Article New York Law Journal

Succeeding at the Pass: Succession Planning Strategies for Family Businesses

In this New York Law Journal article, partners Christiana Lazo and Thomas Norelli and associates Tony Meyer and Maria Bourdeau discussed common governance, tax and technical hurdles families face when planning to pass a family-owned business to the next generation. 

Business succession planning for family-owned businesses requires solving a myriad of thorny issues and potential conflicts. This article presents approaches to some common governance, tax and technical hurdles families face when planning how to pass the business to the next generation.

Business succession planning for family-owned businesses requires solving a myriad of thorny issues and potential conflicts to address a family’s chief question: how will the family business, which may represent the lion’s share of the family wealth, be governed, managed and accessed by future generations?

Consider the below approaches to some common governance, tax and technical hurdles families face when planning how to pass the business to the next generation. (A topic for another article would be the hurdles families face if they wish to pass the business to charities, instead!)

Liquidity Planning for Estate Tax Liability

Payment of the estate tax liability can be a challenge for estates of family business owners. Generally, the estimated estate tax payment (a hefty 40% bill on assets above the exemption) is due nine months after the owner’s death. If a significant portion of the decedent’s estate is comprised of family business interests, then the estate may have significant liquidity concerns, requiring a fire sale or leveraging the business to meet the liability.

Of course, engaging in estate planning techniques early and often can help remove the family business interests from an owner’s estate, significantly reducing estate tax liability. Unfortunately, not all owners can be convinced to part with their interests sufficiently to eliminate the estate tax liability (or the liquidity strain) entirely.

I.R.C. Section 6166 may provide some relief for these estates. It permits an effective fourteen-year estate tax deferral (ten years of payments beginning five years after the estate tax return is due) if more than 35% of a decedent’s estate is comprised of interests in closely-held active trades or businesses. By eliminating the estate’s immediate need for liquidity, a Section 6166 election can avoid the need to dismantle or significantly leverage a successful business.

However, qualification for deferral is by legislative grace and strictly construed. Many estates with interests in closely-held businesses do not qualify because they do not meet one or more of the requirements (the 35% valuation threshold, the “closely-held” requirement, or the active trade or business requirement).

Businesses that are vertically structured with tiers of holding companies—a common scenario in modern businesses—frequently struggle to meet the “active trade or business requirement.” (While there is an election to qualify a “holding company” for a watered-down form of deferral, only holding companies organized as corporations may qualify for it.) Estates comprised of family businesses must therefore conduct a careful review and develop a sound strategy (whether through Section 6166 deferral or otherwise) to meet the estate tax liability timely.

Developing Governance Guardrails

When a family business passes from one generation to the next, the number of owners can often increase dramatically, ripening the potential for damaging governance issues. As the number of family owners multiplies, so too does the diversity of owner expertise, familiarity with, and appetite for, business management and expectations regarding the liquidity a family business should generate for its owners. So, too, then does the possibility multiply for this diversity to brew conflict among the family members.

A purpose trust can serve as a useful governance guardrail. If the business can be restructured to bifurcate voting (e.g., general partner) and non-voting (e.g., limited partner) interests, then all voting interests can be contributed to the purpose trust. The purpose trust consolidates governance of the business within a perpetual owner, avoiding complications with successive generations’ estates.

The purpose trust also gives the current owners the ability to scaffold how management decisions will be made in future generations. Frequently, the purpose trust will yield management decisions to a voting committee. Membership on the voting committee can be appointed by any mechanism and can include any constellation of family and non-family members. The estate tax considerations of contributing these voting interests to the purpose trust should be carefully considered.

Buy-sell and voting agreements are two other governance guardrails to consider. First, the buy-sell agreement gives other family members and/or the family business itself the right to purchase or redeem shares before another family member divests of the family legacy (a right of first refusal [ROFR]). They may also give those family members who wish to exit the family business a right to do so by granting a redemption right.

Care should be taken in structuring these agreements consistent with I.R.C. Section 2703 to ensure that any redemption right triggered by an owner’s death is binding for estate tax purposes (otherwise, a family’s liquidity upon the death of an owner and the estate tax liability such death triggers may not match).

Next, voting agreements can direct how family owners will vote their interests, requiring owners to vote as a block and potentially further binding owners to a specific vote (such as for a particular family member to be the business manager) before such vote occurs. Such agreements add certainty of result and stability to business governance regimes.

Importantly, purpose trusts, buy-sell agreements and voting agreements are not a panacea for owners who struggle with who should be in charge when they no longer are. While these structures provide guardrails necessary for steady governance, owners establishing these structures still must perform the hard work of determining who will succeed them (or at least who will determine who will succeed them) in leading and managing the family enterprise before these structures can fulfill their intended purpose.

Funding Succession Structures

Most family businesses do not sit on much available cash. This can present liquidity problems in funding the buy-sell agreements (or redemption rights) referenced above.

One option for funding redemptions is for the family business to purchase life insurance on each member with death benefits that correspond to the value of such member’s interest. When an owner dies, the insurance proceeds infuse the family business with cash sufficient to redeem the decedent’s shares.

Importantly, based on the Eighth Circuit’s recent decision in Connelly v. IRS, the value of the life insurance payout may be included in the total value of the company when determining the value of the decedent’s interest for estate tax purposes—not ideal given the liquidity concerns the estate tax liability already raises in these circumstances. While the Connelly decision may not be consistent with other circuit court decisions on this issue, it underscores the careful planning required to address the succession of business interests (and how this succession raises real liquidity concerns at multiple levels).

A buy-sell agreement should provide unambiguous direction on the purchase price for any ROFR—and how and when that purchase price must be paid. Permitting satisfaction with a promissory note transforms an owner’s exit from an immediate liquidity problem into a long-term liability for the purchaser, but delays the exiting owner’s own liquidity salve. Although the exiting owner may benefit from income tax deferral from this delayed payment, the competing concerns of the family business and the owners must be weighed in crafting these agreements.

Navigating Tricky Tax Distribution Mechanics

When the sole owner of a family business dies, multiple new family owners may succeed to that sole owner’s interests. When these family businesses are structured as pass-through entities, this can introduce liquidity strains on the new owners who may have tax payments due without distributions (and without accessible liquidity to pay for the liability). Tax distributions may become necessary, and determining the amount of those distributions can be contentious.

Some governing documents permit or require distributions based on members’ actual or estimated income tax liability. Properly structuring the governing documents to address these tax distributions, balancing flexibility for the family business against certainty for the members, can help reduce the potential for family conflict. The likelihood that owners may be resident in different states, and exposed to very different tax rates and liabilities, must be considered in the process.

Articulating a Vision with a Family Constitution

Family succession planning not only requires structuring for tax, governance and ownership—it also benefits when the family’s overarching ethos is clearly articulated to guide future generations in how the business and the family should operate. A family constitution can enumerate the business code of the family, providing set principles, values and considerations for what makes a business (and a family) good. The family constitution can set forth guidance on how family wealth should be used, accessed and managed by those family members contributing to the success of the joint family enterprise and on who is allowed to participate in that enterprise (and when).

Addressing these issues in a precatory and non-binding family constitution, rather than a binding governing document, helps preserve flexibility and avoid conflicts over strict entitlements that can become a drain on operations and a bulwark to business innovation. When appropriate, current family owners should include the next generation of owners in the drafting process, generating buy-in and developing their sense of belonging in the process. Ultimately, the family constitution can account for the varying needs, preferences, temperaments, and abilities of the next class of family owners, providing a roadmap for how wealth can be generated and enjoyed by succeeding generations.

Reprinted with permission from the September 10, 2023 edition of New York Law Journal. Further duplication without permission is prohibited.