The generation approaching retirement have been one of the most entrepreneurial in recent memory taking advantage of growth in the economy and extensive business opportunities.
But how does a family business survive the retirement or death of the founder, when every important decision has been made by that founder over the years and the founder’s family all have different attitudes towards the business and how they live their life?
The author is James Ward, Partner and Head of the Private Client team at Kingsley Napley LLP explains that family businesses are renown for creating capital value and reliable income streams. There is an opportunity for them to be passed down to the next generation free of Inheritance Tax on the founder’s death. However, such companies are often reliant on the founder’s skills and personal relationships and therefore the transfer of the business needs to be done delicately. As well as corporate planning advice to find the optimal structures for doing so, for example in terms of a revised shareholders agreement and governance, it is wise to marry this with private client advice covering succession and taxation issues.
A house or a share portfolio, which are often part of the residuary estate of an individual on their death, can be easily sold and the proceeds divided between any children. However, a family business is its own legal entity that will continue beyond the death of the founder. It is crucial for the founder to consider how to deal with share transfers either during his or her lifetime or on their death.
Gifting of shares
Traditionally gifting was seen as a sensible approach. However, if the founder holds the majority of shares in their name, and these have the ability to cover the voting percentage for ordinary and special resolutions, the effect of splitting the shareholding into a number of smaller percentages can be problematic with family voting dynamics. It can make company governance unworkable.
There is a chance this could create the ability for some family members to block business sales or significant decisions such as dividend payouts and purchases, for example, and that this can change the landscape significantly from when the founder was making these decisions. This can be very difficult after death but even worse if the founder is still alive and seeing the business not operating in a way that he or she would have wanted.
Therefore, the gifting of shares to children should be considered very carefully and often needs to be done alongside a shareholders agreement that prevents mismanagement of the business. Quite often this is on death as opposed to during lifetime as, if business relief is applicable to the shares, then there will be no Inheritance Tax passing the shares down to children alongside a Capital Gains Tax uplift on the value of the shares to the probate value. It should also be noted that a gift of shares in the founder’s lifetime is subject to the seven year gifting rule with a tax implication if the shares are sold within that period.
Trusts
An alternative solution is to use Trusts that keep the shareholding together, accompanied by directions set out in a carefully drafted Letter of Wishes and well-chosen Trustees.
Trusts can be set up during lifetime or on death. However, they should be done alongside a detailed shareholders agreement covering aspects including key decisions, dividend payments and so on.
Sibling rivalry & incentive plans
Another issue that often occurs is that one sibling is involved in the business and one is not. This can be very difficult when business founders want their children to benefit equally as the person working within the business can become disincentivised if half of their hard work is benefiting their sibling who is doing something else. In such circumstances one child taking on the reins of the family business is not an easy option and resentment can easily build up.
Solutions such as having a larger share of profits going to the sibling(s) working in the business or creating a meritocratic salary and bonus structure can be helpful. It is also possible for shares to be awarded through long term incentive plans growth shares. In the end it is important to protect the family member(s) involved in the business as the business will only continue if the key decision makers are incentivised. In that respect a family business is not unlike any other business.
Exit
Sometimes the prospect of the founder handing over the business to family is not feasible and an exit needs to be considered. An exit can take many different shapes including Employee Ownership Trusts, trade sale to competitors, Private Equity involvement or some form of joint venture and investment with another organisation to provide a larger and more commercialised management structure and share register.
The Inheritance Tax implications here require careful planning. When it comes to Inheritance Tax an exit is often better done post-death as Inheritance Tax can be mitigated. Any exit before the death of the founder would see shares turn into cash which would be taxed at 40%.
In my experience what is most crucial when it comes to family businesses and succession planning is to make sure that all of the family are involved in the process. Things can go awry when done deals are presented to family members because they do not feel they have been consulted and often end up being disappointed.
Open dialogue between family members and an unemotional decision-making process about the future of the business is absolutely key and should ideally be done many years in advance of a retirement or succession plan.
Having the correct governance in place surrounding board meetings, shareholder meetings and shareholder agreements are also crucial so that there is a framework in place that provides certainty for the future of the business and to help avoid family disputes.
Read more:
Key considerations for succession planning for business owners