After the Sale of a Family Business

By Gayllis R. Ward, S. Mackintosh Pulsifer, and Kurt A. Brimberry

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Planning must be flexible enough to allow for tax laws that can change annually; even the best-laid plans must be updated frequently. It’s also an opportunity to establish a new approach to financial life that will not only help the former business owners manage their assets effectively and productively, but also ease the transition through what can be a difficult and emotional time. In addition to myriad financial concerns, subtle but important intangibles lurk beneath the surface. Entrepreneurs may be superb at running their companies but lack the skills and experience to manage a large estate. When multiple generations of family members are involved, there can be surprises, unfulfilled expectations, and strong emotions. Family members’ financial needs or personal goals may have been different from what the business owner envisioned. Communication and education are critical issues.

Financial and personal issues must be carefully balanced. Advisors involved in the sale may be unable to deal with the seller’s long-term financial needs or how the sale will affect the client’s retirement plan or estate plan.

The following steps will help an advisor guide clients after the sale:

Define key objectives and issues. Discuss in detail key issues that the sellers must consider as they plan their financial lives after the sale. These may include the need to develop strategies for future income and expenses, and the implications of any options or equity they may have retained with their company, as well as the need to revisit their investment, tax, trust, retirement, and estate planning strategies.

Communicate with all parties. Establish a system for communicating with everyone involved. When working with a large, extended family, it is especially important to make sure information is communicated in a consistent, evenhanded way, and that no one is unintentionally left out. An effective flow of communication is vitally important.

Gather information. Soon after the sale of the business, take stock of all of the client’s assets and liabilities. Drill down into issues such as the client’s liquidity needs, and document financial as well as personal details about family members involved in the estate. This information is needed in order to facilitate the client’s investment and tax strategies and other financial matters in the future, and to facilitate communications with family members.

Key information to gather includes the following:

• Background on family members. Family needs and goals drive the investment and estate planning process. Identify each family member’s role in the business, assess his business and financial knowledge, and learn about his aspirations and objectives. Gather information on any family member working in the business as well as those not actively involved in daily business; she may have relied on special dividends from the company, used company stock as collateral for loans, or had some other interest in the company.
• Income needs. The family’s income needs will change after the sale. His income may drop when he no longer receives a salary from the company, and the value of his assets may not generate enough cash to match his prior income.
• Expenses. Any attractive benefits and perks previously offered by the company will disappear, implying a change in lifestyle. Autos, health and life insurance, retirement plans, club dues, and other business benefits may or may not continue, depending on how the sale was structured.
• Employment contracts. If any family members retained employment contracts with the buyer, the terms of those contracts must be documented. Sellers that continue to work under contract for the sold business should invest their assets quickly and move on.
• Trust structures. The seller’s family may have used trusts and other sophisticated planning vehicles in place before the sale of the business. If so, these entities probably owned stock in the family business and received a share of the proceeds. These entities must be carefully reevaluated in light of the seller’s newfound wealth and aspirations.

Designated Special Purpose Accounts

Immediately after the sale of a business, as long-term strategic decisions are still being evaluated, it can be helpful to recommend that sellers establish investment accounts for managing the transition. A core account should hold the principal from the seller’s business and the bulk of the net worth. A tax reserve account is strictly for taxes that may be payable at year-end following the sale. Payment would be made on April 15 or in quarterly installments during the year following the sale. This account should be invested conservatively in liquid investments. Finally, a personal account should be limited to a modest proportion, such as 10%, of the value of the business sales transaction. If sellers choose to control how this account is invested, that may provide an outlet for channeling some of the control they lost over their assets after selling the business, without putting core assets at risk.

Investment Management

The windfall that often accompanies the sale of a business may be the appropriate occasion for considering a new approach to investment management. Ideally, the investment management firm should provide sophisticated, independent investment advice, and also have the in-house trust, estate, and tax expertise necessary for managing a large portfolio and for creating a comprehensive plan for the disposition of its assets.

Asset allocation decisions have enormous impact on the volatility of a portfolio and the income it generates. Guidelines should be developed that clearly delineate the business owner’s investment objectives, risk tolerance, asset allocation ranges, maximum holding in a single name, liquidity needs, and other areas. Clear benchmarks should be identified and tracked. Diversification is critical, both by asset type (equity, fixed income, and cash equivalents; large-cap; mid-cap; small-cap; domestic versus international) and investment style (growth versus value).

In addition, taxpayers with substantial assets increasingly face alternative minimum tax issues. To avoid such pitfalls, fixed income allocations should be actively managed by an investment counselor with dedicated specialists, not with a buy-and-hold strategy.

Anyone with more than one investment manager may want to consider having one advisor serve as master custodian, which can simplify recordkeeping and analysis of a wide range of information. Many believe that a master custodian is the best way to simplify tax reporting and tracking cost-basis history. A master custodian also has the ability to configure different accounts managed by multiple investment counselors into a master account for analysis purposes.

Intergenerational Planning

An individual, working in conjunction with other family members, must determine the financial goals for future generations. For example, how much wealth should be passed on to whom, and when? Should wealth be passed outright, or should senior family members retain some control? How much should be given to charity? Should charitable gifts be outright, or should the family retain control, such as through a family foundation?

Depending on the answers, assets may need to be organized into tax-efficient structures such as trusts, charitable foundations, or partnerships. Long-established trusts and partnerships will need to be reviewed. In addition, individuals will need a plan for managing these entities and investing their holdings. In many instances, a specialized investment plan will be necessary, with assets invested on behalf of grandchildren handled differently than those used to meet current cash flow needs.

Once the big familial decisions are made, the next step is to determine how to implement them. Investment and tax considerations are secondary but still important. Estate planning typically focuses on making gifts now and paying gift taxes up front before the asset has appreciated substantially. This strategy is sound as long as the asset’s appreciation is sufficiently substantial. The Bush administration’s tax proposals, however, would permanently eliminate estate taxes while retaining gift taxes. If this happens, accelerating gift taxes, which could be avoided altogether at death, would no longer be a viable strategy. The motivation for retaining the gift tax is actually income-tax oriented: to prevent people from shifting assets (via gifts) to low-income taxpayers.

Much traditional estate planning is on hold while the transfer tax system remains in flux. This does not mean that the newly bought-out family members should do nothing; they should merely avoid transfers that incur gift taxes.

Before deciding what specific trusts or other structures to fund, taxpayers should consider a threshold question: Should they create a centralized family entity such as a family limited partnership (FLP) or limited liability company? Many people who sell a business often hesitate to use their newfound cash or marketable securities for family gifts or transfers. Transferring some of that cash or stock to a centralized family entity enables an individual to retain control over family finances through the entity and carefully designate interests in the entity. Recent court cases, however, such as Strangi v. IRS (TC-Memo 2003-145), introduce a note of caution: In exercising retained powers, the protocols of the structure chosen must be observed, or the assets may be subjected to unnecessary estate taxes.

Once the structure is in place, an individual can begin making gifts when appropriate from a tax standpoint and desirable from a personal standpoint. Currently, no-tax or low–gift tax techniques are popular, including grantor retained annuity trusts (GRAT), charitable lead annuity trusts (CLAT), special needs trusts, and generation-skipping trusts (GST). Major charitable gifts are always possible, such as the funding of a private foundation. Although low interest rates make charitable remainder trusts (CRT) less attractive, they remain available.

Minority Shareholders

The rights of minority stockholders must be carefully assessed when selling a closely held family business, and the relationship with these stockholders must be managed accordingly. Closely held family businesses commonly have ownership concentrated in one or two people, often the chairman or CEO. Minority interests, however, may be held by many more people, such as spouses, siblings, or nieces or nephews of the principal stockholders.

When the business is sold, minority stockholders may be in position to exercise more influence and power. For example, the need to obtain the required stockholder consent to a sale may empower a minority group after the sale. In addition, dissident stockholders may have rights under state law that complicate the structuring of a merger or sale transaction and its consummation.