QUESTION: How important is it for small businesses to have a succession plan in place in the event an owner dies, becomes disabled or decides to retire?

ANSWER: The plan is critically important for many reasons. Many times, the business is the biggest asset in a family and often the primary source of income. With good planning, the business can continue to run and produce money.

Depending on how the business is set up, be it an LLP, S-corp., partnership or sole proprietor, the business may be forced to close if there is no plan. Statistics show that it is very difficult for a business to stay in the family for more than three generations. The demise of Kakesako Jewelers after 58 years is one of the examples in the local community.

Q: What are some of the problems that can develop due to lack of good succession planning?

A: The company will close its doors and people will lose their jobs. Families can be torn apart and hard feelings can last a long time if people feel shortchanged.

Q: What is the first step a business owner should take in the planning process?  

A: A formal, written succession plan, often called a buy-sell agreement, is the first step in assuring an orderly and successful transition in business ownership. The agreement sets a fair price that is reasonable to all parties. The price will set the value for estate tax purposes.

A buy-sell agreement says that the surviving owner will buy the deceased owner’s share of the business for a specified price. This means that cash is needed and a well-structured life insurance policy will provide the exact amount of cash at exactly the right time.  Each owner can own a policy on the other owners.

Q: Is the process different if the co-owners are related?

A: When the owners are related, special consideration must be given to the family dynamics. When all is said and done, the goal is to have everyone happy and content with the outcome. Problems often occur when the family has members that are not involved in the business. For example, if there are three children and only one child is active in the business, is it fair to leave the business to the active child and nothing to the other two siblings?  Estate equalization, using a life insurance trust, can create the cash to leave to the nonbusiness siblings so that there is fairness in the legacy planning.

Q: In the case of the death of an owner, how do the interests of the surviving owners differ from the interests of the heirs of the deceased?

A: The surviving owners typically look to retain total control of the business without interference from the deceased owner’s heirs. The deceased owner’s heirs want their income to continue, but may have no real interest or skills to help run the business.

Q: What are some of the estate planning strategies owners should consider when setting up a succession plan?

A: By having a well-drafted plan, the IRS will use the valuation established in the plan. With the IRS hungry for revenue, leaving the IRS to value the plan can be a costly mistake.

Q: Do the strategies differ depending on whether the succession is the result of a death, disability or retirement of one of the owners?

A: Yes. Life insurance can fund the uncertainty of premature death and also provide funds when the business owner lives to retirement in the form of cash value. Life insurance cash values can be used to fund retirement plans when structured properly. In the event of a disability, there are disability buy-out policies that will provide the cash needed to make a smooth succession.

In summary, it’s all about cash.

The agreements will create clarity; the insurance will create the cash. In all cases, businesses crafting succession plans should consult with their advisers on how the tax implications will affect them.

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Interviewed by Alan Yonan Jr.