What Is Your Plan to Leave Your Business?
What if You Can’t Work Tomorrow?
Study after study reveals the majority of business owners, anywhere from 60-80%, lack a succession plan. Of those business owners, 50-70% do not have a specific transition plan. You have spent a large part of your life and poured your heart, soul, and money into your business, making sure it is successful. You, your family, your employees, and your employees’ families all rely on your business for their livelihood.
You will exit your business at some point. We all do. We may retire. We may sell our business, or we may exit by force, by way of a disability, sickness, a changing economy, or due to government regulations. All of these life events threaten our business, our family, and our lifestyle. Throw in other complex issues, such as concerns for estate taxes and the changing workforce, and we all have a potential business catastrophe in the making. We can’t control most of these events, but we can de-risk our business and build a hedge against the derailing of our business with proper planning.
What is your succession plan?
Succession planning is part of the estate plan that is focused on the ongoing operation and prosperity of your businesses or company. This can be a small family business or a larger business. Effective business planning is concerned with supporting the growth and ongoing operation of your business while equipping the business to withstand difficult circumstances, such as losing an owner unexpectedly.
The issues within the scope of succession planning can be summarized as business succession and continuity planning, business asset planning, planning for key persons, and implementing life insurance strategies for key people. These strategies include executive bonus plans, deferred compensation plans, and split-dollar plans.
Without a clear succession plan, disputes can arise among partners—or their surviving spouses—that will lead to loss of time, lead to expensive litigation, and possible business failure.
One of the most often overlooked business documents of a business is a Buy-Sell agreement.
It is not just enough to have a Buy-Sell agreement, but it needs to be funded correctly and updated yearly. As your business makes changes and grows, so will the business’ needs and your family’s needs. If you do not have a properly funded Buy-Sell agreement in place, your business and your family’s income are at risk.
What Is A Buy-Sell Agreement?
It is a written legal contract between a business and its owners that specifies how a specific event, such as death, divorce, disability, or departure for any reason, affects the management and control of the business.
A Few things it Accomplishes
- Facilitates the orderly transfer of business interests when business owners depart from the business due to certain specified events
- Establish a value for the purchase price of the business and for estate-tax purposes
- Creates a legal obligation for the departing owner to sell his or her business interest, and a legal obligation for the buyer to purchase the interest
- Creates a market for the departing owner’s interest in the business when no such market exists in the absence of such an agreement
- Ensures that the survivor of a deceased owner is compensated for the deceased owner’s interest
- Prevents a deceased’s interest from being locked up in probate
- Provide a source of funds
Basic approaches to structuring Buy-Sell Agreement
Cross-Purchase Buy-Sell Arrangement:
- Anticipates that a co-owner will be the buyer of a departing owner’s business interest. It obligates the remaining owner to buy out the interest of the deceased or departing owner.
Entity Purchase Buy-Sell Arrangement:
- A buy-sell agreement between the business and the individual owners
- The business will be the buyer of a deceased/departing owner’s business interest. (Where the business is in the form of a corporation, this buy-sell agreement is known as a stock redemption agreement.)
The One-Way Buy-Sell Arrangement:
- A legal contract between the business owner and some third party addressing the disposition of the owner’s business interest upon his/her death, disability, retirement, or other departure.
- It obligates the purchaser to buy out the interest of the deceased or departing owner.
A Hybrid Approach:
- At the time of the structuring of the arrangement, it is difficult to determine if one method is better than the other.
- Generally, defers the choice until a triggering event occurs.
- Generally, allows the business with the first right-of-refusal to purchase the deceased/departing owner’s interest.
- The remaining owners are then given the option to purchase the business interest, but if they do not, the business is obligated to purchase the remaining interest.
What are Triggering Events?
Events that may prompt the purchase of a departing owner’s interest by the remaining owners or the business are called “triggering” events.
A trigger event normally prompts one of three events:
- an option of a buying owner to buy out the selling owner’s interest.
- an option of the selling owner to force the buying owner to buy him/her out.
- a mutual obligation on both, the buying-owner to buy, and the selling-owner to sell the ownership interest.
Although some transfers of interest are clearly advantageous and should be permitted, others may not be as desirable.
In these situations, it may be better to force the sale of the business and for the remaining owners to purchase an owner’s interest. It could be particularly advantageous if the departing owner’s interest is on the verge of being transferred to a potentially undesirable owner, such as a soon-to-be ex-spouse.
Common triggering events
- Termination of Employment
- Pledging of an Owner’s Interest
Are you comfortable with your current business plan?
There is nothing wrong with getting a second set of eyes on your business plan. It is important to review it at least once a year. Do you know what your current plan will accomplish in these situations? These are only a few problems that can arise and destroy your business.
Death of a Business Owner
Do you want to inherit the owner’s spouse, ex-spouse, or other family members? Should the owner’s heirs inherit the role of ownership or is it more desirable for the surviving owners of the business to be able to buy out the interest of the deceased owner?
- What if they know nothing about the business?
- What if they want total control?
- What if they just want the money from the business? Will they force the sale of it?
- How will you finance buying the business? Can you finance it? How much will you have to buy it for?
- How is disability defined?
- Many Buy-Sell agreements do not have the proper definition of what a disability is. Oftentimes, there is a discrepancy between what a Buy-Sell agreement says a disability is and what your insurance says a disability is.
- Agreements that rely on the definition of “disability” within an existing disability policy may require the opinion of a physician or may depend on the interpretation of a formula that takes into account the tasks the owner performs in the normal course of business.
Common Causes of a Disability
- Heart Disease
- Nervous system Disorders
- Mental Illness, including depression
- Injuries sustained from accidents, such as auto accidents
Termination of Employment
Depending on the agreement and how your business is set up from a legal structure and a tax structure, the owner(s) of the business may or may not be an employee. This is vital in structuring a Buy-Sell agreement correctly.
- Are the owner’s employees of the business?
- Or otherwise, actively engaged in the business?
- What if an owner steps down, changes roles in the business, retire, or otherwise terminates employment with the business?
- Should the business owner be able to sell their business interest to anyone? Or should this trigger an event where the other business owners get First-Right-of Refusal
- Do you want your business partner’s ex-spouse as your new business partner?
- There is no way to guess how a divorce judge will disperse a business owner’s assets (which include the owner’s interest in the business).
- Buy-Sell agreements can allow the divorcing owner to have the first option to purchase his or her interest back from his or her soon-to-be ex-spouse.
- Buy-Sell agreements can often provide that if the divorcing owner does not exercise this right, then the remaining owners and the business have the option to buy the owner’s interest from the divorcing owner’s spouse.
- Do you want the bank as a business partner making day-to-day decisions?
- Most buy-sells prepare for the bankruptcy of an owner by mandating that the remaining owners and the business will have an option to buy out the bankrupt owner’s interest, rather than be forced into having the bank as a business partner.
Determining the Purchase Price
Once you have defined the types of events that can trigger the purchase of an owner’s interest in a business, you need to set a price in which the business will be bought.
When a Buy-Sell agreement is established, each owner will not know whether he/she will be on the buying side or the selling side. It is best to put into place a neutral procedure for determining the price and value of a business.
- The foundation of this planning is built upon an accurate estimate of the value of your business.
- You may have some opinion of what your company is worth, but what could your business be sold for if put on the market?
- With the proper planning, you can increase how much you sell your business for
- Fair market value depends on many variables.
- Legal and tax considerations make the valuation process even more complex.
Ways to Approach the Evaluation of the Business
- Do business owners have the time or discipline to get together every year to have a debate and determine the value of the business?
- Will optimism be high, and an unrealistic value is assigned?
- What if an owner is planning to leave and wants the value of the business much higher than the true value?
Agreement of the owners can be ineffective, difficult to determine, and expensive to determine. An owner may want a specific formula for valuing the business, but the formula may not reflect the true value of the business.
The business Valuation clause outlines that a business valuation expert will assess the appropriate method to value the business.
There should include ground rules such as:
- How the price is determined
- Who can or can’t be a buyer
- How a business sale will be funded
Business Valuation Formulas
- Book Value and Adjusted Book Value
- Capitalization of Earnings
- Discounted Cash Flow
- Accepted discounts, including lack of marketability
- Minority ownership
- May get out when we want to get out. May be forced to get out
Uncle Sam Needs his money too!
- Buy-sell agreements have tax implications
- There are certain ways that a sale or buyback of a company can be structured to minimize taxes or to allow them to be paid overtime
- Without consideration of tax matters, an owner planning to fund his or her retirement by selling shares could wind up with drastically reduced proceeds
- If a corporation uses appreciated property in redemption, the corporate-level gain is triggered
- The cost basis in the interest acquired needs to be considered if payment over time is desired, then care should be taken to determine whether the purchaser will be able to deduct interest payments
Issues by Entity
These are only a few issues that could arise.
- Certain events can cause a member to cease being a member of the LLC. Usually set forth in the company’s operating agreement. Such events can include:
- The expulsion of a member. If there are no provisions for such an expulsion, dissolution of the LLC may be the only way to get rid of a member. This can create multiple problems.
- A member may assign their ownership interest to a third-party buyer, creditor, or involuntarily to a bankruptcy trustee.
- Death or incapacity of a member.
- When a member does terminate, is the member still entitled to allocations and distributions?
- What is the price at which the remaining members of the LLC can purchase the withdrawing member’s interest?
- Provisions dealing with expulsion and the rights of the partners and the partnership upon expulsion of a partner from the business.
- Active withdrawal
- Will a withdrawal automatically result in the termination of the partnership?
- How to value a partnership interest upon withdrawal, and how that purchase price is to be paid to the former partner or the partner’s estate.
S corporations have strict definitions of what a permissible shareholder is. Because of this, much of the focus for these organizations is on the protection of their special tax status.
Voluntary or involuntary transfer of shares may result in a Shareholder that is not allowed to own stock, becoming a stock owner. In this situation, then the S corporation could lose its tax status. Such provisions and issues include the following:
- Quarterly distributions of dividend income will allow shareholders to pay the taxes owed on allocations to income.
- Transfers to trusts for estate planning purposes should be allowed, but only if the trust meets the specific requirements.
- If a transfer that jeopardizes the corporation’s “S” election should occur, an immediate option in the remaining shareholders and/or the corporation to purchase the interest should be triggered.
- Careful consideration should be given to loans, stock options, restricted stock, to ensure no impermissible second class of stock is created which could terminate the S corporation election.
Estate Planning Considerations
- Continuity and Control
- An agreement clearly stipulates what happens to the business owner’s interest in the business upon an owner’s death enables the business to continue operating with little interruption.
- Eliminating Need to Negotiate Price
- A detailed, pre-determined pricing mechanism set forth in a buy-sell agreement can remove the burden of negotiating a purchase price from the heirs.
- This ensures the heirs get a fair price for the deceased’s interest in the business.
- Fixing Interest Value for Estate Tax Purposes.
- A buy-sell agreement allows the opportunity to set the value of a decedent’s ownership interest for estate tax purposes.
- If the decedent will not have a taxable estate, then it may not be desirable to set the price as low as possible. This will only increase the amount of gain in the hands of heirs when the business is eventually sold.
- Preservation of Entity Tax Status.
- In an S corporation, allowing shares to become owned by the wrong kinds of shareholders can jeopardize the S corporation’s status.
- In general, if shares are allowed to pass to a trust, the trust should be examined to ensure it complies with the S corporation requirements.
- Liquidity to the Estate.
- A properly funded buy-sell agreement can provide much-needed liquidity to a deceased owner’s estate.
We are here to help
As you can see, putting together a solid succession plan can be complicated. There are a lot of moving parts. It requires an expert team of lawyers, business advisors, life insurance specialists, and a CPA experienced in this field. It may also include a wealth manager and an advisory board.
As with everything else, it is important to be proactive instead of reactive. DO NOT WAIT UNTIL RETIREMENT- or worse, until you are unexpectedly forced to exit your business- to put a plan in place. In order to sell a best-in-class business, it takes time to evaluate the business, to find a buyer, and to improve in areas that need improving.
Waiting too long to plan may prevent you from reaching your goals and will drastically increase your risks.
Call us today at 785-430-3717 so we can de-risk your business. Or contact us here
- This content is for general informational purposes only.
- It is not intended to provide fiduciary, tax, or legal advice and cannot be used to avoid tax penalties, nor is it intended to market, promote, or recommend any tax plan or arrangement.
- We do not give legal advice.
- You are encouraged to consult with your legal, tax, and financial professionals for specific advice or product recommendations.
- Every situation is different and requires a team of knowledgeable professionals working to create the correct agreement.
- Andrew Keehn and Blackstone Wealth Protectors expressly disclaim all liability for anything the reader chooses to do or to omit doing in reliance upon this document’s contents.
- Posting and receipt of this information is not intended to create, nor does it create or constitute, a client relationship between Andrew Keehn or Blackstone Wealth Protectors and the reader.