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Succession Planning: What Owners of Small Businesses Need to Know

You have probably heard about using a will or other estate planning tool to protect your family, but what about your business? Small businesses rely heavily on their owners, and the unexpected death of a business partner could leave a key role unfilled. Without a succession plan in place stating who should take over, the business may be at risk of collapse. This could in turn mean that the owner's heirs will not have a valuable business to inherit. To ensure a smooth transition, you must have a succession plan in place.

What Happens to a Business Interest When an Owner Dies?

As a general rule, your business interests are part of your estate. You can include them in your will, trust, or other estate planning documents. You may choose to leave your business to specific heirs or to have your business divided as part of your total estate. Exactly how it happens depends on the type of business.

Sole Proprietorships

An unincorporated sole proprietorship dissolves upon the death of the owner. The business's cash, inventory, and other assets are the owner's personal property and become part of the owner's estate just like their other personal effects. There is no separate business to pass on.

If you wish to leave your business to an heir to continue running it, you can include this in your succession plan. The process would be similar to a sale to another sole proprietor. Your heir would receive the business assets, including its contracts and intellectual property, but it would technically be a new business entity.

Partnerships

What happens to a partnership upon the death of a partner depends on the partnership agreement and whether the deceased owner or owners owned a majority interest. The three general options include the following:

  • Dissolve the partnership, end the business, and distribute the business assets to each partner.
  • The living partners buy out the deceased partner's estate's interest in the partnership. The living partners continue to run the business.
  • The living partners accept the deceased partner's heir as a new partner with the same interest as the deceased partner. The business continues running as before.

The typical rule is that if a majority of the partnership changes hands within a year through death, sale, or other partnership changes, then the partnership is technically dissolved. However, the partnership agreement can specify that the partnership will continue as a new partnership.

When the partnership agreement is silent, which option is used by default depends on the state.

Limited Liability Companies

Limited liability companies (LLCs) function similarly to sole proprietorships if there was one owner and partnerships if there were multiple owners. For LLCs with multiple owners, the LLC operating agreement will control what happens if a business owner dies. Like partnerships, this could include dissolving the LLC or the deceased owner's estate taking over the interest in the LLC.

Corporations

Both S corporations and C corporations are fully separate legal entities from their owners. When an owner dies, the corporation continues and the owner's shares in the corporation become part of their estate. The heirs who receive those shares obtain all dividends, ownership, and voting rights granted by those shares.


Some closely held corporations use a buy back agreement to ensure continuity of ownership. In a buy back agreement, when a shareholder dies the corporation buys their shares at a predetermined price. The proceeds go to the estate, but the heirs do not continue as owners.

What about Estate Taxes?

All owners of small businesses must consider estate taxes in their succession plan. Estate taxes vary based on the value of the business and the overall size of the owner's estate including their other assets. Both the federal and state government may impose an estate tax.

The biggest problem for many family-owned businesses is that most of their net worth is tied up in the business. With federal estate tax rates as high as 40 percent, these families are often forced to sell their business to pay the taxes even though they want to continue to run it. To avoid this, estate tax planning should also be a part of the succession plan.

Who Should Take Over in the Short Term?

The first step in a succession plan is keeping the business going between the time of an owner's passing and the completion of the transfer of ownership and other needed transition steps. While this will likely be a difficult time for everyone involved in the business, there must be as little interruption to operations as possible.

If customer orders are not fulfilled or vendors are not paid, the business may lose the relationships it has built up over the years. In addition, customers will be wondering if the business will continue at the same level of service without the owner, and keeping things as close to normal as possible will reassure them.

The goals at this stage are continuity and avoiding power struggles. You need to make sure someone will take charge without having people fighting over who this should be. Ideally, this should be a co-owner or trusted manager who is already familiar with the roles the deceased owner played. It is not ideal to have an heir who was not already playing a management role to jump right in because they may not be familiar with the business or be able to gain the trust of the employees.

Your operating agreement and employee handbook should spell out who takes over in the absence of key individuals. In addition to providing clarity to everyone working for the business, it helps those who will be asked to step up to be mentally prepared for the additional responsibilities.

Sell or Continue?

Whether you want to see your business as part of your heirs' inheritance or have them continue running it sets the stage for the remainder of your succession plan. In addition to your own preferences, you must make sure that your heirs are ready, willing, and able to take over before passing on the responsibility of running the business. This requires a heart-to-heart talk to find out if their goals and life priorities match your own.

Who Should Take Over Permanently?

The final thing you need to think about is who should be in charge of your business going forward. If you want a minority owner or non-owner manager to take over, it is recommended you put a buyout agreement in place that allows them to purchase your interest from your heirs. This could include a cash price or a royalty paid to your heirs for a certain number of years.

If you want to have an heir take over, you should ensure that they have the education, experience, and business acumen to do so successfully. If you are near retirement and nearly ready to hand over the reins anyway, this is relatively simple. If your chosen heir is not ready yet, you may need an intermediate plan that has a trusted advisor taking over operations until your heir is ready to take over.

Succession Planning Tools

To meet your goals, there are a number of succession planning tools that you can use.

  • Will or trust – Because your ownership interest is your personal property, you need to approach it from both a personal estate planning standpoint and a succession planning standpoint. Your personal estate plan should set out who should receive your shares in the business.
  • Operating agreement – If you have multiple owners, succession planning should be considered within the operating agreement. Who takes over on a temporary basis? How are long-term decisions made? Will the surviving owners buy out the deceased owner's estate?
  • Buy-sell agreement – A buy-sell agreement is a predetermined sale triggered by the death of an owner or some other event. This type of agreement gives one party the opportunity to sell their ownership interest to another party without the other party's consent at the time of sale. The price is set when the agreement is signed, and it could be a fixed price, based on fair market value, or based on some other valuation method.
  • Sale during life – Many business owners who are near traditional retirement age may want to take a reduced role in their company. Often, they will sell all or most of their ownership interest to a relative, key employee, or third party. They will also sign a contract to remain in a board member or management capacity or some other role. The succession planning benefit is that you start the transition during your life and avoid a sudden change in the future.
  • Private annuity or self-canceling installment note – Private annuities and self-canceling installment notes are special ways of selling a business that are typically used within a family. With an annuity, you sell your business in exchange for the annuity. The buyer then pays you according to the annuity until your death. A self-canceling installment note (SCIN) is technically a loan but works like an annuity. You sign a promissory note in exchange for your business interest, and the buyer makes payments during your life. Upon your death, the balance due is canceled rather than being owed to your estate. Both of these options give you an option to pass your business interest on to your family that falls between an outright gift and a cash sale. It also provides you with a continuing income stream.
  • Grantor retained annuity trust – A grantor retained annuity trust (GRAT) is a special kind of trust that takes title to your business interest. You retain the rights to your share of the business's income for the rest of your life. Upon your death your beneficiary receives the business interest held by the trust, which helps to bypass the probate process.
  • Limited partnership or non-voting interest – Ownership and control does not have to be fully tied together. In some situations you may want some family members to have a continuing financial interest in the business but may not think they are right to run it. A limited partnership or non-voting share in a corporation gives them the right to receive dividends and the proceeds of a future sale without giving them the right to vote on day-to-day operations.
  • Employee handbook and organizational chart – When you do much of the work by yourself and work alongside a small team of long-time employees, you may think that you do not need an employee handbook, organizational chart, or other formalities that are often found within the HR departments of big corporations. However, making sure everything goes smoothly today is only one purpose of these documents. You should also have in writing what everyone in your organization is responsible for and who they report to. If something happens to you or a key employee, someone else should be able to read what you were responsible for and know what they need to do to take over. If your succession plan calls for a new owner, this will allow them to become familiar with what everyone does and why existing processes are in place.

Are You Prepared?

You can find these and other succession planning tools in our document center. As a good succession plan covers many different aspects, both legal and non-legal, a complete succession plan will contain a number of different documents that you should keep together in a safe place just as you would with your personal estate planning documents.

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