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Succession Planning

Las Vegas Succession Planning Lawyers

The transition of a company to its successor owners must be planned for in advance and properly executed to be successful. Unfortunately, the vast majority of company owners delay planning for such succession or completely fail to do so. Owners should begin planning while they are still healthy and active in their companies. In family companies, only approximately thirty percent (30%) succeed into the second generation and only approximately fifteen percent (15%) survive into the third generation. A succession plan is essential to the continuation of the company, no matter what the company's structure or size.

Succession Methods

There are a number of succession methods to implement an orderly transfer of the ownership of the company. Some common succession methods are:

Buy-Sell Agreements

A succession method most appropriate to closely-held companies is the buy-sell agreement. Inc. magazine calls buy-sell agreements "the next best thing to immortality." Buy-sell agreements protect the company against unexpected events such as an owner becoming disabled, dying, desiring to sell to a third party non-owner, retiring, becoming divorced or bankrupt, or terminating his or her employment with the company. Such events can threaten the stability and survival of the company. A buy-sell agreement is a contract between the company owners that dictates who can buy the interest of the departing owner, establishes a purchase price through a defined valuation method, and provides the terms of payment, while also setting the value of the business interest for estate tax purposes. A properly drawn buy-sell agreement will ensure the continuity of ownership and management of the company, and provide staff, bankers, customers, suppliers and other interested parties with an important sense of security. Buy-sell agreements are funded by a variety of sources: disability insurance, life insurance, a sinking fund of the company, installment payments and borrowed funds.

Family Limited Partnership

A succession method commonly used in family companies is a family limited partnership. It is often used by parents and grandparents as a vehicle to transfer ownership during their lifetimes while retaining control and management of the company. The owner of the company is the general partner, thereby retaining control over the company, while the successors are limited partners. Proper utilization of a family limited partnership can reduce the owner's taxable estate even though the owner retains control and management of the company, fully utilize and compound the gift and estate tax credits and exemptions available to the owner, spread income among children and grandchildren in lower marginal income tax brackets, remove a substantial amount of future appreciation from the owner's estate, and place assets beyond the reach of creditors of the owner.

Recapitalization

Because stock in a Subchapter "S" corporation cannot be held in a family limited partnership, the recapitalization of the family business that is a Subchapter "S" corporation can be used to achieve the same result and benefit of a family limited partnership. Recapitalization of a Subchapter "S" corporation typically involves the cancellation of all of the old shares of stock and the reissuance of one class of stock consisting of voting and nonvoting common stock. The owner again maintains control and management of the company by retaining the voting stock while transferring the nonvoting stock to the successors. Recapitalization can also be utilized when a family business is a "C" corporation.

Gifting

Another succession method that allows the owner to transfer ownership to the next generation while retaining control and management of the company is gifting. In a corporation, shares of the stock of the company are gifted by the owner; in a limited liability company, units of ownership of the company are gifted by the owner. Current law allows an annual gift tax exclusion of Fourteen Thousand Dollars ($14,000.00) per recipient per calendar year. The spouse of an owner can also consent to the gift and allow the owner to utilize the annual gift tax exclusion of the non-owner spouse. Accordingly, under current law an owner (and their spouse) can gift ownership interests in the company having a value as of the date of the gift of Twenty-eight Thousand Dollars ($28,000.00) per recipient each a calendar year with no gift tax consequences and without being required to file a gift tax return (Form 709). Since the gift constitutes a minority interest in the company, the value of the gifted shares or units can be discounted for gift tax purposes resulting in a larger number of shares or units being gifted. However, the valuation of the gift is subject to IRS scrutiny and possible challenge, and therefore the valuation method should be reasonable and have a defendable underlying basis. Outside appraisals and valuations by the company's CPA can be utilized when determining the value of the gifted shares or units. Gifting can also similarly reduce or eliminate estate tax in the owner's estate. Gifting permits the owner to plan and implement a succession and change in ownership plan that allows family members increasingly meaningful roles in the company with the owner still retaining control and management.

Testamentary Transfers

Another possible succession method is via testamentary transfers. However, testamentary transfers are subject to potential federal estate tax. Current law provides for an estate tax applicable exclusion amount of 5.34 Million Dollars ($5,340,000.00) per decedent. Estate tax is due in full nine (9) months after the date of death, but if the estate includes a closely held business whose value exceeds thirty-five percent (35%) of the adjusted gross estate, the personal representative of the estate may elect to pay the estate tax in as many as ten (10) annual installments following a deferral period of as many as five (5) years. The amount of tax that may be deferred is limited to the tax attributable to the business interest. A closely held corporation may redeem stock from the estate of a decedent owner of from the beneficiaries of the estate to pay estate taxes if the stock comprises thirty-five percent (35%) of the gross estate, and this redemption of stock is generally not treated as a disqualifying disposition for purposes of the installment payment of the estate tax.

The most common method of testamentary transfers is through the establishment by the company owner of a revocable living trust during the owner's lifetime. One of the primary reasons to establish a revocable living trust is to avoid the expense and delay of probate of the owner's estate, but such a trust can also be utilized for company succession purposes. The terms of the trust can pass the right to ownership of the company to one or more beneficiaries in various ways, some of which are:

Outright Bequest - An outright bequest passes the company interests to the beneficiary, often a family member or members involved in the company, as part of his or her inheritance. The decedent will often then provide for non-company assets passing to other family members who are not involved in the company. This allows for a smooth succession of the company to the family member involved in the company without interference from, or the financial burden of purchasing the company interests of, family members who are not involved in the company. This method also promotes harmony in the surviving family members as monetarily they are treated "fairly".

Option To Purchase - An option to purchase gives a beneficiary or beneficiaries the right to purchase ownership of the company pursuant to defined purchase terms set forth in the trust. The option will normally set forth a price or valuation method and the terms of payment (cash, installments with applicable interest rate, et cetera). Such a price or valuation method will establish the value of the decedent's interest in the company for estate tax purposes, subject, however, to potential IRS scrutiny and challenge. Again, the option is usually provided to family members involved in the company operation or non-family key employees of the company. This gives the right to the beneficiaries involved in the company the right to purchase the company interest and also furnishes a potential buyer or buyers for the company. This is a right, not a mandatory obligation, but a specific time period in which the option can be exercised is also set forth in the trust. If the option is not timely exercised, the option is forfeited. If the option to purchase is timely exercised, the company interest is sold per the defined purchase terms and the sale proceeds then pass to the beneficiaries as set forth in the trust, usually the family members of the deceased owner. In this way a family member who is exercising an option to purchase is able to use and leverage part of his or her inheritance to fund the purchase of the company interest. Again, an option to purchase method promotes family harmony in the surviving family members as monetarily they are treated "fairly". An option to purchase agreement can also be entered into as a separate agreement outside of a trust and can be funded by the party having the option owning and being the beneficiary of a life insurance policy under which the owner is the insured.

Right of First Refusal - A right of first refusal gives a beneficiary the right to purchase the decedent's interest in the company by matching an offer to purchase by another party, which third party offer the company is willing to accept. In essence, under this method the beneficiary is given the right to purchase the company interest on the exact identical sale terms another party is willing to purchase such company interest, which sale terms the trust is willing to accept. The trust is required to notify the beneficiary of the terms of an offer to purchase from another party that the trust is willing to accept. The beneficiary then has a limited time period in which to exercise his or her right of first refusal. If the right of first refusal is exercised, the beneficiary purchases the company interest on the exact identical sale terms of the third party offer. If the right of first refusal is not timely exercised, the trust consummates the sale of the company interest to the third party under the proposed sale terms. Although occasionally used in a situation where family members are involved in the company, this method is more often used for the benefit of non-family key employees of the company. The beneficiary of a right of first refusal must compete with any interested third party buyers, and this often results in the highest possible sale price for the company. Like the option to purchase method, a right of first refusal agreement can also be entered into as a separate agreement outside of a trust and can be funded by the party having the right of first refusal owning and being the beneficiary of a life insurance policy under which the owner is the insured.

Key Employees: A succession plan must always take into consideration the company's key employees. If the key employee is a succession candidate, the company may wish to provide for such succession through the above-noted methods of a buy-sell agreement, an option to purchase or a first right of refusal.

Stock Options

Another succession alternative for the company is the granting of stock options to the key employee. Stock options are contracts between the company and the key employee giving the key employee the right to purchase a certain number of shares (corporation) or units (limited liability company) at a fixed per share or unit purchase price. Such stock options must be exercised within a certain defined time period. The key employee hopes that the price of the stock or units will increase over the option price set forth in the stock option agreement with the passage of time. Stock options are used not only as a vehicle for succession, but also to attract, compensate and retain key employees.

Buy-Sell Agreement/Insurance

The disability, death, divorce, bankruptcy, and desire to sell to a third party of a key employee can dramatically affect the well-being and stability of the company. A buy-sell agreement as discussed above, in conjunction with the obtaining of disability insurance and life insurance on the key employee, can ensure the continuity of the company after the disability, death, et cetera of a key employee and a means for funding the buy-out.

Affirmative/Negative Incentives

Also a company may wish to retain a key employee via certain incentives, sometimes referred to as affirmative incentives and negative incentives.

Affirmative Incentives - Examples of affirmative incentives are deferred bonus plans that provide for the payment of bonuses over a period of time that are contingent on the continued employment of the key employee by the company, stock options as discussed above, split-dollar insurance where part of the insurance premiums are paid by the company, supplemental executive retirement plans that provide for the payment of a specified benefit amount at retirement, and disability wage continuation programs that provide for some form of the continuation of wages in the event of the disability of a key employee.

Negative Incentives - Also a company can utilize negative incentives to discourage a key employee from leaving the company. The most common negative incentive is the use of a covenant not to compete as part of the company's employment agreement with the key employee. A covenant not to compete can prohibit the former key employee from: 1) competing with the company for a limited period of time in a certain geographical area; 2) soliciting, inducing, recruiting, or causing another person in the employ of the company to terminate his or her employment for the purpose of joining, associating or becoming employed with any business or activity which is in competition with the company for a limited period of time; 3) diverting or attempting to divert any existing business of the company for a limited period of time, and 4) using or disclosing trade secrets, marketing information, sales information, business method, product specification or other technical information of the company that the former key employee has acquired by reason of his or her employment with the company. Although not favored by most Courts, covenants not to compete are enforceable if they are reasonable under the circumstances, namely as long as the covenant is reasonable in terms of length of time and geographical area restrictions. "Reasonableness" can vary from industry to industry and from company to company. For example, a limit of two years within one hundred (100) miles of the city limits of metropolitan Las Vegas may be reasonable in one industry or company while not reasonable in another. A covenant not to compete also often provides for the payment of a certain amount of damages known as liquidated damages by the former key employee if he or she violates the terms of the covenant not to compete, and the allowance of an injunction (Order of the Court) that directs the former key employee not to violate the covenant not to compete. Courts will strictly construe the language of a covenant not to compete, and in the case of an ambiguity, language in a covenant not to compete is construed against the drafter. Accordingly, it is of paramount importance that a covenant not to compete be very carefully drawn by a knowledgeable practitioner.

Summary

Proper business continuation and succession planning is essential for any company. Failure to plan for orderly company succession can be catastrophic, resulting in not only monetary losses but even the loss of the company itself. Proper planning will ensure the survival and smooth continuation of the company, and avoid disputes and possible litigation among the surviving owners, family members and key employees.

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At the Las Vegas, NV Law Firm of Jeffrey Burr, we represent clients throughout Southern Nevada, including in Overton, Logandale, Mountain's Edge, Henderson, Aliante, Boulder City, North Las Vegas, Mesquite, Pahrump, Summerlin, Southern Highlands, Green Valley, Laughlin, Clark County, Nye County and Lincoln County.

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