For business owners, succession and retirement planning are joined at the hip, but the financial calamity that has resulted in people deferring retirement and in some rare cases, pulling out of the stock market, has them pondering the financial version of hip replacement surgery.
With the economy and other miseries injecting uncertainty into succession/retirement plans, there still are too many clouds over the horizon. The recession has eroded the value of their businesses, the asset where upwards of 70% of their wealth and future retirement income is stored, and even the 2009 stock market rally hasn’t convinced people to put all their skin back in the game.
“We’ve had a decent [market] comeback based on where we’re at, but it’s still an uncertain environment,” said Brent Lindell, a financial advisor for Savant Capital Management. “There is a record amount of cash still sitting on the sidelines.”
Congress, which at year’s end was fully immersed in the health care debate, never did get around to deciding how to handle the estate tax, which now stands at 0%. Not only does that give business proprietors some incentive to expire before year’s end, it throws another wrench into the exercise of long-term succession planning.
However exercised you are, succession and retirement planning should become a yearly ritual. According to the federal government’s General Accounting Office, the oldest baby boomers will turn 65 in 2011, the beginning of what has been called a “tsunami of senior growth” over the next decade, when the senior citizen population is projected to grow by 36 percent. Since many business owners and executives will retire in that time, annual reviews are recommended to make the necessary adjustments to financial portfolios and to react to changes in tax and investment law.
This article is mainly about business succession, which is when the owner sells the company to a family member or other person(s) designated to assume control. That’s a different concept than business continuity planning, which is a form of crisis management that occurs when the person who has run the business unexpectedly dies and the family wants to sell. The operation still needs to continue when the venture is on the market, and someone needs to step in to perform the day-to-day management.
In either event, “The owner of a business is going to exit that business at one time or another,” noted attorney Greg Monday, a partner with Foley & Lardner. “It’s very risky not to plan for that exit.”
Taking Stock
Even though there still is one year to go in the decade of the ’00s, many already consider it a lost decade. At the end of 2009, the Standard & Poor’s 500 was up 65% over its March 2009 trough, but for the first time since the economically calamitous 1930s, the market had thus far lost value during the past decade.
That 25% decline since 1999 has placed would-be retirees in the unenviable position of playing catch up, with the potential for more bad news on the horizon. Even with signs of economic stabilization — including the prospects of higher corporate earnings in 2010 — investors worry about the market impacts of tighter Fed policies.
Some are forecasting a W-shaped market, where following the downturn and the recent rally, the market plunges again before stabilizing. “They worry that the market came back too fast,” Lindell said, “and it’s going to give a lot of the wealth back again.”
Other economists are looking for a 10% return in the market this year, but their forecast isn’t nearly as bullish on bonds. With interest rates sitting at nearly an all-time low of 1 to 1.5%, people can’t get much for sitting on their cash. “It’s a quandary right now in terms of what people are going to do to put their money to work,” said Lindell, who believes the situation is creating turmoil in people’s minds. “You’re having to fold yourself into the fetal position. How long can people lay in that fetal position and protect themselves when their money isn’t doing anything for them?”
With regard to the stock market, the traditional advice still applies. Monday, who believes the equity markets will continue to improve in 2010, stresses diversification in family and individual wealth so that no single investment is relied upon fully or to a disproportionate extent.
In a diversified portfolio, the normal grouping for someone who is closing in on retirement or at retirement tends to range anywhere from 50% to 70% in stocks, which fight inflation, and 30% in fixed income assets such as bonds, which cushions blows like the one investors just experienced. “An investment portfolio should feature asset diversification so that you’re not relying entirely on the value of the business,” Monday stated. “The latter has taken a hit in many companies, which is causing owners to defer retirement by three to five years, or until value can be restored.”
Yet according to Monday, it will be difficult for a person who is retiring in the next two years to recover lost market wealth without taking an inappropriate risk. His recommendation is to achieve a baseline level of wealth in lower-risk investments and only expose a designated percentage of assets to higher-risk investments. “They have to adjust their expectations,” he added.
Lindell differed somewhat, noting clients that stayed in the market are in the process of recapturing lost value. The S&P 500 was at 1,565 on Oct. 9 of 2007, it had dropped to a low of 677 on March 9, 2009, and had climbed to 1,140 by early January 2010. “The people who backed off or completely went out, of which I only had one or two, basically locked in a loss,” Lindell said.
Ultimately, an owner’s decision to retire from a privately held business also is based on expected lifestyle and the future cost of living. “You have to be realistic in what you think it’s going to cost to live,” said Dan Potter, director of private wealth services for Grant Thornton. “Inflation is going to be a problem going forward, if not next year in the coming years, with all the [government] spending that’s going on. You have to be realistic about that, and then realistic about returns on equities.”
Estate Tax
The economy and the stock market aren’t the only factors creating uncertainty. The future direction of the federal estate tax has not been settled, and nobody really knows when Congress will act. Under a law enacted during the George W. Bush administration, there is no estate tax in 2010 but the top rate is set to return to pre-Bush levels of 55%, with a $1 million exclusion, in 2011.
Observers had thought that Congress would keep the 2009 structure, a 45% top rate with a $3.5 million exclusion, until fashioning a more permanent solution, but no action was taken by year’s end.
It’s hard to believe a revenue hungry national government will keep the tax at zero in 2010, especially when health care is taken off its plate, but the guessing game persists. “If anybody gives you a specific answer there,” Potter said, “they are probably guessing anyway.”
The estate tax, which applies to transfers of property at death, is one of three transfer taxes. The others are the gift tax, which applies to transfers of property during life, and the generation-skipping tax, which applies to transfers either during life or at death to individuals who are two generations or more below that of the transferrer.
According to Potter, there is talk about retroactively adjusting the estate tax. If that happens, the question becomes one of constitutionality. “There is precedent for recognizing a retroactive tax in the transfer tax area as being constitutional,” Potter noted.
The standard is whether Congress has a legitimate legislative interest in passing the retroactive tax. The basis for having a legitimate legislative interest is raising revenue, and that would justify the tax and protect it from constitutional attack.
However, the transfer tax, itself, is about wealth redistribution. “That was one of Obama’s goals when campaigning, and it appears to me that a transfer tax is primarily about wealth redistribution and secondarily about raising revenue,” Potter said. “The question then becomes whether wealth redistribution is a legitimate legislative interest. There is no precedent for that.”
Lawmakers can treat the estate tax differently than the other two types of transfer taxes. “They are treating it differently right now in that what happened for 2010 is that the estate and the generation-skipping taxes are completely repealed,” Potter explained. “The gift tax remains intact for transfers during 2010, and the exemption is $1 million.”
Potter said the estate and generation-skipping taxes are not going to go away. For the purposes of planning, he said business owners should assume they will come back beyond 2010, if not sooner. “If nothing is done in 2010, they will come back under the pre-Bush regime of $1 million of exemption and a 55% rate,” he stated.
Potter thinks there’s an opportunity to take advantage of the current situation. “I think you have to take a hard look at it, understand the risks involved, and take an educated risk by structuring lifetime transfers with protections that will kick in should a retroactive tax be passed,” he said. “I would also strongly recommend taking a hard look at current estate planning documents. Make sure the plans you have in place are not negatively impacted by the current situation.”
Tax implications might go beyond estate wealth. With individuals’ marginal income tax rates expected to increase, Potter said that businesses operating in a single-level tax environment, such as LLCs or S-Corporations, should look at whether it makes sense to operate in that environment if corporate tax rates end up lower than individual rates.
Ultimately, the single-level of the tax should be the more advantageous, but in a rising tax environment for individual income tax rates, people should examine that question with the long-term objectives of the owners and the business in mind.
One option would be transitioning to a C-Corporation, which brings a corporate-level tax on dividends. Potter is quick to note that if you’re not going to be selling the company, and if you’re going to be reinvesting for growth and not paying dividends, it might make sense to look at a C-Corp as an alternative in the short term.
“Typically, the single-level tax wins the day from an economic perspective,” he noted. “It really depends upon the goals and objectives of the business.”
Succession Foot Draggers
The overall succession plan is really a long-term business strategy designed to identify a successor to the person currently in the top management position, whether that’s a majority owner of a company, a CEO or president, or somebody that is in voting control of the company. Many times, the majority shareholders, usually a mother and father, assumes that if nobody is ready to take over the business, they will simply sell the
business. To Monday, that’s always a fanciful expectation because it isn’t easy to sell a business, especially in this economy. In addition, it’s more difficult to place a value on a business right now, particularly when the lack of buying and selling means there are fewer comparables.
One of the rare positive outcomes of the decision of some to defer retirement is that it gives succession planning foot draggers an opportunity to play catch up.
Succession planning takes place for three types of succession: ownership, control, or management succession. The first step is identifying a successor interested in buying the business, whether it’s a family member, another member of the existing management team, or a new boss recruited from the outside. “I think you have to look at each separately because you’ve got to concentrate on skill sets and you’ve got to look at the long-term strategy of the business,” Potter said. “Develop the long-term strategy first, and then look at the skill sets needed in the key positions that will help drive successful implementation of that strategy.”
Putting outside people on business boards can be scary for the family, but it’s also scary for the board members because they have fiduciary responsibilities. In privately held family businesses, Potter said the tendency is to look within the family for a successor, but the founders have to fight that tendency, focus on what’s best for the long-term interest of the business and value creation, and look not to family relationships but to who has the strongest skill set to drive the business strategy.
While it’s tough to tell an interested family member that he or she is not going to be handed the keys, this bullet has to be bitten.
“There are a number of ways to go about this, essentially professionalizing the organization through the setting of a compensation committee, having a dividend policy, and those sorts of things,” Potter explained. “It’s about having a board of directors with individuals that strategically occupy seats on the board who are not family members, who bring skill sets and relationships that will help the business grow.”
According to Potter, establishing dividend policies, arms-length compensation arrangements, objective measures for performance, continuous review, and a clear delineation of expectations and goals for each position will help the business fill seats with people who are best suited to be successful based on merit. Through that process, companies develop committees with non-family members to professionalize the organization and to look at various executive positions from an arms-length compensation perspective.
With this approach, family members become more passive owners, and policies are created to deal with the natural tension that develops between passive shareholders who want to cash in their dividends and the active individuals who want to use the cash for growth, Potter said.
There are other aspects to maintaining business value. Mid-level managers in a business that is slated to be sold as part of a retirement exit might be left out in the cold following the acquisition, or they might find themselves unhappy with new management.
In such scenarios, nobody’s job is safe, so it’s important for them to keep job skills up to date and have their own retirement plans in order.
Middle managers can plan for their next move if they have some advance notice that the owner is selling. Employee-protection provisions are possible in the acquisition deal, but they could affect the purchase price. In some cases, owners may compensate key employees who remain with the business because of the value of holding together the existing staff.
Exit and Other Planning
In a depressed market, people fall into two categories regarding an ownership succession. One is that they don’t feel as wealthy as they used to, and therefore don’t feel comfortable transferring value out of their estate. In the other, people are optimistic about the future, view the depressed market as an opportune time to make wealth transfers, and see the depressed value of their business as artificial from a long-term perspective.
In any event, Monday said succession plans should be reviewed each year to account for changing conditions, or the possibility of an unexpected exit. “People plan for a lot of things that are unlikely to happen,” he said, “or less likely to happen.”
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