The Dilemma of the Family Business – To Sell or Not to Sell
As family business owners near retirement age, they face many difficult decisions: Will they be able to support their retirement needs? Should they pass down the business to the next generation or sell to a third-party? Are they going to be able to truly let go of the business?
Helping business owners clarify their retirement goals, plan ahead for the tax impact and loss of recurring income due to the sale, and navigate through complex family dynamics is key to successfully advising these clients. The following is an overview of these issues and concerns.
Using Cash Flow Modeling to Organize and Assess Goals
The first critical step in the planning process is for a business owner to determine and organize their goals. It is a challenge to create a financial plan if the ultimate end goal is not defined. Many times though it is difficult for business owners to articulate their goals. This is often due to the concern of not knowing all of the possible options available or an overall lack of clarity as to the impact (both positive and negative) of their financial decisions. If they are provided clarity as to their options and the impact of these decisions, they will likely be more definitive as to their desired financial direction and the actions they need to take to achieve it.
One way to provide this clarity is to develop different what-if cash flow scenarios. For example cash flow models can be created to show the impact of selling or not selling the business, of selling the business for less then what was initially expected, of taxes incurred from a sale, and other possible what-if scenarios. By illustrating the impact of these decisions on their ability to obtain their desired retirement lifestyle, the owner will be better equipped to make decisions and determine goals.
Keeping the Business – Family Dynamic Concerns
The statistics regarding family businesses does not provide optimism regarding their long-term sustainability.
- Estimated that 40.3% of family business owners expect to retire.1
- 70% of family businesses would like to pass their business on to the next generation, of which only 30% will actually be successful.2
- Nearly 43% of business owners have no succession plan in place.3
The lack of success in transitioning the business from one generation to another results from the difficulty in balancing the personal well-being of the founder/patriarch-matriarch and maintaining family harmony, while continuing the prosperity of the business.
Sustaining this balance is difficult because these goals will often seem to conflict with one another. But, if the founder/owner is able to address the following issues as they transition the business it will help maintain this balance:
- Founder’s transition – what do I do now
- Ownership, today, tomorrow and over time
- Effective governance, to maintain long-term decision making
- Management of day-to-day operations
- Family employment that is based on merit rather than entitlement
If any of these issues are not properly addressed it could cause considerable family disharmony. For example, if the owner’s retirement depends on receiving cash flow from the business, he or she will likely never truly retire and let go. This can cause friction among the subsequent generation who desire to run the business free of the founder’s influence and create their own identity. Ultimately, family harmony may have been better preserved by selling the business in the first place.
Even if these issues are addressed, planning is still needed to transfer ownership of the business while minimizing any possible gift or estate taxes. This is especially the case if the value of the business is substantial.
Selling the business – increasing value and minimizing taxes
Ultimately, a business owner may determine the best thing to do for the family is to sell the business. If this is the case, the two primary goals are likely to be to obtain the highest possible sale price and minimizing the amount of taxes incurred from the sale.
Increasing the value of the business is often directly linked to increasing the overall profitability. The owner of the business should consider hiring professional advisors who could help increase business efficiencies and take other measures that could help increase the value.
To minimize taxes, planning will likely need to be done well before there is binding agreement to sell the business. Most times this plan should be developed years before a possible sale. One area to examine is how the business is incorporated. Often a potential buyer wants to purchase the assets of the company instead of it’s stock for various tax reasons, typically to benefit the buyer. In that situation, an owner of a corporation that has made an S-corporation election will likely incur substantially less taxes than an owner of a C-corporation. The selection of corporation entity and the structuring of the purchase (asset sale vs. stock sale) can have significant tax consequences which should be analyzed before the sale is finalized.
If the owner is philanthropically minded, making charitable gifts of company stock could be a viable option to minimize their tax exposure, while also fulfilling their charitable wishes. In this situation, a gift of S-corporation stock to a charitable entity could have adverse tax consequences. Therefore, even though an S-corporation is more beneficial if the sale is structured as an asset sale, it actually is not as beneficial as a C-corporation if the desire it to make charitable gifts of stock.
As has been outlined, what an exiting business owner ultimately does with their family business is often a very difficult decision. In addition to the complicated tax issues involved, there are often underlining family dynamic concerns that, if not dealt with properly, could result in significant family disharmony. It is important for a business owner to seek the expertise of advisors who can help navigate through these various complex and difficult issues.
Daniel Fan serves as the Director of Wealth Planning for First Foundation Advisors. In this role, he oversees the firm's Wealth Planning department and advises clients on sophisticated wealth strategies. Mr. Fan has over 15 years of experience as a Wealth Planner and specializes in evaluating and optimizing all clients' wealth plans to meet their financial needs. Mr. Fan is a Certified Financial PlannerTM and holds his Juris Doctorate and Master's in taxation from Pepperdine University School of Law and Golden Gate University respectively. He earned his Bachelor's degree from the University of California, Los Angeles. Please contact Daniel Fan at email@example.com for additional information.
1 2016 Family Business Survey. Retrieved February 2017 (https://www.pwc.com/ax/en/services/family-business/family business-survey-2016.htm).
2 Peak Family Business Survey. 2011. Retrieved 2014 (http://www.amserv.com/index.cfm/page/family-business-statistics/paid/10715.html).
3 Mass Mutual American Family Business Survey, 2007.