According to a recent study, very few family businesses actually make it to the third generation. And part of the reason for this is that they don’t have effective succession plans in place.
Succession planning in family businesses requires careful consideration of who will take over a company, and how.
In this blog, we’ll guide you through everything you need to know about creating a succession plan, and how a business advisor can make the process so much easier, and more official.
Fundamentals of Succession Planning
Succession planning in a family business is an important aspect of wealth transfer planning. The process encompasses creating strategies for how control of the business, and the wealth and responsibilities associated with this, are handled after you retire. In essence, it covers every aspect of how the company reins are given over to the next generation.
By extension, this means that you can provide for your family, and your business contacts, with the assurance that your company operations and culture will continue to thrive, despite your absence.
And that’s why succession plans usually have two primary goals.
Business continuity
Your succession plan is a roadmap for transitioning business leadership, while ensuring the company still runs smoothly. It can help you to identify potential risks and proactively address them before they have a negative effect on your operations. This is a critical component for maintaining stability. After all, your customers and suppliers will want assurance that their relationships will still be prioritized after a change in leadership, and will expect business as usual.
But even better than continuity, a success plan can help foster growth. By identifying and preparing your company’s future leadership, you’ll be able to bring fresh perspectives, skills and even ideas to the business, to drive it forward.
Preserving your legacy
While business continuity is important, a huge consideration in succession planning has to do with how your business will continue to honor its goals, values, and missions under new leadership. Because such businesses often have strong emotional ties, a company is more than a way of generating income – it’s part of a family heritage.
A succession plan will account for how the business stays in the family, and provide guidance on how it can adapt to different challenges and opportunities, while remaining true to its roots. Importantly, your plan should outline how decisions must be made to ensure unity and collaboration among the family and any non-related employees. This goes a long way in helping prevent conflict, by ensuring effective communication and balanced control.
However, in order to ensure your success planning is effective and compliant, you also need to factor in the various tax and accounting considerations that go hand in hand with the process.
Tax Considerations in Succession Planning
It’s essential that you consider the tax implications of succession planning for family businesses. After all, how you transfer ownership of the company can affect your tax liability in different ways. You’ll also naturally want to save as much money as possible during the process rather than giving it over to the IRS. As such, your succession plan must account for tax efficiency.
There are several ways of transferring business ownership. The simplest method is to transfer ownership through your will, as part of an estate plan. However, this may mean your successors will be saddled with estate taxes. Alternatively, the business can be gifted to the next generation, either in its entirety, or in part. This can mean a lower tax liability, as the IRS allows taxpayers to gift up to $12.92 million in a lifetime, without being taxed. You could also sell your company to your successor. But remember that this means you may be liable for income tax.
Another option is to set up a trust. And there are several options available here. An irrevocable trust lets you move your business into a trust, with your successors listed as the beneficiaries. In a revocable trust, you retain control of the business until certain predefined conditions are met (such as an heir reaching a certain age etc.). These trusts come with strict instructions for how the business should be managed after this time.
When in doubt, get help
If you structure your succession as a sale, remember to account for capital gains tax. These tax rates vary drastically and can be as high as 43.4% for short-term gains or those subject to depreciation recapture.
Federal taxes aren’t all you need to consider. Remember that some states can also levy additional taxes which can increase your tax burden.
As such, it’s essential to consult a tax professional when you’re drawing up a succession plan, to ensure you have a strategy to save as much money as possible, while maximizing potential benefits and staying compliant with IRS regulations.
Accounting Considerations
Succession planning for family businesses also has implications for your accounting. There are a number of key issues that must be addressed before the process begins. These include a comprehensive review of the company’s financial health. That way, you can set realistic expectations for successors.
Another important aspect to consider is how the succession will be funded, and how this will affect cash flow. Whether it involves selling the business, transferring it to family members, or implementing an employee share ownership plan, it is important to plan how the transaction will be funded, so that the necessary preparations can be made.
Also, remember that the transaction will require disclosure. And that means your reporting needs to be in order. Not only do accurate, comprehensive and transparent financial records facilitate the transition, but they help to ensure that there are no outstanding issues that could complicate the process.
As such, it’s necessary to update financial statements to reflect any changes in ownership structure, liabilities, and capital.
Another crucial accounting aspect to consider is a business valuation – this will have a significant impact on your planning.
Valuation of the Family Business
Accurately determining how much your business is worth is a vital component of succession planning. Your company’s fair market value forms the foundation for organizing the succession. After all, it protects the stability of business assets to safeguard your family members. Knowing the value is also important for your tax planning and overall business continuity.
But how is this value determined? There are several ways to do this.
- Income-based methods calculate the current value of your future cash flows.
- An asset-based method establishes your business’ net asset value, by subtracting total bills from total assets.
- Market-based methods compare your company to similar ones that have been sold or are currently on the market.
- The discounted cash flow method estimates value by projecting future cash flow and discounting these to the present, using a rate that accounts for opportunity costs and risks.
Despite the many ways to establish how much your business is worth, valuation can be problematic in family businesses. After all, you need to keep family dynamics and hierarchies in mind, and these can cause emotions and possible conflict.
Thankfully, a professional with experience in the industry will know all about this, and be able to navigate the process with ease.
Managing Family Dynamics and Governance
Perhaps one of the most pressing concerns of succession planning for family businesses is navigating family dynamics. After all, this is something entirely unique to your industry.
Whether you’re dealing with family members refusing to work together because of sibling rivalry, feuds or jealousy, managing expectations and relations between family members can be daunting. And if you also have employees who aren’t related, this can add another level of complication.
One of the best ways to maintain family harmony and business continuity is through strict internal governance. Basically, you’ll need to establish standard operating procedures (SOPs) for various business aspects. This might include how to resolve disputes, choose investments, make new hires, or anything else relevant to your company.
You need a strategy
In this regard, a business advisor or mentor can be an invaluable tool. They can use their expertise to help you prepare for and implement succession planning. Moreover, these professionals can help your business avoid the common pitfalls in succession planning, like poor management, unforeseen risks, and unresolved family issues.
If you need help with succession planning for family businesses, schedule a Discovery Call with one of our CPAs or business advisors.
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