Saying that family businesses are the backbone of the American economy is an understatement. Approximately 90 percent of all businesses in this country are either family-owned or family-controlled. They come in all shapes, sizes and colors, representing all sectors of our economy. From agriculture to services, technology and manufacturing, family businesses generate an estimated one-half of the U.S. Gross National Product and pay half of all wages earned in this country.
Not all family businesses are traditional small businesses either. In fact, roughly one-third of all businesses included in the Fortune 500 are family businesses. But not all of the family business statistics are rosy.
Family businesses tend not to outlive their founders. At any given moment, 40 percent of family businesses are in the process of transferring their ownership. Unfortunately, two-thirds of all initial transfers fail. Of the one-third that survives an initial transfer, only one-half will survive a second transfer. It is estimated that by 2040 about $10.4 trillion in family business owner net worth will be transferred.
Why Family Businesses Do Not Survive
Why such a dismal success rate? The reasons are as varied and unique as the businesses and business owners themselves. Nevertheless, many of the failed transfers can be traced to three causes: people, taxes and cash.
Family Business Owners and Estate Planning for the Family
The family element in every family business can mean the difference between its success or failure during the transfer process. The retirement, disability or death of the business owner are all common events that can trigger a business transfer.
Tough questions must be asked and answered. Otherwise, a business that took decades to build can be destroyed overnight.
For example, who will run the business after you? Will it be your spouse, one of your children or a non-family member key employee? If your spouse will not run the business, will he or she still be financially dependent on it… or can you make arrangements to ensure they are financially independent of it?
What arrangements have you made for the inheritance of your children who are not active in the business? Have you in-law proofed your estate?
Thinking ahead to the second-generation transfer of your business, what provisions have you made to encourage thrift and industry among your grandchildren?
Estate Tax Uncertainty
The only certainty about the federal estate tax is its uncertainty with each change in Congress and the White House. Additionally, some states now impose their own estate taxes, independent of any federal estate taxes.
Accordingly, careful monitoring of the economic, political and legal climate is required. Why? Without proper estate-liquidity planning, your family may have to sell the business just to meet an estate tax cash call.
Coordinating Financial and Estate Plans
If your financial and estate plans are not carefully coordinated, there may not be enough cash to fund your objectives. An appropriately-funded estate plan can meet all of your people-planning objectives and provide liquidity for estate taxes (and business debts). Life insurance, owned in the proper amount, type and manner, may be effectively used to fund such money matters.
The Business Buy-Sell Agreement (BSA)
A BSA is a lifetime contract providing for the transfer of a business interest upon the occurrence of one or more triggering events as defined in the contract itself. For example, common triggering events include the retirement, disability or death of the business owner. An interest in any form of business entity can be transferred under a BSA, to include a corporation, a partnership or a limited liability company. Also, a BSA is effective whether the business has one owner or multiple owners. As a contract, a BSA is binding on third parties such as the estate representatives and heirs of the business owner. This feature can be invaluable when the business owner wants to ensure a smooth transition of complete control and ownership to the party that will keep the business going. Subject to certain Family Attribution Rules under Internal Revenue Code § 318, a BSA can help establish a value for the business that is binding on the IRS for federal estate tax purposes as provided under Internal Revenue Code § 2703.
Entity Buy-Sell, Cross-Purchase Buy-Sell and Wait-and-See Buy-Sell Agreements
A BSA is commonly structured in one of three general formats: An Entity BSA, a Cross-Purchase BSA or a Wait-And-See BSA. Under an Entity BSA, the business entity itself agrees to purchase the interest of a business owner. Conversely, under a Cross-Purchase BSA, the business owners agree to purchase one another’s interests. The Wait-And-See BSA gives the entity a first option to purchase the interest before the remaining business owner(s).
In addition to these three general formats, a One-Way BSA may be used when there is one business owner and the purchaser is a third party. The selection of the appropriate BSA format is critical for a variety of tax and non-tax reasons beyond the scope of this discussion. However, no BSA is complete without a proper funding plan. Like a beautiful automobile without fuel in the tank, a BSA without cash to fund the purchase is going nowhere.
Funding a Buy-Sell Agreement
Some common options to fund the purchase obligation under a BSA include the use of personal funds, creating a sinking fund in the business itself, borrowing funds, installment payments and insurance. Of these options, only the insured option can guarantee complete financing of the purchase from the beginning. Accordingly, a proper BSA will include both disability buy-out insurance and life insurance. Since the health of the business owner determines their insurability, any delay in acquiring appropriate coverage could be fatal to the success of the BSA and, with it, the survival of the business itself.