The business section of the March 20th issue of the Arizona Republic had a front page article titled "Families Passing Business Torch". My practice often involves working with families on the subject and I found the article very timely, particularly since studies tell us that during the next several years 30 to 40 percent of both family, as well as non-family owned businesses will "attempt" to transfer ownership. I say "attempt" because 2 in 3 family businesses fail after transition to the second generation. As business owners approach retirement age, they are dealing with several complex questions and conflicting goals.

The business owner wants to monetize his equity in his corporation, and in many cases there is a desire to maintain family ownership of the business. If the business is sold to outsiders to achieve personal financial security, the children are left without the legacy of the family business. Alternatively, if the owner decides to transfer the business to family members, then the owner will likely be without the same personal financial security and may have to deal with a significant gift or estate tax liability.

In many cases, business owners adhere to what I call the "avoidance of the unknown syndrome", which translates into: if I don't think of the problem it doesn't exist. Statistics tell us that these situations often wind up resulting in a forced sale of the business by the owner's estate in order to settle the estate taxes. One very notable example is the Robbie family's compelled sale of their ownership interest in the Miami Dolphins and Joe Robbie stadium. The cover page of the March 26th issue of the Wall Street Journal mentions that treasury officials continue to be opposed to a reduction or elimination of the estate tax contending it would be too costly and a sop to the rich.

There are many different options to accommodate the objectives of business owners relative to succession planning, but some of them are necessarily more painful than others and/or more tax expensive than others. One strategy that has been around for about fifty years and is currently employed by about 12,000 U.S. corporations is the Employee Stock Ownership Plan (ESOP). Simply stated the most notable advantages to a business owner are:

He can sell a portion of the business to the employees in a very tax-friendly manner, Keep or retain actual control of the company in the family; and Significantly reduce his income, gift, and/or estate tax liability. The ESOP strategy is often used as an ongoing tax shelter to be used later for succession with much additional tax benefit.

This represents the best of all worlds since the business owner is able to (1) to achieve personal financial security by liquidating a portion of his single largest asset and (2) to keep the family business in the family. When properly structured, the ESOP can enable the business owner to obtain greatly enhanced liquidity and diversification -- with far more real value. Approximately fifty years ago, Louis Kelso was successful in convincing Senator Russell Long, the then chairman of the Senate Finance Committee, to propose legislation that would provide very dramatic tax and cash advantages to business owner ESOP sponsors.

Congress enacted the legislation and today, fifty years later, those benefits remain available to business owners of closely held companies. Under Internal Revenue Code Sec. 1042, a shareholder who sells stock to an ESOP is able to forego the payment of any capital gains taxes due -- if the sale meets the specified conditions. Essentially the business owner has a year to reinvest the cash from the sale of his stock to his ESOP into some alternate type of security.

This provides a superb means of income during the retirement years and if held until his death the business owner's family will never have to pay capital gains tax on the ESOP stock sale. An aggressive gifting program to family members can produce significant income and estate tax savings for the closely held business owner. If the business owner has a philanthropic inclination, by using a strategy called "CRUT" (charitable remainder unitrust) a significant amount of annual income can be guaranteed for Mr. Business Owner during his and his spouse's lifetime in addition to a large upfront tax deduction. And in fact, structured properly the family wealth can be magnified, as well as providing a significant sum of money to the charity.

Currently, the U.S. gift and estate tax rates are significantly higher than capital gains and even ordinary income tax rates. Combining an ESOP with estate planning techniques can result in business owners successfully keeping the business within the family or where this is not the intent, provide a very unique mechanism to transfer ownership to non-family members. In both cases, because of the dramatic tax and cash advantages it makes good sense for business owners to explore their options and the ESOP strategy is certainly worth looking at.

Family Business Succession Planning
- The Robert Morris Associates Bankers Journal, July 1997 Volume 20, Issue 3

Frank Amato is Managing Member of the Arizona ESOP Group, located in Scottsdale, AZ. He is receptive to any comments and/or questions at (480)222-0199 or (480) 227-3064.