Estate and succession planning for family-owned businesses.

For business owners, few things are easier, but more costly, to put off than succession and estate planning. Important operational decisions, financial strategies, and customer relations may leave little time or desire to consider a succession plan, especially when such planning will require difficult choices to be made about family members and their futures. Without careful planning, however, the death of a business owner may cause confusion and critical delays, fractionalized ownership and control, intractable management disputes, and crushing tax consequences. Even with planning, unforeseen events or intrafamily rivalries can result in gridlock or worse, destroying a well-run business and poisoning family relations. Trusts and similar arrangements can address many of the persona[, practical, and financial issues that arise in transferring the ownership and control of a family-owned business.

Among the most difficult personal and practical issues that business owners must confront is how, when, and whether to "pass on" the business to their children. In making these critical decisions, parents often need the assistance of trusted advisors who can assist them in realistically and critically assessing the needs of a business, its structure and management, and the capabilities and potential of children as managers. Parents' wishes to treat their children equally may conflict with their desire that the business they built continue to grow and prosper, or that their children inherit their work ethic and values as well as their money. Or the hope that their children will work together for the common good may not mesh with the reality that one child is more capable or more highly motivated than the others or that one or more children are not interested in continuing the business. Alternatively, a founder may be unpleasantly surprised to learn that a key manager cannot or will not work for his child, or that his children expect him to cede control of his life's work and let them make the decisions.

Discussions with professional advisors can help a business owner thoughtfully consider and constructively address these issues. For example, one child involved in the business may be provided control of an enterprise, while another child is provided nonbusiness assets, nonvoting interests, or insurance proceeds. A trust may also provide that, as a condition of obtaining a controlling interest, a child expected to manage a family business must grant the other children redemption rights on specific terms or that any beneficiary receiving business interests first executes a stock control agreement. A trust may also provide for the appointment of a special trustee to operate or liquidate a business if a spouse is unable to do so or a child is too young to have an active role in management. The unique issues that face every business and every family cannot always be solved by an estate or succession plan, but an attempt to consider tensions and potential conflicts objectively and to implement a plan to address them, even an imperfect or preliminary one, is far better than leaving things to chance and the vagaries of the probate process.

Financial and tax considerations also play a vital role in succession planning. Should a business be sold or transferred to children by lifetime or testamentary transfers? Do the parents have independent resources or will they need to convert the value of the business to cash for their retirement? Will the business have access to capital after the founder is no longer active in the business? How will the business retain key nonfamily personnel? Will there be sufficient liquidity to pay estate taxes, fund a buy-out, or provide for family members not involved in the business? Trusts and other estate planning instruments can establish a framework and strategy for managing intrafamily gifts, protecting family assets, providing for an owner's retirement, structuring charitable giving, minimizing taxes, and avoiding legal controversies.

Succession plans for family-owned businesses will generally utilize one or more trusts and other legal arrangements. The following instruments are commonly used, alone or in combination with one another, to transfer business interests, protect family assets, and reduce income, gift, and estate taxes:

* Revocable (Living) Trusts--A revocable trust is a basic estate planning tool. The trust may be amended during life to address changing circumstances and intentions and, on death, functions like a will to establish property rights. Unlike a will, a trust allows for continuous management of ownership and control in the event of death or disability, avoids the time and expense of court-administered probate proceedings, and protects the privacy of one's assets and estate plan.

* Irrevocable Life insurance Trusts--An irrevocable life insurance trust (ILIT), if properly drafted and administered, allows for insurance proceeds to escape taxation on death. Premiums are often paid using tax-free annual gifts. Or an ILIT may be used as part of a split-dollar insurance plan or trusteed buy-sell arrangement. ILITs can be essential in assuring that a business stays in the family and does not have to be sold to meet estate tax obligations. Insurance proceeds can also provide liquidity to equalize bequests or to provide for children who do not participate in the family business.

* Intentionally Defective Grantor Trusts--A "defective" grantor trust is an irrevocable trust that is effective in shifting ownership of assets out of a grantor's estate but for which the grantor remains treated as the owner for purposes of income taxes. Once a trust is "seeded" with a transfer from the grantor, business interests may be sold to the trust at discounted values in exchange for an installment note payable by the trust. Utilizing current low interest rates, a defective grantor trust can provide a highly leveraged gifting structure for the transfer of a family business or other assets.

* Grantor Retained Annuity Trust--Like a sale to a defective grantor trust, a transfer of discounted business interests to grantor retained annuity trust (GRAT) may lock in current low interest rates to leverage the value of gifts of property expected to appreciate in value. The use of a GRAT can yield particularly favorable results if the business interests transferred in trust generate cash sufficient to offset all or part of the annuity obligation.

* Family Limited Partnerships--The family limited partnership (FLP) and family limited liability company (ELLC) remain popular techniques to centralize the management and control of family-owned assets and provide a structure for intergenerational transfers of property at discounted values. Closely held businesses and real estate, in particular, can generate substantial valuation discounts. Given recent IRS challenges to certain FLP structures, careful drafting and operating guidelines are critical to the successful implementation and administration of these entities.

The thoughtful and creative use of trusts and other instruments can set a clear course for future business ownership and management, provide income for parents and elders, minimize or eliminate taxes on the sale or transfer of business interests, and allow successors to focus their time and attention on the health and growth of the enterprise. Investing the time to define clear objectives, to identify and address potential problems, and establish the legal framework for transferring ownership and control will yield long-lasting returns for business owners and their descendants.

William R. Burford is a tax and estate planning attorney with the law firm of Rutter, Hobbs & Davidoff Incorporated in Century City.