Whether your company has one or a dozen shareholders, a solid succession plan, sometimes including formal transfer arrangements, is a requirement for its continued success.
Sooner or later, every business—whether guided by a well-thought-out plan or forced by circumstances—must replace its leader. Succession planning is the name of this game.
Done right, succession planning enables new management to lead the business without missing a beat. Done wrong (or not at all), an unexpected occurrence like the death or disability of the leader can create a nightmare in terms of operation of the business, and it can lead to expensive tax consequences.
The more stockholders a company has, the more challenging the succession planning problems can be. Over the years, we’ve developed a flexible system to handle succession planning, no matter how many shareholders are involved. This three-step system produces foolproof results every time, whether there is one stockholder or dozens. Let’s look at one situation.
Joe is one of 10 shareholders who each own 10 percent of Success Co. All 10 owners are the children of four brothers who started the business many years ago. Each of the “Big 10” works for Success Co., is healthy, and has one or more children of his or her own. For the purposes of succession planning, let’s assume that each shareholder owns 100 percent of his or her shares in the company. This gives each shareholder the freedom to do what he or she wants with the stock that each owns, as long as it does not interfere with the company or the other shareholders.
Joe and his fellow shareholders have at least one common goal: create a succession plan that satisfies the needs and wants of both the company and of each shareholder.
Step 1 of our system classifies the Big 10 into three separate groups based on the likelihood of each shareholder’s own children coming to work for Success Co. (Working for the company is a requirement for becoming a shareholder.) The makeup of these three shareholder groups is:
1. Big 10 members who already have children working for Success Co.
2. Members who are sure that none of their children will ever work for the company.
3. Shareholders who are uncertain whether their children will someday become employees.
Obviously, shareholders can move among the groups if their children later decide to enter or leave the family business.
Joe currently falls into the first group. His son Sam already works for Success Co. Before our succession planning system was put into place, Joe could sell his stock to Sam (using an intentionally defective trust, as described later), gift it to him, leave it to him after he dies or combine these options in some way. The significant point here is that there was no existing buy/sell agreement that could force Joe to sell his stock to Success Co. or to his fellow stockholders.
Step 2 of our system creates such a buy/sell agreement to which all 10 shareholders are beholden, whether they are in the first, second or third group. Any buying or selling of stocks that might eventually take place could be insurance-funded for tax benefits.
Usually, the buy/sell agreement will cover all aspects of the succession plan, but occasionally, separate agreements may be needed to cover unusual situations. Step 3 of this succession planning system creates any special plans required by certain shareholders.
For example, as mentioned, an intentionally defective trust (IDT) can and often should be used for the transfer of a company’s stock, whether it is from a single owner like Joe or multiple owners such as the Big 10. However, it is most commonly used by the single owner, so to best explain how to use it, let’s now assume that Joe owns all 100 percent of Success Co.
In order for Joe to transfer the company to his son, we would first recapitalize Success Co. into 100 shares of voting stock and 10,000 shares of non-voting stock. Joe would then sell only the non-voting shares to an IDT at their fair market value, say $7 million, and keep the voting shares for himself. This enables him to maintain control of the company. He would receive from the IDT a $7-million, interest-bearing note, which eventually would be paid off using future cash flow from Success Co.
The best part about using an IDT? The entire stock transaction is tax-free. Joe pays no capital gains taxes on the note payments. Because IDTs are not recognized for income tax purposes, even the interest he receives from those note payments is free of income taxes. Success Co. also is now out of his estate, so it will not be subject to estate taxes at his death.
As the beneficiary of the IDT, Sam will receive the non-voting stock after Joe’s note is paid off, but he has no liability. He never pays a single penny out of pocket for the stock nor any taxes as a result of the transaction.
Of course, it would take a large book to cover every possible business succession situation. In practice, however, the right buy/sell agreement coupled with an IDT solves almost every succession problem, whether the business is owned by one or by many.