The small business market represents an enormous marketing opportunity for advisors. Entrepreneurs who develop their own businesses are often so wrapped up in day-to-day management that they have not taken the time to meet with a financial advisor to discuss estate, retirement and executive benefit planning. In fact, they may not have even taken the time out of their schedules to determine who will take over their businesses when they pass away.

Meanwhile, the financial advisors to these entrepreneurs–including CPAs, attorneys and life underwriters–likely have not scheduled appointments to discuss the need for proper business succession planning because their involvement in this area is peripheral or they lack the expertise to provide comprehensive advice. Failure to address business succession planning not only could result in the advisor losing a huge market with unlimited sales potential, but also in the client potentially losing a valuable asset to transfer to family members.

A large percentage of job creation in the U.S. stems from the small business community, which is growing exponentially due to numerous socioeconomic factors, including corporate downsizings, the scarcity of replacement positions for experienced workers, and growth in the technology industry. Many Americans are finding this an opportune time to establish their own enterprises. However, small business owners face many challenges in developing successful businesses. Among them: how to increase revenues, contain costs, staff adequately, meet financing obligations and modernize, to name a few.

In addition, they must determine whether the business can provide enough income to support them and their families through retirement. These many considerations can severely limit the time entrepreneurs have to think about the future of their businesses upon their death, leaving this an issue that financial advisors must address and work with their clients to resolve.

Quite often, a business owner will die before a business succession plan has been completed. As a result, the business is handed down to a surviving spouse and/or child who had no experience in running the business while the owner was alive and possesses little or no interest in continuing to run it after the owner has passed away.

Complicating the situation further is the estate’s inability to liquidate its interest in the business. As a result, the estate and the surviving family members must dig into their own pockets to cover estate taxes and other settlement costs. The surviving spouse or family members are therefore burdened with a business to manage, taxes to pay, and an uncertain financial future, coupled with the loss of a loved one.

A formal business succession plan can effectively address these issues by: (1) outlining and implementing the objectives of the business owner; (2) creating a vehicle that will provide income to a surviving spouse; and (3) effectively transferring ownership to those family members with the experience and desire to continue running the business. Ultimately, the plan will accomplish the goals of the business founder while resolving issues inherent in the succession of a family business.

Typically, the business succession plan is designed as a cross-purchase buy/sell agreement between two business owners. As part of the cross-purchase arrangement, the owners enter into a contract for the purchase and sale of their respective interests. Normally, this agreement is binding and obligates all parties to either buy or sell their interests in the event of the death of a named party.

Rather than trying to accumulate or borrow the funds needed to purchase the deceased’s interest, life insurance should be purchased on the business founder. The policy would name the succeeding individuals as both owners and beneficiaries on each respective policy, thereby providing the assets needed for the purchase.

Since the parties involved in the buy/sell agreement are active participants in the business, either as employees or shareholders, the company may assist in the purchase of life insurance, which is usually accomplished through bonus payments made by the company to the owners. Furthermore, assuming these bonus payments are considered “reasonable allowances” for salaries or other services rendered, the company can deduct these payments as a business expense.

Upon death, the business owner’s stock becomes part of his or her estate. If the surviving spouse is the beneficiary of the estate as established through a will or trust, the unlimited marital deduction will allow the stock to pass to the surviving spouse’s estate tax-free. The spouse would then sell the deceased owner’s stock to the surviving owners under the terms of the buy/sell agreement. In turn, the surviving owners would use the life insurance proceeds, which generally would be received income tax free, to purchase the stock.

Once the stock is sold, the surviving spouse is provided with cash that he or she may invest to provide income for the remainder of his or her lifetime. Thus, the sale of a small business interest through the use of a buy/sell agreement creates financial security for the surviving spouse while also avoiding current income or estate taxation. Additionally, any trepidation on the part of the surviving spouse concerning the continuation of the business has already been addressed and dealt with under the buy/sell agreement.

An entity purchase agreement (known as a stock redemption agreement when used with a stock issuance company) can also be used to structure the business succession plan. The entity purchase agreement requires that the company, rather than the co-owners, purchase life insurance on each owner and use the death benefit proceeds to purchase the stock from the deceased owner’s estate.

One key difference arises when a family-owned C-corporation has current or accumulated earnings and profits. In this situation, stock redemption at the death of a shareholder may be treated as a dividend distribution, rather than a capital transaction, due to the family attribution rule, which causes untold problems for the estate.

Under the Internal Revenue Code, one way for the sale of stock to a corporation to qualify as a capital transaction is through a complete disposition of the stockholder’s interest, including all interests that are both actually and constructively owned. Any redemption of less than the stockholder’s full interest may not qualify as a capital transaction, and would instead be treated as a stock dividend, potentially resulting in the application of a much higher tax rate.

In addition, a sale of all directly owned stock from the estate to the corporation may not reach the level of complete redemption. In this situation, the requirement of complete redemption will not be satisfied if ownership of the stock can be attributed to the selling stockholder; his or her estate; or family members, including a parent, spouse, children or grandchildren. The family attribution rules are very complex, and all potential issues in this arena should be discussed with a qualified attorney prior to entering a binding agreement.