Business Succession Planning

How to sell your business when you retire, die or become disabled.

do it for love

65-75 % of small business owners do not have any type of succession plan in place should they retire, become disabled or die.

7 out of 10 thought about it. 1

25 % have retirement succession plans

35 % have death succession plans

17 % have disability succession plans

1 Trends in the U.S. Small Business Market, LIMRA 2013

Business Succession Planning

Why have a Succession Plan? do it for love

Link to the story shown above https://www.youtube.com/watch?v=QIDwqvC4pVs

Every business regardless of its revenue, assets or number of owners − should have a Business Succession Plan!

Who Needs a Buy-Sell Agreement?

Who Will Keep or Buy An Interest In A Closely Held Business?

• Partner or Co-Shareholder

• The Business Entity itself

• Key Employee

• Third Party (i.e., competitor, vendor, etc.)

• Family Member

What is a Buy Sell Agreement?

• Business Owner’s “Will”

• Sale Triggered by Death, Disability, Retirement and Other Events

• Purchase of Appropriate Interest by

– Business,

– Remaining Owners,

– Key Persons or

– Family Members

What happens to a business when a owner dies? 1. Federal Estate Taxes are due within 9 month

2. Cash flow is affected.

The Need for a Buy-Sell Agreement

Advantages to the estate if you die.

• Provides liquidity for taxes and expenses

• Prompt payment

• Sets fair and reasonable price

• Determines the value of a deceased shareholder’s

interest for Federal Estate Tax purposes

• As little conflict as possible

The Need for a Buy-Sell Agreement

The Need for a Buy-Sell Agreement

Advantages to the departing owner upon retirement, disability, etc.

• Provides money to help meet ongoing expenses

• Converts business wealth to personal wealth to pay

for retirement

• Prompt payment

• Sets fair and reasonable price

• As little conflict as possible

Advantages to remaining owners

• As little conflict as possible

• Prompt exit of heirs and the heirs family

• Continuity of management

• Stability for employees, vendors and clients

• Establishes a fair and reasonable price

The Need for a Buy-Sell Agreement

You can learn from other business owners planning mistakes

H.L. Hunt Value of estate: $8 billion Amount contested: $4 billion Feuding parties: great-grandchild and nephew, among others

You can learn from other business owners planning mistakes

Carl Pohlad – previous owner of the Minnesota Twins Sold Twins for $24 million for estate planning IRS claims value is $293 million Dispute still unresolved

Other Triggering Events

• Loss of Professional License

• Bankruptcy

• Felony conviction

• Divorce, etc.

Children in the Business

• What are plans for succession?

• What about those not active?

– Is there spouse shareholder that is not active in the business?

– Are there non-related shareholders that are not active?

• Family block

– Are there minor children?

– Is there a right of first refusal offer?

Children in the Business

• Buy-sell agreement – is this the best way to transfer?

• Are other transfer strategies more appropriate?

– Installment sale to intentionally defective grantor trust

– Grantor retained annuity trusts

– Family limited liability companies

– Family limited partnerships

Who will buy the business if there are no heirs or business partners?

• Vendors

• Competitors

• Key employees

Key Employees

• If not buyers:

– What happens to them under new management?

– Employment contracts?

• Ties key employees and helps retain business value

• Protects employees future

• Prevents defections

– What about protecting the buyers?

• Establishes a more stable business

• Protects value

Buy-Sells and Estate Planning

• Business planning is a part of estate planning

• Buy-sells play an important role for several reasons

– Legacy planning

– Fixing the estate value

Fixing the Estate Tax Value (General Rules, part 1)

• Price must be fixed or determined according to a

formula which is fair and reasonable when agreement

is made

• No party to the agreement can transfer during lifetime

his/her interest in the company without first offering it

the other parties at price set in the agreement

…..(continued)

Fixing the Estate Tax Value (General Rules) …continued

• Estate MUST offer to sell at death at contract price

– (mere OPTION to sell NOT sufficient)

• Agreement must be bona fide business agreement, and

not a device to

– pass decedent’s share on to the NATURAL OBJECTS OF HIS

OR HER BOUNTY for LESS THAN A FULL AND

ADEQUATE CONSIDERATION

…(continued further)

Fixing the Estate Tax Value (General Rules) …continued

• Terms of the agreement must be

– Comparable to what persons dealing

“AT ARMS’ LENGTH” would do

• Family members are “the usual suspects”

Valuation

1. Separate specialized area of expertise

2. Who might know

•Business Owners

•“if you were buying … if you were selling”

• Accountant

•Brokers in that area of business

•Professional Appraiser:

especially gives credibility to the number

General Methods of Valuation

•Book Value

•Earnings Based Formula – Capitalization

•Dividend Paying Capacity

•Multiple Formula

•Appraisal

•Revenue Ruling 59-60

General Methods of Valuation

•Revenue Ruling 59-60

1. Nature of the business and its history

2. Economic outlook and the condition of the business

3. Earning capacity of the company

4. Dividend paying capacity

5. Goodwill and other intangible value

6. Previous sales and the size of the block to be valued

7. Comparable sales.

Business succession for disability Chism vs. Commissioner 1963

• When an employee/owner is disabled he/she no longer is an

employee.

• Wages can only be paid to employees.

• Any money paid that is greater than $25 is a gift.

• Income paid after disability is a taxable distribution AND

taxable income to the employee/owner.

• A formal document or a qualified sick pay plan is necessary

to avoid double taxation.

Types of Buy Sell Agreements

• Entity Purchase / Stock Redemption

• Cross Purchase

• Wait-and-See Approach

Entity Purchase Agreement

•An agreement between the business and its owners

•An entity purchase agreement between a

corporation and its shareholders is commonly known

as a Stock Redemption

•If funded with life insurance, the business is the

owner and beneficiary

• “Employer” owned life insurance must

comply with “EOLI” rules

Stock Redemption

29

Owner B $50k Basis

Insurer

Owner B, Family or

Estate

3. Policy Proceeds

C Corp ($1 million)

2. Buy Insurance on A & B

Owner A $50k Basis

1. Buy-Sell Agreement

Case Study – C Corp Redemption

Stock Redemption

Results At Death

• No income tax to B’s Estate

• A owns business outright

• A’s basis remains at $50,000

Entity Purchase

31

Owner B $50k Basis

Insurer

Owner B, Family or

Estate

3. Policy Proceeds

S Corp, LLC or

Partnership ($1 million)

2. Buy Insurance on A & B

Owner A $50k Basis

1. Buy-Sell Agreement

Case Study – S Corp Redemption or

Partnership/LLC Entity Purchase

Results At Death

• No income tax to B’s Estate • A owns business outright • A’s basis increases

– For S corporation, can increase to $550,000 – For partnerships and LLCs, amount of increase depends

Why?

Entity Purchase

• S Corporation Redemption 1. B’s estate receives promissory note for payment of buy-out price 2. Business elects to “terminate the tax year” 3. New tax year starts with remaining shareholders 4. Business receives life insurance proceeds 5. Insurance proceeds increase the remaining shareholders’ basis

• Partnership or LLC Entity Buy-Out 1. Complicated tax rules resulting in basis adjustment 2. Insurance proceeds increase the remaining owner’s basis

Entity Purchase

Results At Death

Cross Purchase

• An agreement between or among the owners of a

business

• The agreement obligates the surviving owners to

purchase from the departing owner or the deceased

owner’s estate, his or her business interest at an

agreed upon price

Cross Purchase

Insurer

Owner B, Family or

Estate

1. Buy-Sell Agreement

3. Insurance Proceeds on B’s Death or Disability

Owner A ($500k policy on

B)

Owner B ($500k policy on A)

Owner A

2. Buy Insurance on Each Other

4. Pay Buy-Out Price paid to owner A

5. Transfer Ownership Interest

Cross Purchase

Results at Death • A receives $500,000 income tax free • A pays $500,000 to B’s Estate • No income tax to B’s Estate on the transaction • A owns the business outright • A’s total basis is $550,000

Wait-and-See Approach

• At the time the agreement is structured, it may be difficult to determine which method is better

• The wait-and-see approach defers the choice until a triggering event occurs

How the Wait-and-See Approach Works.

• Business has first option to purchase deceased/departing owner’s interest

• If not exercised, remaining owners have the option to

purchase • If remaining owners do not purchase, the business

must complete the purchase

Owner A

Insurer

Owner B, Family or

Estate

3. Policy Proceeds on B’s Death

2. Buy Insurance on Each Other

Wait-and-See Approach

Owner B

Business ($1 million)

1. Buy-Sell Agreement

4. Loan or Capital Contribution, if needed

5. Business has first option to buy business interest

6. Option to Buy if Business Declines

Wait-and-See Approach

Results at Death It depends on choice!

A similar approach can be used for other circumstance such as retirement disability, etc.

Comparison of Business Continuation Arrangements

Cross Purchase Entity Purchase

Basic Mechanics • Each owner buys policy on other owners

• Surviving owners use insurance proceeds to buy-out deceased or disabled owner

• Business buys policy on each owner • Business uses insurance proceeds to buy-out

deceased or disabled owner

Advantages • Addition to basis • No AMT concerns

• Simple to administer – fewer policies

Disadvantages • More difficult to administer – more policies (N x (N-1))

• Potential transfer-for-value concerns

• Personal funds used to pay premiums (unless bonused or split dollared)

• No addition to basis for C corporation shareholders (contrast to S corp and partnership)

• Possible AMT for C corporations • Premiums not deductible • Potential realignment of ownership control • Constructive ownership: attribution rules

Options for Funding a Buy-Sell Agreement

1. Surplus

2. Sinking fund

3. Installment payments

4. Borrowing

5. Life and Disability Insurance

Surplus

1. Rely on Corporate Surplus and Asset Liquidity

2. Uncertainty of Corporation Having Surplus at Any

Given Time: i.e., No Guarantee of Funds for

Premature Death

3. Rely on Self Enforcement

Sinking Fund

1. Essentially, a Savings Account

2. Uncertainty of Individual’s Ability to Save

3. Rely on Self Enforcement

4. No Guarantee of Funds for Premature Death

Borrowing

LOANS

• Ability to Borrow Uncertain

• Cost of Borrowing Uncertain

• There is an Interest Expense

Installment

BUYER SIGNS NOTE

• Parties Agree to Pay The Purchase Price in Installments

• Payments Spread Over a Number of Years

• Family Must Rely on Continued Financial Health of Obligated Party

• Common As a “Fall Back” Plan

Life and Disability Insurance

INSURANCE FUNDING

1. Most Reliable

2. Ascertainable Costs

3. Cost Recovery

4. Generally, Least Expensive Option

5. Guarantee of Funds in the Event of Premature Death

6. Cash Value Grows Tax Deferred – Supplements Lifetime Buy-out

Conclusion

1. Do you have an Existing Agreement?

2. Do you need a review and update?

3. Here is where to start

– Contract terms

– Price

– New parties

– Funding

Please complete the evaluation.

Please note if you would like CPE credit.

Thank you for coming.