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Selecting the Right Exit Path — Transferring Ownership to Children, Part 1

T. Ray Phillips — Wed, 28 Jul 2010 19:03:20 +0000

The purpose of Exit Planning is for you to achieve your financial and lifestyle objectives after you leave your business. One of the fundamental objectives that needs to be decided early in the Exit Planning Process is selecting your successor.

Trends have indicated that the majority of owners of smaller-sized businesses prefer to transfer the business to other family members, an employee or a co-owner. Only a small percent of these owners want to sell to an outside third party. Unfortunately for owners, the people they first identify as their successors often do not end up as the ultimate owners. Much effort is wasted focusing on the wrong successor target or, worse yet, wrongly assuming a child or employee wants to own the company typically doesn’t take into account alternative plans.
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This and the next few Exit Planning Review™ articles will aim to save you some effort by setting forth the advantages and disadvantages of transferring the business to each category or potential purchaser: family member(s), co-owners, employees and outside third parties. There are pluses and minuses to each choice. Knowing what they are will help you determine which method is most suitable for you. Take time to compare the relative merits and disadvantages of each departure option before making your decision.

Option One: Transfer of Ownership to your Children
If you are a typical business owner, there is a 50 percent chance that you want to transfer the business to your children. If you are a typical owner; however, there is a substantial possibility that you will end up transferring the business to someone else because of the difficulties associated with this type of transition. Therefore, it is in your best interest to realize the difficulty of this transaction, as well as prepare the business for the possibility that it will be conveyed to another type of buyer.

Advantages
• Fulfills personal goals of keeping the business and family together.
• Provides financial well-being for younger family members unable to earn comparable income from outside employment.
• Allows you to stay active in business with your children.
• Allows you to control your departure date.
• Enables you to fix value by starting with the question, “How much do I need or want?” rather than being told, “This is how much I am willing to give you.” This is especially useful in situations in which the business is worth less than the amount needed to live on – if the business were sold to a third party. When you keep the business in the family, you can sell for what you need to live on even if the business value does not justify that sum of money.
Disadvantages
• Great potential exists to increase family friction, discord and the feeling of unequal treatment among siblings. The normal objective of treating all children equally is difficult to achieve because one child will probably run or own the business at the perceived expense of the others.
• Reaching financial goals is normally diminished not enhanced; although with careful planning and implementation, financial goals can often be achieved while transferring the business to the children.
• Because family is involved, your control may be weakened. You can lose effective control even though you still have voting control – due, of course, to the vagaries of family dynamics.
• The real risk of transferring the business – because of family ties – to someone who can’t or won’t run it properly, threatens your financial goals and the existence of the business.
Many of the disadvantages can be minimized or avoided through proper planning, but it is important to be knowledgeable of both the advantages and disadvantages associated with the transfer of ownership to children when choosing a successor. In the next Exit Planning Review™ issue, we will look at the second exit path option – sale to other owners or employees.
If you have any questions about selecting the right exit path, please contact us to discuss your particular situation.

Article presented by T. Ray Phillips, CFBS, AEP, ChFC with The Family Business Legacy Co., LLC, is a member of Business Enterprise Institute’s Network Of Exit Planning Professionals™. © 2009 Business Enterprise Institute, Inc. To contact T. Ray Re: subject matter in this article, call (317) 208-6312 OR e-mail trphillips@finsvcs.com

DISCLAIMER: The information contained in this article is general in nature and is not legal advice. For information regarding your particular situation, contact an attorney or tax advisor. This newsletter is believed to provide accurate and authoritative information related to the subject matter. The accuracy of the information is not guaranteed and is provided with the understanding that none of the providers of this newsletter, including Business Enterprise Institute, Inc., is rendering legal, accounting or tax advice. In specific cases, clients should consult their legal, accounting or tax advisors.

The example provided is hypothetical and for illustrative purposes only. It includes fictitious names and does not represent any particular person or entity.

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Putting All of Your Eggs in One Basket

T. Ray Phillips — Mon, 12 Jul 2010 20:12:33 +0000

Putting All of Your Eggs in One Basket

We have all heard the old proverb that it’s dangerous to put all of your eggs in one basket.” But does the proverb apply in the world of business ownership? Specifically, is it a valid warning or just a worn-out cliché? It seems to make good sense to concentrate all of your business effort and ownership in one entity rather than creating multiple entities to own your business and its operations.
In fact, concentrating all of you business wealth and assets in one entity can instead:
• Make it easier for future creditors to attack and attach all of your business assets;
• Result in unnecessary income taxation and avoidable estate taxation;
• Complicate, not facilitate, key employee incentive planning; and
• Consequently, delay your exit from the business.
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If using multiple entities solves the problems listed above, why, then, aren’t more business owners doing it? That’s what Ryan DeVault asked us not long ago.
Ryan is the owner of a growing document storage business. He was prompted to meet with us because he wanted to create incentive plans for his key employees. Part of the company’s growth strategy was to acquire several locations in a four-state area (for document storage purposes) and to create an incentive plan for each branch location manager.
Of course, Ryan wanted to retain the corporate identity and branding so it had never occurred to him that it might be good tax-planning, good continuity planning and good asset protection planning to create multiple entities. Upon discussion of some of the benefits, however, this is what Ryan decided to do:
• Create a new entity — an LLC (Limited Liability Company) or Subchapter S Corporation — for the business operations at each location;
• Create a new entity, probably an LLC, to acquire the real property at each location; and
• Create an LLC to own the equipment at the various locations (shelving, fork lift trucks, etc.).
Why did Ryan (or why would any owner) create all of these entities when doing so would seem to result in significant additional professional fees?
First, Ryan was concerned about liability exposure as he widened his operations. He predicted that he would not be able to control the operations as closely as he had when he had but a single location. In his mind, lack of control and direct supervision equaled greater risk exposure. Properly designed and implemented, creating multiple entities can limit the risk of that particular operation or that particular asset owned by the Limited Liability entity to the assets of that entity.
Second, Ryan felt that the best way to motivate and to retain key branch managers was to “give them a piece of the pie.” He was unwilling, however, to sell or bonus them an interest in the entire business. Of course, they could never afford to buy much of the business. But they could afford to buy an interest in a new entity; an entity in which the assets were confined to the business managed by that employee. It makes good sense to provide ownership to key employees in only those business operations that they can affect by their performance.
Third, Ryan wished to provide income to his two children who were approaching college age. He wanted income paid to them, in their tax bracket, to pay for college and other expenses. He was also interested in transferring wealth from his estate to their estates while indefinitely controlling both the income and the resulting wealth. To achieve those objectives he created a separate entity to own income-producing assets (such as the equipment LLC, or the real estate LLCs) and assigned to the children a small portion of those LLCs. The children would then receive their distributed share of the income in their income tax brackets rather than in Ryan’s.
It goes without saying (almost), that using a multiple entity approach must be carefully considered; you need input from all of your advisors: legal, tax, accounting and financial.
The next two issues of The Exit Planning Review™ will discuss the use of multiple entities in more detail. As this discussion progresses, you will see how employing a multiple entity strategy will decrease professional fees over time rather than increase them.

The example provided is hypothetical and for illustrative purposes only. It includes fictitious names and does not represent any particular person or entity.