Why a Succession Plan Is One of the Most Important Things You’ll Build
By Elaine Ervin, National Construction Practice Leader, and Dan Gaffney, National Wealth Services Practice Leader, Moss Adams LLP
Transition is inevitable. Whether it’s driven by industry competition and consolidation, reaching retirement age, or a change in business or family circumstances, at some point as a business owner you’ll have to segue from one chapter of your life to another.
This isn’t always easy. If you’re like most contractors, you’ve invested a lot of intellectual equity in your business, to say nothing of financial resources, time, and good old-fashioned blood, sweat, and tears. But being able to reap the rewards of all that labor and leaving a lasting business legacy require you to take control of the transition process—and not let it control you.
The reality, however, is that few owners adequately plan their exit from their business. After all, you’re busy running the company. With all the day-to-day pressure, who has time to think five or 10 years down the road, much less 15 or 20? Yet just as every contractor needs a business plan, they also need a succession plan to map out the transfer of ownership, ensure the future success of the business, and achieve their personal financial goals.
This holds true whether the transition is to family, key employees, or a third party. And it’s especially timely now as we witness a range of external factors that could greatly affect owners’ ability to maximize their financial success in a business-exit scenario.
RISING TAX RATES?
Most income tax rates are scheduled to increase in 2013, and many tax breaks are set to expire. For example, at the time of this writing, the ordinary income tax rate for the top bracket remains at the historically low figure of 35 percent that dates back to 2001 and 2003. But absent any action from Congress, that rate will rise to 39.6 percent on Jan. 1, 2013. Equally as important for business succession purposes, gift and estate tax rates will also rise—dramatically—from 35 to 55 percent. What’s more, gift and estate exemptions, currently at a generous $5.12 million, will shrivel to just $1 million (see chart).
This means that, in just a few weeks’ time, it could become a great deal more expensive to transfer business interests or other assets to your heirs, if that’s your intention. But it also means that, in 2013 and later, it will become even more important to proactively plan for succession to mitigate higher tax rates and preserve your business and personal wealth.
Having a plan in place is essential, because before you can even consider whether it makes sense to gift assets now or continue to wait, you need to answer several very important questions, such as:
- How much is your company worth?
- How much money will you need for retirement?
- How much can you gift while still maintaining your cash flow?
- How can you retain some control over gifted business interests?
Answering these questions confidently requires having a business valuation performed as well as sitting down with your accountant, financial advisor, and attorney and mapping out what the future really looks like for you, your family, and your business. And this involves asking additional questions. For example, is your business’s entity structure set up in the most tax-efficient way? And do you understand your long-term exit alternatives and how each could be affected by your business’s cash flow, employment agreements, profit-sharing plans, and retirement plans?
Of course, we don’t know what will happen with regard to taxes. Congress could come together and agree to extend the 2001 and 2003 tax rates. Or it could decide to extend them for only certain income brackets. Or it could do nothing, allowing rates to rise as described above. No matter what happens, it’s important to develop a succession plan that takes this uncertainty into account and helps protect you, your family, and your business from the harsher effects of volatile income, gift, and estate tax rates and exemptions.
VALUE: WHEN LESS COULD EQUAL MORE
It’s no secret that contractors suffered more than others during the recent recession. The credit and housing crises did grievous harm to projects of all kinds. Federal stimulus dollars mitigated the carnage, but many contractors saw their business income shrink and were forced to tread water for an extended period.
The result? Contractors that had been riding high all of a sudden saw their businesses lose a tremendous amount of value. Public construction firms are a good indicator: From October 2007 to December 2008, companies in the S&P 500’s Construction Index lost nearly 65 percent of their value. And even though their stock performance has improved over the past few years, the index is still down overall by close to 19 percent.
But the door that appears to have momentarily shut if you were hoping to sell your business at the height of the market may have opened a window for another opportunity: the ability to gift business assets or ownership interests to heirs at lower valuations.
To be sure, this may not be a strategy for everyone, but it offers the chance to ease one’s estate and gift tax burden by taking advantage of the gift’s reduced value. And by gifting when values are low, you also give the gift of appreciation: As the economy recovers more fully, construction picks up, and your business appreciates in value, so will the gift.
A strategy like this takes planning. Which heirs are the right ones to whom to gift business interests? How much should you gift at a time? What effect will this have on your estate plan? These and other questions must be sorted out well in advance of any gifting scenario.
A GENERATION REACHES A CROSSROADS
From the time they were, well, babies, baby boomers, through their sheer strength in numbers, have made a large collective impact on the U.S. economy. It’s no different today. Boomers represent more than a quarter of the nation’s population, and they control the vast majority of its wealth. They’re also retiring in ever larger numbers—or at least thinking very hard about doing so.
Why is this so important? If a significant number of your management team members are 55 and older and you haven’t identified and groomed the next generation of C-suite inhabitants to take their place, not only will you risk losing valuable employees but you could also place your business’s longevity in jeopardy.
A succession plan can help you evaluate and develop that next generation of managers, ensuring your business remains well run and financially healthy, enhancing long-term value and transferability. It can—and should—also contain contingency plans in case, for example, something happens to you or another manager, putting business continuity at risk.
Creating a plan for orderly, predictable, transparent management succession would be an important activity regardless of the average age of your management team. But with the impending boom in boomers’ retirement, it’s vital.
REASSURE YOUR SURETY
Increasingly, creditors want to see contractors’ business succession plans before deciding how much to lend. Likewise, bonding companies want to make sure you have business continuity plans in place in the event of a sudden ownership or management transition. Both banks and sureties want to know that your business can:
- Complete all pending and anticipated contracts
- Meet its financial obligations despite the cash required to fund an ownership transition
- Smoothly transition management to well-trained and -developed successors
- Secure future debt
In many privately held construction firms, the owner is the personal guarantor for the company’s debt. Many bonding companies also require personal guarantees. In a transfer or sale scenario, you’d want to be released from those guarantees, and any successor needs to understand that he or she will take them over.
However, if your successor is buying your company in installments and guarantees exist, then your personal assets may still be tied to those guarantees, essentially yoking your retirement to the company’s continued success. In this scenario, for your golden years to be funded, your company needs to continue to do well long after you’ve retired in order to relieve you of your obligations as guarantor. A strong succession plan will include long-term strategies for building transferable value and enhancing profits and cash flow, which help ensure that the new owners can set the stage for your release from personal credit guarantees.
REVISIT YOUR ENTITY STRUCTURE
C corporation. S corporation. Limited liability corporation. Limited partnership. Each has its advantages, and you may have chosen the structure that made the most sense when you started your business. But your needs—not to mention the economic and tax landscape—may have changed, especially if you’re considering retirement, selling your business, or transferring it to the next generation.
Put simply, the right change in entity structure could help you preserve more of your wealth during a business transition event.
WHAT ABOUT AN ESOP?
When most owners mull over their exit strategies, they’re accustomed to a set of familiar choices: passing the business on to the next generation, selling it to key managers, or selling to a third party (such as a private equity firm or perhaps a competitor interested in making a strategic buy). But many owners overlook an alternative exit strategy: selling all or a portion of the business to an employee stock ownership plan.
It’s not for everyone, but it has certain advantages, and more owners are taking a longer look at ESOPs as a means of business succession. For one thing, just as with any other sale, it provides a liquidity event for the owner, but it also provides a reliable income stream after the sale that can outperform a traditional retirement fund, such as a 401(k). An ESOP also confers certain tax advantages—an ESOP-owned S corporation pays no federal income tax, for example—and the sale process, which lets the owner retain an executive position at the company, allows for greater business continuity.
You’ve worked hard to build your business, and you’d never knowingly place its future at risk. But neglecting to plan for eventual ownership transition and management succession puts too many things in jeopardy: business continuity, lender relationships, employee and customer retention, and your long-term personal and family financial goals.
Taking the time to evaluate your management team, develop worthy successors, create contingency plans, and get granular on the financial and tax details of your business exit strategy is energy well spent—and money, time, and heartache saved down the road. And remember that it’s not just about your business: A good plan takes a 360-degree view of your business needs as well as your personal and family wealth needs.
It’s also a good idea to turn to your CFO for help. He or she should be knowledgeable about the business’s cash flow, bonding, and overall financial position, which puts him or her in a great position to advise you on the business financial planning, management succession, and ownership transition elements of succession planning.
Leaving your business may not be something you’re considering now or even want to consider in the near future. But transition at some point is inevitable. And if you don’t create a succession plan, others—your lenders, your competitors, the IRS—will create one for you.
Changes to Top Tax Rates*
|Ordinary earned income||35%||39.6%||14%|
|Net investment and passive income||35%||43.4%**||24%|
|Long-term capital gains||15%||23.8%**||59%|
|Estate and gift||35%||55%||57%|
|*As currently scheduled based on sunset of 2001 and 2003 tax cuts.
**Top marginal rate with 3.8% health care tax on net investment income with AGI over $200,000 (single filers) or $250,000 (joint filers).
Elaine Ervin has practiced public accounting since 1986, specializing in closely held companies. She participates in all phases of audits and reviews, including planning, compliance testing, supervision, and report preparation, and has an extensive background in bonding and banking issues as they relate to financial performance. She can be reached at (206) 302-6399 or email@example.com.
Dan Gaffney has more than 16 years of public accounting experience. He works extensively with closely held businesses, advising his clients on tax issues, strategic and operational business planning, cash flow management, estate planning, retirement planning, and business succession planning. He can be reached at (425) 303-3195 or firstname.lastname@example.org.