Avoiding pitfalls when planning for business succession

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When it comes to business succession planning, there are lessons to be found in the journeys of others. We talked to three local professionals to find out common mistakes and overlooked considerations in structuring succession deals.

“Something  that seems really obvious in business succession planning but does not always happen is having a backup plan in place,” said Joseph Donovan, senior vice president of Paramax Corporation, a local investment banking firm with offices in Rochester and Buffalo.

Donavan says that in addition having a backup plan in place, running your business succession plan before finalizing a deal is also an important, sometimes overlooked step to make sure it’s viable.

He also stresses that consummation of the ultimate transaction should be well understood by all parties and emphasizes the importance of working with an experienced team of advisors throughout the process. Depending on your succession plan, this team could include an M&A advisor, banker, attorney, tax advisor, wealth advisor and/or estate planner.

Steven M. Mills CPA, partner emeritus, Insero Advisors, LLC, a Rochester-based public accounting firm, says that oftentimes the biggest mistake his team sees with business succession planning is not thinking about it early enough.

“For existing clients, we try to make this a part of a client discussion on a regular basis, annually if possible or at least every two years,” Mills said. “Things happen fast in today’s world, and we need to be prepared. At the outset/formation/acquisition of any business, any possible exit plan is always part of the discussion as to the choice of entity so that informed decisions can be made as early as possible, with the flexibility needed.”

Along those lines, even for existing businesses, Mills says that owners need to consider the process far in advance of any eventual transaction.

“There are so many things that can be done when succession planning (whether this involves a sale or a transfer to employees or family, etc.) is done in a thoughtful and intentional manner that are often just not possible (or practical) if the preparation process is delayed,” said Mills, explaining this could include certain tax elections, gifting, transfer of ownership and more.

Other overlooked considerations Mills notes are lack of obtaining valuations when making gifts; not considering the future tax effects of any transfer-installment sales; gifting of low tax basis property, etc.; not recognizing the importance of insurance (which can be a valuable asset in the structure of any family transfer); deciding to change state residency too late and not involving professional advisors soon enough.

“No one knows everything, and all have their areas of specialty,” Mills said. “In addition, many times one or another of these advisors may have a longer relationship with the client, and more knowledge of any situation is always a good thing. When going into any transaction, it is absolutely imperative that clients make sure they have a good team of all of these advisors.”

Anthony “Tony” Duffy, senior counsel at The Bonadio Group, a Rochester-based public accounting firm, says pricing and tax options can differ dramatically depending on the nature of the deal and whether it’s an inside transaction or a third-party deal.

“A common mistake for inside transactions is managing taxes for both sides of the transfer,” Duffy said. “These arrangements are done over several years and therefore are dependent on the success of the buyers. So, within reason, they allow some tax advantages for those successors.”

He notes the structure of other contracts, leases, deferred comp, and employment agreements can be part of this process as well. A second issue Duffy and his colleagues see pertains to transfers completed mid-tax year.

“When the entity is any type of flow-through taxpayer, often advisors do not consider the taxable income that may be allocated to the seller in the year of sale,” he said. “Any combination of installment sale and ‘hot assets’ can pose issues as well. For successful companies, this trailing income tax liability, at ordinary income tax rates, can be quite significant for the seller.”

For a larger company, Duffy says they recommend considering an Employee Stock Ownership Plan (ESOP), as it can be very tax efficient, can occur over time, and has its own retirement plan protections and efficiencies. And, while it may be fairly complex and expensive to set up and maintain long-term, it can have some tremendous benefits and outcomes.

As far as some tax considerations companies need to keep in mind when structuring a succession deal, Duffy says it’s important to keep in mind that stock sales result in capital gains and favorable tax rates for the seller, however, they are not so good for the buyer.

“On the other hand, asset sales are more likely to generate ordinary income taxed at higher rates,” he said. “This leads to a better tax result for the buyer, but not as good a result for the seller.”

For gifts, Duffy says it’s important to remember that the tax basis passed to the recipient is the old historic tax basis from the donor. There is no adjustment in tax basis to align with the current value when gifted.

Duffy also stresses that working with a team that may include lawyers, CPAs and professionals with extensive experience in structuring transfers can be of great help to businesses. He also says bankers and investment advisors may not actively participate but should also be aware of plans as they are being developed.

“If it’s an outside sale, M&A advisors will help owners assess a potential sale early and establish a plan to favorably position the company and find appropriate buyers,” he said. “This is a very specialized consultant.”

He says internal transfers may also consider industry-based consultants who can assess the proper qualifications of the successors and assess important questions like: Do they have the skills, expertise, and knowledge to carry on the business? Do they need some management/executive training?

“There is no cookie cutter approach,” said Duffy about succession planning, who stresses it’s critical to avoid putting it off and that, as best practice, should be performed over 3-5 years with edits made to the plan as all options are considered. “Give yourself time to consider your unique options.”

Caurie Putnam is a Rochester-area freelance writer.