The legal side of succession planning for business owners

January 16, 2014

The following article, “Succession Planning for Business Owners – A Focus on the Legal Side of Succession Planning” comes to you from Timothy Williams, an attorney with Timothy L. Williams and Associates, and a shareholder in EctoHR, Inc.

It would be an understatement to say that privately held businesses are the backbone of the American economy. Some 90 percent of all businesses in this country are privately held and, of those, a large number are either family-owned or family-controlled.

These businesses come in all shapes and sizes, representing all sectors of our economy. From food distribution and wholesaling, agriculture, services, and technology to manufacturing, privately held businesses generate an estimated one-half of the U.S. Gross National Product and pay half of all wages earned in this country.

Not all privately held businesses are traditional small businesses. In fact, about one-third of all businesses included in the Fortune 500 are privately held businesses. Despite the prevalence of privately held businesses, not all of the statistics are rosy.

Privately held businesses tend not to outlive their founders. According to the Family Business Institute, only 30 percent of family owned businesses survive to the second generation, and 20 percent survive to the third generation. By the fourth generation, only 3 percent are still in existence.

Why Privately Held Businesses Do Not Survive
Why do privately held businesses have such a dismal success rate? The reasons are as varied and unique as the businesses and business owners themselves. Nevertheless, many of the failed transfers can be traced to a few specific causes. Among the principal causes are taxes and a shortage of cash.

Privately Held Business Owners and Estate Planning for the Family
The family element in most privately held businesses can mean the difference between its success or failure during the transfer process. The retirement, disability, or death of the business owner are all common events that can trigger an undesired and potentially unplanned business transfer.

Tough questions must be asked and answered before any of these events occur; otherwise, a business that took decades to build can be destroyed overnight.

For example, who will run the business after the founder retires, passes away, or becomes disabled? Will it be the owner’s spouse, one of the founder’s children, or a non-family member/key employee? If the founder’s spouse will not run the business, will he or she still be financially dependent on it – or did the founder make arrangements to ensure they are financially independent of it?

What arrangements has the founder made for the inheritance of his or her children who are not active in the business? Has the founder placed his or her affairs in order?

Estate Tax Uncertainty
The only certainty about the federal estate tax is its uncertainty with each change in Congress and the White House. Additionally, some states now impose their own estate taxes, independent of any federal estate taxes.

Accordingly, careful monitoring of the economic, political and legal climate is required. Without proper estate liquidity planning, the family may have to sell the business just to meet an estate tax cash call.

Coordinating Financial and Estate Plans
If the business founder’s financial and estate plans are not carefully coordinated, there may not be enough cash to fund the objectives. An appropriately-funded estate plan can meet all of the people-planning objectives and provide liquidity for estate taxes and business debts. Life insurance in the proper amount may be effectively used to fund such money matters.

The Business Buy-Sell Agreement
There are two fundamental means to structure and trigger the transfer of the ownership of a privately held business. The founder may transfer ownership during his or her lifetime by initiating such action. Alternatively, a business buy-sell agreement can be established which automatically transfers the ownership upon the happening of certain events.

A business buy-sell agreement is an agreement providing for the transfer of the ownership in a business upon the occurrence of one or more triggering events. Common triggering events include retirement, disability, death, divorce, bankruptcy, imposition of a lien, and insolvency of the business owner. An interest in any type of business entity can be transferred under a business buy-sell agreement, including a corporation, limited liability company, and partnership. Additionally, a business buy-sell agreement is effective whether the business has one owner or multiple owners.

A business buy-sell agreement is binding on third parties such as successor trustees, courts, etc. This feature can be invaluable when the business owner wants to ensure a smooth transition of complete control and ownership to the party that will keep the business going. A business buy-sell agreement can help establish a value for the business that is binding on the IRS for federal estate tax purposes as provided under Internal Revenue Code § 2703.

Entity Buy-Sell, Cross-Purchase Buy-Sell and Wait-and-See Buy-Sell Agreements
A business buy-sell agreement is commonly structured in one of three general formats:
1) an entity business buy-sell agreement;
2) a cross-purchase business buy-sell agreement; or
3) a wait-and-see business buy-sell agreement.

Under an entity business buy-sell agreement, the business entity itself agrees to purchase the interest of a business owner. Conversely, under a cross-purchase business buy-sell agreement, the business owners agree to purchase one another’s interests. The wait-and-see business buy-sell agreement gives the entity a first option to purchase the interest before the remaining business owner(s).

In addition to these three general formats, a one-way business buy-sell agreement may be used when there is one business owner and the purchaser is a third party.

The selection of the appropriate business buy-sell agreement format is critical for a variety of tax and non-tax reasons. Although beyond the scope of this article, a good reference point is that for federal tax purposes, in order for the founder(s) to enjoy favorable taxation on the gain they realize on the sale of the business, the sale must occur in a single moment. In other words, all of the ownership must be bought out at once, even if monthly payments are structured for all or a portion of the sale price.

Funding a Buy-Sell Agreement
A business buy-sell agreement cannot be properly implemented without a proper funding plan.
Some common options to fund the purchase obligation under a business buy-sell agreement include the use of:
1) personal funds, creating a sinking fund in the business itself;
2) borrowing funds;
3) installment payments; and
4) insurance.

These options are generally used in combination with one another. Of these options, only the insurance option can guarantee complete financing of the purchase from the beginning. Accordingly, a proper business buy-sell agreement will include both disability buy-out insurance and life insurance. Since the health of the founder(s) determines their insurability, any delay in acquiring appropriate coverage could be fatal to the success of the business buy-sell agreement and, with it, the survival of the business itself.

Contact EctoHR, Inc.
EctoHR, Inc. is ready to assist your company with all aspects of HR. Contact a team member at EctoHR by calling 810.534.0170, or by email to hr@ectohr.com.

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