Keep / Sell / Liquidate?
The most fundamental estate planning question for small business owners is whether to keep the business in the family, sell it as a going concern, or liquidate the enterprise. There are no clear-cut answers. The ultimate decision rests on many interrelated factors — financial, personal, and family. Seven key questions guide this analysis.
1. Can the Business Survive the Death of the Owner?
The success of many small businesses is closely bound to the skills and talents of the owner. For businesses that cannot continue without the owner’s unique input — as with Charles Schulz and the Peanuts® strip discussed earlier — the best the heirs can hope for is to collect outstanding receivables, liquidate assets at estate sale prices, and lock the door. A lucrative source of family wealth and income disappears rapidly. The estate plan must account for this, providing other assets to care for beneficiaries.
Many other businesses could continue after the owner’s death if a competent successor can be found. Sometimes an “heir apparent” is obvious: a son or daughter, a surviving partner, or a key employee. Business owners must honestly analyze their individual situations to decide if the business can continue beyond their death.
When a business cannot be expected to survive the owner’s death, the owner can take certain precautions to ensure maximum value:
- Explore tax-advantaged alternatives to provide disability and retirement income
- Increase “lifetime perks,” taking as much from the company as possible while it is a going concern
- Have the business purchase key person life insurance on the owner’s life
- Liquidate the business before death — an owner with deep knowledge of the business’s assets and liabilities can strike a better deal. A planned liquidation almost always results in a better outcome than a forced liquidation upon the owner’s death
2. What Is the Cost to Replace the Owner’s Talents?
Assuming the business can survive, it will still suffer from the loss of the owner’s input. Competent replacements can be found — at a cost. The question is whether that cost is prohibitive. Some skills are interchangeable and easily replaced; others are highly specialized. The owner must analyze personal contributions to the enterprise and estimate what it would cost to replace them.
A key person life insurance policy is one commonly used solution. The business owns and is the beneficiary of a policy on the owner’s life (and on the lives of other key personnel). Upon the key person’s death, the proceeds indemnify the business for the loss, providing funds to recruit, hire, and train a replacement. Another long-term solution is grooming a successor during the owner’s lifetime — in a perfect scenario, the owner becomes easily replaceable before death.
One frequently overlooked role of the small business owner is as a source of capital. Small business owners routinely supplement business cash flow with personal loans or infusions of personal funds. Many financial institutions will not lend to small businesses without the owner’s co-signature. Upon death, the business may simultaneously lose a key person and a key financial backer. Key person insurance fills this gap as well.
3. Can a Family Member Operate the Business?
One commonly held goal of small business owners is to hand the business to the next generation — the prevalence of “& Sons” in business names attests to this. If the business can survive and the owner’s talents can be replaced, the next question is: who will run it? Three options exist:
Interfamily dynamics must also be considered: Will all family members be involved, or only one or two? Will those not involved resent those who are? Can family members work together? Are there existing conflicts that will erupt after the owner dies? If any of these questions cannot be satisfactorily answered, the owner should seriously consider selling to outsiders.
4. Is the Business an Appropriate Investment for the Family?
Business owners have a great deal invested in their companies — both financially and emotionally. But it is important to take a clear-headed look at whether retention is actually in the family’s best interest. Would the family be better off if proceeds from selling the business were invested in a well-diversified portfolio? Can the business adequately compensate the family for the additional risk of concentrating all their wealth in a single closely held enterprise?
Most businesses, like people, have a natural lifespan. What is the condition of the business? What is the industry outlook? Are new technologies making the company obsolete? These difficult questions are best addressed objectively by the owner during their lifetime. Otherwise, the family may make unwise investment decisions based on perceived loyalty or personal affection for something that was once a great business.
5. How to Provide for Family Members Not Involved in the Business?
Often only one or two family members have the desire or ability to operate the business. How does the owner provide for the others? If the owner has substantial non-business assets, non-business heirs can be accommodated easily. The problem arises when the family business is the only major asset in the estate, or when other assets must be sold to pay estate taxes on the business.
One option: transfer ownership to all family members but leave effective control in the hands of those actively working in the business. Trust arrangements can be effective in these situations (though they can cause problems for S corporations). A family buy-sell arrangement can also solve these thorny questions, discussed in detail on the next page.
6. Are Non-Family Members Available to Take Over?
If family members lack the desire or ability to continue the business, sale to outside parties is the alternative. Finding someone with the interest, ability, and financial resources to acquire a closely held interest is not easy. Possible buyers include:
- Co-owners — for partnerships, surviving partners are the obvious candidates. A buyout kills two birds with one stone: it relieves the heirs of finding a buyer and eliminates potential disputes with the estate. The same applies to closely held corporations with multiple shareholders.
- Key employees or management team — employees who have shown unusual ambition, loyalty, and capability. The challenge: inducing them to stay long-term, and whether they have the financial resources to fund the purchase.
- ESOP (Employee Stock Ownership Plan) — a qualified retirement plan that acquires company stock. Upon the owner’s death, ESOP funds can purchase the owner’s interest, effectively passing the company to employees as a group. ESOPs are available only for larger businesses (annual sales exceeding $10 million), are expensive to establish and maintain, require annual business valuations, and must be in place before the owner’s death. Companies with ESOPs often report gains in employee morale and productivity. Under the right conditions, an ESOP can be a very workable solution.
- Initial public offering (IPO) — for larger closely held corporations, taking the company public can be rewarding, though time-consuming and expensive. An IPO can be structured so the family retains control, or so that a management team takes over. Ideally done during the owner’s lifetime to provide continuity of management.
- Competitors, suppliers, or customers — often overlooked potential buyers. A deal between two competitors may solve similar estate planning problems for both owners. A vendor or customer may be looking to expand through acquisition.
- Business broker — if the owner cannot find a buyer independently, a broker specializing in closely held business interests (for a commission) may help. The business’s marketability depends on depth of management, financial strength, and demand for that type of business.
7. When Should Ownership Be Transferred?
If the plan calls for the business to remain in the family, the timing depends on: Has the owner groomed the next generation? How will the transfer affect family relationships? Does the owner wish to phase out gradually or transfer all at once? Lifetime gifts, installment sales, private annuities, and buy-sell agreements are all available for intrafamily transfers — each discussed in detail in the pages that follow.
In many cases, the owner can reconcile the desire to retain control during their lifetime with the practical need to arrange the sale in advance through a buy-sell agreement — negotiating the price and terms now but delaying the actual transfer until after death.
8. What Is the Value of the Business and the Expected Tax Bill?
Even if willing and capable family members are available to take over, a substantial estate tax bill can seriously jeopardize a family business. The owner’s objective is to minimize the business’s valuation for tax purposes. Without a formal valuation method in place, the IRS will appraise the business — and will attempt to place as high a value on it as possible.
The estate planner has several tools to minimize the federal tax bite, most involving a lifetime transfer of ownership (full or partial) to freeze the business’s value in the estate. The annual gift tax exclusion allows gradual transfers of ownership without immediate tax consequences. The lifetime applicable exclusion shelters significant transfers for qualifying owners. Installment sales, estate freezing techniques, and IRS-approved discounting methods are also available. These strategies are discussed in the pages that follow.
Summary — The Retain vs. Sell Decision
As the analysis above demonstrates, the factors surrounding the keep-or-sell decision usually work against retention of the family business. This likely explains why only about one-third of privately held businesses are successfully transferred from one generation to the next, and fewer than one in ten make it to the third generation.
Retention has the greatest chance of succeeding when the business is a commercial operation — such as manufacturing or retail — that does not rely too heavily on the unique talents of the owner; when the company has adequate working capital; when a capable successor management team is already in place; and when the interest passed to the next generation is a majority interest, giving the heirs control over their own destiny.
A failure to address these issues honestly and objectively can cause the business to fail. What was once a major source of family wealth disappears — leaving heirs to pick up the pieces.