A sound business plan is the foundation of success for virtually any small company. Most banks won’t lend money to the owner of a new business without first seeing a business plan.
Those plans have proven to be particularly effective in the past decade, considering that small businesses created nearly 80% of the net new jobs in the U.S. and covered 44% of the total private payroll, according to 2004 statistics from the Small Business Administration. Growth was the bottom line.
But while small business owners have been busy plotting their growth, few have taken time to prepare for the next step: business succession. Only 22% of small business owners surveyed by PricewaterhouseCoopers in January 2005 reported doing any succession planning.
That shortcoming has real and often dire consequences. Many small businesses wind up being liquidated in a fire sale because the owners did not take time to plan for an orderly disposition or continuation of perhaps the largest asset in their estate.
It doesn’t have to be this way. There are many planning strategies that business owners can use to pass their companies to the next generation, to partners or other interested parties. Four strategies provide certain tax advantages for small business owners, particularly owners of closely held businesses:
o Profit-sharing buy-out plan;
o Bailout charitable remainder trust;
o Employee Stock Ownership Trust (ESOT); and,
o SERP-Structured buy-out plan.
Each of these planning techniques has unique tax advantages.
The Profit-Sharing Buy-Out
For business entities with a profit-sharing plan, the plan trustee can be authorized to purchase life insurance with the monies in one owner’s or partner’s segregated profit-sharing account on another co-owner’s life.
A profit-sharing plan is unique not only because the co-owners share an insurable interest in each other’s life but also because of the nature of a profit-sharing plan’s segregated account structure. The life insurance premiums are paid with tax-deductible corporate dollars that have been contributed to the profit-sharing trust.
Each owner incurs taxable W-2 ordinary income on the term element cost of the life insurance in his or her profit-sharing account. This “term” is an “economic benefit” provided to the pension plan participant.
It is the same economic benefit generated by any pension-owned life insurance or split-dollar plan. The “economic benefit” cost is generally determined by using IRS Notice 2001-10 table rates.
Noteworthy is the fact that incidental death benefit rules that normally limit the amount of pension plan assets that can be used to pay life insurance premiums may not be applicable to profit-sharing plans. Normally, pension law stipulates that life insurance death benefits must be “incidental” to the plan’s primary purpose of providing pension benefits.
Depending upon the life insurance plan, regulations restrict the amount of pension deposits that can be used for premium payments to only 25% or 50% of cumulative qualified plan deposits. However, two exceptions permit a profit-sharing plan to escape these rules should the owner’s profit-sharing plan participants desire to do so.
First, if a profit-sharing plan uses trust monies that have been in the pension trust for at least two years, then the trustee can use 100% of such funds for life insurance premiums without violating the incidental death benefit rules. Second, segregated account balances of those employees who have participated in the profit-sharing trust for at least five years can be used for life insurance premiums.
When an insured owner dies, tax-free death benefits are deposited in the surviving owner’s profit-sharing plan account. The plan trustee can then distribute that portion of the death benefit equal to the net amount at risk income tax-free to the surviving business owner.
That distribution enables the successor owner to fund his or her obligation under a separately structured cross-purchase buy-sell agreement. Transfer for value restrictions might not be applicable to such profit-sharing strategies.
Corporate owners who already have provided for their retirement security through other means may want to use the profit-sharing plan solely to fund their business continuation agreement in a tax-advantaged way.
Bailout Charitable Remainder Trust
A business owner can transfer his or her stock in a C corporation to a CRT and realize the following benefits:
o A charitable deduction equal to the computed present value of the named charity’s remainder interest in the CRT;
o A stock sale without capital gains taxation because the tax-exempt CRT sells the stock back to the corporation;
o The immediate removal of the business interest from the taxable estate for estate tax planning purposes with the CRT gift; and,
o The effective tax-free disposition of the owner’s business interest to other family minority owners who may be active in the business. They become sole owners of the business once the corporation redeems the stock from the CRT.
There can be an understanding between the business owner, the CRT and the C Corp. that the corporation will redeem the owner’s stock from the CRT. However, there cannot be any pre-existing obligation for the taxpayer’s corporation to execute such a redemption of stock from the CRT. The CRT bailout strategy can work in tandem with the ESOT strategy discussed below to make it even more effective.
Employee Stock Ownership Trust
An ESOT trust can be established to purchase the stock of business owners using tax-deductible corporate dollars as a funding mechanism. This is the only qualified plan that is permitted to leverage a corporate buy-out via a trust with borrowed funds.