A conversation about the higher estate tax exemption led to a practical question for family business owners: when should ownership transfer, and when should control change hands?
When Should Business Owners Transfer Ownership?
Owners should evaluate whether to transfer business interests during life or at passing. Retaining ownership until death—the Grim Reaper plan, as we call it—makes sense only under certain circumstances. The owner should consider it, for example, if there’s a highly appreciated asset that is difficult to transfer without a massive tax hit. Because the heir to those shares would get a step-up in basis, it can appear to work out mathematically for the owner to hold this percentage during life.
However, there are many other parts to consider. Holding until passing can lead to many potential problems, and we rarely make the recommendation to wait until passing to transfer. The successors may be building value for other heirs, causing incentive misalignment and creating the opportunity for unnecessary conflict between siblings. Authority gets grayer each passing day, so employees can find it difficult to know who exactly is in charge. Often though, the greatest monetary risk for highly successful businesses is the increase in estate tax associated with the growth in business value.
If transferred during life, the lost opportunity for a step-up in basis often pales in comparison to the associated estate tax, which is 40% of the overall value of the taxable estate as opposed to capital gains tax on the increase in value over the current owner’s tax basis in the business. And at the end of the day, at least one of those taxes is being paid, and if the cash isn’t there to do so, the only option may be to liquidate. That result is a failed succession plan.
It’s important to understand that this succession plan would also mean relinquishing control well before death. An owner should never maintain control until passing unless death is unexpected or premature. Planning to do this is asking for failure.
Why Succession Timing Matters as Much as Ownership
With the Grim Reaper plan, it’s common for the owner to maintain control even though the next generation is prepared. The heirs are chomping at the bit to begin the next iteration and make the company their own, but that growth is stunted because they don’t have control.
When owners who are at an advanced age are in protection mode instead of growth mode, they harm the next generation’s ability to drive the business forward.
If the owner waits too long, the heirs who have been building the company will reach an age where they’re looking to exit, and it’s unclear who is coming up behind them. It doesn’t make sense to transfer stock to the next generation only to have them bought out two years later. The timeline just doesn’t work.
Ownership and Control Are Not the Same Thing
For owners of especially valuable businesses, I emphasize separating the ideas of control and ownership. Though we often associate owning the business with controlling it, this is fundamentally untrue.
Ownership is an economic benefit, while control is running the business. You could own 10% of the company and still control it. It’s hard for successors to have authority without control because there’s always an end around.
An end around in a family business might look like this.Say I’m a family heir. My dad founded the business, but I’m running the day-to-day. If I just turned 40 years old, and there’s an executive who has been working with my dad for 40 years, that person will remember me in diapers.
If I did something the executive didn’t like, it would be human nature for this person to go to my dad, and if my dad has control at the end of the day, I’ve got to do what he says. That’s the end around. You can’t have a functioning organization under that structure.
