Updated: Jan 31, 2019
As hard as it may seem to believe, only 10-20% of small business owners have any kind of succession plan in place. Even more startling, less than 27% of family owned businesses transfer successfully to the next generation.
If your goal is to protect your business asset, so that in the event of your death, it will provide your family the true asset value, then planning must begin to take place, sooner than later.
Another concern is the insufficiency of retirement income if counting on the business to be the primary source of that income. The key to a successful business plan is finding methodologies to accomplish your goals for retirement, perpetuating a family business, or successfully transitioning it to key employees. Let’s explore how to transfer the business successfully.
If the goal is to sell the business during your lifetime or at death to a family member, co-owner, third party or an employee, then an entity purchase buy-sell or cross purchase buy-sell agreement may be the most opportune vehicle to use. There are other methods such as a wait and see buy-sell, one way buy-sell or even an employee stock ownership plan, all of which will serve different purposes in transferring the business.
A cross purchase arrangement is best suited for a business with few business owners. The arrangement requires the departing business owner or estate of the deceased business owner, to sell their interest in the business to the remaining business owners at an agreed upon price. It is possible to have the agreement applied to one or more of the existing business owners. The purpose of a cross purchase agreement is to allow for continuity of management, a source of income for the business owner and his/her family, and lastly, a clear direction for future ownership of the business.
Once the cross purchase buy-sell is in place, it will require the participating owners to purchase the other participating business owners interest for an agreed upon or determinable price based upon one of many triggering events. Triggering events may include death, disability, retirement, divorce, or involuntary termination.
One funding method is to have the business owners purchase a cash value life insurance policy on each of the participating owners in order to fund the purchase obligations. At the first business owner’s death or departure from the business, the other participating business owners may use the cash values or death benefit in order to purchase the decedent or departing business owner’s interest.
The use of a cross purchase buy-sell agreement will also allow for a step up in basis on the deceased or departing owner’s shares, thus allowing for a lower taxable gain upon future sale by the remaining participants.
The use of an entity purchase buy-sell or stock redemption is often suited best for businesses with three or more business owners. The plan requires the business to purchase a departing or deceased business owner’s interest, as opposed to the individual owners or shareholders purchasing. The purpose of the entity purchase is similar to the cross purchase agreement in as much as it will provide for continuity of management, a source of income for the business owner or his/her family and a clear direction for the future ownership of the business.
The mechanics of a stock redemption operate by providing that the business will purchase the participating business owners interest for an agreed upon or determinable price upon the occurrence of one of the same triggering events listed under the cross purchase agreement. The business will be the purchaser of the cash value life insurance policy on each of the participating business owners lives in order to fund the purchase obligation. At the business owner’s death or departure from the business, the business will use the death benefit proceeds or the available cash surrender value to purchase the business owners interest.
The use of a stock redemption will not provide for a step up in basis and thus may create greater taxable income upon the sale of the remaining shareholder/owners interests at a future date. This can be resolved through the use of a Trust or Partnership arrangement.
Due to the complexity and variables, it is imperative that the business owner work with a planning advisor in order to determine the best approach for the goals intended.