Formulating and implementing an effective exit strategy and management succession plan is often one of the most difficult challenges facing the owner of a closely held business. Often an owner has spent a career building the business and has given little thought to how or when he might pass ownership and management to others, whether they be family members, co-workers, or third parties.
Any succession plan will have to consider the likelihood that a significant part of the owner’s assets, tied up in the interest of such business, are often usually illiquid. An important issue will be how the owner can convert such business interests to liquid assets for his support upon retirement or to pay estate taxes upon his death. Any succession plan must take into account a relatively unique set of current circumstances that will directly affect the structure of the plan: (i) relatively low interest rates which may make it easier to sell the business or make use of certain gifting techniques; (ii) historically low capital gains and dividend tax rates; (iii) to some extent, a return to fairly high values of assets, such as marketable securities and real estate; and (iv) an increasing estate tax exemption and some possibility of full repeal of the estate tax within a few years.
Identifying the Owner’s Goals for Business Interests
The owner, with the assistance of an estate planning attorney and other professionals, may identify a number of goals for the interest in the closely held business.
Market for Interest – How can the owner of a closely held business create a market for his or her interest, such as through a buy-sell agreement?
Identifying the Appropriate Successor-in-Interest – Who is the most appropriate successor-in-interest for the business from the viewpoint of continuing the proper management and control of the business? A common issue is whether a particular family member, such as a child, should receive a controlling interest where such person has the capabilities and the inclination to competently manage the business. Or, should the business be sold to a third party, such as an unrelated employee of the business, or to a competitor? Should the surviving spouse be the successor-in-interest? Would co-owners want to be in business with a surviving spouse?
Coordinating Succession Management Goals with Family Estate Planning Objectives – Does the selection of the most appropriate successor-in-interest conflict with the owner’s objectives to treat his family members “fairly?” What does “fairly” mean? Does that necessarily mean “equally?” Where one child would be better at managing the business than another, should the owner consider conveying shares of his estate in approximately equal values to his children, but such shares be composed of different assets (i.e., business interests to one child and other assets to the other child)? Does the business owner have enough assets to “equalize” the amounts passing to his children?
Maximizing the Liquidity of the Business Interests for the Support of the Owner After Retirement – How can the owner maximize the cash flow from a disposition of his interest in the business? What methods are available to reduce or defer income taxes on disposition?
Minimizing the Potential Estate Taxes that May Be Incurred with Respect to the Business – What techniques are available to minimize the potential estate taxes of the owner with respect to his interest in the business? Where estate taxes will be incurred, what steps are available to defer payment of such taxes and how are such deferral techniques affected by the owner’s particular succession plan?
Coordinating Goals of Disposition of Business and Making Charitable Gifts – How can the owner coordinate his goals for disposing of the business with his philanthropic objectives?
General Strategies for Buy-Sell Agreements
Creation of a Market for Interest – Buy-sell agreements for interests in a closely held business, such as a corporation or partnership, can serve to meet the owner’s goal to create a market for his shares in the corporation (or interest in a partnership). Such an agreement can also serve to control who is the successor-in-interest and may allow the remaining owners to avoid having to become co-owners with particular persons after the death of the owner, such as the deceased owner’s spouse or children.
Liquidity – If the owner’s goal is to create liquidity for his estate at his death, the buy-sell agreement for his interest will be very attractive.
Coordination with Goal of Deferral of Taxes Under IRC §6166 – Where the owner would also like his estate to qualify for estate tax deferral under Internal Revenue Code §6166 and wants to utilize a buy-sell agreement to create liquidity, care should be taken in the sale to avoid an acceleration of the deferred taxes.
Establishing Value for Estate Tax Purposes – If the owner’s goal is to have the buy-sell agreement establish the value of his interest for estate tax purposes, such a goal may be difficult to achieve when the owner and his family own more than 50% of the interest in the entity. Under Internal Revenue Code §2703, buy-sell agreements are disregarded for valuation purposes unless all the requirements listed below are met:
- The agreement must be a bona fide business arrangement.
- The agreement must not be a device to transfer property to members of the decedent’s family for less than full and adequate consideration. The buy-sell agreement must not be designed to serve a testamentary purpose. Factors that may be considered include whether the decedent was ill at the effective date of the agreement, whether there were negotiations between the parties, whether the purchase price is based on appraisals, and whether the price must be revalued from time to time.
- The agreement must have terms comparable to those of similar arrangements entered into by persons in an arm’s length transaction.
Cross-Purchase Versus Redemption of Stock – Consideration should be given to the relative merits of a sale to one or more of the remaining owners or a redemption of the interests by the business entity, where the owner’s shares will be sold at his death. Under a cross-purchase by another owner, the purchaser will benefit from an increase in the tax basis of his stock equal to the purchase price paid, whereas in a redemption, the remaining owners do not receive a basis increase.
A redemption offers the advantage of the consideration coming out of the business rather than out of the assets or after-tax income of the other owners. However, in order for the redemption to be treated as a sale for capital gains purposes, the requirements of §302 of the Internal Revenue Code must be met. In the context of a partnership, sales and liquidations (redemption of a partnership interest) can have significantly different tax effects in some situations.
Financing the Purchase of Interest in a Closely Held Business – How the purchase of interest in the closely held business will be paid for is an important issue. Should the buyer be required to make a significant down payment, with the balance of the purchase price payable over time through a promissory note? Should the note be secured by a pledge of the interest in the closely held business as collateral? Should the parties consider financing the purchase with life insurance on the life of the selling shareholder? There are many issues to consider in planning for succession of the ownership and management of a closely held business. Care should be taken to coordinate the succession plan with the overall estate plan of the owner.
Craig Dalton, an attorney no longer with Poyner Spruill, was the original author of this article.