Business Succession: Transitioning to the next generation

Statistics demonstrate that family owned businesses are the lifeblood of Australia’s economy. For example:

In order to ensure the long-term ongoing success of family owned businesses, it is critical that the current generation can either sell their business, or effectively transition their business from the current generation to the next generation.

This article focuses on the legal issues to consider in transitioning a business from one generation to the next.

How is the Business Currently Structured?

The way that a family business can be transitioned, and what steps need to be taken, depend on the current legal ownership structure of the business. Business structures come in all shapes, sizes and levels of complexity. However, three of the most common family business structures that we see are:

The specific existing structure of a business will determine what legal mechanisms are available to the owners to transition the business to the next generation.

Where There’s a Will There’s a Way?

Where businesses (or shares owned in businesses) are held in personal names, one mechanism for transitioning the business is via the existing owners last will and testament (‘Will’). While it may seem relatively simple to transition a business in this manner (and generally, without any tax or duty consequences), there are a few significant downsides. Because ownership only passes on the death of the current owner, this means that:

Also, where a business or equity interests in a business are owned by discretionary family trusts, transitioning that equity via a Will is not possible.

Due to the comments set out above, it is usually either sub-optimal or not possible to transition equity in a business using a Will.

Tailored Transition Options

There are many other legal mechanisms to transition a family business, which generally cater for a more robust succession solution than relying on the Will of the existing owners. These mechanisms are set out in the table below.

Each of the options set out in the table above have different practical, legal and tax consequences.

Preserving Harmony

It is important to consider what legal mechanisms need to be put in place to ensure that the business will operate harmoniously going forward. The most appropriate option will depend on multiple factors, including:

It is important that the succession plan for the business, and the associated legal mechanisms which implement it, take into account the factors set out above. Failing to address the practical matters set out above will inevitably create risk that the succession process will not go according to plan.

Clearly Defined Interests vs Flexibility

Where existing business interests are owned via family discretionary trusts, it should be considered whether that structure is appropriate, post-transition. For instance:

Tax Consequences

Any proposed changes to the current structure must consider the tax or duty consequences of those changes. On one hand, making changes to the current structure could trigger adverse tax (e.g. capital gains tax) consequences and duty consequences. However, on the other hand, there may be rollovers, concessions (e.g. the small business CGT concessions) or exemptions available to shield against adverse tax consequences.

In some circumstances, no tax concessions or rollovers may be available, and making a change to the current structure could trigger a large tax bill. In those circumstances, consideration needs to be given to what other kinds of ‘legal mechanisms’ could be put in place to achieve a similar outcome, but that do not trigger unpalatable adverse tax or duty consequences. In the context of the control of a family discretionary trust, this could involve ‘hardcoding’ certain procedures into the trust deed regarding the transition of control.

Family Constitutions?

Finally, any family business (particularly one transitioning from one generation to another) should strongly consider putting in place a ‘Family Constitution’. A Family Constitution is set of rules developed collectively by a family group that defines and emphasises family values, decision making principles and how inter family conflicts should be resolved.

A Family Constitution is generally not a legally enforceable document (in contrast to trust deeds, co-ownership agreements and company constitutions). However, its strength lies from family groups addressing issues that are often placed in the ‘too hard basket’ and agreeing on a core set of family principles. As Ray Dalio (founder of the world’s biggest hedge fund) says:

“The most important thing for you to do is write down your principles to clarify them.”

This article in no way constitutes legal advice. It is general in nature and is the opinion of the author only. You should seek legal advice tailored to your individual circumstances before acting on anything related to this article.