Module 4 — Business Succession Plans

One of the most commonly used tools in the estate plans of small business owners is the buy-sell agreement. Simply defined, a buy-sell agreement is a contract between a business owner and a potential purchaser (or purchasers) detailing the terms of a potential sale of the owner’s business interest. The sale is typically triggered by the owner’s death, but can be written to cover disability, retirement, divorce, personal insolvency, or loss of a professional license.

Depending on the owner’s and purchaser’s circumstances, the agreement may take several forms — obligating the purchaser to buy, or simply providing a right of first refusal; including a formal funding provision, or leaving financing to future arrangements. A properly designed buy-sell agreement can:

• Establish a value for the business acceptable to the IRS for estate tax purposes
• Provide the owner’s estate with liquid assets that can be distributed to heirs or invested to provide income for survivors
• Free surviving business owners from interference by the deceased owner’s heirs

Beyond estate planning, a properly executed and funded business succession plan can increase employee morale, reduce turnover of key employees, retain customer loyalty, and improve credit standing with banks and suppliers — all parties with a direct stake in the business’s continued success.

Establishing Business Value for Tax Purposes

A major advantage of a bona fide buy-sell agreement is that it fixes the business’s value for estate tax purposes, potentially avoiding a much higher IRS appraisal. To qualify, the agreement must:

• Be a bona fide business arrangement — not a device to transfer property to family members for less than full consideration
• Give the potential purchaser at least the option to buy the deceased owner’s interest
• Establish a determinable price or formula (which may or may not approximate fair market value at the time of sale)
• Be comparable to terms arrived at through arm’s-length transactions
• Not allow the owner to dispose of the business during their lifetime at a price higher than allowed in the agreement

The valuation clause is among the most important features of the agreement. Three approaches to establishing a determinable price:

Partnerships

When a partner dies, the partnership technically must dissolve. Surviving partners must either liquidate or reorganize. Liquidation is almost never desirable. If they reorganize, surviving partners typically want to continue without interference from the deceased partner’s heirs. Because of the legal situation created by a partner’s death, the surviving partners are both the most motivated and most logical potential buyers for a buy-sell arrangement.

Closely Held Corporations

Although a corporation’s legal existence is not affected by a shareholder’s death, closely held corporation shareholders face the same practical problems as partners — and typically want to continue operations without interference from the heirs. They are natural candidates for buy-sell agreements. Shareholders have two options: they can act individually (cross purchase) or the corporation itself can act as the buyer (stock redemption). These structures are compared in detail below.

Family Members

An owner who wants to keep the business in the family but has only one willing heir faces the challenge of treating all beneficiaries fairly. A buy-sell arrangement can solve this: the estate sells the business to the capable heir at the agreed price; the sale proceeds are then distributed among all the beneficiaries (including the purchaser). This allows the owner to treat heirs equally while directing the business to those who can manage it.

Employees and Others

In sole proprietorships — and corporations with a single shareholder — finding a buyer is more difficult. Key employees, management teams, or all employees through an ESOP are possibilities. Competitors, vendors, and customers are also potential buyers. Business brokers can help when no buyer can be found independently.

Sole Proprietorships

A one-way buy-out between the proprietor and the potential buyer (family member, key employee, etc.). The owner drafts the terms of the agreement, which becomes effective upon the owner’s death.

Partnerships — Cross Purchase vs. Entity Plan

Partnership buy-outs take one of two forms:

Corporations — Cross Purchase vs. Stock Redemption

Corporate buy-outs mirror the partnership structures. In a cross purchase, individual shareholders agree to buy one another’s shares. In a stock redemption, the corporation agrees to repurchase a deceased shareholder’s shares — the remaining shareholders’ proportionate ownership automatically increases as the redeemed shares are retired.

A “wait-and-see” agreement gives the corporation the first option to redeem; if it declines (or only partially redeems), individual shareholders purchase the remainder. If any shares remain after that, the corporation redeems the balance. This provides maximum flexibility while still guaranteeing a mandatory outcome.

Cross Purchase vs. Entity Plan — Comparison

Executing a buy-sell agreement is only the first step. Unless the potential buyer has financing available, the plan has little chance of success. Four funding mechanisms exist, with widely varying reliability:

Who Pays the Premiums?

In a one-way buy-out (sole proprietorship), the potential buyer owns and is the beneficiary of the policy on the proprietor’s life and pays the premiums. Since the proprietor relies on the buy-out to protect heirs, the buyer’s ability to pay premiums is critical. Several solutions exist: the proprietor may lend funds to the buyer; give the employee-buyer a raise to cover premium cost; or the business may adopt a split-dollar arrangement where the proprietor pays the portion of the premium attributable to the increase in cash value and the employee-buyer pays the rest.

In a cross purchase plan, each partner or shareholder individually owns and pays premiums on policies covering the other owners’ lives. The buy-out agreement should contractually obligate each party to pay premiums — a lapsed policy can cause the entire plan to fail. The agreement should also address what happens to policies on the surviving partners’ lives held by the deceased’s estate after the buy-out is completed (survivors may purchase the policies from the estate, or the estate may surrender them).

In an entity or stock redemption plan, the business owns the policies, is named as beneficiary, and pays the premiums. The premium is not a tax-deductible business expense; death proceeds received by the business are income-tax-free. For C corporations in a lower tax bracket than the shareholders, premiums are paid in after-tax dollars that cost less than if the shareholders paid personally. If borrowed funds finance any portion of the buy-out, the interest is tax-deductible for the corporation (but not for individual shareholders in a cross purchase).

The entity plan also requires fewer policies: three policies for a three-partner firm vs. six under a cross purchase; twelve vs. six for four partners; twenty vs. ten for five partners. Fewer, larger policies also typically cost less per dollar of coverage than many smaller ones. Many insurers offer joint “first-to-die” policies for entity plans covering multiple lives.

An insured mandatory buy-sell agreement should include provisions that:

• Properly value the business interest (stated price, formula, or appraisal); the IRS requires the price to reflect fair value at the time the agreement is drafted
• Obligate the estate to sell and the buyer to purchase at the agreed price (eliminates uncertainty of first offer and option-to-purchase alternatives)
• Prevent the owner from selling during their lifetime without first giving the potential buyer an option at the agreed price
• Prevent the owner from selling during their lifetime at a price higher than the buy-out price (establishes the IRS-acceptable tax value)
• Release the owner’s heirs from any business debts upon completion of the transaction
• Obligate the potential buyer to maintain adequate life insurance and pay premiums
• Address disposal of insurance policies on surviving partners’ lives after the buy-out (purchase from estate, surrender, or continuation in trust)
• Provide contingency financing if business value exceeds insurance proceeds; address who receives any excess insurance proceeds

Benefits to All Parties