SUCCESSION PLANNING AND EXIT STRATEGIES

For the High-Net-Worth Business Owner

A Panel Discussion

In Brief

Opportunities for the CPA to Help

The principal asset of the millionaire next door just might be an interest in a family-owned business. More often than not, the family-owned business will have a CPA serving as the tax and business advisor, controller, or CFO. The CPA is in an ideal position to start the owner of that business on the road toward succession and transition or exit strategy planning. The rewards of good planning are liquidity, with a diversified portfolio that can enhance the quality of life for the owner and ease the estate tax burden. The price of poor planning can be an owner unhappily trapped in the business, huge estate taxes, and a fire sale of the business at the wrong time upon death of the owner.

Four experts in succession planning--Dirk R. Dreux, IV, a family business consultant and associate director of the University of Connecticut's Family Business Program; Steven M. Etkind, a CPA and attorney with Sadis & Goldberg LLC, specializing in estate and business succession planning; Joseph E. Godfrey, III, managing director of Americana Financial Services Inc., and consultant and advisor on succession planning and exit strategies matters; and Martin (Mark) E. Moshier, a CPA and now vice president in the corporate wealth transfer group of Key Bank in Albany, N.Y.--met with CPA Journal editor-in-chief James L. Craig, Jr., to explore how to get the CPA and the typical small-business owner on the path to success.

About the Panelists

The CPA Journal: For many high-net-worth individuals, their largest asset is an interest in a business that they or members of their family founded. At some point, issues of transition and succession arise. Planners also often speak of succession planning and the need to have an exit strategy. Is there a difference between the two?

Dirk R. Dreux, IV: Succession planning is concerned with keeping control of the business primarily within the family or among some collection of existing related shareholders. To do this properly, believe it or not, it probably takes three to five years. It begins with an assessment of the business and the interests of its principal owners: What are the prospects for continued success of the business? What are its capital needs? Where will future management come from? From my perspective, the most important piece in the succession puzzle is management. There is often a very limited amount of management know-how in the family business, especially beyond the specifics of the operation of the business itself. And without a continuing, viable business, all other concerns soon disappear. The goose must be nurtured, or there will be no golden eggs.

CPA Journal: Then, the key to succession planning is making sure the business continues. At some point however, the business owner is going to want to enjoy the fruits of her labors. Is that where the exit strategy enters the equation?

Joseph E. Godfrey, III: I developed a formal definition of "exit strategy" for a course I taught:

A plan by which an entrepreneur, executive, or investor will disengage and extricate him- or herself from a business or investment, and walk away with cash or cash equivalents that represent the present value of a fair return on his or her time, talents, and capital.

This definition goes to more than just the family business owner. It applies to the person who has accumulated wealth in a major investment and now wants to convert that vehicle into cash. There are two aspects to a strategy: what to do while still living, while there are choices and options, and what to do after death. Some never think (or don't want to think) about the latter condition--but all the mortality tables I know still show the probability of death as 100%.

CPAJ: For today's discussion, let's focus on exit strategies for the family-owned business. Does this mean that the owner of a family business must decide between keeping the business going or taking cash out to enjoy life?

Godfrey: The two are not mutually exclusive. The owner can enjoy life while at the same time continuing the business and working on succession issues. One of the vehicles, which becomes very attractive, is the employee stock ownership plan (ESOP). With that, you can take some of the chips off the table, put them in your pocket, and continue to play the game. The money comes out on a tax-advantaged basis because of the favored treatment given ESOPs in the law while giving employees--family members or not--the opportunity to become what I call "partners in prosperity" through owning part of the business.

CPAJ: Let's assume you are a CPA with an ongoing tax and business relationship. The tax return begins to show an accumulation of wealth, much of it in the business the client started some years ago. At what point should the CPA begin to address the issue of succession?

Dreux: I think that time should be no later than when the owner reaches her 55th birthday. Or when the children first enter the business. I have never seen an owner step down before feeling financially secure. Otherwise owners tend to remain active in the business until they physically can no longer do it. Often children join the family business somewhat reluctantly or out of desperation. The parent/principal owner may have a tendency to overpay the child or place him in positions of authority beyond his capability. This can keep the owner in the business longer than desired in order to keep the business running. These issues have to be addressed or the owner will not be able to remove herself successfully from the business. By successfully, I mean leaving the business able to run effectively without her input.

CPAJ: Do the rest of you agree with the age 55 threshold?

Martin (Mark) E. Moshier: I often see quite capable children coming into the business, yet the owner will fail to address the issue of succession. Which children should be given important management positions, what should be done with important nonfamily member employees, and the like are not dealt with. When the succession issue is not addressed, I see children getting frustrated, and some actually choose to leave the business.

Godfrey: Perhaps more important than age, is the amount of wealth that has been accumulated. The tendency is to put off dealing with the issues, but the consequences can be severe. Malcolm Forbes was prepared for his death. He had purchased huge amounts of insurance with the result that his holdings did not have to go on the auction block to pay the estate taxes. Bill Paley of CBS did not do the planning, so his family ended up having to sell his stock holdings.

Steven M. Etkind: The sooner the owner starts planning, the better the results will be. And the upside for an accountant addressing these issues with clients is that it will deepen their relationship. Often, the CPA finds the client was thinking about the issues but had no one to talk to.

CPAJ: Every CPA dealing with a tax return should be thinking in terms of helping the taxpayer address these kinds of issues.

Assume a CPA sees a client who, at age 55, has developed a very successful business. The CPA doesn't feel all that comfortable in giving succession advice. What's the best way to start the process?

Etkind: I would start by asking several questions. The first would be: How much of the person's net worth is tied up in the business? Then, I would explore the owner's feelings about the prospects for the continued success of the business. Many owners have concerns about threats to the business--lawsuits, competition from megastores, a weak economy. From a financial planning perspective, is it wise to have such a large percentage of the owner's net worth tied up in the business? Are there options out there to diversify?

Dreux The CPA may be reluctant to bring others into the picture to help because of a fear of losing the client. In my experience, this fear is unfounded. The traditional provider of the tax and accounting services is safe. The owner may procrastinate addressing the issues, but the CPA should persist and call in expert help as needed. The stakes are too high and, perhaps more importantly, the owner will ultimately appreciate the efforts. I had an experience where it took a lawyer for a family business four years to finally admit he needed help in working out succession issues. In the meantime, the business had grown substantially, increasing the cost of strategies that were available earlier.

CPAJ: The CPA has met with the client and established that the business comprises a large part of the estate. He has also learned that the owner has some interest in enjoying life more, through the purchase of a boat or a larger residence and, in general, wants a richer lifestyle. The owner also has a child that is doing very well in the business and would like to eventually take over.

Moshier: We would ask the owner to quantify her financial desires. Then, we will outline a number of scenarios to achieve the goals. One vehicle is the ESOP, as Joseph noted earlier. Others are a grantor retained annuity trust (GRAT) or a family limited partnership. We then schedule in rough terms how those vehicles would work and the impact each has in minimizing estate taxes.

CPAJ: Mark, what led to this conversation to begin with?

Moshier: We work with the lenders at the bank; they have the client relationship. They see the owner of the family-owned business and the need for succession planning. Our group reviews the owner's needs on a no-fee basis, but when we see the interest in one of the suggested solutions, we ask the customer to involve her accountant and attorney in the process. We are pleased to quarterback the initiative or simply assist, depending upon the interests and skills of the others involved.

Godfrey: The CPA cannot sit on the sidelines on these issues. If a client were to die with a huge estate tax that could have been avoided through proper planning, the CPA becomes exposed to the risk of a lawsuit for malpractice. There are law firms making a huge business out of this in other parts of the country.

Moshier: Sometimes bankers can be more successful in getting owners to focus on succession planning than accountants. Some clients don't take their accountants up on their overtures to help for fear of incurring large fees, but this should not discourage the CPA from pressing the issue.

Godfrey: Success usually comes through an interdisciplinary approach. In the Estate Planning Council of New York City, of which I am a former board member, we bring the various disciplines together--the CLU, the investment advisor, the attorney, the accountant, the trust officer, the lender--recognizing that there are no "one-size-fits-all" solutions in succession planning. The best answer is usually a team approach. The top-flight professional wants to make sure the right decision is made within the right time frame.

Etkind: For the accountant to maintain control and remain involved, it is important to be involved in the early stages. Many succession plans that I assist with were initiated by an insurance agent, a broker, or lender without the help of an accountant. The owner didn't realize the accountant was familiar with these kinds of matters. This shows the importance to the accountant of raising the issues, maybe initially in vain, so when other professionals speak out, he will be brought onto the team.

CPAJ: Where's the money?

Etkind: There are four common ways for the owner to take the cash out of the business. One is through a leveraged recapitalization. The company borrows the money and makes a distribution to the owner or buys back a portion of the owner's interest. The downside is that income taxes are usually triggered. A second way is to go public and file for an initial public offering, but many small business owners don't want the regulatory burden and restriction of being a public company. Going public is not a great liquidity answer. A sale to a third party is another option, but sales of minority interests usually are made at sizable discounts.

A very attractive fourth option, similar to a leveraged recapitalization, is the use of an ESOP. The advantages here are the tax incentives. In this case, the owner or owners sell at least 30% of stock to the ESOP and, as long as certain conditions are met, pay no Federal capital gains tax on the sale. In addition, the company repays the loan incurred by the ESOP to fund the stock purchase through tax deductible contributions to the ESOP. We often find the owner is able to take out up to ten years of company earnings in year one.

Moshier: The company typically uses its borrowing power to secure the loan, the proceeds from which it in turn loans to the ESOP.

CPAJ: After the transaction is all said and done, who has the money?

Godfrey: The owner has the money, which must be invested in securities of domestic operating companies. The securities may be senior or junior stock or debt instruments, but not mutual funds, U.S. Treasuries, or municipal bonds, because they don't qualify as domestic operating companies. The ESOP owns the stock and has a liability to the company. The company has a receivable from the ESOP and a loan payable to the bank.

Dreux I've seen some ESOPs where the loan was made directly to the ESOP with the company guaranteeing the debt. How common is that?

Moshier: In most cases, the loan is made to the company. It seems to be easier for loan and credit officers to deal with. We are seeing some tightening in the credit markets, and, where there is a greater credit risk, banks may ask the owner to pledge some of the sale proceeds as collateral for a time.

Etkind: If I remember the accounting requirements correctly, even if the debt is just guaranteed by the company, the full liability is still shown in the company's financial statements.

Also, ESOPs and these purchase transactions are done under ERISA, and there must be an independent trustee for the ESOP and an independent appraisal of the value of the stock.

The debt to the bank is repaid through tax-deductible payments by the company to the ESOP, which the ESOP uses to repay the loan to the company, which in turn is used by the company to repay the bank.

It is the greatest mismatch of taxability in the tax code. The owner gets proceeds from the sale of stock with no tax and the company has tax-deductible payments for the proceeds. This taxpayer subsidy is designed to motivate business owners to establish ESOPs.

CPAJ: But when does the owner get to buy the boat?

Etkind: There is a huge market for ESOPs nationwide. GE Capital and others issue special ESOP bonds that qualify for purchase with the proceeds. The bonds have a long life, so the owner cannot possibly outlive them. The interest rates are variable; the bonds always trade at par and are treated as the equivalent of money market instruments. Banks or brokerage houses will lend up to 85­90% of the value of the bonds to the owner--enough cash to buy the boat. The interest income on the bonds pays the margin debt. The bonds will be stepped up in value with no capital gains tax upon the death of the owner, changing the initial deferral of tax into a permanent elimination of capital gains tax.

CPAJ: Let's work through an example. Ms. Owner sells one-third of her stock in a company to an ESOP for $1 million. What does she do now?

Etkind: She invests the million with GE Credit at an interest rate of LIBOR. She then monetizes the bonds in a margin account at a broker for $850,000 at a cost of LIBOR plus 1%. The net cost is the interest on $850,000 at a point premium, offset by the interest income of LIBOR on a million. Depending upon the rates, there may not be a net cost.

CPAJ: This is quite intricate. Not for the fainthearted. Mark, are you seeing many of these deals?

Moshier: We are seeing a resurgence in ESOP transactions. But of those customers I see beginning to explore an ESOP, only 10% or so go through with it, because of its complexity and for other reasons. What they often find is that the value they expected to get for their stock is not as high as they thought.

We must not forget that on the other side of this are employees who benefit. Owners who think in those terms very often are more willing to proceed with the ESOP.

CPAJ: Is there a real benefit to the employees?

Moshier: I tell my customers to make no mistake about it: They are giving a portion of the company to the employees.

Godfrey: As the loan to the ESOP is paid down through company contributions, stock of the company is allocated to employees, which is subject to all the vesting and other rules of a typical pension arrangement.

CPAJ: Has the owner in fact sold 33% of her company?

All: Absolutely.

Godfrey: There are many variations on this theme: One example is a management buyout, used if there are no family members that want to continue the business. ESOPs can also be used as a tool of corporate finance.

CPAs don't have to know all the intricacies. They are, however, in a position to be the gatekeeper when the owner of a closely held company is looking at succession or trying to exit an investment in a privately held company.

CPAJ: Are you saying the ESOP can have real motivational value?

Godfrey: A well known--and true--story in the ESOP community is the one about the janitor at Elliott's Hardware in Dallas, Texas. He never earned more than $10,000 a year, yet at retirement received a check from the ESOP for over $1.6 million. Has this type of payout served to motivate the employee's of Elliott's Hardware? The word is that it has.

Etkind: Think of it in this way: After a number of years, the owner of the company will have taken out 20 to 30 years of company earnings tax free. It starts typically with the sale of a third of the company. Ten years later, another 30 to 40% might be sold, and then the balance ten years or so later.

CPAJ: Dirk, in the meantime, what's happening to the owner's son?

Dreux Hopefully, he is a major participant in the ESOP. But keep in mind, ESOPs are not for every business. The company becomes a market maker for its stock. When an employee seeks to monetize the retirement benefit that the ESOP has provided, the company will be called upon to purchase the stock.

Etkind: The plans can be designed in such a way that the employees never actually receive a certificate of stock. The value of the stock is the measure of the monetary amount the employee will receive.

CPAJ: Then in some respects, the owner has never really sold the company.

Etkind: One of the biggest myths with ESOPs is the matter of control. The employees don't have to be given a right to vote the stock except for six supernatural events of the corporation, such as mergers or liquidations. Control rests with the board of directors, over which the employees may in fact have no vote.

One of the biggest problems with ESOPs, often overlooked, is the next layer of management after the owner. A very successful family succession model is to sell a percentage of the company to an ESOP and gift a large block of stock to the children. The parent has the cash and is basically out of the business. And that block of stock, which is a minority interest, will be subject to a valuation discount.

Moshier: My experience is that my clients do not want to give up percentage control, that is, sell below a 51% equity interest. But I find those that have implemented an ESOP are satisfied with the results.

Dreux For what type of company is an ESOP appropriate?

Moshier: First, there should not be a lot of preexisting debt. You do not want to impair the health of the company. There should also be a good relationship between the company and its employees, as well as a genuine interest in sharing the wealth with them. The owner must be willing to forgo top dollar in the sale and be satisfied in keeping the ownership of the company local. ESOPs also work well where the owner wishes to diversify her holdings and not necessarily use the proceeds for consumption purposes.

Etkind: An ESOP transaction can also create liquidity upon death of the owner. Her assets will include marketable securities of some kind--GE Credit notes or some other--that can be used to pay estate taxes. There will be no need to have a fire sale of the business to raise the funds needed to pay Uncle Sam.

Godfrey: Also, if the employees view themselves as owning eQ to wQ of the company, they might want to raise the capital to buy the balance of the company so they may avoid some unknown third party entering the picture.

CPAJ: Does insurance play a role at all in the typical ESOP? To create liquidity?

Etkind: An ESOP can reduce the need for insurance on the owner's life. However, there is plenty of room for creativity in using some of the proceeds from the ESOP sale to fund an irrevocable life insurance trust and remove some assets from the estate. Charitable giving vehicles can also be integrated for additional benefits.

Godfrey: Accountants should know that New York State has a program known as Ownership Transition Services, which helps those that live or work in New York decide what to do with their businesses. The fee to join the program is $500.

Etkind: The program is funded by the Department of Labor and provides consultants, such as appraisers and attorneys, experienced in ownership liquidity alternatives. The state found that 70% of businesses do not survive after the death of their owners, leading to a loss in jobs. It concluded that helping businesses before the owner dies is a better way to save the business.

CPAJ: Let's get back to the people issues.

Dreux The critical issue is understanding what drives the business and whether management can keep it going. Very often the principal owner is the main force behind the company, and when she dies, or more likely, becomes disabled, the company suffers. There must be true management succession.

Godfrey: No business succession plan works without management.

Dreux My point of view is that if you protect the viability of the business, matters seem to work out.

Another problem we see is that other members of the management team are often about the same age as the owner. What can happen is that a whole generation of management will exit at the same time, which leaves a big gap until the next level of management.

CPAJ: I'm the CPA. Who helps me with this problem?

Dreux You have to speak to your client about reviewing her management group realistically. Very often there is no strong marketing component, no competent CFO able to assess risk and reward.

CPAJ: But this is going to cost my client money to fix.

Dreux It's only a life's work at risk!. Or the career of the child being paid higher than market compensation. There is a lot on the table. Also, the CPA has a client at risk if the company has to be sold.

Etkind: The accountant is in a unique position to be a major contributor and advisor. If he does not seize that opportunity, others will fill the space.

Moshier: In some ways, it doesn't matter which professional has the closest contact. The issues of succession, including management, must be continually raised.

CPAJ: Gentlemen, this has been most interesting. We hope that this taste of succession planning will help readers as advisors, owners and employees to do the planning that is so essential. It is telling CPAs to push the issue of succession planning for clients or in their businesses. Thank you for participating. *

Additional Considerations for the High-Net Worth Advisor Dong Business Sucession Planning

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