stock, and the pro rata distribution requirements. S corporations are allowed to have one class of stock that has both voting and non-voting shares, so that gives owners some ability to sell value but retain some control. Use of non-voting minority shares is a good option, but unless all parties are comfortable having new leadership as minority shareholders (with the accompanying per-share distribution rights), S-corporation owners might look to more sophisticated solutions. One popular alternative involves having family members own (directly or through various entities) any real estate used by the business, with the business paying rents to the real estate owners. Another alternative, given the correct facts, would involve termination of the “S” election (either through consensual filing or through an intentional rules violation), and then utilization of some of the other vehicles listed above under the C-corporation umbrella. Extreme caution should be used when terminating the S election, as once terminated, the S election cannot be refiled for five years. Any plan that involves an S-election termination also should be planned well in advance so that the business can take advantage of any tax attributes that might have limited value after the termination.
Succession planning is a critical step in the life cycle of a long-lived business, and sufficient time and care should be taken during the process. If the business will transfer in part to non-family members, the complexity increases substantially. Every set of facts is different, and the solutions available vary widely as a result. If you want to discuss your business’s current succession plan, or if you want to start putting the pieces together to begin succession planning, contact Mark Brumbelow or Eric Elliott at PYA, (800) 270-9629.