Pass it on: smart succession planning ensures a smooth transition to the next generation - Tax Talk

Entrepreneur, Sept, 1996 by David R. Evanson

FOR YEARS, all you thought about was how to get your business going. Now you're actually making money from that idea. So it's time to sit back and take it easy, right? Au contraire--it's time to plan for your future

Oh, we know: You're young, you can't even think about retirement yet, you still have 25 good years or more . . . there are million reasons not to worry about the future right now.

But consider this, says Lyle Benson, a CPA in Baltimore: "In most cases, your business is going to be your largest asset. Even if you don't want to retire, even if you just want to get out of this venture and into another one, you still have to sell your share of the business to someone--and that could mean hefty capital gains." And that, of course, means hefty taxes.

Here's where succession planning comes in. Death and taxes, while" inevitable, shouldn't have to be dealt with at the same time. Savvy business owners need some sort of exit plan. A succession plan aims to ensure that when you retire or die, not only will your business continue according to your vision, but your heirs won't be saddled with a huge tax bill for carrying out your plans.

* PRIME CONCERNS

All things considered, there are three main reasons to have a succession plan in place. First and foremost, family businesses in particular need to make sure they have some kind of succession plan, says Barton Francis, a partner in the accounting and consulting firm Shellenhamer & Co. in Palmyra, Pennsylvania. According to the Center for Applied Research at the University of Pennsylvania in Philadelphia, only one-third of all family businesses pass successfully to the second generation, and of those, only 15 percent reach the third generation.

A succession plan for a family business should address the following questions:

* Do you want your children to take over the business? Some but not others?

* Are your children able to take over the business? Or should they just own it and someone else manage it?

* If you die, will your spouse get control of the business?

* If you sell your business outright to your children, will you pay capital gains?

* Providing for you and your spouse's retirement is a second good reason to create a succession plan. After all, if you can't afford to retire, you're probably going to be reluctant to even think about selling your business to someone else. Benson gives an example: "Let's say you started your family business with a $10,000 investment. Now it's grown to $1 million. There's $990,000 that will be subject to capital gains [if you sell]. Sure, if you die, you don't pay capital gains, but then there's the estate tax. What a trade-off!"

That brings us to the third reason most business owners create succession plans: tax savings. "If you die without some kind of plan in place, estate taxes start at 37 percent and ratchet up to a whopping 55 percent fairly quickly," warns Scott H. Mustin, a partner with the law firm of Krekstein, Wolison, Mustin & White LLC in Philadelphia. "The government generously gives [your heirs] nine months to pay this tax. It's easy to see why some businesses don't make it to the next generation." The taxman cometh--and the taxman taketh away.

The IRS permits you to transfer up to $600,000 in assets plus annual gifts of $10,000 during your lifetime without incurring gift taxes; married couples can transfer twice that amount. Still, says Mustin, "if you have a $5 million business, estate taxes could come in at around $2 million. Where's the money going to come from to pay for that?"

* OF MICE AND MEN

The first thing to do, according to Francis, is to decide who gets the business next. Keeping in mind that there's a big difference between who runs the company and who owns the company, be realistic in your choice, he says. If your kids don't want anything to do with the business, don't force them. An uncooperative heir can scuttle the whole estate plan after you're gone.

Once you've made the ownership decision, it's a good idea to get a business valuation, says Francis. He suggests using a valuation specialist who has a successful history with the IRS. Most entrepreneurs are shocked to find out how the IRS would value their businesses. "Highest and best use" is the phrase most often bandied about. That means that while you think you could realistically get $100,000 for your business assets, in the eyes of the IRS, they might go for $200,000.

In addition to giving you an idea of what your business is worth, a valuation provides a good starting point for projecting what your tax liability would be if you (or your heirs) were to sell the business. Minimizing this tax liability is at the core of any succession plan, says Mustin.

And, of course, any succession plan must comply with the tax code. The good news here: In the event of your unexpected demise, there are a few sections in the tax code that might give your heirs a break. For example, IRS Code Section 303 permits, under certain circumstances, the corporation to cash out the owner's stock (upon his or her death) if the proceeds are used to pay estate taxes and administrative expenses. There's also Section 6166, which allows a portion of the federal estate tax to be deferred for up to 15 years (with interest) if the estate qualifies.