A family-owned business is one of the most common types that exist today, and is the backbone of American enterprise. The contemporary family business owner, however, faces various challenges. One notable challenge is how to keep the business in the family, which leads to many significant questions. If the business is to be kept in the family after the death of the founder, which family members should succeed in ownership? Which members should continue to run the business?
In addition to these considerations, a family business owner must examine whether the business is capable of providing enough income to support the founder and his spouse during retirement. Transitioning a family-owned business from the founding generation to successive generations can be a difficult task, both financially and emotionally.
The issues that affect family-owned businesses often give rise to a conflict between business prosperity and family unity. In many cases, the founder of the business dies before any business succession planning has been done. As a result, the business is passed on to a surviving spouse and/or children who did not gain any experience running the business while the founder was alive, and who have no interest in running the business after her death. Further complicating the situation is the fact that the estate cannot liquidate its interest in the business. Surviving family members must dig into their own pockets to cover estate taxes and other settlement costs. Most important, the surviving spouse and/or children are left with a business to manage, taxes to pay, and an uncertain financial future.
A business succession plan can effectively address these issues by outlining and implementing the objectives of the business owner; creating a vehicle that provides income to a surviving spouse; and effectively transferring ownership to those family members with the experience and desire to continue running the business. This simple tool will meet the goals of the business founder while also resolving some of the issues inherent in the succession of a family business.
A Cross-Purchase, Buy/Sell
Typically, a business succession plan is designed as a cross-purchase buy/sell agreement between the active family members and the business owner. As part of the cross-purchase arrangement, individual owners enter into an agreement for the purchase and sale of their respective interests. Normally, this agreement is binding and obligates all parties to either buy or sell their ownership interest in the event of the death of a named party. Rather than trying to accumulate or borrow funds to purchase the deceased’s interest, a life insurance policy, or policies, is purchased on the life of the business founder, naming the succeeding family members as both owners and beneficiaries on each respective policy.
Since the parties involved in the buy/sell agreement are active in the business either as employees or shareholders, the company may assist in the purchase of the life insurance policy. This is typically effected through the use of bonus payments made by the company to the owners. Further-more, assuming these bonus payments are considered “reasonable allowances” for salaries or other services rendered, the company may deduct these payments as a business expense.
At the time of the business owner’s death, the stock in the business becomes part of the estate. If the surviving spouse is the beneficiary of the estate as named in a will or trust, the unlimited marital deduction allows the stock to pass to the surviving spouse free of estate taxes. The spouse then sells the decedent’s stock to the active family members under the terms of the family buy/sell agreement. In turn, the active family members use the life insurance proceeds, which they would generally receive free of income tax, to purchase the stock.
Once the stock is sold, the surviving spouse is provided with cash that she may invest to provide income for the remainder of her lifetime. The sale of a family-owned business interest through the use of a buy/sell agreement creates financial security for the surviving spouse while allowing him or her to avoid current income or estate taxation. In addition, any trepidation on the part of the surviving spouse concerning the continuation of the business is addressed and dealt with under the buy/sell agreement.
Making Sure the IRS