In working with advisors on exit planning strategies for business owners, I find two common concerns. The first is focus. “Succession planning” and “business continuation planning” are terms advisors commonly apply to a process that, in real life, is much more egocentric.

Most business owners are primarily focused on how they can exit their business successfully. To the extent that means the business will continue, partners will take over and employees will stay on, this may be a benefit. But, exiting successfully is the goal and focus for most business owners.

The second concern is how some advisors apply old techniques to new situations, particularly regarding the business’s legal form. Many advisors apply exit planning strategies designed for C corporations to S corporations and LLCs.

Most companies filing a corporate income tax return are S corporations; it is time to reevaluate the recommended exit planning strategies. Three examples of non-traditional strategies demonstrate some new techniques available to business owners.

S Corporation Stock Redemption

Traditionally, the preferred method for selling an owner’s business interest was a cross-purchase agreement. The agreement allows small C corporations to overcome concerns related to family attribution rules, alternative minimum tax and the lack of increased basis for the remaining owners.

With S corporations, these concerns rarely apply. There is no corporate AMT; the family attribution rules generally have no adverse affect. Also, owners can secure increased basis for surviving shareholders in S corporations through coordinated planning with life insurance and short year tax elections.

Life insurance proceeds paid to an S corporation increase the basis for the shareholders. A planning goal for S corporations is to have all the basis increase from life insurance proceeds allocated to the surviving shareholders.

The buy-sell agreement can specify that at an owner’s death, the business will buy the stock for a note. Once redeemed, the surviving shareholders close the tax year for income tax purposes.

Only then do they collect the corporate-owned life insurance proceeds and pay off the note to the decedent’s estate. With a cash basis S corporation, this transaction can allocate the entire life insurance basis to the surviving shareholders.

There is no adverse tax affect for the deceased shareholder. Yet the technique can save the surviving owners significant income taxes when they later sell their interest in the business.

Leveraging the Business Continuation General Partnership

Stock redemptions aren’t always the preferred exit planning strategy, even for S corporations. For example, the owners may want to avoid creditor access to life insurance values. Or they may be concerned that the life insurance proceeds will be attributed to, and included in, the majority shareholder’s estate.

A business continuation general partnership may be the ideal compromise between a redemption and cross-purchase. A wait-and-see buy-sell agreement is established for the corporate stock. To fund the agreement, the owners establish a general partnership, which purchases life insurance on the stockholders. Special provisions are required to keep the death proceeds out of the deceased partner’s estate.

If, at the death of an owner, a cross-purchase is chosen, the life insurance proceeds are distributed from the partnership to the partners, who use the proceeds to buy the deceased owner’s stock. Having the life insurance in the partnership keeps the life insurance out of the corporation, yet avoids the purchase of multiple policies on each life.

Employee Stock Ownership Plan

In some cases, a business owner wants cash now but desires to exit later. Among other benefits, an ESOP lets business owners cash in some of the equity in the business.

An ESOP is a qualified plan that invests primarily in company stock. It provides the owner with a market for the stock at a fair market value independently determined annually. Additionally, it offers employees a chance to become equity owners in their employer’s business though participation in the qualified plan.

In recent years, the tax advantages of an ESOP, particularly for S corporations, has lent additional impetus to using this qualified plan as part of an exit strategy.

When the S corp. stockholder sells shares to the ESOP, there is a capital gain tax to the extent the purchase price exceeds basis. The new owner, however, is a qualified plan trust, a tax-exempt entity.

No income tax is paid on S corp. earnings attributed to the ESOP, thus permanently eliminating future income taxes. If the ESOP ultimately becomes the sole owner of the business, all income taxes are eliminated.

Further, if the ESOP’s purchase of the stock was leveraged through bank loans, the fact that the ESOP pays no income tax helps expedite the ability to pay off the loan. Planned properly, an ESOP offers the business owner an efficient way to exit the business at a fair price.

Steve Parrish, JD, CLU, ChFC, RHU, is a national advanced solutions consultant at Principal Financial Group, Des Moines, Iowa. You can e-mail him at parrish.steve@principal.com.

Planned properly, an ESOP offers the business owner an efficient way to exit the business at a fair price