Tampa, Fla.

How should business owners value their companies when planning for succession? Which form of ownership transfer will yield the fastest payback for sellers? What role can life insurance play when a key employee is buying the business?

These questions, among others, were discussed during two educational sessions of the Society of Financial Service Professionals annual Financial Service Forum, held here last month. The back-to-back presentations collectively covered a range of succession planning and estate planning issues. Financial advisors, the speakers said, should treat the two areas of planning as part of a package when working with business owner clients.

“The two areas are related,” said Lyne Stebbins, vice president of advance planning & professional services at Guardian Life Insurance Company of America, New York. “Succession planning and estate planning go hand-in-hand.”

John Brown, president of the Business Enterprise Institute, Golden, Colo., identified several steps in the “exit planning” process: setting objectives; determining a value or sale price for the business; and preserving, protecting and promoting value (using, for example, non-qualified deferred compensation plans to retain key employees being groomed for succession). Additional steps include converting business value to cash or selling the business for a promissory note, contingency planning, and wealth preservation (or estate) planning.

Though seemingly straightforward, the process can be an emotional one for clients, the speakers noted, with many business owners reluctant to think about leaving the business and making hard choices about succession.

One solution, according to Stebbins, is for the advisor to help business owners think about exit planning in terms of the daily business decisions with which theyre familiar and comfortable.

How the company is valued will hinge on who the business owner has flagged as a successor, Brown said. If the business is to go to an “outsider” or third party, then the owner will want to sell the ownership interest for cash at the highest (or fair market) value. If the successor is an “insider,” such as a key employee or family member, then the owners should aim for less than fair market value, assuming the transaction is not an all-cash deal (a common scenario with key employees, who typically dont have the funds for a buyout).

Why? In a word, tax avoidance. When the owner sells the business, taxes are paid twice: first by the buyer, and secondly by the seller. The lower the value of the business, the less the buyer pays in tax for the acquisitionand the less the owner pays in capital gains tax. Lower taxes, in turn, mean the seller can build up a retirement nest egg more quickly, in part funded by discretionary cash flow from the business.

“Cash flow will determine how quickly the owner gets paid, which is a fundamental element in determining how much risk [the business owner] is taking in the exit planning process,” said Brown.

“Any transfer for less than fair market value, even if the transfer involves only a partial ownership interest, must have a valuation from a valuation specialist, such as a CPA,” he added. “If the IRS comes calling, the valuation specialist should answer that call, not you, the financial advisor.”

Sale of a partial interest in the businessor even gifting the business to the buyercan yield for the seller a faster payback on the transaction than a full ownership interest sale, said Brown.

Though life insurance can also play a role in funding a buy-sell agreement, Stebbins observed that such policies generally are restricted to cross-purchase or stock-redemption agreements between co-owners of a business. Less common are key person policies used for business acquisitions.

“Employing life insurance, where the insured is the key employee, to purchase the business is certainly a possibility, as you have a ready-made sinking fund,” said Stebbins. “The problem in many instances is that [business owners] dont start thinking about this until 5 years prior to retirement. The insured likely would accumulate only enough money for a down payment.”

An alternative arrangement, wherein the business owner is the insured but the successor owns the policy, might fully pay for the acquisition. But this ordering of the parties is less appealing, observed Stebbins, who questioned why business owners would pay for their own buyout.

Succession challenges notwithstanding, Stebbins warned that business owners will have another set of hurdles to confront in estate planning. The Economic Growth and Tax Relief Reconciliation Act of 2001, which gradually phases out the estate tax before sunsetting in 2011, might actually increase beneficiaries tax liability.

At the federal level, EGTRRA repealed the stepped-up basis rule for property received from a decedent whose death occurs after 2009, thereby transforming the estate tax into an income tax payable by estate beneficiaries when property is sold.

EGTRRA also replaced, beginning in 2005, an estate tax credit with a more onerous federal tax deduction. The law additionally prompted a number of states to decouple their estate tax credits from the federal estate tax.

“Some heavy-duty planners who do a lot of work in areas that cross state lines, as in the tri-state [New York, New Jersey and Connecticut] region, will have a nightmare,” said Stebbins. “Its tough enough for ordinary business owners to understand how trust structures work. The added complexity engendered by the federal-state decoupling might prompt clients to stick their head in the sand, like the proverbial ostrich, and do nothing.”


Reproduced from National Underwriter Edition, October 28, 2004. Copyright 2004 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.