An astonishing 93 percent of family business owners depend on the family business as their primary source of income, according to the 2007 Laird Norton Tyee Family Business Survey.1 This statistic has far ranging ramifications on the success or failure of family business succession. A family business owner's dependency on the business for cash flow is an often unspoken obstacle to beginning a healthy
An astonishing 93 percent of family business owners depend on the family business as their primary source of income, according to the 2007 Laird Norton Tyee Family Business Survey.1 This statistic has far ranging ramifications on the success or failure of family business succession. A family business owner's dependency on the business for cash flow is an often unspoken obstacle to beginning a healthy succession process. Why would a business owner transfer management and ownership of the family business to the next generation, without being certain about his own retirement security and that of his spouse?
As advisors to family businesses, we've all seen clients who fit this description: an entrepreneurial business owner with a very valuable business and business real estate, a large principal residence and vacation home, but little money in a brokerage account or in retirement plans. The business owner supports his lifestyle by taking distributions from the business. Aside from the lack of investment diversification, this approach is all well and good until the business owner begins thinking about passing ownership of the business to the next generation with a minimum of transfer taxes.
The start of the estate-planning process that leads to ownership succession is sometimes the first time that a business owner contemplates how he will maintain his lifestyle when the children own the business. This is a frightening process for anyone, particularly in the context of having to deal with the loss of control that comes with transferring ownership of a business that he has spent a lifetime building. Many times, however, the cash flow concern is unspoken, as many advisors are more concerned with the tax-efficient transfer of shares to the next generation. But the business owner realizes that once ownership is transferred, access to the business as a “personal piggybank” may be over. Not solving the cash flow issue can result in the business succession process effectively ending before it begins.
We as advisors need to do better. We need to be able to show the business owner that there are many ways to replace some or all of the necessary cash flow from sources other than the ownership of the business. Guaranteeing the cash flow of the business owner and his spouse is the first step in a successful family business succession plan.
A frank discussion and analysis of the business owner's (and spouse's) cash flow needs help to frame the issue. Once the advisor determines annual cash flow needs, he can propose alternatives to satisfy those needs. The family business will remain the best way of satisfying the business owner's cash flow needs. But how the business will satisfy those needs will change. Historically, the business owner's cash flow has come from what has been described by Michael D. Allen as “control assured” income.2 While the business owner controls the business, cash flow comes from “control assured” income, like salary, bonuses, C corporation dividends and S corporation and partnership distributions. Before a business owner transfers control to the next generation, Allen recommends that the business owner replaces “control assured” income with what he calls “contract assured” income, like rents from the business real estate, deferred compensation, salary continuation agreements, buy-out payments and the income from such estate-planning techniques as grantor retained annuity trusts and installment sales to intentionally defective grantor trusts. Following the business owner's death, his life insurance can supplement the cash flow for the surviving spouse.
Once the business owner's cash flow and financial security issues are resolved, the business owner frequently becomes much more amenable to discussing transfers of ownership and control to the next generation. By reducing their dependence on the family business for cash flow, business owners no longer need to rely on the business to maintain their lifestyle and can focus their attention on effective succession planning.
- Michael D. Allen, “Representing the Patriarch in Family Business Succession,” ALI-ABA Course of Study Materials, Estate Planning for the Family Business Owner (July 2006).