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Business Succession Estate Planning and Trusts

Business Succession
What You Need to Know


Estate planning for the closely-held business is not a one size fits all project.  There are multiple techniques available to the planner, depending upon the owner’s goals, the goals of other family members, and the goals of non-family stakeholders.  This   article highlights some of the more popular options that are used by business owners and professionals, as well as high net worth individuals, to provide maximum asset value and minimum taxes at the time of transition. Click here to watch a short video on funding business owner buyouts.

In addition, there are multiple techniques available, some of which involve relinquishing ownership of assets while alive, and gifting assets during retirement. Other techniques require the transfer of an interest in an asset that is appreciating while freezing the asset value at the time of transfer, and other strategies involving sales to non-family members or even liquidation of the business.

While the following may not be an exhaustive list of all the strategies available in each situation, these are the most used estate planning techniques for the closely-held and family business owners, professionals and high net worth individuals.

What Should You Consider Before Gifting?

As a business owner you can transfer an interest in your business to the next generation and remove assets from your estate by gifting property to the next generation family member.  Gifting works best when you will not need the assets or the income from the asset.  In 2016 each person has an annual exclusion amount of $14,000 and that can be transferred to an individual without any gift tax.  The $14,000 amount is indexed for inflation so that it increases each year based on the inflation index.  As long as you do not give more than the exclusion amount, it will not reduce your lifetime exemption.  As an owner you will still have your lifetime exemption amount available at the time of death.

By gifting during his or her lifetime, the gifted assets are removed from the owner’s estate and the income from those assets is transferred to the next generation.  Assuming the owner is giving an appreciating asset, then by transferring assets by a gift during her life, the appreciation accrues to the benefit of the recipient of the gift. This can be a significant saving in federal estate taxes which have a 40% tax rate in 2016. In Oregon the 2016 inheritance tax rate ranges from 10% to 16%.

While gifting removes assets from your estate, the disadvantage to the person receiving the gift is that person now has the donor’s basis in the property.  Therefore, if the next generation recipient intends to sell the property rather than keep it for the long-term, the sale will create a significant capital gains subject to tax.  On the other hand, if the asset is transferred at death, then the beneficiary receives the asset with a stepped up bases.

Since the state and gift tax rates on gifts have changed frequently over the past fifteen years, there is a risk in using gifting as an estate planning strategy for the small business owner.  Further, there is a risk in projecting whether the asset will appreciate, and if it does, by how much.

If a closely-held or family business owner is contemplating gifting a business interest to the next generation, then she should obtain a valuation of the interest to be gifted.  In addition, the business owner should file a gift tax return even if the gift is within the annual exclusion amount.  If a gift tax return is filed, then the statute of limitations for the IRS to challenge the valuation starts.  If the statute of limitations runs prior to the time of death, then the IRS will not be able to challenge valuation at the time of death.

While gifting is a great estate planning tool you can use whether or not you are a business owner you have to match your gifting with consideration of:

  • Your income tax situation;
  • Control of your business;
  • Your current and future cash flow needs for business and personal concerns;
  • Your investment strategy;
  • Your retirement plan;
  • Your charitable motivation; and
  • Your next generation’s needs and goals.

You should plan a session with your financial planner and estate planning attorney to discuss your options and reflect on your personal values and goals before starting a gifting program.

Intra-Family Sales for Cash and For Cash Plus a Promissory Note- Balancing Estate Tax and Inheritance Tax versus the Capital Gains Tax

 Intra-family sales, if properly structured, provide a method of freezing an estate and avoiding the gift tax at the time of transaction.  As with most of the techniques involving the transfer of assets, obtaining an accurate valuation of the asset or the business interest prior to the transaction is an absolute must.  The IRS is very strict with respect to Intra-Family Sales, and if the sales are not made at the fair market value of the ownership interests transferred, the IRS can treat the transaction as a gift.  By using an appraisal prior to the transaction, the business owner will have a bases to rebut any assertion by the IRS that the transaction was a gift and not a sale.

Just as with any gift, with an Intra-Family Sale the buyer’s adjusted basis in the property will be the amount paid for that property.  That amount could be substantially less than the value at the time of the owner’s death.  If the buyer intends to resell the property, she will have a lower basis and the sale will create a capital gains tax liability.  Before making a sale of an asset to a family member, the owner must conduct a careful analysis of the fair market value and the basis she has in the property. The sale, even though it is to a family member, is a taxable event for income tax purposes.  The owner needs to weigh the gain in reduced estate and inheritance tax against any capital gains tax liability incurred in making the sale.  Any Intra-Family Sale should be undertaken only after consultation with a tax adviser.

In the usual circumstance, the sale is structured as cash with an installment Note or simply an installment Note.  In some situations the owner’s intent is to transfer the asset to the next generation, whether not she receives the entire face amount of the Note.  In this latter situation, the transaction will often be set up as a self-canceling installment Note.  A detailed explanation of this technique is included in the chapter on estate freeze techniques.

As mentioned, the IRS takes a hard line position with respect to sales to family members.  Accordingly, before doing an Intra-Family sale, the owner should be certain that the recipient has the ability to meet the required payment obligations, and that the payment obligations are not tied to the income generated by the asset.  If either of these situations is present, the IRS will treat the transaction as a gift subject to tax.

What is the Difference Between a Private Annuity and an Installment Note?

The sale of a business interest to a family member can also be made utilizing the technique of a private annuity.  The main distinction between the private annuity and a Note is that with a private annuity payments are made to the owner over the owner’s lifetime and provides the owner with a retirement income that will last for his lifetime.  Although there is an income tax liability incurred by the owner with the receipt of each annuity payment, the owner can spread that liability over his or her life.

The advantage of a private annuity over the installment Note discussed above, is that no part of the annuity contract is included in the owner’s gross estate because the right to the annuity payments ceases upon the owner’s death.  Compare this to the installment sale where any unpaid installments are included in the owner’s estate at the time of her death.

While private annuities have some advantages, especially for the owner who requires retirement income from the business interests over his entire life, private annuities also have some disadvantages.  One of the disadvantages is that the private annuity is unsecured, while the installment sale is a secured transaction.  This puts the owner at risk regarding payment of the private annuity.  The second issue with a private annuity is that the annuity payments are calculated based on internal revenue code interest rates, IRC 7520, and treasury regulations, which can create a large payment if the owner outlives his or her life expectancy.

The IRS Requirements for Redemptions

A redemption is a repurchase of shares by the company.  Depending on the business structure the company may be required to meet certain exceptions in the Internal Revenue Code.  For example, if the company is a corporation, then the redemption must meet one of the exceptions contained in IRC 302.  Because these are complex rules, the most likely exception to apply to a closely-held business is a complete termination of the interest.  There are specific requirements to comply with the rules for a complete termination.  Because of the complexity, if you are considering a redemption of shares as part of your strategy you should consult a qualified tax advisor.

Buy-Sell Agreements-What is the Purpose and Common Types of Buy-Sell Agreements?

A buy-sell agreement is a contract that provides a flexible way to plan for ownership succession. A buy-sell agreement is a legally binding contract between or among shareholders/members and the company that requires the shareholders/members or the company to purchase the stock or interest of the business owner. The valuation method or the value agreed upon is written into the buy sell agreement. A buy-sell agreement can be used to keep the business within the owner’s family or provide a method to transfer the interest to a non-family member.

Disability or death of the owner typically triggers a purchase option.  A buy-sell agreement will address how price is to be determined. See the chapter on “Valuation “for an explanation of the methods available.

There are three common types of buy-sell agreements: redemption agreements, cross-purchase agreements, and hybrid wait and see agreements. These agreements have many common characteristics, but the structure, operation, and tax considerations of each are different and must be carefully considered.

When Does the IRS Treat a Stock Redemption as a Dividend?

A redemption agreement, or an entity purchase agreement, is a contract between the entity and the business owner. A stock redemption occurs when the business itself purchases stock, usually at a price agreed upon in the buy-sell agreement.  The net effect is to concentrate ownership of the company in the hands of the remaining shareholders.  Stock redemptions must be for all stock of the deceased owner, otherwise the IRS may treat the redemption as a dividend subject to taxation.

When Does a Cross Purchase Agreement Cause Economic Harm?

A cross-purchase agreement is an agreement among the business owners. Each owner agrees to sell his or her interest in the business upon a triggering event.  The usual provision is for a sale upon the death, disability, or retirement of one of the owners.  Stock retention and funding of a cross-purchase agreement are major issues and will be discussed fully “Under Funding a Buy-Sell Agreement.”

If business owners have a wide disparity in ages, then using a cross-purchase agreement may cause economic problems. Under a cross-purchase agreement the younger owners, who are often “poorer,” must pay larger premiums for insurance on the older owners. Additionally, if ownership is unequal, the smaller owners must buy more insurance to insure the larger owners. For example, if the entity is worth $10 million and has two owners, one with a 25% interest and one with a 75% interest, the 25% owner will have to purchase more insurance coverage on the older owner, and the older owner will have to purchase less for the younger owner.

The Flexibility of a Hybrid or Wait and See Plans

A buy-sell agreement may combine the features of a redemption and a cross-purchase plan.  In a hybrid plan the shareholders are given the right to purchase stock, but the company is required to redeem the remaining shares.  The hybrid approach provides for more flexibility than a cross-purchase or the redemption plans, but creates a larger problem in the funding process.

7 Events that Trigger Buy-Sell Provisions

One important consideration in drafting a buy-sell agreement is determining the particular events that will require a transfer of an interest in a closely held business from one party to another or give some party an option to either buy or sell their interest.  Those triggering events typically include:

  • The owner’s death,
  • Owner’ retirement,
  • Owner’s divorce,
  • Owner’s bankruptcy,
  • Termination of employment,
  • Disability, and
  • The desire of owner to gift or sell his or her interest in the business to another person.

The buy-sell agreement should state whether these events trigger a mandatory or optional buy out requirement.

How Smart Business Owners Fund a Buy-Sell Agreement 

Cash is King

In Business Succession
Cash is King

Cash is one method of funding a buy-sell agreement.  A company will use its cash reserves to purchase the owner’s interest.  This can create a problem by causing a cash flow shortage for the business and, thus, not having sufficient funds to maintain operations.  Further, this may deplete the retained earnings of the business.  This method is tax disadvantaged because it is done with after-tax dollars.  In essence, in order to have the cash to purchase the stock, the company will need more money than the actual purchase price.


Becoming a Company Creditor with Installment Notes

An installment payout is an attractive and simple alternative. This method involves an obligation on the part of the company to pay the value of the owner’s stock over a fixed period of time. The buy-sell agreement will specify the terms of the transaction and the Note.

This method leaves the retiring or deceased owner’s estate as a creditor of the company.  The former owner’s risk is tied to the performance of the company over a fixed period, thus, increasing the risk that a diversified portfolio might provide. If the owner is retired, rather than deceased, the loss of control may be hard for him or her to accept.

The Problem of Using Outside Debt Funding

Borrowing the funds to purchase stock is another method of funding a buy-sell agreement. The cost of debt financing will be higher than the price of the stock because the company will have to pay interest on the debt.  One reason this is a poor choice for funding a buy-sell agreement is that the company is taking on new debt for non-operational purposes.  This can create a problem for the business, because there’s no corresponding increase in the value of the business.  Further, because the business has just lost its dominant personality, lenders may require the remaining owners to pledge personal assets to secure the loan.  The pledging of personal assets defeats the limited liability protection of the existing business structure.

The Benefits of Using a Sinking Fund

A sinking fund is a separate fund, usually invested in short-term securities or bonds, to which contributions are made over a number of years in order to buy the stock. When the time comes for purchase of the business interest, the funds will be available.  A sinking fund is really the cash purchase method of funding, except the cash been accumulated over a number of years before the necessary purchase.  Contributions are made with after-tax dollars.  The fund is an asset of the company.

Do You Know the Difference in Using Life Insurance to Fund a Cross Purchase or to Fund a Redemption?

 Life insurance provides flexibility on how it can be used to fund a buy-sell agreement.  It is possible to use life insurance for the purchase of shares from an existing shareholder.

Insurance can be used whether funding a cross purchase plan or a redemption. The main difference is who owns the policy. The buy-sell agreement should state that the agreement is to be funded by life insurance, require periodic review to confirm that coverage is still adequate, and determine if any changes are needed.

In cross purchase agreements, all of the shareholders involved should have policies on all the other shareholders.  This will require multiple policies and the shareholders will be required to pay the premiums on their policies.  To make sure that the policies are properly funded, a separate entity or trust may be set up with the only asset being life insurance policies.  One form of entity that is often used for this purpose is the Irrevocable Life Insurance Trust (ILIT).  Using an ILIT not only provides for funding and payment of premiums, but insures that the policy face amount will be there when the funds for the purchases are needed.  The premiums paid by the owners are not tax deductible and, thus, compensation to the active owners may be appropriate to offset the premiums.

For a redemption, the business can take out corporate-owned life insurance (COLI) to cover the purchase of stock from the shareholders.  Again the cost of insurance premiums is not tax-deductible to the company, if the company is the beneficiary. Thus, the premiums are not deductible as “ordinary and necessary business expenses” or for any other reason.

Life insurance proceeds are not included in a beneficiary’s gross income. However, policy proceeds that are acquired in a “transfer for value” will be taxed as ordinary income unless the transfer is included within one of the IRC’s enumerated exceptions. IRC §101(a) (2).

Life Insurance is one of the most predictable and flexible methods for funding a buy-sell agreement.  In addition to life insurance, consideration should be given to the acquisition of disability insurance in case one of the key owners becomes disabled.  Regardless of who purchases the insurance, shareholders or the company, the earlier in the business cycle that the buy-sell is funded, the lower the cost will be to the shareholders and the company.

What You Should Know About Using a Charitable Remainder Trust to Transfer a Business Interest

A charitable remainder trust (CRT) is a trust typically established to provide ongoing income to the donor, or chosen beneficiaries, for a fixed period of time or life. At the end of the chosen time or at the death of the donor, the assets of the trust are donated to a qualified charitable organization.

A donor is entitled to an income tax deduction,   based on the present value of the charitable remainder interest, for the value of property transferred to a CRT during his or her lifetime A CRT is especially popular with donors who own non-liquid, appreciated property such as company stock, since they can donate that property to the CRT without paying any capital gains taxes and can deduct the appreciated value of the assets from current year income taxes. A charitable remainder trust provides another option to liquidate an ownership interest in a business when the owner has a favored charity to transfer any proceeds from the business to on his or her death.

When the trustee sells the business, the Trust does not incur capital gains tax on the sale of the property because the Trust is a charitable trust and exempt from tax. The Trust provides a method to transfer the business interest without incurring a capital gains tax. The one requirement is that the trustee doesn’t have an express or implied prearranged obligation to sell the transferred property or to invest the proceeds in a specified manner.

There are multiple charitable trust forms that can be used. A detailed discussion is beyond the scope of this book. The use of a charitable trust provides significant tax benefits. Remember that the remainder benefits go to the charity and not the owner’s heirs. Therefore, use this technique only when you want to benefit a charity.

Why You Should Consider a Management Buyout?

Management buyouts are an excellent way to maintain a business when there are no family members wanting to continue operating the business, but management is willing to take control.  A management buyout will keep the company closely held and viable.

Management buyouts can be combined with Employee Stock Ownership Plans (ESOPs) to reduce financing costs. A management buyout can be funded by different methods. However, funds must be available to purchase shares from the retiring owner.  These funds can come from the business as debt, cash flow, or a pledge of future income.  Management contributes cash to purchase company stock.  Other sources of funding include loans or notes for money borrowed from outside lenders.

In addition, the owner can take a Note with regular payments.  Payments will be made with after tax dollars, and include an interest charge. In this case, the owner will retain the risk of the success of the business. The owner will have to relinquish control to avoid the payments being treated as dividends.

Another alternative is an Employee Stock Ownership Plan. This is a tax qualified defined contribution employee retirement plan. Managers can own stock as individuals and also receive stock through their participation in the ESOP together with other employees. An ESOP is set up primarily to invest in the stock of the employing company and it can borrow money to do so. Once established, the ESOP can borrow the funds to purchase stock from the owner. The ESOP loan is paid from pretax dollars.

Management buyouts can meet the desire of the business owner to continue the business. Since the owner hired the management team to help make the company successful, they are likely to be competent successors and are likely to maintain the character of the business.

On the downside, leveraged buyouts strap the business with substantial debt. This debt may restrict the implementation of business plans. Future business plans should be taken into consideration when the management stock buy-out.

What Are The Economic Benefits of Selling to Employees?

There are two common methods of selling to employees: 1) Employee Stock Ownership Plan (ESOP) discussed above; and 2) an Employee Co-op.  Ether option, due to the cost and complexity, should be considered only by companies that are profitable and have a value of at least $5.0 million or net income of $1.0 million.  A detailed discussion of ESOP’s is included in a later chapter.

An ESOP is a tax-advantaged strategy for business succession planning. It can be combined with a management buyout These plans invest primarily in employer stock, can use borrowed funds, no employee funds are generally allowed, stock sold to ESOP can qualify to defer capital gains, and contributions can vary year to year.

Cooperatives are self-governing membership associations in which members select the board and have direct ownership in the company.  A cooperative can offset its tax liability by distributing its earnings as “patronage refunds” to its member employees. The cooperative can manage its cash and capital by retaining up to 80% of these patronage refunds for reinvestment directly in the cooperative.

ESOPs have tax advantages that make them the employee ownership structure of preference in companies that are profitable. A company that sponsors an ESOP may offset taxable income by contributing its stock to the ESOP as tax-deductible contributions to a qualified pension plan.

Companies that are 100% owned through an ESOP and elect S-Corporation tax status retain corporate income tax deductions by contributing cash or treasury stock to the ESOP. After leaving the company, the ESOP employees cash out their accounts and at that time they have to pay taxes.

ESOP’s can also be leveraged. This is done through a loan from a lender to the company who in turn loans the money to the ESOP Trust. A Sinking Fund is then set up to provide for events of death disability, retirement, termination and diversification.

Selling shareholders may elect to indefinitely defer all capital gains on sales proceeds through IRC 1042 regardless of the basis. There are companies that provide various financial products to facilitate liquidity for IRC 1042 transactions. In an ESOP the Board of Directors appoints the ESOP Trustee. The Trustee votes the stock on corporate matters. The trustee votes the stock on behalf of employees. The employees are not shareholders and do not have minority shareholder rights.

In addition to the economic benefits of ESOPs they also have non-economic benefits for the operation of the business. The non-economic benefits include:

  • Golden handcuffs” for key people;
  • Reduced turnover;
  • Reduced worker comp claims;
  • Greater productivity ;
  • Greater profitability;
    • Greater commitment to the company; and
  • Better work environment.

The biggest drawback to ESOPs are that they are expensive to establish and maintain. Further, they usually require professional consultants to maintain compliance with the law.  Professional advisors can help you determine if the tax and non-economic benefits outweigh the cost and compliance issues.

Cooperatives are relatively easy to establish, but their governance, ownership, and tax environment require specialized accounting and legal advice.

Is Liquidation The Best Option for Your Business-Or the Only Option Because You Failed to Plan?

Liquidation of a business does not strictly fit into “Succession Planning.” There isn’t much “succession” when a company simply ceases to exist. In some cases, however, liquidation is, in fact, the best option for the business owner, and therefore we consider it here.

Liquidation value of a business is simply the market value of the assets less liabilities. It is generally lower than the value of the business as an ongoing company. The process of liquidation begins with an appraisal of the value of the company assets. Next, the liabilities are calculated.

A liquidation of assets is treated in a manner similar to dividends—double taxation. When assets are sold by the business, the company is taxed at the corporate income tax rate on the difference between the depreciated value of the asset and the sale price. The shareholders must also pay personal tax when the proceeds pass from the corporation to the owners, to the extent that they exceed the basis value of the stock.

Sometimes, keeping the business in existence as a holding company that provides a continued income to the owner makes more sense. In this case, the company remains in existence, but sells its assets, using the proceeds to make investments. What was an operating company becomes a holding company that invests in a diversified portfolio. In this way, the business continues to provide income to the owner through dividends, but holds no hard assets.

Time to Act, The Sooner You Start Your Business Succession Plan The More Options You Have

We Come to You

The sooner you decide to start your business succession planing the more options you have to make a successful plan. For a short time I am offering a free consultation to business owners serious about planning for their exit from their business. This consultation is usually $295, but for a limited time is free. During this consultation you will be able to have your questions answered and will leave with at least one action that you can immediately implement.  For your convenience we come to you and schedule evening or weekend appointments. Pick up the phone and give me, Russ Pike, a call at 503-888-0952 to schedule your consultation. For more on business leverage click here.