Does your business succession plan work for you?

By Susan C. Barnes
In conjunction with Lincoln Financial Advisors

One reason so few family businesses survive into the second generation is that the owners fail to adequately plan for their succession. Many owners simply wait too long to do business succession planning, so the business must be liquidated to pay estate taxes, which are generally due nine months after death.

You may think that you and your partner can work out succession details when the time comes. However, you need to understand that the death, disability or retirement of a partner or co-shareholder creates different objectives for each party. For instance, a retiring shareholder may want to cash in the value of his interest in the business for the maximum dollars possible. But the remaining owner who continues to operate the business may want to minimize payments to the departing partner in order not to drain the cash flow generated by the business.

Failure to plan ahead for the transfer of ownership upon the death of a co-owner can also lead to conflict. Without a business succession plan, the executor and heirs of the deceased owner may be forced into a sale of the business at an undesirable price. The heirs are unlikely to know the value of the company, and if the surviving shareholders want to purchase the stock of the deceased, they may have a personal interest in keeping the sales price low. Similarly, an outside purchaser of the deceased owner’s shares who is aware of the distressed nature of the sale will also have a bargaining advantage over the heirs.

Unforeseen tax traps

Even if your attorney has drafted a buy-sell agreement to handle issues of ownership and management upon a future transfer of your business, the agreement could contain unknown traps. The transfer plan that was originally designed for your fledgling business may no longer be appropriate for your current successful operation.

Suppose, for instance, that you and your co-owners run an incorporated business. And let’s say that upon the death of any co-owner, your buy-sell agreement requires the corporation to purchase the stock from the estate of the deceased shareholder. The corporation also owns life insurance on each shareholder in order to have sufficient funds to buy the shares. This is known as a "stock redemption" agreement.

One of the problems with this arrangement is that the surviving shareholders do not get the benefit of an increase in the tax basis of their shares when the company buys the deceased shareholder’s stock. This will be an issue if the surviving shareholders eventually sell their shares in the company.

But if the buy-sell agreement had been set up so that the surviving owners personally purchased the stock from the deceased shareholder’s estate (rather then using the corporation to buy the stock), the survivors would get a "step up" in tax basis in the purchased stock. Under this arrangement, called a "cross purchase" agreement, the higher basis will mean a smaller capital gains tax when they later sell the stock. For example, suppose one owner of a two-owner business had put $25,000 into the company 10 years ago and her shares are now worth $1 million. At her death, the surviving owner is obligated to buy back her interest under their buy-sell arrangement. The surviving owner takes that $l million as his basis for income tax purposes. If he then decides to sell it for $1 million, no capital gains taxes would be due.

Compare that to the scenario in which their company buys the stock with the life insurance proceeds under a redemption agreement. In that case, the tax basis in the stock remains at $25,000. If the company stock is later sold, a 20% capital gains tax would be due on $975,000 — the difference between $1 million and $25,000 — for a tax liability of $195,000.

Another tax problem with the stock redemption agreement is that the death proceeds received by the corporation may be subject to the alternative minimum tax (AMT). The AMT rate for corporations is 20% of its "alternative minimum taxable income." Corporations paying the AMT may be eligible for a tax credit that may be used in later years to offset regular taxable income in excess of the AMT in those years. Since 1997, certain small corporations are deemed to have a tentative minimum tax of zero and thus are exempt from the AMT. If the corporate AMT applies, payment of the AMT in the year of the stock purchase could significantly affect cash flow and inhibit the corporation’s ability to survive.

Periodically review your succession plan

There are, of course, many other tax and nontax issues to consider in determining what kind of business succession plan makes the most sense for you. Whatever arrangement you set up, be sure to review it periodically with your attorney and financial consultant.

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