HomeBlogHow the Next Generation Can Ensure a Smooth Leadership Transition

How the Next Generation Can Ensure a Smooth Leadership Transition

Succession planning is an essential part of a business’s lifespan – one that’s often overlooked. A study by the Family Business Institute found that only around 30% of family businesses survive to the second generation, and even less make it to the third (12%) and fourth (3%). This is often due to lack of planning and a breakdown in communication.

As a future successor waiting for your chance to lead, it’s essential to get involved in succession planning early, review the plan often and work with a trusted advisor.

We explore how future successors can mitigate any issues and ensure a smooth business transition.

Embracing the change – How world events affected succession planning

Succession planning has always been a dynamic process but is too often treated as anything but. It’s common for business owners to either put off creating a plan or neglect that plan by conducting few or no reviews.

The recent pandemic and economic turbulence have forced many entrepreneurs to embrace flexibility in their plans, understanding the need to change their strategies based on world events. A key takeaway here is the importance of regular succession plan reviews, allowing companies to adapt to changing economics and an evolving workforce.

As a future successor, this also means getting involved early in the planning and leadership structure. While traditional succession planning places all the power on the older generation and current owners, recent events have encouraged a more modern, multi-generational approach. As part of the younger generation, this means taking on leadership roles early in the company and being included in the succession planning process. This way, a company is better able to adapt when needed.

Getting involved early

Succession is a highly sensitive topic for many family businesses, and can often be an emotional, arduous process.

Succession planning is crucial in businesses for many reasons:

  1. Continuity – a proper succession plan ensures that important aspects of the business (e.g., company vision, long-term goals, key relationships, etc.) are preserved and carried forward to the next generation.
  2. Smooth Transition – A well-executed plan minimizes disruptions and uncertainties that can arise during leadership changes, ensuring that the business continues to operate efficiently.
  3. Preserving wealth – the value of the business can erode during a chaotic transition. Effective planning helps protect and preserve the family’s financial assets.
  4. Talent Development: Succession planning encourages the development of capable successors from within the family. It provides an opportunity for younger family members to gain experience, skills, and knowledge needed to lead.
  5. Retaining Key Employees: A thoughtfully designed succession plan can help retain key non-family employees. When these employees see a clear path for advancement and stability, they are more likely to stay committed to the business.
  6. Conflict Prevention: Family dynamics can lead to conflicts if the succession process is not well-defined. A structured succession plan can help mitigate potential conflicts by setting clear expectations and criteria for leadership transitions.
  7. Maintaining Stakeholder Confidence: Suppliers, customers, investors, and other stakeholders often have relationships with the current leadership. An organized succession plan helps maintain their confidence in the business’s future, preventing uncertainties that could affect these relationships.
  8. Adapting to Change: The business environment is constantly evolving. A proper succession plan involves evaluating the skills and qualities needed for future leaders to navigate changing market conditions, technological advancements, and industry trends.
  9. Estate Planning and Tax Efficiency: Succession planning can integrate estate planning strategies to minimize tax implications and ensure a smooth transfer of ownership, reducing the financial burden on the family.
  10. Business Growth: A clear succession plan instills confidence in potential investors and lenders, making it easier for the business to access capital for expansion and growth.

Tax considerations

Many business owners often don’t spend enough time examining their succession plan until they are ready to pass over the family business. However, it is important for business owners to start thinking about succession planning early to really understand some of the implications of passing on their business, particularly from a tax perspective. After all, you’ve spent years growing your business into your own success story, shouldn’t you spend the necessary time to ensure you are passing it on to the next generation in the most tax-efficient manner?

Estate Freeze

A common way to get the next generation involved is through what is known as an estate freeze. An estate freeze is called that because it essentially “freezes” the value of your estate at  a particular point in time, thereby allowing you to estimate, and plan for, your tax liability at death. This also allows you to pass on future growth to others, including family members, who may eventually take over your business,

For example, you started your business 20 years ago and, since then, it has grown significantly and is currently valued at $10 million. You estimate that you will work for another 10 years, at which point you hope to retire and leave your business to your two children, who both currently work in the business, although do not currently have any ownership interest. You also estimate that in those 10 years, your business will grow in value to approximately $18 million, although there is no certainty around this value.

Undergoing an estate freeze allows you to freeze the value of the shares you currently own in your company at their current value of $10 million. Your children can then subscribe for growth shares in your company at a nominal value, which allows them to participate in the future growth of the company. So the additional estimated $8 million in future growth would belong to your children.

If you are not ready to pass on direct ownership to your children, a family trust can instead be set up to subscribe for the growth shares. This can allow you to retain a level of control over the growth shares, while still allowing for your children to benefit from your company’s future growth. In this case, you will need to be more mindful of certain tax anti-avoidance rules, in particular, the tax on split income rules, which may apply on any distributions made from the trust that come from the company.

Intergenerational Business Transfer

If you are further down the road and are ready to completely transfer ownership of your business to the next generation, new tax rules may make it easier for you to accomplish the transfer of ownership to your children. Furthermore, these new rules also allow you to monetize the value of your company in a more tax-efficient manner than was previously possible.

Under old rules, if an individual wanted to pass on their business to their child or another related party, if the transfer was structured as a sale of the owner’s shares to their successor child’s corporation, for example, the individual would not get capital gains treatment on the sale and would not be able to use the lifetime capital gain exemption on the sale (which allows for almost $1 million of the capital gain to be realized tax-free in 2023) if the shares were considered qualified small business corporation (“QSBC”) shares. Instead, the gain would be taxed as a dividend, resulting in significantly more tax to the business owner. This made it more attractive, from a tax perspective, for the individual to sell their business to a third party.

However, new rules were introduced in 2021 that now allow for certain shares, namely QSBC shares and shares of a qualifying farm or fishing corporation, to be sold to a related party and for capital gains treatment to apply. These changes now allow for business owners to transfer their business to the next generation and benefit from capital gains treatment and the lifetime capital gains exemption, if applicable.

It should be noted that the federal government recently introduced proposals to update these rules. These proposals would require the original owner(s) and next generation owner(s) to meet certain criteria around the transfer of both voting control and economic interests to the next generation. Although these proposals would limit the use of these rules somewhat, they do provide greater certainty around these rules, allowing business owners and their advisors to better structure any potential sale of the business. Overall, the introduction of these intergenerational business transfer rules provides business owners with a better alternative for succession planning, from a tax perspective, than was previously available.

Communicate effectively for a seamless transition

Most failed transitions have one thing in common: a lack of open, honest communication. While succession can be a difficult topic to discuss, it’s also a crucial one. To ensure an easier transition, keep the following in mind:

  • Ask questions and don’t shy away from honest conversations. As a future successor, it’s important to fully understand how the transition will take place, along with why the older generation chose their strategy. Frequent, open dialogue will lead to less surprises and tension in the family.
  • Don’t shy away from voicing concerns. As you prepare to take over the family business, it’s essential to speak openly about decisions you don’t fully support or understand. This allows for the opportunity to compromise on key resolutions.
  • Respect the older generation’s perspective. Succession isn’t just a business decision, it’s a personal one. Many entrepreneurs struggle to give up power and control in a company they built from nothing. It’s important to understand the current leader’s perspective and work collaboratively.

Keeping it in the family

When preparing to take over a family business, it’s essential to understand and participate in the succession planning process. Succession planning is a crucial part of the transition process. A solid, dynamic strategy will ensure a seamless transition between generations. As a family business ourselves, Zeifmans understands the emotional and professional difficulties that often accompany this process. Our team has guided a wide variety of companies through this stage, ensuring each company is set up for long-term success. Chat with our advisors to learn more.

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