When is the Right Time for Succession?
Trying to determine the right time for change is one of the most challenging aspects of Succession Planning. How can we be sure all parties are ready for the next chapter in their lives?
The current owners may feel the next generation do not yet have the skills and knowledge to take over ownership of the business. The future owners may be concerned they have not acquired the information and knowledge necessary to take on the financial and legal responsibilities that come with business ownership.
To determine an appropriate timetable for handover we must firstly recognise there are 3 separate and distinct transitions to be considered. These are:
1. Management Transition
2. Business Transition
3. Property Transition
Generally, this is the order in which the changeover to the next generation takes place. Taking on a senior management role precedes the significant step to business ownership. Any transfer of property can be left until all stakeholders are comfortable with how things are progressing.
Creating a structured environment in which all of the elements of transition can occur is critical to a successful outcome.
There are some important questions to be answered:
– How do we transfer operational, management and business ownership knowledge to the next generation?
– How and when do we assess if the next generation are ready for the changes?
– Are the next generation comfortable with what they are taking on?
Creating a Checkpoint Date
At this time, all parties would determine whether to proceed with the finalisation of the Management transition and commence the Business Restructure (effectively an “in or out” decision regarding future intentions). This decision should require unanimous approval. Some of the following alternative courses of action could then be undertaken:
1. Proceed with the Management Transition
2. Determine a date for the Business Restructure
3. Determine a methodology and timeframe for the property transition
4. Defer the restructure date to a later time
5. Allow the next generation to take up a role in management but not ownership
6. Appoint a farm manager under a collaborative farming agreement
7. Consider preparing the business for a future sale
The period from the beginning until the Checkpoint Date varies according to the circumstances. For instance, have the future owners already been working on the farm for some time or are they new to the role?
If there is more than one sibling involved in the business, the time prior to the Checkpoint can be used to determine if they can work in partnership.
Utilising the period of time up until the checkpoint date is a crucial part of the exercise. A learning environment has to be established for all parties.
Creating a learning environment
To provide the basis for a knowledge transfer from the current to the future owners, consideration may be given to the establishment of a Board of Management and the documenting of policies and procedures.
The Board of Management allows all parties to have a constructive involvement in the business. Family Board Meetings should be held regularly and be properly structured with minutes, agenda’s and action points.
Documenting Policies and Procedures avoids a lot of conflict and frustration. Policies are the rules to be applied and procedures are what must be carried out.
It is common practice for many farmers to keep information and knowledge in their heads. We must create the means by which this can be extracted and imparted to the next generation.
Open communication within a predetermined set of guidelines creates both a healthy business and a healthy family life. It also promotes family unity and goes a long way in preventing future conflict.
Making the Checkpoint Date Decision
Prior to the Checkpoint Date, the family should undertake the analysis necessary to determine the suitability of the next generation to take up management and/or business ownership roles. This process should include:
a) Establishment of an organisational chart that outlines the internal structure of the business including roles, responsibilities and relationships between individuals within the business. It is important the organisational chart provides an accurate representation of the managerial hierarchy and the manner in which different job titles relate to each other. The suitability of individuals should then be mapped against the requirements of the business that have been identified in the organizational chart.
b) Conduct a leadership assessment to determine the following:
I. Does the individual concerned reflect the inherent business and family values and can they impart them to others?
II. Are they able to inspire, motivate, energise and encourage those around them? Do they know how to go about the process of decision making? Do they have good judgment skills but are also flexible enough to change their mind when new information becomes available?
III. Do they have the ability to communicate in a clear but fair manner? People admire leaders who show them respect and understanding. They do not aspire to those who bully them or use their position of power for negative purposes.
IV. Do they have the strength, perseverance and ability to keep going even in the face of adversity?
V. Do they have the lateral thinking and imagination to help the business to navigate through difficult times and also maximise the opportunities when times are good?
c) Determine whether any intended partners can work together as management and/or as business owners. If a sound partnership agreement was in place to provide a set of governing rules, would this alleviate any friction between them? Would a partnership improve the financial and emotional wellbeing of family members or perhaps have negative outcomes? If the decision is to not proceed with the partnership, predetermined alternative pathways should have been considered.
As in all aspects of succession planning, a structured approach gives the best opportunity for success and provides clarity for all involved.
Deciding on an Operating Entity
In too many cases the operating entity of a farming business is treated as a “set and forget”. It may have served its purpose for the last 20 years or longer and everyone has got used to the status quo. This approach can have serious detrimental effects. Many aspects of the business may have changed and the external environment, from a legal and tax perspective, will certainly have altered over time.
If you ask your accountant “what is the right operating entity for my business?”, they may well focus on the tax implications in determining the right structure. If you ask your solicitor, they are more likely to be concerned about protection against unforeseen liabilities. If you ask your business partners or family, they may want it to be simple and inexpensive. All may be right from their own particular perspective.
The following is a brief overview of a few of the advantages and disadvantages of some common structures.
Sole Trading and Partnerships
These are extremely common and are simple structures that are inexpensive to maintain. They serve many farming families well.
One of the important advantages of a partnership is the ability to utilise losses. If a taxable loss is incurred by a partnership, then that loss can be distributed to the partners who can then utilise their share of the loss to offset against other income received that year. This can be important if a partner is earning income in a personal capacity outside of the farm.
They do however, have a number of important limitations.
• They do not protect personal assets and landholdings
from business risks. Farming is a risky commercial business. If the partnership assets and insurance cover are insufficient to cover a claim against the business (or a claim is not successful), each partners’ personal assets, e.g. houses, landholdings etc., can be liable to satisfy these claims.
• With partnerships, each partner is seen to personally own a fractional interest in the partnership and, as such, their share of their assets can become embroiled in their personal dispute. This can be exceptionally disturbing to the other members of the partnership. Further to this, all partners are jointly and severally liable to the activities and actions of the other partners in the partnership.
• They are not conducive to future succession needs and other changes. Although there are a number of restructuring concessions available, in general, when people exit partnerships, by death or retirement, or enter partnerships by the addition of new partners, the old partnership dissolves and a new partnership is created. This event can create both income tax and stamp duty liabilities.
• With a fixed structure like a partnership, there is little opportunity for each partner to share the income and capital of the business with their spouse, children or other entities e.g. companies, etc. As a result, partnerships are very inflexible when it comes to the management of income tax.
Family Discretionary Trusts
Another common vehicle used as the operating entity on a farm is a Family Discretionary Trust. In a trust structure the assets of the family are held by the trustee on behalf of the trust beneficiaries. The trustee is responsible for the day to day activities of the trust. Again, the trustee does this on behalf of the trust beneficiaries.
By using a Company to act as trustee for both trading and landholding trusts, the beneficiaries can protect personal assets from business risks. The beneficiaries are protected if the deed is correctly worded as they usually have no value in their potential interest in the trust. The trustee can be personally liable for the debts of the business but is usually indemnified out of trust assets to the extent they are available.
If the trustee is a company, a Discretionary Trust offers greater protection against business risks. Potential beneficiaries are not entitled to any assets or income of the trust estate until the trustee exercises their discretion. This provides considerable flexibility in relation to trust income and asset protection.
Discretionary trusts are also useful vehicles for succession purposes. They allow for a gradual change in ownership without relinquishing total control. For instance, Mum and Dad can hand over the trustee powers to their children and still remain as the trust’s appointors. The appointor has the power to dismiss and appoint the trustee. At a later time, they can resign their positions.
This methodology can be useful in the event of a marriage break down. By spreading the control of assets there is less likelihood that the trust assets will be included in a marriage settlement.
One of the matters that needs to be taken into account is the potential for the governing deed to come into conflict with the rules and procedures that individuals wish to apply to the business. The trustee is the operator of the business and is answerable first and foremost to the terms and conditions of the Trust Deed.
It is important that any directions do not fetter the powers of the trustee. A solution is the establishment of a ‘Business Management Agreement’ to give the trustee a set of guidelines and a framework to work within. For example, the agreement could contain a decision-making policy that determines how decisions are made (e.g. what decisions by majority, unanimous etc.) it should not, however, dictate to the trustees what those decisions must be.
Partnership of Trusts
One of the conditions of obtaining vital Small Business CGT Concessions is the $6 million net asset value test. The test applies to the relevant taxpayer. If the net value of the business exceeds $6 million, a company or trust structure will not be eligible for the concessions on an asset sale.
The same result does not apply to a partnership of Discretionary Trusts where you have a partner with a less than 40% interest. In this case, the relevant taxpayer is each partner. This means where the partner has a less than 40% interest, you only take into account the value of the partner’s share in the business. If for example, you had four equal partners of the business (25% each) and they did not own any other assets required to be taken into account, the net value of the business could be up to $24 million and still be under the maximum net asset value test.
Companies are useful structures if you wish to cap your tax rate at 27.5%.
• They can’t use FMDs
• They are ineligible for primary production averaging
• They cannot obtain the general 50% CGT concession
• There are tax issues on eventual wind up
This article is simply a brief overview of operating structures and there are advantages and disadvantages with each. Your professional advisor is best equipped to guide you through the maze. Keep in mind, however, that business structures do not manage farms, people do. The structure should suit the needs, aspirations and goals of the stakeholders and not be driven from only one perspective.
Dissolving a partnership or not? (or do all good things have to come to an end!)
A business transition to the next generation will often place two or more siblings in partnership. At this time, we often hear a desire from the participants to allocate land ownership, other assets and debt and split the business into separate enterprises.
Of course, it’s harder to break a bunch of twigs than each individual stick and farming businesses are no different. Apart, they are often weaker, together, they are more resilient. This advantage may not simply be due to the size of an operation. It may also be because of different agricultural business lines creating better cash flow and more stability.
A good example that comes to mind is an enterprise that combines a Seed Cleaning business with a farming operation. One area provides a good asset backing for a healthy balance sheet and the other, good cash flow to improve the profit/loss. The same can be said where there is a mixture of cropping and grazing. In many cases each partner has a particular interest in one part of the business and takes this with them upon separation.
Often, the desire to separate the business is an emotional reaction due to a lack of certainty, control and clarity about the future. It can be caused by problems in decision-making, roles and responsibilities or simply personality clashes.
The solution is to workshop an all-encompassing partnership agreement to address operational, management and equity issues. By establishing a clear set of guidelines and rules, future conflict can be avoided, disputes become less personal and solutions more pragmatic. This gives the partnership every chance of success.
If, however, continuing a partnership is not an option, careful consideration needs to be given to how the dissolution is dealt with to ensure the parting of ways is done with minimal conflict and anguish.
The first step is to examine any existing partnership agreements and the extent that they deal with the termination of the partnership or the exiting of the partner. Of course, the dissolution of the partnership will still be subject to the legislation governing the State in which the partnership is formed. If there is no partnership agreement, or the contract is silent on the matter of termination, the governing law of the State or Territory will apply.
To dissolve a partnership, the partner wishing to leave must usually give written notice to all the other partners making known their intention. If the partner does not specify a date, the time of dissolution is the date on which the partner communicates the notice.
Allocating debts can be a difficult exercise. Even if an equitable arrangement can be agreed upon, you will still need to speak to your Bank to understand their perspective. Partnership Law generally makes each partner jointly liable for all business debts incurred while they were a partner of the business. You should also consider consulting your accountant to ensure you have no outstanding tax liabilities. Any employees of the partnership must receive all their entitlements and superannuation contributions.
Several questions will need to be resolved:
• How will plant and equipment, livestock and produce be dealt with?
• What will be the tax consequences of transferring assets to a new business?
• How will this be best achieved?
In some cases, the partners may decide to maintain the original business purely to hold the existing assets and then transition them over time. For instance, buying new equipment through their new businesses and forming a collaborative farming agreement over the use of the existing equipment held by the original partnership.
When a partnership is dissolved, each of the original partners have the same rights and obligations. They remain responsible for the obligations of the original partnership and remain entitled to share in any surplus assets.
Utilising the services of an independent professional to mediate a satisfactory outcome and structure a sound transition plan can alleviate a lot of stress and potential conflict.
If the business is to be separated, it will be worthwhile to take the opportunity to consider what will be the most suitable structure for any new business moving forward.
Some of the factors to take into consideration in making the decision on the right business structure will include:
• The need for asset protection (particularly of farming land held in personal names)
• The introduction of other family members into the business at a future time
• Future succession needs for the family
• Tax concessions available
• Flexibility for future expansion, succession, tax minimisation
For instance, an important benefit of creating a new Farm Business Trust could be the separation of ownership between the farming land and the trading entity. In many cases, the farming properties and the business are both in the individual’s names. This affords no protection against liabilities which could emerge from the business and trading activities. By creating a Farm Business Trust with a Corporate Trustee as the operating entity, a separation of legal structures would occur, protecting vital land assets from business risks.
There are other issues to be considered and you should seek the advice of your accountant and solicitor. The future business structure should also be part of the overall transition plan.
Generally, our advice would be to do everything possible to keep a unified business. Most importantly, this involves the formalising of the business arrangements. By going down this path, even if you ultimately do decide to break up the partnership, you will know that you gave the existing arrangement every chance of success.