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Maintain Control of Your Business Until All Your Goals Have Been Achieved

Submitted by John Brown on Fri, 05/15/2020 - 8:00am
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Perhaps the most basic tenet of Exit Planning for business owners is that owners should maintain control of their companies until they attain all their goals and aspirations. This tenet applies, perhaps even more so, to transfers of family businesses.

The goals of parents/owners involved in these transfers include financial security for the parents and continuity of the business for the benefit of the family, employees, and perhaps community. None of these goals can be achieved if parents surrender control of the business before they are satisfied that the children running the business have proved their capabilities. Maintaining control does not prevent ownership from transferring to children as the following story illustrates.

Part 1: Background

Stu Smith began his excavation business more than 30 years ago. For years, Stu’s wife (Gladys) urged him to give up his six-day workweeks, retire and give the business to their son (John) who had been working in the business for over a decade. Stu resisted. He was not at all confident of John’s dedication to the business or whether John could run it without him.

To keep the peace, Stu finally agreed to meet with their planning advisor, Tom Gardner, to discuss Stu’s retirement and ownership transfer. Gladys explained to Tom that they needed no more than a continuation of Stu’s salary to maintain their lifestyle. For that reason, they could give the business to John now, put an end to Stu’s 60-hour work weeks, and simply continue Stu’s salary.

Tom was aware of Stu’s concern about John’s ability and commitment to the business. But he was also acutely aware of the considerable risk to Stu and Gladys if the couple “gave” the business to John before they were financially secure.

Tom appreciated Gladys’s viewpoint as he considered all of the couple’s goals and needs. His challenge was to satisfy Gladys’s desire to give the business to John now and keep Stu in control until the couple’s financial security was assured.

What Would You Do?

Tom recommended an ownership transition plan in which Stu and Gladys would transfer most of their ownership (80%), in the form of non-voting stock, to a Grantor Retained Annuity Trust (GRAT). The GRAT would pay Stu and Gladys an annuity of $500,000 annually for five years. At the end of five years, John would receive what remained in the GRAT.

The excavation company’s S distributions averaged over $750,000 annually. The GRAT would distribute $500,000 of its share of these distributions to satisfy the annuity payment to Gladys and Stu.

Assuming that the company continued to perform well under John’s management, all of the stock transferred to the GRAT—80% of the ownership—would be distributed to John at the end of the five-year GRAT term. Stu and Gladys would then gift the remaining 20% to John.

Stu retained 20% of the company ownership and all of the voting stock.

In order for this strategy to work, the business must maintain healthy profitability and cash flow under John’s management. If the business failed to do so, the stock transferred to the GRAT would return, entirely or in part, to Stu and Gladys at the end of the five-year trust term. Let’s return to our illustration.

Part 2: Owner Agreement

After Tom presented his plan, both Stu and Gladys objected; Stu to the costs (fees for both a business valuation and attorneys), Gladys to the failure to turn over control to her son, and both to the intricacy of the design.

"Yes," Tom agreed, “the plan is intricate and there are costs to implement it correctly, but it accomplishes your goals. First, at the end of the GRAT term you will have financial security and the business will remain in the family, and secondly John receives the business tax-free. If you need some time to think about it, I understand.”

Once the couple realized they would all be getting what they wanted, they moved forward with Tom’s suggested plan.

Had the business performed as well under John’s leadership as it had under Stu’s, Tom’s plan would have worked perfectly. But let’s assume that it did not. What then?

 Part 3: End Result

 After Stu retired, the company did not generate the same level of cash flow as it had under his ownership. In fact, at the end of the first year there was no cash to distribute to the parents to satisfy the annuity payment requirement, so Stu and Gladys took stock instead.

To make matters worse, the value of the stock they received had plummeted, so Gladys and Stu received most of the ownership they had transferred into the GRAT back to them.

Stu decided to look into the sudden drop in cash flow and discovered that his son and the company's CFO were embezzling every cent of the cash flow, and more.

After firing their son and the CFO, Stu and Gladys received all the stock remaining in the GRAT at the end of the second year. The GRAT was terminated, Stu stepped back into his sixty-hour work weeks and, over time, the company regained its financial footing. 

There are several morals to this story:

  1. Once the advisor explained how the plan design related to the parents’ goals, the clients agreed to an ownership transfer plan that protected them in the event of a child’s inability to perform—for whatever reason.
  2. Had the advisor failed to recommend and the parents been unwilling to accept such a plan (or another that enabled the parents to maintain control until the child proves his/her ability to perform), a parent’s financial security can be destroyed and dreams of a happy retirement shattered.

Weight Your Options

The GRAT-based plan that Tom recommended had three advantages:

  • It achieved Gladys’s goal: transferred majority ownership of a valuable business to the successor owner-child tax free.
  • It assured Stu that if his son did not perform, part or all of the ownership would return to him.
  • It assured both Gladys and Stu that whatever happened, their financial security and the continuity of their business were not at risk.

Exit Planning advisors use GRATS and dozens of other designs to transfer ownership to children. They tailor each plan to the peculiarities of a family’s situation, but all plans have one common element: They keep control of a business in the parents’ hands until all of their goals and aspirations—both financial and family-related—are achieved.

Takeaways

  • Transferring ownership to children should not put the parents financial or family-based goals at risk.
  • Exit Planning advisors use a variety of plans to protect their clients from losing control of their businesses until successors prove their ability to perform.
  • Use stories like the one in this post to illustrate to your clients the need to maintain control until their goals are satisfied.


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