Although the Rio Olympics ended weeks ago, there are some moments of the games that will endure.
One such moment came during the qualifying round of the women’s 4x100m relay when Team USA dropped the baton during a hand-off. The devastation in the Olympic stadium was palpable as Team USA was not only expected to make it to the finals, but to also win a medal. After years of intense training and meticulous preparation, it seemed as though biggest moment in the team members’ careers was going to be derailed by a force-fumbled transition. Luckily, after a lengthy debate and appeals process, Team USA received another chance and went on to win gold.
Owners of a family business often aren’t as fortunate. When it comes to handing off the business to the next generation, there is usually only one chance to get things right.
Intra-family business transfers are unsuccessful more often than not. In fact, only 30 percent of family-owned businesses survive a transition from the first generation to the second, and only 13 percent survive a transition to the third generation. Let’s explore five common pitfalls that occur during intra-family transfers that contribute to these startling statistics.
1. Attempting to give all heirs an equal stake
If you’re a parent, you have probably heard the words “but that’s not fair!” countless times. As parents, we pride ourselves on loving our kids equally and want to instill in them a sense of fairness, especially when it comes to matters that involve their siblings. However, this approach may not be what is in the best interest of a family-owned business. Oftentimes, there are one or two heirs that gravitate toward running the business, and others whose interests lie elsewhere. Giving all of the children an equal share in the business can breed resentment and demotivate those who are actually managing the business. The transitioning owner can be “fair” to all heirs by making other financial arrangements through proper estate planning that avoids granting equal ownership in the family business.
2. Not having your children invest any of their own funds
When you built your business, you were probably motivated to succeed because you had invested a significant amount of time, money and energy into the company. Your children should also have some skin in the game. If a successor has to invest their savings or take out a loan to buy into the business, they are forced to evaluate their true desires and motivations. This will result in a more passionate and driven owner as opposed to one that had the business just fall into their lap.
3. Failing to take advantage of tax-planning opportunities
The tax consequences of an intra-family transfer can be an unfortunate revelation for many exiting owners and their heirs. However, there are numerous strategies that can be used to minimize the tax effects of transferring the business to the next generation. Family limited partnerships, grantor retained annuity trusts (GRATs), and other gifting strategies can be employed to minimize or defer the potential tax liability of a transfer. Proper structuring to utilize discounts in the valuation of the business can also reduce the tax burden of a transfer. When employing a discounting strategy, a qualified business appraiser is needed to substantiate the value used in a transfer, and defend such value upon an IRS audit.
4. Not building a non-family council to resolve conflicts
The dynamics of a family business transfer can be especially complex as you are dealing with your heirs both as a potential business partners and as your children. Nepotism can unconsciously creep into what should be purely business decisions. Children may disagree with a business decision but go along with it due to the parental authority of the transitioning owner. Establishing a council of non-family members, including other business owners and professional advisers, can help navigate the inevitable challenges and conflicts between family members as they arise. This council can advise owners on issues such as company loans, compensation, perks, performance reviews and transition plans when they involve the family members.
5. Failing to document the terms of the agreement in writing
As we’ve seen, family businesses can be especially prone to conflict. Oftentimes, an owner is overly optimistic about a family relationship’s ability to withstand business disagreements and does not recognize the need to put things in writing. Even if the conflict is not between the owner and their children, there may be conflicts between the siblings in the event of the owner’s death. Therefore, it is important that there is a written document in place that clearly defines the terms of the transfer.
When agreements are oral, there is more opportunity for frustration, confusion and conflict among the family members.
While proactively addressing these five pitfalls can help a business survive the transition to the next generation, many more obstacles can arise. Fortunately, it is not necessary to navigate the complexities of an intra-family transfer alone. Retaining a qualified exit planning adviser can help in successfully passing the baton of the family business.
Alisha McClellan is a director at Johnson Advisors, a Las Vegas-based consulting firm specializing in transition planning, business consulting, accounting assurance and tax services. To reach her, email amcclellan@johnson-advisors.com.