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.

The ESOT effectively creates a market for a departing owner’s stock. Also, if the ESOT already owns at least 30% of existing corporate stock, the owner may be able to sell his stock to the ESOT trust, defer capital gains taxation and diversify the monies received from the sale of his business into a portfolio of qualified domestic stock equities in accordance with IRC Section 1042.

Redirecting ESOT sales monies into a diversified equity account needs to happen within 12 months after the initial sale of the owner’s stock to the ESOT. Capital gains taxes may never need to be paid on that stock sale to the ESOT if the diversified equity portfolio is transferred to the owner’s heirs at his death under the existing “step-up in cost basis” rules of IRC Section 1014.

The SERP-Structured Buy-Out

A properly designed business continuation plan can allow a portion of the company’s purchase price to be re-characterized as a tax-deductible business expense. This is achieved by combining either a stock redemption or cross-purchase buy-sell disposition plan with a separate salary continuation agreement that obligates the business to continue to pay a salary continuation benefit to the owner, who sells his business. These plans are sometimes referred to as “select employee retirement plans” (SERPs).

The SERP creates a financial obligation on the part of the corporation to pay a continuing income stream when an owner retires. Since the present value of this deferred obligation has to be reflected on the company’s financial statements, it reduces the fair market value of the business for buy-out or gift tax purposes.

The result of the SERP-structured buy-out is that the selling owner can reduce his capital gains tax; however, he is subsequently subject to ordinary income tax on his post-retirement compensation benefits. SERP benefits can continue to a surviving spouse and may even be tax-free when a corporate endorsement split-dollar plan is used to informally fund the SERP obligation.

Devaluation of the business for transfer tax purposes occurs by using a present value calculation for the promised SERP benefits. For example, the present value of a corporate salary continuation agreement that promises to pay an owner $100,000 a year for 15 years at the current government valuation rate is $1,024,075.

The applicable federal rate (AFR) for valuation purposes as of May 31, 2005, was 5.2%. That corporate financial obligation reduces the value of a $3 million business to $1,975,924 for buy-out purposes.

Assuming the owner had a cost basis of $500,000 in the business, he would have a capital gains tax of $221,388.60 ($1,975,924 minus $500,000 times 15%) instead of a $375,000 ($3,000,000 minus $500,000 times 15%) gains tax if there were no SERP.

Another plus of the SERP-structured buy-out: it not only reduces the purchase price for the buyer but also allows the business to deduct approximately 34% of the fair market value of the business ($1,024,075 divided by $3,000,000) as an ordinary and necessary business expense.

And, if the SERP benefit were informally funded with corporate-owned life insurance (COLI) on the retiring owner, a double tax benefit could result for the corporation. Some or all of the SERP payments could be made with tax-advantaged withdrawals/policy loans from a non-modified endowment COLI contract. These amounts could then be deducted as a SERP expense.

Assuming a policy is not a modified endowment contract, access to the policy account value through loans is free from current federal taxation; withdrawals are taxed only to the extent that they exceed the policy owner’s basis in the policy.

Distributions from MECs are subject to federal income tax to the extent of the gain in the policy. Taxable distributions are subject to a 10% additional tax, with certain exceptions.

Loans and withdrawals from a permanent life insurance policy will reduce the policy’s account value and death benefit. There may be penalties and fees associated with the use of loans and withdrawals.

Depending upon the performance of a variable universal life policy’s investment choices, the account value available for loans and withdrawals may be worth more or less than the original amount invested in the policy.

Business devaluation using the SERP can be especially attractive for reducing gift tax consequences when the owner gifts business interests to members of his family as an estate planning transfer strategy. Gift taxation can be avoided or minimized when (1) SERP benefits are increased; (2) payout periods are prolonged; and (3) when the AFR rates are as low as they currently are.

Properly designed COLI plans can be used to fund not only the buy-out but also to fund informally the salary continuation obligations of the corporation. First, COLI could provide to the corporation income tax-free death benefits that are then used to execute a stock redemption buy-out of the owner’s stock from his estate.

Should the owner live to retirement, the COLI policy could provide tax-advantaged withdrawals/loans from a non-modified endowment policy to help fund a living installment purchase buy-out obligation from the retired owner himself. COLI that is dedicated to executing a stock redemption obligation is not separately included in the owner’s estate. Nor do the policy death benefits enhance the value of the owner’s stock interest when the stock redemption agreement successfully establishes the value of the purchased business interest in accordance with IRC Section 2703.

Another COLI policy on the business owner could be used in like manner to fund informally the corporation’s obligation to provide SERP benefits to the owner or his spouse should he die while employed.

Clearly, with only one in five small business owners having taken steps to plan for the succession of their business, there is a need for education. Incentives wouldn’t hurt, either.

Perhaps the sizzle of “tax-deductible” funding to execute business continuation “exit” strategies can provide the necessary motivation for business owners to implement a tax- and cost-effective solution to a real problem. Otherwise, your clients who own businesses or their families could face a potential financial catastrophe when the time comes to pass their companies to the next generation.

John S. Budihas, CLU, ChFC, CFP, is a business, estate and trust planning consultant for the individual life division of Hartford Life Insurance Company. He can be reached at john.budihas@hartfordlife.com.

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

The Pluses

Structured SERP Buyout Advantages

o Discounts the business value for intra family gift/sale purposes

o Facilitates Business Transitioning

o Reduces seller’s capital gain tax

o Converts portion of sales price to a tax deductible retirement benefit