Early this year, Prince Alwaleed bin Talal of Saudi Arabia told Charlie Rose that as a 7% shareholder in Rupert Murdoch's News Corp., he believed Murdoch's son James should take over the empire when his father decides to step down. The Murdoch family, however, has not yet announced a succession plan. Nor has Edward "Ned" Johnson, the chairman of mutual fund giant Fidelity Investments. Though Johnson, whose father founded the company, will turn 80 this year, no one is sure whether the next chief executive will be his daughter Abigail Johnson, his son Edward Johnson IV or someone outside the family.
Wealth advisors see similar scenarios almost daily. A family patriarch-or sometimes a matriarch-might believe no one else is truly capable of running the family-owned business, especially in a tough economy. "Some never give their kids a chance," says John Moore, a former director of Benjamin Moore Paints and a fourth-generation family member who frequently consults on family business governance issues. "The nature of many people who start businesses is that they want to stay in control of the business and feel they've earned the right."
On the other hand, many are so busy running the business they keep putting off the succession plan, says Kal Grant, a wealth advisor with J.P. Morgan's Private Wealth Management division in Dallas. Yet not having a plan in place can make customers, suppliers and creditors nervous.
While the economy presents special challenges to any newbie successor, lowered valuations make this an ideal time for generational transfers. Grant is finding that many clients want to sort out their estate plans in preparation for all of the estate tax uncertainties ahead, and that presents an excellent opportunity to start talking about the family business. "We start by asking, 'What is your five- to ten-year plan for the family business?'" she says. "Most people love to talk about their family business. But as an advisor, you have to understand what they really want."
A McKinsey study published in January says that less than 30% of family businesses survive into the third generation of family ownership. That is not necessarily an indication of failure. "I'd say no more than half of my clients want to pass their business on to the next generation," says Grant. Some would prefer to sell the company, give a share of the newly liquid assets to their children and another 10% to 20% to charity, then take the rest and go live on a beach. Others, including clients well into their 60s, wish to sell the business and start a new one, though eventually the new venture might go to the next generation.
But even in the most classic case-that of a patriarch who wants to hand over the business to his oldest son-the succession process will require a battalion of advisors: not just a lawyer, a CPA, a wealth manager, a business appraiser, a banker, a trust officer or an insurance professional, but often also a psychologist, who can work out the family dynamics, and a management consultant or executive coach who can help develop the new generation of leaders. It is a process that focuses on three distinct things: the financial and legal structure of the transfer, the emotional impact on the family and the actual running of the business under a new leader.
The Financial Structure
While the economic downturn has left many businesses with more debt than cash, the lower valuation offers a family business owner a chance to reduce the size of the estate by gifting shares in the corporation to the next generation. The value of the gifts might be lower than it was a few years ago, and interest rates are at all-time lows for gift transfers.
Many advisors are recommending that their clients set up their gifting through grantor trusts with family members as beneficiaries. In this structure, the grantor owns the assets for income tax purposes, but the transfers are recognized for gift and estate tax purposes, so that the assets are not subject to estate-taxes. A grantor trust also offers protection against potential creditors and fiduciary oversight.
Louis Mezzullo, a lawyer with Luce, Forward, Hamilton & Scripps, in Rancho Santa Fe, Calif., who specializes in estate planning, offers an example of how such a trust can create an equitable distribution even in a family where not all of the children are closely involved with the business: Mr. Entrepreneur owns 100 shares of his company, an S corporation having a fair market value of $20 million. He also owns commercial real estate with a fair market value of $20 million.
He has four children, two active in the business and two not, and he doesn't want the children who are inactive in the business to be owners. He can recapitalize the corporation to create a split between voting and non-voting stock.
Transferring the non-voting stock might result in a lower value, which is desirable for the purpose of wealth transfer, so Mezzullo suggests Mr. Entrepreneur create 90 shares of non-voting stock in the S corporation. He can transfer all of the non-voting stock to a grantor trust, naming as beneficiaries the two children who are active in the business. Then he can transfer the commercial real estate to a limited liability company (LLC) in exchange for a 10% voting membership interest and a 90% non-voting membership interest. That non-voting membership goes into a grantor trust with the other two children as beneficiaries. At his death, Mr. Entrepreneur would complete the transfer of his business by leaving the voting stock in the corporation to the two children active in the business, while the other two children receive their remaining inheritance through the voting membership interest in the LLC.
Grantor retained annuity trusts (GRATs) are also popular now, as is generally the case when interest rates are low, because earnings that are higher than the prevailing interest rates when the trust is set up will not be subject to estate tax. In this type of grantor trust, the grantor retains the right to receive a fixed dollar amount for a specified period of time, after which his interest terminates and the asset is distributed to the beneficiaries or the trust continues. A GRAT is a useful technique if the head of the family business wants to step down but continue getting income from that business. However, the caveat in using a GRAT to draw down the value of an estate is that if the grantor dies during the term of the trust, at least some of the assets will still be included in the estate and thus subject to estate taxes.
Most advisors warn against allowing young children or any family members who don't work for the business to hold voting stock. "Not only is there risk of exposure to liabilities, but also each member of the partnership has an equal say in the management of the partnership," says Mezzullo. "But giving equity interest only to heirs who are going to run the business isn't always possible, because the business is often the family's main source of wealth, and often the most illiquid asset." When that is the case, he recommends transferring shares with a series of put and call options designed to discourage casual buying and selling. The children who are not active in the family business have the right to sell their shares at any time, but at a put rate that is somewhat below fair market value, while those who are running the business can offer to buy out their siblings, albeit at a call price that is slightly above the market value.
The Family Dynamics
All it takes to set up the financial transfer structure is a team of experts. Making sure everyone in the family is happy with the succession plan is another matter entirely, and generally the biggest challenge, experts say.
"You see plans that are great from the financial and legal standpoint but fall apart because they don't take the soft side into account," says Sam Lane, a corporate psychologist and consultant with the Aspen Family Business Group, an international family business consultant. In the best-case scenario, says Lane, the family starts preparing the younger generation around the age of 15. While most advisors recommend an annual family meeting, Lane recommends bringing the family together for a discussion of the business two or three times a year.
Family meetings are always a good venue to talk about a family mission statement with the next generation, and the mission should incorporate the ethos of the family business. Mezzullo suggests designing one mission statement that sets out the core values of the family and the role the family wishes to play in the community, including charitable desires, and a separate mission statement for the company. The company statement, he says, "will highlight the different considerations that go into the business relationships as opposed to the family relationships." Also on the table at family meetings should be an annual review of the strategic plan for the family business-a five- to ten-year plan. This might spell out the timetable for the business succession plan, with specific dates.