How to avoid a major pitfall inherent in family business succession plans

A successful Florida auto parts manufacturer was started 28 years ago by a husband and wife, and eventually their two sons joined the company.  Their youngest child, a daughter, was never interested in working at the family firm. 

When the father died, the mother continued to run the business with her sons. But she unexpectedly died a year after her husband passed away.

Since the parents loved their children equally, the estate plan divided their entire estate evenly among all three children.  Their two most important planning goals were to treat the children fairly, and be assured the business would be run by the two boys, who were active in the company. 

The daughter, divorced with two young children, had received financial support from her parents and now asked the brothers for her share of company dividends.

When the brothers explained that corporate earnings would now be retained to expand the business and no distributions would be made for the foreseeable future, tensions between the siblings started. The brothers, who drove company cars and received company benefits, had recently given themselves salary raises since they were now covering mom and dad’s previous duties.

So now troubles have begun for a family that was always close. Resentment continued to build from the financially strained sister — who watched as her brothers were living very comfortable lives off a company created by parents who intended to provide for all three siblings.

To make matters worse, the oldest son unexpectedly died in an auto accident and left his entire estate, including his business interests, to his wife. And she was the in-law that no one in the family liked or trusted.

So now, the brother’s widow and the dejected sister have gained combined control of the business, leaving the only surviving active son without the power to run the business. Months later, the business was sold to competitors, marking a tragic end to an otherwise healthy family business. 

In our experience assisting hundreds of family business owners and instructing numerous Wharton School Conferences, this scenario is all too common. According to statistics from The Wharton School Family Business Program at The University of Pennsylvania, only one-third of all family businesses survive to the second generation. Less than 13% make it to the grandchildren.

A significant factor contributing to the these poor survival statistics is attributed to business owners who fail to adequately plan for the transition of the family enterprise when they die. It’s clearly at the top.  

Buy-Sell Agreements

This family’s dilemma could have easily been avoided with a well written Buy-Sell Agreement, which would have maintained ownership and control in the hands of those “active” in the business, while quite adequately providing fair treatment for those not involved in the business. 

The two basic forms of BSAs are the Corporate Stock Redemption and a Shareholders’ Cross-Purchase. The former provides for businesses to redeem shares of departing shareholders, while the latter provides for the individual shareholders to buy from each other. There are many tax and logistical reasons for family businesses to utilize a Cross Purchase BSA. 

At the second death of the parents, a BSA in the example of the siblings would have provided the two sons the ability to purchase their parents shares with use of tax-free proceeds from a properly written life insurance policy. When the parents’ estate received the proceeds for the shares, the estate would have newly created liquidity and the estate plan would allow fair treatment with a larger cash/non-business inheritance for the daughter/sister. Step two would be creating a BSA between the brothers, so when the older brother died, his unpopular widow would have received fair market value payment for the stock, since the sons also held life insurance on each other. 

A BSA (sometimes called the business owner’s will) is a legally binding contract between all the shareholders. It provides for the orderly transition of a shareholder’s interests at “fair market value” in the event of certain “trigger events,” which most commonly include death, retirement, disability if unable to perform daily duties, divorce and bankruptcy. 

The agreement should also include a provision that values the business at a “per-share,“ and if updated annually, should prevent disagreement between buyer and seller the day a shareholder exits the firm.  Business valuations should be performed by qualified valuation experts with special valuation credentials such as CVA, MAFF, CBV, and others.  If done properly, the valuation should hold up to the IRS for estate taxes when a shareholder dies.

A key element of any well drafted BSA includes a source of funding for the eventual purchase of a departing shareholder’s stock. Without proper funding, the BSA becomes mostly ineffective and can cause unexpected financial strain on a business and its’ shareholders at the worst possible time — the departure of a key executive. In the event of death, lack of funding can cause contention between the surviving family shareholders and the deceased shareholder’s family. When evaluating funding options such as a sinking fund, installment purchase or paying premiums for life insurance — the lowest cost option is usually funding life insurance but all options should be considered.

In the event of a retiring or exiting shareholder, an installment purchase over a five or 10 year time frame is often used to ease the financial burden on remaining shareholders and the business.    

In the event of death, there is no better vehicle than life insurance for the purchase of a deceased owner’s interests. The exact amount is delivered exactly when it is needed the most, and if designed correctly, proceeds will be 100% tax-free. However, the tax code includes numerous traps for family businesses and without proper design and use of the correct type of policies, there can be unexpected tax exposures. This is another area, similar to business valuations, that must be done with expertise and knowledge of life insurance products, estate tax law and the tax code. 

John Resnick and Billie Resnick are principals of The Resnick Group in Naples. The firm assists affluent business owners in estate planning, business succession and life insurance. They are co-authors of The American Bar Association’s national guide, “Due Diligence of Trust Owned Life Insurance.”