Strategies For Business Succession Planning: More Art Than Science

Once a business owner dies, becomes disabled or retires, one of three things can happen to the business: It can be sold, continued by a family member, or liquidated.

Unfortunately, liquidation is more often than not the unintended default plan. Recent reports have shown liquidated businesses lose 60% of their fair market value due to the forced sale of inventory and equipment, the difficulty of collecting accounts receivable, and the zero value placed on goodwill and other intangible asset values.

But this situation can be avoided through a properly designed business succession strategy. Some of the questions that need to be addressed are found in Figure 1.

Business owners should also be aware that financing the buyout through a loan might not be the most cost-effective strategy. Many states preclude a corporation from purchasing its own stock except out of surplus funds or from a stated amount of capital. Corporate creditors cannot be placed in jeopardy.

Even though an installment sale may still be an option for a given business owner, deferral of long-term capital gains taxation may be unavailable under applicable tax law. Also, a corporate redemption sinking fund can cause an unintended accumulated or retained earnings excise tax assessed at the highest marginal rate for individuals.

All these factors require that business owners proactively design a plan if they want to successfully meet their business continuation objectives. Nowhere is the adage truer that a failure to plan now is a plan to fail later.

The strategy that business owners select depends upon:

(1) The type of business entity involved.

(2) The number of owners, their age and ownership differences.

(3) Whether or not cost basis adjustments are desired.

(4) What effect the carry-over basis income tax regime imposed by 2001s Economic Growth and Tax Reform and Reconciliation Act for the year 2010 may have.

(5) Whether or not the application of IRC Section 318 family attribution may cause an adverse tax consequence.

Lets review strategies available to target those concerns that have a higher priority for all parties involved:

Stock Redemption or Entity Buyout. This strategy is desirable when one or more of the following issues must be addressed: there are more than two shareowners; the corporation is in a low marginal income tax bracket; cost basis issues are not relevant; significant age and ownership interests among the owners exist; neither corporate creditors or the potential for an alternative minimum tax consequence are a concern; and family attribution is not an obstacle.

Family attribution concerns are only applicable to IRC Section 302 stock redemption plans, which require the corporation to redeem all of the stock actually or constructively owned by the deceased owners estate. IRC Section 303 partial stock redemption plans are not affected by the attribution rules and permit a redemption of a sufficient amount of stock from the estate to pay death taxes, administration, and funeral expenses. Properly structured buyout plans are treated as a capital transaction, a payment in exchange for the stock.

Corporations can deduct the purchase price of their stock when it is either sold to or purchased by an employee stock option trust (ESOT).

S-corporation stock redemption plans present some unique opportunities. Generally, at the death of a shareowner, the surviving owner realizes a pro-rata step-up in cost basis based upon his or her ownership interest. A full step-up in cost basis for the surviving owner may be available if the timing of the close of the taxable year after the death of an owner, the execution of a buyout note, and the receipt of the life insurance death proceeds are in accordance with relative tax law.

Also, the AMT is not an issue for these entities. However, care must be taken when an S-corporation converts from a C-corporation. If corporate assets are sold within 10 years of the conversion a double tax may result. Gain recognized at the corporate level is taxed as well as any gain realized by the shareholder upon the liquidation or distribution of the sale proceeds.

Partnership and Limited Liability Company plans are referred to as entity buyouts.

Cross Purchase Buyout. Works best when two equal owners are close in age and each desires a cost basis increase at the death of the other. The cost basis issue may take on added importance especially after the repeal of the estate tax when the modified carry-over basis income-tax rules created by EGTRRA become effective in 2010.

Where life insurance is used to fund the buyout, the corporate pocketbook can be opened to pay the life insurance premiums on the policys owned by each shareowner on the other owners life. This can be accomplished through either a Section 162 bonus or a collateral assignment split dollar plan. It is even possible to create a tax-deductible corporate premium payment plan to fund a cross purchase. This can be accomplished with a properly designed profit sharing plan or a welfare benefit trust.

The Optional Buyout. This “wait-and-see” strategy provides added flexibility. This hybrid plan defers the choice of electing a stock redemption or a cross purchase solution to the death of the first owner. This added flexibility may better meet the future needs of all parties concerned since it can accommodate future tax law changes and other relevant family and business circumstances that may exist later.

Trusteed Buyout. Provides a solution to the multiplicity of policy issue that exists when cross purchase buy-outs are implemented for more than two shareowners. A properly designed irrevocable trust owns one policy on each shareowner as occurs in a corporate stock redemption plan. The owners, however, should be partners in a bona fide partnership to avoid the adverse tax consequences of a potential IRC Section 101(a)(2) transfer-for-value situation.

The Structured Buyout. A non-qualified deferred compensation plan may be combined with a buyout to discount the market valuation of the business and convert a portion of the purchase price into a tax-deductible expense. A buyer can expense the present value of a deferred compensation corporate obligation in one year. Courts have upheld valuation discounts for bona fide covenant-not-to-compete agreements, payable and deductible over a period of years.

Here is how a buyer of a $2 million business can deduct 39% of the purchase price and how the seller can minimize capital gains and spread out the ordinary income taxation on the balance over 10 years:

John Seller owns a business appraised at $2 million. The corporation structured a salary continuation plan for John a few years ago agreeing to pay him $100,000 a year for 10 years when he retires or sells the business. The present value of this corporate obligation as reflected on its balance sheet, using the applicable federal discount rate, is $772,173.49. The appraised fair market value of $2 million can now be discounted to $1,227,826.51. The balance is paid through a tax-deductible corporate obligation that pays John $100,000 for 10 years.

Shared Ownership or Private Split Dollar funded cross purchase buyouts. The following shortcomings can be corrected with a split ownership life insurance policy approach to a cross purchase agreement: (1) the inclusion of 100% of the business interest in the estate of the surviving owner can be avoided; (2) the inequitable premium payments required when one of the owners is much younger than the other can be minimized; and, (3) the lack of access of each insured to the policy cash values on his or her life can become a reality. Here is an example of how this works:

John and Mary each own 50% of Respectable Enterprises, Inc., which is valued at $6 million. Mary is only 30 years old while John is 50. John and Mary each create an irrevocable life insurance trust to insure the other owner. They can be the trustee of their respective trusts and name their family members as trust beneficiaries. Each trustee subsequently purchases a $3 million life insurance policy on the other owner and then enters into a shared ownership or private split dollar arrangement with the insured owners spouse.

Marys trust would purchase a policy on John and enter into a split ownership arrangement with Johns spouse, Helen. Mary would only gift the term premium cost of the pure insurance to the trust and thereby avoid any gift tax consequences or use of her lifetime exemption. Helen, who pays the balance of the insurance premium, now owns the cash value of the policy that insures her husband John. When John dies, the pure insurance is paid, income tax free, to the trust. Mary in her fiduciary capacity as trustee would then purchase Johns business interest from his estate under a buyout agreement. The cash value amount is payable, income tax free, to Helen.

The trust, not Mary, now owns 50% of the business. When Mary dies her estate would qualify for a 50% minority interest discount and the trust could distribute the remaining 50% to her designated family beneficiaries.

It is almost a foregone conclusion that parties to any type of buyout plan would want to use tax-free dollars at the precise moment they are needed (when a shareholder dies). Life insurance dollars are a perfect solution since it is not known when a buyout obligation will be triggered.

Life insurance can be programmed to track the future growth of the fair market value of a business. In addition, the purchase price of the business can often be contractually guaranteed for an annual deposit of less than 5%. It is recommended that the insurance be in-force before the clients attorney drafts the buyout agreement.

Drafting and designing an effective business continuation plan is an art and not a science due to all the factors that need to be considered. Tax laws will continue to change and that should be taken into consideration. The combination of flexible planning tools and life insurance products can help ensure your clients who own businesses are prepared for almost any eventuality, including death, disability, or retirement.

John S. Budihas, CLU, ChFC, CFP is a business, estate and trust planning consultant for Hartford Life in Sarasota, Fla. He can be reached via e-mail at john.budihas

@hartfordlife.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, June 24, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.