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Business Succession Planning: Got an Exit Strategy??

  • christian590
  • Dec 3, 2014
  • 8 min read

BUSINESS SUCCESSION PLANNING: GOT AN EXIT STRATEGY??

By F. Stephen Glass Glass, Culbreth & Sandri, PLLC

201 West Chatham Street Cary, North Carolina 27511-4770

sglass@gcslawyers.com

Did you know that, statistically, less than one-third of all family owned businesses survive into the second generation and about 12% will still be viable into the third generation?

The leading cause of this failing rate of succession is the failure of the business owner(s) to design a proper business succession plan.

A business succession plan (“BSP”) is a documented road map for business owners, heirs and successors to follow in the event of the death, disability or retirement of the business owners. It can also be used to facilitate the orderly sale of the business for fair value. The plan can include a program for the distribution of business interests and other assets, debt retirement schedules, life and disability insurance, buy-sell agreements, and, importantly, the establishment of the value of the business.

The starting point for a BSP is to clearly establish your exit goals and objectives — what you want your BSP to accomplish for you. Some key considerations are:

  • Is there someone capable of running the business when you exit?

  • How much control of the business do you want to maintain when you exit?

  • Are there key employees who should be retained?

  • Are there sufficient assets to pay the estate tax upon your death to allow the business to be retained in the family?

  • How much money do you need from the business to reach your financial goals? Your BSP should be flexible and comprehensive enough to permit you to handle the following occurrences without destroying your business:

  • Your partner decides to move to Tahiti for an early retirement and wants his share of the business assets NOW. Do you have a buy-sell agreement in place that will enable the purchase of his business interest without bankrupting your business (and you)?

  • A key manager becomes disabled and most likely will not return to work.

  • Your partner gets a divorce and the spouse gets his/her interest in YOUR company.

  • One of your children has worked his/her way up in the businesses. The other(s) haven’t, but how will you treat each of them equitably upon your exit?

Your BSP should protect your goals regardless of the situation that might arise. Do you have an exit strategy that will protect your goals and allow you to maximize your financial goals upon your exit?

BUSINESS SUCCESSION PLANNING: BUY-SELL AGREEMENTS

A buy-sell agreement is a legal contract, common in closely held businesses. It is an agreement you can enter into now that provides for the future sale of your business interest. A buy-sell agreement is also referred to as a business continuation agreement or shareholders’ agreement.

Advance planning for the orderly succession to your business interest is important. “Business succession planning” determines how a person’s interest in a business will be transferred upon certain agreed-upon triggering events which might include:

  • The death or disability of an owner

  • The divorce of an owner

  • The retirement of an owner

  • The involuntary transfers (judgments against an owner, bankruptcy, etc.)

  • Business disputes among owners

  • Certain business valuation issues.

A buy-sell agreement or “shareholders’ agreement” will also permit an owner to preserve the family’s control over the business. Because a company is a legal entity separate from its individual owners, it is usually advisable for owners of closely held companies to enter into a buy-sell agreement to regulate the relationships with each other and with the company. LLC and Partnership Operating Agreements should contain similar provisions. Buy-sell agreements may also create a mechanism for liquidating the shares or interests of children who are not active in the family business. Mechanisms that are often used include either (1) stating the price for which the business interest may be purchased upon a triggering event or (2) establishing a formula for determining the price of that interest.

It is important that a buy-sell be adopted by the company early in its formative stage when feelings and attitudes are in harmony. If a buy-sell is not in place when a dispute arises among the owners, it may be impossible for the various factions to carry on the business of the company.

Generally, types of buy-sell agreements fall within these categories:

Cross-purchase agreements. In a cross-purchase agreement, the other owners of a company are obligated to buy the departing (either by retirement, disability, death etc.) owner’s interest. The company itself as an entity is not a party to the buy-sell agreement. Cross-purchase agreements enjoy certain tax advantages, in that proceeds from the sale of stock are treated as capital gains rather than as dividends. The purchasing owners receive an increase in their basis equal to the purchase price as result of the purchase. In addition, if the cross-purchase agreement is funded with life or disability insurance, the insurance proceeds to the individual owners are tax-free.

In the case of a cross-purchase agreement, policies are owned by the individual owners or partners on the lives of each other. If there are more than three owners, however, policy ownership can become complicated and it may be wiser to use the entity purchase. As an alternative to this, you may establish a trust outside of the entity to hold the contracts and avoid multiple policies. Also, when insuring a cross-purchase agreement, a split-dollar funding technique may be utilized in which the individuals own the policies and the company pays the premium, thus avoiding personal- income taxation on the full premium.

Cross purchase method alternatives include the “trusteed buy-sell”, which is an arrangement where a trust purchases and owns one policy on each owner's life. The owners have an equitable interest in the trust in proportion to their interest in the company and pay a proportional share of the premium payments through contributions to the trust. At the death of a owner, the trust purchases the decedent's interest. The surviving owners receive a distribution of the decedent's business interest from the trust in proportion to their equitable interest in the trust.

Advantages: Stepped-up basis, no capital gains treatment and income tax-free insurance proceeds; one policy per owner.

Disadvantages: Unless the business is taxed as a partnership, the purchase by the trust of the decedent's contributed premiums is subject to income tax.

Redemption or entity repurchase agreements specify that the company, by way of agreements made between the company and the individual owners, is obligated to purchase the stock of the departing owner. The major advantage to this type of agreement is simplicity — each owner deals with one entity, the company, rather than several other owners. The company generally purchases life insurance on each of the owners in order to fund the redemption of a deceased owner's stock and the company is the owner and beneficiary of the life insurance on the owners. When the redemption occurs, the remaining owners' basis in the company is increased proportionately, since the interest is split fewer ways.

“Wait-and-see” agreements allow the owners to defer the decision between the entity purchase and the cross-purchase until such time as they can determine the most tax-wise strategy. With a “wait-and-see” agreement, the decision as to whether the entity or the individuals will purchase the interest of a departing owner is deferred until a buy-out situation actually occurs. Waiting allows the decision to be based on the circumstances present at the time the buy-out occurs. The “wait-and-see” agreement gives the entity the first option to purchase the departing or deceased owner’s stock. This agreement benefits the seller by guaranteeing a buyer -- providing there is sufficient liquidity -- and helping to avoid dividends and by possibly fixing the value for estate tax purposes. The agreement can benefit the buyer by eliminating potential friction at the time of sale, avoiding the possibility of hostile buyers, avoiding doing business with heirs and, if funded with life insurance, by providing the buyer with the cash to meet the purchase price.

Cross Purchase Agreement or Redemption? The tax basis of the purchaser of shares is higher with a cross purchase agreement than with a stock redemption agreement. With a stock redemption, the seller must sell all stock, or make a "substantially disproportionate" sale, to avoid dividend treatment on the stock purchase price. The purchaser uses pre-tax dollars to purchase under a stock redemption arrangement and uses after-tax dollars with a cross-purchase agreement. In an S-Company, the income tax cost is the same to the purchaser, whether under a cross-purchase or a redemption. A cross-purchase offers a step up in basis for the surviving owners.

BUSINESS SUCCESSION PLANNING: VALUATION: HOW MUCH IS YOUR BUSINESS WORTH??

How much is your piece of your business worth? The valuation provision of your buy-sell agreement should be given careful thought. Valuing a closely held business is fraught with potential difficulties, but it is a critical part of the agreement. There are different valuation methods that should be carefully considered, some of which are:

  • capitalized earnings formula

  • book value

  • professional valuation appraisal

  • agreed price, or

  • arbitration

Which one is the best? The one that best fits the needs of the shareholders, the feasibility of funding and the needs of the business. The method chosen should be carefully defined so there is less likelihood that a disagreement could occur regarding the value to be used for the sale and purchase of the shares of the corporation.

Some business owners value their business at a low level (below fair market value) in their buy- sell agreement, thinking this will reduce their estate tax liability. However, a buy-sell agreement price is binding for estate tax determination only if it meets of specific conditions and complies with IRC Section 2703. If these conditions are not met, the IRS can reject the value for purposes of determining the tax due from a deceased shareholder’s estate. In a worst case scenario, the heirs may end up owing the IRS more in estate tax than they received from the sale of the deceased shareholder’s shares back to the business or to surviving shareholders.

A buy-sell agreement must be updated regularly to ensure its provisions adequately address current business circumstances and the present value of the business interest. Certainly, when there is a change in structure, ownership, ownership intent or a substantial sustainable increase in profits, the business valuation should be updated immediately.

SOME QUESTIONS TO ADDRESS WHEN CONSIDERING YOUR SHAREHOLDER AGREEMENT:

  • Valuation date: What is the date of the valuation of the departing (or deceased’s stock)? Is it the date of termination? The date of death (as may be required for estate tax purposes)? Or the date of the end of the latest fiscal year?

  • Value to be used: Will it be book value (possibly useful for companies with a high concentration of liquid receivables and inventory assets as compared to fixed assets); or, adjusted net asset value (the fair market value of tangible assets less liabilities, plus the value of intangibles such as goodwill, patents, and copyrights); or, a fair market value based on the economic earnings of the company, or the ratio of selling price to revenues of similar companies (a direct market data method of business valuation)?

  • Discounts: Will minority and marketability discounts be applied to the shares or will they be redeemed at one-third of the 100% of the value of the company, however value is determined?

  • Annual valuations: Will the stock be valued on an annual basis so that the changing economics of the company are considered on a somewhat timely basis?

  • Appraisers: Will a competent business appraiser be engaged to value the stock? (For estate tax purposes the Internal Revenue Service’s requires an independent opinion of value rendered by a qualified business appraiser)? Or will the value of the stock be negotiated by the remaining owners of the company?

  • Life insurance: Will the purchase of the stock be funded by life insurance?

  • Unwanted owners: Does the shareholder agreement stipulate that the departing or deceased shareholder cannot sell its shares to anyone other than the remaining stockholder?

 
 
 

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© 2014 by Christian Taylor. 

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