Family business succession planning.

A 10-step process can make it easier.

A primary goal in financial planning is to help clients decide how, when and to whom to transfer their wealth. In planning for closely held business owners, two issues should be addressed:

* The disruptive effects of a change in management and ownership on the operation and the value of the family business.

* The liquidity necessary to pay estate taxes.

Family businesses are of particular concern because nearly 90% of U.S. businesses are family-controlled. Additionally, family businesses produce over half the gross national product.

In the course of estate and retirement planning for family business owners, CPAs must address both personal and technical issues in formulating a plan to achieve the owner's goals. This article provides a 10-step process CPAs can use to help solve closely held business owners' succession problems.

THE PLANNING PROCESS

Succession planning is a dynamic process requiring the current ownership and management to plan the company's future and then to enact the resulting plan. It typically begins immediately before the owner's retirement. However, most practitioners encourage clients to address succession issues immediately rather than wait until retirement. As is the case in other estate planning engagements, there is no due date for succession planning because the owner may die or become incapacitated at any time.

A client usually can be sold on succession planning's value by imagining the potentially traumatic outcome if little or no planning occurs. According to the Wharton Center for Applied Research, only one-third of family companies passing from the first to the second generation remain viable, while only 15% continue to the third generation.

Marketing pointer. Patience and persistence are necessary to motivate clients to act. If a client resists, consider switching tactics and sell the engagement as the creation of an emergency plan. A family business owner may be more willing to address emotionally charged issues if he or she views the solutions as temporary rather than permanent.

Frequently, the focus is on taxes because the family business represents the largest concentration of wealth in the estate. When planning for large estates, both families and planners frequently ignore personal issues. CPAs must prevent clients from making the critical error of maximizing tax savings but destroying the business with a poor succession plan. In succession planning engagements, communication skills and an understanding of family and business relationships are as important as the estate tax issues.

Working with family businesses affords unique opportunities and challenges. Among the most significant are:

* Family members may show more commitment to the business because of potential ownership benefits.

* Family members may be committed out of a desire to be appreciated and loved by other family members.

* Family businesses may have difficulty attracting and retaining desirable employees. Qualified individuals may avoid family-owned businesses because of a perception nepotism limits advancement opportunities.

* Family relationships often play a greater role than skills or education in determining the makeup of management.

* Family businesses are partly rational and partly emotional.

TEN STEPS

Step 1 - Gather and analyze financial and legal data. The first step in data gathering is to understand the business. Review the company's history, get acquainted with current operations and become familiar with the industry. Then review financial statements, income tax returns, business plans and all pertinent legal documents.

Besides reviewing financial and legal information, CPAs need to understand the business's customer base. Consider the impact of a principal's death on it. Identify key clients and explore ways to avoid losing an important client or block of clients. All of these activities will help you understand what changes will occur in the business after the owner's death.

Next, translate the balance sheet to current fair market values. Analyze the debt, capital structure and cash flows. Review accounts receivable, inventory and any fixed assets to determine if there is sufficient collateral for a leveraged buyout. Review cash flow to see if new fixed payments such as debt repayments or dividend distributions can be made.

Step 2 - Contact the client's attorney. After gathering the documents, it's a good idea to contact the client's attorney. Working closely with the attorney helps create team harmony and avoid potential legal problems due to the CPA's unauthorized practice of law. Additionally, if you are engaged by the attorney instead of the client, all information is protected by attorney - client privilege. Finally, initiating the contact in a cooperative manner may help you develop a new referral source.

Step 3 - Determine the value of the business. Business valuation, like financial planning, is more art than science. The client's perception of the business's value at the beginning of the engagement may be surprising. There may be another surprise when the client hears what value can be placed on the business for estate tax purposes.

The goal in valuation is to determine the price at which the business will change hands between a willing buyer and a willing seller, assuming

* The buyer is not under any compulsion to buy.

* The seller is not under any compulsion to sell.

* Both parties have reasonable knowledge of the relevant facts.

The Internal Revenue Service computes a value based on a business's "highest and best use." This means a business is valued at the highest possible value that can be reasonably justified.

Planning pointer. When reviewing potentially taxable estates, analyze the possible use of favorable valuation discounts for the loss of a key person, a lack of marketability or a minority discount for a lack of control. Alternatively, consider making recommendations to avoid exposure to valuation premiums for control.

Planning pointer. It often is wise in the case of a multimillion-dollar business to consider using a valuation specialist with a history of successful confrontations with the IRS. If a local expert is not known, ask one or more estate planning attorneys in the area for recommendations. Alternatively, write the American Society of Appraisers, P.O. Box 17265, Washington, D.C. 20041, or call [phone]. Another source of information is the Institute of Business Appraisers, Box 1447, Boynton Beach, Florida 33425; phone: [phone].

Step 4 - Compute projected estate and transfer taxes. Estimate the taxable estate at various future dates (for example at five-year intervals or at the owner's projected retirement date) as well as estate and inheritance tax liabilities. Also project estate liquidity to help the parties determine if sufficient liquid assets will be available. (Liquidity often is a problem in closely held business owners' estates.) Remember, federal estate taxes ordinarily are payable nine months after the date of death.

Also pay particular attention to the existing business structure and heirs. Inappropriate entity selection could have a disastrous impact on the estate. For example, a non-qualifying trust could cause the loss of an S corporation election. Or desirable basis adjustments may be available through a partnership's Internal Revenue Code section 754 election but unavailable through an S corporation.

Planning pointer. In projecting estate taxes, consider some of the beneficial IRC provisions, including those in sections 6166, 2032A and 303. If none is currently available, determine if it's desirable to create an opportunity to use such provisions by making adjustments to the estate's size or composition.

Step 5 - Gather personal and personnel information. Learning how to work with family members often is the planner's greatest challenge. Gaining an understanding of both the family system and the business system provides critical information about how family relationships affect the conduct of the business. Recognizing each family member's role and his or her effect on business performance is important. Pay attention to relationships and people, looking at each family member, the family as a whole, each key business member as well as the business as an organization.

Discuss the business's history and the future outlook with the current owner. Solicit his or her thoughts about why the business has been successful, how current compensation is set and who the valued nonfamily employees are.

Within the business, identify key management personnel. Think about how the business could operate effectively in the owner's absence. Current personnel may need to be developed or trained to assume greater leadership roles. Analyze family members' and current management's potential and capacity for growth to determine if possible successors exist within this group.

Planning pointer. By observing the business unobtrusively, you may learn some important things about the family business's corporate culture - norms, code of ethics, unwritten rules, etc. Business and family dysfunctions - sibling rivalries, parent-child conflicts, family members' belief systems that treat employment as a birthright, family resentments - also can be discerned.

Step 6 - Identify dispositive and financial goals. The closely held business owner typically wants to minimize transfer taxes, maximize the wealth transferred to the next generation and have adequate income in the event of retirement or disability as well as provide for a spouse, if applicable, on death. In other words, they usually want it all. It's important to ascertain the principal's desire to maintain jobs for family members, even if they are not a part of the key management team.

Step 7 - Analyze the needs of family members. Learn if any family members are interested in owning or running the business and if they appear to have the potential to fulfill these roles. Potential can always be developed, but if all family members prefer to sell their shares, management successors must be found outside the family and potential buyers should be courted before a forced sale is imminent. This can even mean finding a future buyer immediately.

Step 8 - Identify potential ownership and management successors. After evaluating the data and learning the owner's wishes, identify potential purchasers, including existing management, family members, an existing company such as a competitor or customer, a leveraged buyout fund or perhaps an employee stock ownership plan.

Planning pointer. Future management should not be limited to the future owners in a well-developed succession plan.

Step 9 - Make recommendations, modify goals and provide methodologies. Once the client decides what he or she wants to accomplish, it's up to you to explain the ramifications. The older generation's emotional and financial fears and needs should be balanced with the younger generation's abilities, hopes and needs. Consider how to resolve conflicts when more than one family member is interested in and capable of running the business. If the business is to be sold, set dollar amounts or ranges for the sales price. If the business is to be retained, analyze management succession and decide if the owner's replacement should be developed or brought in from outside.

Planning pointer. The surviving spouse's role, if any, should be clearly determined because he or she may own or control the business for an extended period of time.

Caution. Don't try to predict what will happen. Only explain what can happen. Once the owner dies, children may start fighting over control, wealth and even lost love and attention. Unfortunately, children's spouses frequently become involved in these struggles as well.

Step 10 - Assist the client in implementation. After developing a succession plan, the planning team should create an action plan to implement it. The plan should be in writing and indicate who is responsible for what and by what date.

This is the phase in which most breakdowns occur. Practitioners too often identify problems and expect the client to address them. It is imperative the planning team and the client accept responsibility for seeing the process through to fruition.

Planning pointer. As advisers meet their responsibilities, regularly update the action plan so other advisers know who is doing his or her job and who isn't. The client must receive a copy of each update for it to be effective.

You should follow up at least annually with the client and other specialists and verify no changes have occurred in the tax laws, goals, family relationships or other major premises used in developing the plan.

INTERGENERATIONAL 

PLANNING

Business succession is an intergenerational planning engagement and each generation may need to be educated about the various steps in the process. To market succession planning successfully, CPAs need to focus on the idea of planning for the business's future, with estate planning being only one facet of such an engagement. CPAs also need to understand that many closely held business owners ignore planning for death for psychological reasons. When performing estate, tax and personal financial planning engagements for closely held business owners, CPAs must be aware of both tax and human factors. By implementing a succession plan designed to address personal as well as tax issues, CPAs can help clients stabilize the business, maximize the wealth transferred to the next generation and minimize transfer taxes.

EXECUTIVE SUMMARY

* BUSINESS SUCCESSION PLANNING engagements have the dual goals of predicting what effect a principal's death will have on the business and determining if adequate liquidity is available to pay estate taxes.

* IN THE COURSE OF ESTATE AND retirement planning for a family business owner, CPAs must address both personal and technical issues. Early planning is critical because only one-third of family companies survive from the first to the second generation.

* CLOSELY HELD BUSINESS OWNERS must be persuaded to deal with questions of their own mortality, the suitability of other family members to carry on the business and the desirability and availability of outside buyers.

* A 10-STEP PROCESS of data gathering, analysis and decision making can be an efficient way to plan for a family business's future. Included are estimates of the business's value and projected estate taxes, a determination of goals and the development of a succession plan in consultation with the client's other advisers.

* BY IMPLEMENTING A SUCCESSION plan that addresses tax, legal and personal concerns, clients will able to stabilize the value of their businesses, maximize the wealth passing to the next generation and minimize estate transfer taxes.

BARTON C. FRANCIS, CPA, CFP, MST, is a partner of Shellenhamer & Co., Palmyra, Pennsylvania. He is chairman of the American Institute of CPAs personal financial planning practice subcommittee.