The Five Major Threats to Estate Plans
(Part one of a series on estate and succession planning issues.)
During the next 20 years close to 80 million baby boomers will be retiring. Their parents are aging, and passing on as well. A staggering $10 trillion will be transferred from the World War II generation to the boomers. This is the largest intergenerational transfer of wealth in history.
The majority of this wealth is held by the country’s 12 million privately owned businesses. Experts predict that more than 70 percent of these businesses will be changing hands within the next two decades. This impending shift in ownership could be dubbed the "business transfer tsunami," and it will undoubtedly intensify the need for adequate estate planning for business owners and their families.
There are numerous benefits to establishing a solid estate plan. First, it ensures that the estate will go to the person or people you want to have ownership. It may also minimize the tax rates that heirs will be subjected to, which can run as high as 45 percent. Through the use of wills and trusts, you can also dictate when and how the inheritance is bequeathed. This minimizes the possibility that beneficiaries may squander their inheritance. In essence, estate planning is something that you do for somebody else. It’s a present that’s difficult to wrap, but is well worth the effort.
In my experience crafting estate and succession plans, I have seen many business owners make the same mistakes repeatedly. I shudder to think of the wreckage this "business transfer tsunami" will leave in its wake unless business owners and their advisors immediately address the five major threats to a successful business transfer.
Threat No. 1: Disconnect between the business owner’s estate plan and business agreements. The business owner's personal estate plan should dovetail with business agreements. This integration of interests will make the transition of assets much smoother and easier in the event of his or her death. Unfortunately, two distinct plans are commonly designed and implemented by different advisors at various times.
This disconnect can be lethal to the business. For example, in one family business, the father bequeathed all of his stock in his will to the oldest son who was active in the business. The intent was to pass control so the son could continue growing the business. Unfortunately, the lawyer who wrote the will did not confirm the ownership of the stock. The business owner's stock certificates were actually owned jointly with his wife. When the business owner died prematurely in an auto accident, the oldest son was left with no stock whatsoever. He had to purchase stock from his mother whose transaction was greatly influenced by younger children who were not involved in the business.
Threat No. 2: Failure to have an updated power of attorney. A successful estate and business plan must include a power of attorney. This is the legal document that establishes an orderly transfer of control of the business in the event that the business owner becomes incapacitated due to various misfortunes such as a stroke, dementia or accident.
If the business owner becomes incapacitated, has no power of attorney and has not addressed disability in the business agreements, there could be real problems. Business operations could be interrupted, and partners and or family members could be faced with the expense and publicity of a public guardianship hearing that would be required to have the business owner formally declared as an incapacitated person. The court would also appoint a guardian to act on behalf of the owner’s interests. The guardian would step into the shoes of the owner and have the ability to exert the same level of control. It’s possible that the business owner would not even know the court-appointed guardian.
Threat No. 3: Incorrect names on deeds to business real estate. The business owner's estate plan and business plan must always integrate the ownership of both the company and the related real estate. Careful integration can guarantee significant tax and estate planning benefits. Therefore, a well-crafted plan will encompass a careful review of the deeds to all real estate upon which the business operates or owns. It’s important to be aware that the language on the deed trumps that in the will and in any business agreements.
The downside of failing to address these issues is evident in a case I had in which a father and three sons had a thriving business. The business was operated as a limited liability company (LLC). There was a well-drafted operating agreement that included stipulations regarding ownership and management of the company in the event of the father’s death. Unfortunately, the father and a stepmother owned the real estate jointly. When he died, she became the outright owner of the business real estate. The children who were not in the business put pressure on the stepmother to increase the rent for the LLC operating on the real estate. Worse yet, they eventually forced the LLC to move and sold the real estate to a third party. There was no commercial lease with the LLC, so, in effect, the business lost control of its real estate.
Threat No. 4: Outdated or inadequate business organizational document. Most business owners only give consideration to legal documents when they establish the business. However, the attorney and/or accountant should review those documents annually to confirm they are up-to-date. Outdated business documents can cause needless expense and delay.
For example, whenever a corporation is sued or audited by a taxing authority, the first thing they want to see is the corporation's minute book. If the shareholders are not holding annual meetings and keeping updated minutes in the book, they may be personally liable for corporate debts or taxes due to their failure to "act like a corporation." In addition, many business agreements for corporations and partnerships require annual valuations that must be agreed upon by all shareholders, partners or members. At best, failure to keep valuations current can end up requiring expensive business appraisals. At worst, they may result in costly lawsuits.
Threat No. 5: Wrong form of legal entity for the business. The most common business operating entities include the sole proprietorship, partnership, corporation and limited liability company. There are distinct benefits and drawbacks to each form. When a business is started, careful consideration is given to choose the form to provides the greatest benefit to the owner. Establishing an entity in the wrong form, however, can be disastrous.
For example, if a father decides to bring his two oldest sons into a business established as a general partnership, he loses control of his business. The corporation would be a better entity to gift partial interests of the business to children who are active in the business.
(Next month we’ll examine the best strategy to transfer business interests to your family members.)
Mark James is a practicing attorney, professor and author of 10 books about estate and financial planning, including Estate Planning Success for Business Owners. For more information about his books, please visit Barron Publishing Co.
