“I gave everything I could to make my business a success. And ever since my kids joined me in the effort, I have felt a huge sense of satisfaction in building my dream with them by my side. Now, I want nothing more than to pass my business to my family, so they can continue to grow my legacy.”

This is the sentiment of many family business owners. Sounds easy, right?

But the odds do not favor intergenerational longevity.

According to the Small Business Administration:

• Only 30 percent of the country's 21 million family-owned small businesses make it to the second generation.
• A mere 15 percent make it to the third.

Transferring a business within a family raises a host of complex financial, estate, tax, and legal considerations—underscoring the importance of planning ahead. Developing a formal succession plan can help you address these issues up-front, so your family isn't left in a bind later.

Your plan can also help you address other critical succession factors, such as grooming your heirs to take over the business and dealing with family needs and concerns.

There are a variety of strategies that can be used to transfer your business to the next generation. Let's take a look at a few options:

Transfer through inheritance. The most obvious way to pass your business to your family is through your will. There are specific issues to consider, however:

Taxes: With an estate tax that can be as high as 45 percent, your heirs could be forced to sell the business to pay Uncle Sam. One way to avoid this is to buy a life insurance policy on yourself and name your children as beneficiaries. Upon your death, the policy's proceeds can be used to pay the tax bill.

Your spouse: You may also need to consider your spouse in this situation. If the business is your largest asset, and you give it away to your kids through an inheritance, there are no proceeds to leave behind to take care of him or her. And since your salary from the business cannot be paid after you die, your spouse could be left without an income.

Active and inactive business inheritors: Another issue arises if you leave your company to children who are both active and inactive in the management of the business. Friction can occur when the active and inactive members have different ideas as to what should be done:


• Active members may want to reinvest profits while inactive members may want profits to be distributed.
• Inactive members may want to sell their portion and walk away with cash.

This could cause a serious cash flow crunch if the business buys the shares back. Even worse, the inactive members could end up selling their equity to outsiders.

Things get even trickier if you are leaving your business to grandchildren. In this case, they'll get slapped with the generation-skipping transfer (GST) tax, which ensures that the government doesn't miss out on estate taxes when assets skip a generation. GST essentially applies an additional estate tax on top of the standard estate tax rate.

Sell upon death with a buy-sell agreement. If you want to maintain control of your business indefinitely, you can create a buy-sell agreement to trigger the sale of the business upon your death at prearranged terms and pricing.

• To ensure that your kids can afford the purchase, you can buy a life insurance policy on yourself and name your children as the beneficiaries.
• When you die, the business will be sold and the proceeds will be transferred to your estate as cash.
• This makes it easier to distribute your estate among your spouse and other beneficiaries, and no portion of the business will need to be sold to pay estate taxes.

Keep in mind that you are bound by the terms of the buy-sell agreement as soon as you sign the contract. This can limit your ability to sell or give away portions of the business, unless such provisions were made in the agreement.

Sell with a financing strategy. If you are financially reliant on your company, but you want to retire or pursue other interests, you may wish to sell the business to your children so you can use the proceeds to support your lifestyle and new endeavors.

There are two key challenges to this approach:

• Your kids will need to come up with enough money to fund the purchase.
• You'll be on the hook to pay capital gains taxes.

Fortunately, several financing strategies can minimize these burdens:

• Installment sales: The buyer makes fixed payments over a period of time based on a prenegotiated schedule. Your kids won't have to come up with the full purchase price up-front, and you won't have to report taxable gains until the year you receive payments. So, if you are in a high tax bracket when you sell the business, you can wait to start payments in later years when you expect to be in a lower tax bracket.
  
  
• Private annuities: The buyer makes ongoing payments for the rest of your life. These payments are based on the fair market value of your business over your expected lifespan, plus an additional IRS annuity factor. While you will receive an ongoing income, if you die before your expected lifespan, you will receive less than the business is worth. On the flipside, if you outlive your expected lifespan, your family will pay more than the business is worth.
  
  With private annuities, you can spread capital gains taxes over the course of the payments, as long as the transaction is unsecured. An unsecured transaction means you have no rights to the business or its assets if the buyer defaults on the payments—which can be a substantial risk. If this happens, your only option may be to take the buyer to court to recoup your loss. Alternatively, you can structure a secured transaction, but you are then required to pay all capital gains taxes when the business is sold.
  
  
• Self-canceling installment notes (SCINs): Similar to an installment sale, the buyer's payments and your taxable gains are spread out over a fixed period of time. The difference is that the payments are canceled upon your death. If you die before fair market value is paid, your children get a bargain price. The buyers, however, are required to pay a premium to compensate you for the risk of premature death. Otherwise, the exchange could be considered a gift and subject to gift taxes.

Transfer with gifting strategies. Any gifts that you give during your lifetime, including gifts of business equity, are subject to the IRS's gift tax. Fortunately, the IRS offers a $12,000 annual exclusion per recipient, which allows you to give away a portion of the business over a period of time without getting hit by the gift tax.

Family limited partnerships (FLPs) are commonly used to facilitate the gifting of a business. Here's how they work:

• An FLP is a limited liability entity in which both general partnership and limited partnership shares are created.
• You retain the general partnership shares so you can retain full control of the business.
• Over time, you give away limited partnership interests to your family, within the limits of the gift tax exclusion.

The benefit of the FLP is that limited partnership shares can typically be discounted—by as much as 35 percent—because they are noncontrolling interests.

Each of these strategies involves complicated financial, estate, tax, and legal considerations. That's why it's not a good idea to tackle succession alone. Establish a team of experienced professionals—an accountant, an attorney, and a financial advisor—to help you develop your succession plan. Your team can help you weigh the pros and cons of each transfer strategy and determine which one is best for you and your family.