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Business Planning

Family business is the backbone of our economy, representing an overwhelming number of all business enterprises and one-half of our gross domestic product.  However, most family-owned businesses are challenged to survive past the current generation of ownership.  The fact of the matter is that many family-owned businesses do not successfully transition from the first to the second generation and even fewer survive after the transfer to the third generation.

The sorry track record of family business succession is due to many factors, but a chief cause is the lack of leadership from the current owner generation.  The fact is too many business owners do not address the continuity risk to their business from the death or disability of a key person, do not adequately protect the business from litigation, do not properly develop the next generation to assume leadership of the business or fail to develop a feasible buy-sell plan.  Often is a combination of these acts of omission.

There can be delicate family issues in play as well, and often the path of least resistance for the owner is to focus on day-to-day business management and not enough on the big picture issues - until it is too late.

The solution is working with a planning team when times are good, relationships are healthy and well in advance of a future target transition date. 

The business planning team will take an unemotional look at all aspects of the family business, evaluating the strengths and weaknesses, looks for ways to reduce continuity risk and design a comprehensive plan that considers all the elements of a good transition.

Do not let your family business become another fatal statistic.   Invest the time and money to develop the right business plan sooner rather than later to protect the business for many more generations to come.


Business Formation

An important business planning decision is selecting the right legal form of business organization to best meet the business and personal needs of the owner.

The traditional forms of business organization – sole proprietorship, general partnership and regular corporation – are typically no longer as suitable for the modern small business owner as they used to be.

The usefulness of the sole proprietorship is all but over for businesses of substance.  The ease and informality of a proprietorship is more than offset by the unlimited liability risk of commingled ownership of your business and personal assets.  The same argument holds true for a general partnership – the unlimited liability of a general partner trumps the ease of operation of a partnership.  Lastly, the traditional corporation offers few benefits and a raft of drawbacks, including the double taxation of business income and owner distributions. 

More modern business structures more suitable to small business are the limited liability company ("LLC"), the limited partnership and the Sub S corporation.  Each entity yields good liability protection for the owner's personal wealth with pass-through income taxation to the owners and facilitates the fractional transfer of the business to the next generation. 

An LLC is often the best entity form for the typical small business.  Inexpensive to form and easy to maintain, business income produced by an LLC passes through to the owner as self-employment income with only modest record-keeping responsibilities.  The LLC is flexible by design and can even elect to be taxed as a corporation if desired.

An Sub S corporation also enjoys direct pass-through of business income and create additional tax reduction opportunities.  On the other hand, the Sub S is more expensive to establish and maintain and is not as flexible as the LLC in many planning respects.

A limited partnership confers a number of business, estate and income tax planning opportunities.  It can be an effective way to organize a family business to limit liability, reduce the owner's estate, shift income taxes and retain legal control through ownership of the partnership's general partner interest.


Business Transfer

The definition of wealth for most business owners includes the emotional desire to see the next generation of their family take the reins of the business and succeed.  Too often, however, the business owner fails to take the necessary planning actions to see the vision through to completion. 

Transferring ownership and control of a family business is an emotional decision even for the most well-intentioned entrepreneur.  A number of factors must be considered when designing your business transfer plan, but the overriding element is to start early by placing the next generation in positions of responsibility in early adulthood and gradually increasing their decision-making capacity over time.  Allowing them to make "mini- mistakes" will build their confidence to make more important strategic business decisions later on. 

When the time finally arrives to transfer ownership control of a family business, the most common transfer technique is a hybrid between gift and private installment sale with customized loan repayment terms.  There are special income-tax planning concerns associated with a related party installment sale that must be considered before the sale is executed. 

Interest on the family installment note must charged or the IRS will calculate and assess it for you using their own interest rate tables.  Advanced estate transfer strategies may be required to discount the value of the asset transfer to stay clear of adverse gift tax consequences. 


Buy-Sell Agreement

When a business owner dies, the business often dies too.  Not because anything was done wrong, but no planning was done and that is wrong!  For a small business with multiple owners, business succession planning means the creation of a legally binding agreement as to how each owner's interest will be transferred in the event of their separation from the business – for any reason.

Separation can result from a death, permanent disability, divorce, bankruptcy or even an estrangement from the other partners.  A buy-sell agreement is a legal document that binds the owners of a business to sell their interest to their partner(s) in the future. 

The buy-sell agreement guarantees a buyer, which is particularly important for a minority owner because the likelihood that a capable heir or third-party would have an interest in a minority stake of a family business is low. 

Likewise, an incumbent owner should select their business partner, not inherit them.  A good buy-sell agreement includes a methodology to value the business to determine the sales price between partners.  As long as the formula is reasonable, the valuation is binding for tax purposes. 

How to fund the buy-out is another important planning consideration.  Life and disability insurance can provide an inexpensive source cash to finance the purchase.  Ownership of the insurance policies must be planned because it can have unintended tax consequences for the acquiring owner.

A well-designed buy-sell document can ensure a smooth succession of your business and avoid disharmony among the owners.  It is also much easier to reach agreement on the buy-sell terms pre-separation when things are going well.


Key Person Protection

For the average small business, its biggest asset is the ability, initiative and judgment of its owner or a key employee(s).  The loss of the leader or other important individual involved in a closely held business will likely have a negative impact on the earnings power and stability of the business. 

"Loss" means the death, disability or separation of the key person from the business. The loss of a key person can create serious financial issues such as the cost to recruit and train high caliber replacement personnel plus the opportunity cost of lost business during the transition. 

Life and disability insurance are the common risk management tools to protect the business against the unexpected loss of the services of a key person.  Term life insurance owned by the business on the life of the key employee is the simplest and cheapest risk management tool.  Alternatively, cash value life insurance could produce a return on the cumulative premiums paid into the policy and provide other financial benefits to the key person in retirement.

Disability buy-out insurance is another viable risk management instrument that transfers the financial obligation to buy out a permanently disabled business partner away from the business.
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Securities offered through Cambridge Investment Research, Inc., a Broker Dealer, Member     FINRA/SIPC.   Investment Advisory Services offered through Cambridge Investment Research Advisors, Inc.  Cambridge and Harvest Rock Advisors, LLC are not affiliated.  Cambridge does not provide tax or legal advice.



This communication is strictly intended for individuals residing in the state(s) of DE, FL, IL, KY, ME, MD, NJ, NY, PA and VA. No offers may be made or accepted from any resident outside the specific states referenced.
 


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