Running a small business is a journey that is not for the faint-hearted. It involves daily obstacles, long-term strategic planning, and sometimes the pressure of meeting stakeholder demands. Small business owners often find their name on the door, along with the weighty responsibility it carries. Not surprisingly, after devoting a substantial portion of their lives to building something of value, few—if any—business owners would be satisfied to close their businesses upon retirement and walk away empty-handed. Yet, the prospect of succession planning is often met with great reluctance. 

After investing years, even decades, in building equity and nurturing their enterprise, small business owners must confront the inevitable need to plan for the future. Whether this future may see the next generation taking the reins or transferring the business to a third party, a good advisor can help business owners navigate their options, simplify the process, and implement a strategy that best meets the owners’ goals and objectives.

Small Business Facts and Figures

Small businesses are undeniably the backbone of our economy, and the data[2] underscores the urgency of addressing their future:

• A staggering 99% of businesses in the United States fall under the category of small businesses.
• These roughly 32 million small businesses collectively contribute 44% to the nation's GDP.
• A significant 35% of these enterprises are owned by individuals age 50-59, with an additional 18% being in the hands of those age 60-69.
• It's estimated that over 40% of closely held business owners anticipate exiting their business within the next five years.

An “external succession,” by contrast, is a plan to sell the company or its assets to a third party. But it may also take other forms, such as a merger with a transition period that allows the retiring owner to work for the acquiring company for a period of time. In the case of a business with multiple owners, the approval of such a plan must comply with the company’s governing documents, including its certificate of incorporation/articles of organization, its by-laws, and any shareholder or operating agreements. External succession planning introduces new participants and motivations into the mix. Advisors in this scenario must leverage networks and market opportunities and maintain strict confidentiality around the owner and the company. On that note, a business owner who wishes to explore sale or merger opportunities should have a strong non-disclosure agreement before exchanging sensitive or proprietary information.

A succession plan may incorporate the elements of both an internal and external strategy. To illustrate, a sole business owner may decide to transfer the business to a non-owner family member, key employee, or to a third party they will groom to take over the company. In that instance, the business owner may seek to agree with their would-be successor to transfer small equity interests in the business over a period of time that is consistent with the business owner’s retirement objectives. In essence, the owner is taking a party who is a non-owner (i.e., external), making them a co-owner, and then following an internal plan.

As may be evident, there are as many different succession plans as the mind can conceive. However, each of them presents unique challenges and considerations.

Stock Sale vs. Asset Sale

Stock sale plans. Stock sale plans involve transferring ownership of the existing entity. This approach usually offers a smoother transaction process that takes advantage of the fact that the company is a legal entity separate and distinct from its owners. When the stock in a corporation is transferred, or the membership units in a limited liability company are transferred, ownership has changed, but the company continues its existence. Because of this, in most cases, the contractual relationships with employees, customers, suppliers, and lenders do not need to be assigned or transferred.

However, purchasers and sellers must still be wary of “change in control” clauses that may appear in specific contracts, particularly loan documents and guarantees. These clauses may require a lender’s consent or constitute an event of default if more than a certain percentage of the company’s ownership interest changes hands.

Stock sales are often preferable when the company has a permit or license required for conducting its business, because there is no need to delay the sale or make it contingent upon the purchaser qualifying for a new permit or license.

Purchasers, on the other hand, may be averse to a stock sale since they will necessarily be inheriting the company’s liabilities in addition to its assets. These liabilities could include any unasserted claims against the company, whether known or unknown. Although this risk may be minimized by insurance and having the seller agree to indemnify and hold the purchaser harmless, sometimes the risk outweighs the benefits, and the purchaser will have a distinct preference to start with a clean slate.

Not surprisingly, most internal succession plans involve the transfer of stock or membership units.

Asset sale plans. In contrast, an asset sale does not involve the transfer of stock or membership units but, as its name implies, the assets. The purchaser may be more selective about which liabilities, if any, it is willing to assume. Asset sale plans typically will involve the assignment of individual contracts, making them more time consuming and potentially tricky; for example, leases often contain clauses requiring the landlord’s consent to be assigned.

If the business has individual contracts with customers, there is the risk that some customers will not agree to conduct business with the purchaser, who might be a stranger.

Transitioning key employees may present the most significant challenge. In most instances, it will be necessary for the seller to provide a termination notice to at-will employees; at the same time, the purchaser must negotiate salary and terms with the individuals it wishes to keep. In other instances, executives with employment contracts may have clauses that permit the seller to assign them to any successors.

Asset sales also present critical legal considerations. As noted above, the selling entity may still be responsible for paying its liabilities. The seller could also be subject to unknown claims, which may not be asserted until after the sale has been consummated. Sellers, therefore, are often advised to purchase tail insurance. In addition, there may also be important local requirements. For example, in New York State, the seller—unless exempt—must file a bulk sales tax return that may require them to collect and pay sales tax.

Other Considerations

The choice between these succession types depends on multiple considerations, including the motivations of all stakeholders, the preferred buyout methods, the need to safeguard customers and business continuity, and the dynamics of family involvement in the business.

Even if a business continues to operate with one owner, advisors should ask tough questions about the business's fate in the event of the owner's death or incapacitation, the grooming of possible successors, and the complexities of any family relationships that could be impacted if the owner dies or is unable to manage the business.

Estate planning, including estate tax consideration, can play a significant role in succession planning for the retiring owner selling a business. For example, in 2023, New York State has an estate tax cliff that will be triggered when the value of an estate exceeds 105% of the $6.58 million threshold ($6.909 million). Unlike the federal rule, the tax rates apply to the entire value of the estate, not just the amount that exceeds the estate tax threshold. Meanwhile, the federal exemption is $12.93 million, with an anticipated reduction to $7 million (adjusted for inflation) in 2026.

If payments occur over time, there is a risk that a business owner’s estate will lack the liquidity to meet its tax obligation. To avoid this, an advisor may recommend relief under Internal Revenue Code Section 6166. This provision allows estates to defer payment of taxes if certain conditions are met. Those conditions include if the interest qualifies as a closely held business and exceeds 35% of the decedent’s adjusted gross estate.

To be eligible for IRC Section 6166, businesses must be structured:

• As a sole proprietorship; or

• As a partnership, including certain limited liability companies taxed as partnerships, provided either:

• 20% or more of the entity’s total capital interest is included in the deceased’s estate, or

• the entity has a maximum of 45 partners; or

• As a corporation, provided either:

• 20% or more of the corporation’s voting stock is included in the deceased’s estate, or

• the corporation has a maximum of 45 shareholders.

If the above requirements are met, an estate may elect to pay only the interest on the tax due for the first five years and make the remaining payments in equal installments over a ten-year period.

To maximize estate tax savings, advisors can leverage strategies like the Grantor Retained Annuity Trust (GRAT) to shift wealth to family members while minimizing their gift and estate tax exclusion.

Closing Thoughts

A successful advisor must be cognizant of all the competing considerations the small business owner should be taking into account when helping to establish a succession plan:

• How long does the owner wish to work?

• Does the owner seek to maximize the value they receive from the business, or is the owner primarily concerned about transferring control to a family member?

• Does the owner already have an estate plan, and how will the transaction affect that plan?

• Which family dynamics are at play, and will a business transfer to one family member upset those dynamics?

• Which company agreements exist and address the topic? Does the nature of the business and the transaction lend itself better to a stock or asset sale?

• Which experts should be incorporated as part of the planning team?

Succession planning can be highly complex. It is not just a financial endeavor; it’s a multifaceted process that requires careful consideration and expert guidance. Throughout the process, pitfalls await the unprepared and inexperienced. Therefore, advisors should endeavor to engage clients in succession planning discussions as early as possible to prevent complications.

Moira Laidlaw is a senior partner at Hollis Laidlaw & Simon P.C. Her practice encompasses a broad range of trust and estate planning services, including wills, trusts, guardianship, probate, and estate administration. Her depth of experience also includes elder law, special needs planning, Medicaid and long-term care asset protection. As an executive committee member of the New York State Bar Association’s Elder Law and Special Needs Section, Ms. Laidlaw helps advocate and set policy on matters that impact the elderly and special needs community. Moira is a Certified Elder Law Attorney (CELA), one of approximately 400 attorneys in the U.S. who hold this designation, as accredited by the National Elder Law Foundation and the American Bar Association. She has also been recognized as a SuperLawyer. Moira is admitted to practice in New York, Connecticut and New Jersey. Her firm has offices in Westchester, Manhattan, Long Island, Rockland and Stamford.

David Simon is a co-managing partner at Hollis Laidlaw & Simon P.C., who is primarily focused on commercial civil litigation, but his clients rely on his ability to find practical, cost-effective solutions in a wide range of matters. He represents a variety of businesses and individuals in matters related to contract disputes, employment issues, corporate governance and succession planning.  In the employment arena, Mr. Simon represents individuals and businesses with all aspects of the employer-employee relationship, and beyond. He negotiates and drafts employment agreements and severance/separation agreements. He represents clients in cases of workplace discrimination including sexual harassment, wrongful termination, retaliation, claims under the Americans with Disabilities Act, and wage and hour claims. Mr. Simon routinely litigates cases involving post-employment restrictions including covenants not-to-compete, confidentiality, and non-solicitation agreements. His clients include emerging technology companies, not-for-profit corporations, insurance agencies, and a wide range of small businesses. Collaborating with the firm’s trusts and estates attorneys, Mr. Simon draws on his commercial litigation and transactional experience to devise and implement succession plan strategies. He also handles estate administration proceedings as well as contested guardianship matters.

[1] The authors would like thank Ronald Pence for his invaluable assistance with this article.

[2] “Small Business Statistics of 2023,” Kelly Main, Forbes Advisor https://www.forbes.com/advisor/business/small-business-statistics/#small_business_ownership_statistics_section. December 7, 2022.