Conventional wisdom in business succession planning needs a change
When a business has multiple owners and none of the owners plan to pass their share to children who are actively engaged in that business and its management, a cross-purchase buy-sell agreement, as we all know, carries certain benefits over a redemption (entity purchase) agreement.
In a redemption, the business owns life insurance on both owners. When one dies, the business retires his or her shares into treasury, leaving the remaining owner with his or her original shares and original basis. This is true for all C-Corporation and for S-Corporations, as well as and LLCs that use accrual accounting. S-Corporations and LLCs that use cash basis accounting can still benefit from a step-up in cost basis.
In a cross purchase agreement, the life insurance on “A” is owned by “B: and vice versa. When one dies, the other owner buys the deceased owner’s shares and therefore benefits from a step-up in cost basis regardless of the form of business enterprise.
The deceased owner’s estate benefits from a step-up in cost basis regardless of whether a redemption or a cross-purchase agreement is used.
However, 50 percent of the value of the business is included in the estate of the first owner to die and 100 percent of the value of the business is included in the estate of the surviving owner. Estate taxes (federal, maybe, and/or state) may not be due until the death of the owner’s surviving spouse. But, the government still gets to tax 150 percent of the value of the business—or more!
More? That’s right. If 50 percent is valued at $500,000, then 100 percent could be valued at $1,500,000 instead of only $1,000,000. Why? Because the IRS recognizes discounts for minority (interests without voting control) interests and 50 percent is not voting control. If we use a discount of one-third, for example, for lack of marketability and lack of voting control, then a business valued at $1,500,000 for 100 percent would result in a value of $500,000 (not $750,000) for 50 percent.
If there are three equal stockholders, then the 150 percent (or more), above, becomes 183.33 percent of the value of the business subject to estate taxes.
- 33.33 percent in the estate of the first owner to die
- 50 percent in the estate of the second owner to die
- 100 percent (or more) in the estate of the surviving owner
With four equal owners, that becomes 208.33 percent and so on. Using irrevocable trusts in business succession
Each owner should have an irrevocable life insurance trust to hold his or her personal life insurance as part of his or her personal estate planning. That same trust, or a separate business irrevocable trust, can also own life insurance on the life of his or her business partners (insurable interest is established when the buy/sell agreement is signed).
So, in our 50/50 ownership case, instead of “A” owning insurance on the life of “B”, “A”’s irrevocable trust owns insurance on the life of “B” and vice versa. Upon the death of the first owner to die, the surviving owner’s trust buys the deceased owner’s 50 percent. When the surviving partner dies, only 50 percent is included in his estate.