Forms

Business Succession Planning is written for all advisors, including lawyers. The Forms portion of the book is especially helpful to lawyers, but all advisors need to be familiar with common forms used with succession planning for business entities.

The forms section contains a sample shareholder agreement. This document contains owner agreements about triggers for buying and selling as well as management agreements. A similar document to be used by limited liability companies is the limited liability company operating agreement. Similarly included in the forms section is a limited partnership agreement. Other agreements of more specific application are a form annuity agreement for use in a business transfer and a qualified subchapter S trust, used with ownership of S corporations by trust entities.

Installment Payment of Estate Tax

Generally the most significant liquidity need of an estate is its liability for federal estate taxes. These taxes are due nine months from the date of the decedent’s death. Recognizing that closely-held businesses are likely to face serious liquidity problems, and attempting to create a relief provision to make it unnecessary to sell the business interest to pay death taxes, Congress enacted a provision to permit the deferral of estate tax payments. §6166.

§6166 is available only if the decedent was a U.S. citizen or resident at the time of death, and the value of the decedent’s interest in a closely-held business exceeds 35% of the value of the decedent’s adjusted gross estate (defined in the same manner as under §303. §6166(a)(1). If these tests are met, the personal representative of the decedent’s estate can elect to defer for 5 years payment of the portion of the estate taxes attributable to the closely held business interest (multiply the total estate tax liability times the ratio of the value of the business interest to the value of the adjusted gross estate) and thereafter pay the deferred portion in up to 10 annual installments. The estate tax attributable to non-closely held business assets is due at the regular time, 9 months from the decedent’s date of death.

Chapter 22 of Business Planning Succession describes the installment payment of estate tax and the intricacies of using that method of paying federal estate taxes.

Redemptions to Pay Taxes

Redemptions of stock may be necessary to pay death taxes attributable to stock ownership in closely held corporations. Congress enacted a special relief provision, § 303 of the Internal Revenue Code. § 303 treats as an exchange (and not a dividend) a redemption of the decedent’s stock so long as more than 35% the decedent’s adjusted gross estate consists of the stock of the closely held corporation.

Chapter 21 of Business Succession Planning deals with redemptions to pay taxes pursuant to this provision and explains the requirements of § 303 and important preparatory strategies if it is foreseeable that § 303 will be used.

Gifting of Ownership Interests

Consistently business owners are told by tax advisors that it is better to not own a business interest at the time of death. From the point of view of the owner’s estate, there is the problem of having to include the value of the business interest in the estate. Aside from the issues involving payment of the tax, there is the issue of the appropriate value to place upon the business interest and whether that value will be attacked by taxing authority. From the point of view of the business, there is the problem of who will become the new owner or owners of the business interest. Will the new owner or owners also be managers of the business? If they are not managers, will the aspect of investment return on the owners’ interest be emphasized in a way it was not before?

There is no panacea in simply gifting business interests to children. Frequently much of the wealth of the family is in the business. There are tax and natural incentives to transfer the business to the children. There usually is a strong, if not overwhelming, desire on the part of the parent to treat children equally. Frequently not all of the children will be involved in the business. When this is the case, the effect of having inactive or non-managing owners should be carefully considered as a part of the overall estate planning process. The tension between owner-managers and passive owners is usually that certain benefits are available from the business to owner-managers. These may include fringe benefits, life style enhancements involving travel, automobile use, and other business-related expenses that will not be available to passive owners. The value of these benefits will be difficult to develop, but it will affect the profit of the business, which will be the primary concern of the passive owner.

Chapter 20 of Business Succession Planning deals with the means by which the gift of a business interest can be accomplished and the factors involved with that process. The chapter covers why the gifting of a business interest is more attractive from an estate tax perspective than a gift at death. The difference in the basis acquired by the donee as compared to a purchaser of a business interest is explained. Also techniques of gift giving are explained.

Covenants Not To Compete

A buy-sell agreement should consider means by which a business and the remaining owners are protected against the perfidy or talent of a former employee-owner. Part of this consideration should be the acknowledgement that any former employee-owner is entitled to earn a livelihood with the skills and experience possessed by that person. These concerns are dealt with by the terms of noncompetition, nonsolicitation, and confidentiality clauses.

Chapter 19 of Business Succession Planning deals with the issues concerning these clauses. Many states have enacted legislation governing noncompete agreements. Often these clauses are sought to be enforced by injunction. Frequently there are provisions for damages as well. Court cases often evolve, rightly or wrongly, about the reason for employment termination and the nature of the trigger compelling sale of ownership in the buy-sell agreement.

Transfer Restrictions

For an ownership agreement to work effectively it must limit the marketability of ownership interests involved in the agreement. Otherwise, the agreement is avoided simply by an owner with a marketable interest selling that interest to a party not bound by the agreement. If this can be done, it will prejudice the economic interest of minority ownership interests who will not have marketable interests.

On the other hand, there is a policy in common and statutory law against restrictions on alienation of property. While these concepts come mostly from the law of real property, it has generally been held that an absolute prohibition on transfer of ownership interest or a restriction on transfer of ownership interest that requires consent of the other owners is invalid.

Therefore ownership agreements involving buy-sell provisions typically have given the other owners, either acting on behalf of the business entity or in their own interest, the first option, right of first refusal, or first opportunity to purchase the interest at an agreed upon price.

Chapter 18 of Business Succession Planning deals with Transfer Restrictions and some of the issues involved with drafting and enforcing these restrictions.

Estate Tax Considerations

Chapter 17 of Business Succession Planning deals with estate tax considerations of succession planning. For obvious reasons it is a survey of issues, among them are the following:

1. Whether by creating an enforceable market for the shares of a corporation a buy-sell agreement will establish the value of a deceased shareholder’s shares?

2. Can certain redemptions of corporate shares be taxed as a dividend?

3. Will certain transfers contemplated by a buy-sell agreement be treated as a gift under § 2703?

4. What provisions are required in a buy-sell agreement (such as lifetime restrictions and having an obligation to purchase) for an enforceable market for the shares?

5. Does the agreement price have to relate to fair market value of the corporation at the time of death?

6. What are the circumstances required to show the existence of a valid business purpose for the agreement and other requirements of § 2703(b)?

7. What is the effect of a buy-sell agreement on the estate tax marital deduction?

8. What is the appropriate use of § 2032, allowing an alternative valuation date?

9. What are the considerations in using the provisions of § 6166, permitting the payment of estate taxes in installments?

10. Is it possible to fix values on shares for gift tax purposes or for purposes of the generation-skipping tax on lifetime transfers?

11. In buy-sell agreements with insurance funding, will insurance be included in the estate of the insured under § 2042?

Beware the “New Loss Corporation”

§ 382 of the Internal Revenue Code states the general rule that the amount of taxable income of any “new loss corporation” for any post-change year that may be offset by pre-change losses shall not exceed the § 382 limitation for such year. Where an “ownership change” (significant shareholders have increased their stock ownership by more than fifty percentage points) occurs, the amount of the corporation’s net operating loss carry forwards (NOLS) as well as its built-in losses and operating losses incurred prior to the ownership change, allowed for a post-change year is limited to the value of the corporation times the long-term tax-exempt rate contained in § 1274(d).

Where a corporation is valued for tax attributes such as NOLS, this tax code provision must be considered carefully. Chapter 16 of Business Succession Planning covers the limitation of § 382 and also discusses certain exceptions, including those for buy-sell agreements.

Employment-Related Restrictions

Something that is frequently over looked in the review of buy-sell agreements is the effect of employment-related restrictions with respect to the body of law, regulations, and tax provisions concerned with employment status. Employment law and regulations are a state concern. That is one reason why it is important to identify a state jurisdiction when drafting a buy-sell agreement. From the federal tax aspect, § 83(a) of the Internal Revenue Code provides that an employee who receives substantially vested stock “in connection with the performance of services” must recognize as ordinary income the difference between the value of and the amount paid for the stock received.

In an effort to create shareholders, sometimes stock is transferred to employees under conditions or at a lesser price than might otherwise be charged. This can bring certain tax consequences that may not be anticipated. Chapter 15 of Business Succession Planning discusses the effect of § 83 and related regulations on buy-sell agreement arrangements.

Funding the Buy-Sell Arrangement

Funding is critical to the essential value received and the enforcement of the buy-sell agreement. Where funds are immediately available, such as with life insurance proceeds, the price can be paid immediately rather than over time. Where funding is available, it is much more likely the buy-sell agreement will be implemented.

There are a number of different methods to fund a buy-sell agreement, and Chapter 14 of Business Succession Planning reviews these methods. The method can be determined by the trigger causing the transfer. There can be differing tax implications for each funding method. Most importantly the funding cannot drive the value determination, it must the value that is then appropriately funded.

Value

At the heart of the buy-sell agreement is the value used for the transactions provided for by the agreement. Critical to the appropriate functioning of the buy-sell agreement is the understanding that the value and terms of sale will vary depending upon the trigger causing the sale.

Another common misunderstanding is that value will not be the same for one owner buying from another owner as it will be for an outside (non-owner) buyer. The outside buyer will pay for intangible knowledge not possessed by a non-owner. The inside (owner) buying an additional ownership interest should not have to pay for these intangibles. This is the difference between “fair value” and “fair market value.”

These concepts as well as the test for value involved with the funding of the purchase are contained in Chapter 13 of Business Succession Planning.

Triggers and Payment Terms

When an event occurs that is contemplated by a buy-sell agreement to cause a purchase or sale of a business interest, that event is called a trigger. Common triggers include death, disability, retirement, withdrawal from employment, competition with the corporation, certain contemplated sales or transfers, pledges and transfers pursuant to foreclosure, tag-along provisions, and deadlock.

For each trigger, a buy-sell agreement should set forth the procedure for the transfer contemplated including the payment terms. Chapter 12 of Business Succession Planning reviews and discusses triggers and related transfer procedures.

S Corporations

The shareholders of a corporation must file an election with the IRS to be treated as a small business corporation under a discrete set of taxation rules in Subchapter S – Tax Treatment of S Corporations and Their Shareholders, Subtitle A – Income Taxes, Chapter 1 – Normal Taxes and Surtaxes, Title 26 – Internal Revenue Code, United States Code. Subchapter C of Subtitle A governs Corporate Distributions and Adjustments for corporations not electing S corporation tax treatment. Hence, the nomenclature C corporations and S corporations has been established.

An S corporation must maintain its status as a “small business corporation” under § 1361 of the Code at all times. Generally this requires that the S corporation, having properly elected S corporation status, not have more than 100 shareholders, not have a shareholder who is not a person (with certain statutory exceptions), not have a nonresident alien as a shareholder, and not have more than one class of stock.

The buy-sell agreement must provide a procedure that prevents the S corporation from “ceasing to be a small business corporation” and thereby terminating the S election “on and after the date of cessation” pursuant to § 1362(d) of the Code.

Generally the two problem requirements have to do with a shareholder being an individual (especially in the case of the shareholder’s death) and there only being one class of stock. Chapter 11 of Business Succession Planning reviews these requirements and describes the various methods of dealing with the issues of S corporations.

Structure of the Buy-Sell Agreement

The three basic structures of the buy-sell agreement may be analyzed from the aspect of the source of funding of the purchase, from the perspective of the shareholders purchasing shares, from the perspective of the shareholders selling shares, and from the perspective of the corporation.

Chapter 10 of Business Succession Planning reviews the structure of the buy-sell agreement from these perspectives. It is important an advisor take into consideration the tax and other legal aspects of these structures. Adding to the complications brought by these factors is the frequent use of the hybrid structure whether the aspects of the structures are combined in one structure.

Creating the structure of the buy-sell agreement requires the business succession team to communicate and act together to document a solid and understood structure for the buy-sell agreement.

Buy-Sell Agreement

Once a succession plan is created in written form, the plan should be made enforceable. The document that makes the succession plan enforceable is the buy-sell agreement. In the corporate context the buy-sell agreement might be called a shareholder agreement. In the LLC or partnership context buy-sell provisions should be in the operating or partnership agreement.

The buy-sell agreement has a number of more specific functions or purposes and these are detailed in Chapter 9 of Business Succession Planning. Of course a primary purpose of the agreement is to deal with value. The purposes are accomplished through one of the three basic structures of the buy-sell agreement: cross purchase, redemption, and hybrid.

Creating the Succession Plan

Business owners of owner-managed businesses frequently do not prioritize and schedule planning time. In addition, the owners have difficulty planning as a group and in having critical conversations. If there is a group and a scheduled planning meeting, the meeting is often not conducted appropriately.

Chapter 8 of Business Succession Planning deals with the process that can create the succession plan. It deals with the two basic tactics to get the group discussing the planning issues, the questions technique and the fire drill technique. The chapter goes on to discuss the topics that must be reviewed and decided upon before a written plan can be produced. The production of such a written plan is a difficult but valuable basis for successful business experience.

External Systems

Internal ownership systems are usually accounted for and understood. Ownership interests are purchased and held as capital accounts. External ownership systems involving those who have a critical interest of the business but are not owners are less well defined. The easiest example is the husband, who is an owner of the business, and his wife, who is a stakeholder of the business, one who has a critical but not direct ownership interest in the business.

In Chapter 7 of Business Succession Planning entitled External Systems the observation is made that if the stakeholder is ignored, frequently the plan will have to be revised to recognize the interest of the stakeholder. At the same time there need to be boundaries between the governance of the external system and the governance of the internal system.

For example, the well advised family-owned business has two areas of governance, one for the business and one for the family. For example, the family might have a family council and the business might have a holding company. The boundaries for these areas of governance need to be established and respected. If this is not the case, then the establishment of these governance structures and boundaries is the first step. The governance of the business must involve appropriate selection of personnel based on merit (not relationship to the family) and the culture of the company. The strategic and operating plans for the business must deal with the culture of the business and the process of authority and delegation. As appropriately selected managers come into the business, the planning cycle (analysis, written plan including actions, implementation, and analysis) should continue and involve these new managers. Frequently the issues of control, delegation, and trust are at the forefront.

The creation of a written plan containing wise decisions evolved from polling a group of diversely informed individuals (including those new managers) is the best way to deal with these issues.

Control, Power, and Prestige

For the dominant owner, the succession plan will be acceptable depending on the factors relating to control, power, and prestige. These factors will determine whether the dominant owner is comfortable with the plan. That comfort level will usually have something to do with the ability of the dominant owner to stop the succession process until some significant point is reached in the planning process.

As an example, a dominant owner of a corporation may agree to a sale of shares up to the point that the dominant owner is no longer owner of a majority of shares in the corporation. At that point the dominant owner may not feel comfortable owning less than a majority of the shares unless other things (such as the receipt of an appropriate amount of money) have occurred.

Chapter 6 of Business Succession Planning is titled Control, Power, and Prestige and deals with the importance of these factors in compiling an effective succession plan.

Meetings and Decisions

Many businesses hold meetings ostensibly “to make decisions.” In Chapter 5 of Business Succession Planning, the argument is made that meetings are not where decisions should be made.

Wise decisions are made when a manageable group of diversely informed individuals aggregate their judgments. The process of aggregation, polling, is done by the decision-maker, the one who has authority to make the decision.

While a meeting may be a place where information is efficiently disseminated, it is not a good place for decision-making. Polling is better done outside the meeting and is most accurate when done in writing. A meeting may, however, be an excellent place to announce a decision.

Creating a succession plan is done by documenting a series of decisions. It is essential for the quality of the planning that meetings be used appropriately.

Values

Years ago I gained an insight from a fine book, Estate Planning for the Healthy Wealthy Family, Baris, Garrity & Neeleman (Allworth Press). For the authors this insight was “axiomatic” - that if you exercise personal choice in the development, management, consumption, and disposition of personal and community resources in harmony with your core values, you will likely experience a sense of self-fulfillment and personal well-being.

While I was doing succession planning work with business owners, I had not been asking about the owner’s core values. I now ask the owners to be able to articulate their values as is appropriate in the planning process. I find this leads to some definitional work and then hard work. What we discover is that this is work of a lifetime, not just for a planning project, and that it is valuable and rewarding work that should be diligently continued.

A value is a guiding principle that informs and controls thoughts, desires, feelings, choices, and behavior. A value is not a preference, but an enduring and essential attribute of character. Most owners are only vaguely aware of the principles that comprise their personal value systems. Most unthinkingly embrace an array of concerns and standards to which they assume most caring and intelligent people adhere. Few have consciously attempted to resolve the tension that inevitably arises when those concerns and standards conflict. If an owner’s value system is to serve effectively as the framework for the formulation of a plan, the owner must first clarify and prioritize its components. To bring clarity and order to the owner’s personal value system, the owner should reflect on the circumstances and experiences that have informed and shaped the owner’s hopes, fears, and perspectives. The product of this reflection should be memorialized in writing. The writing should be reviewed and altered from time to time to reflect changing circumstances and perspectives.

Chapter 4 of Business Succession Planning deals with Values. Advisors should encourage each owner to seek the resources, especially those available from counseling professionals, necessary to effectively think about and articulate his or her values. Ask each owner to work to define their values and then, as is appropriate in planning discussions, articulate relevant values. The planning results are much better where the owners are able to define and articulate their values.

Critical Conversations

Most of the meaningful discussions concerning ownership of a business will be considered to be critical conversations. A critical conversation is one where a meaningful exchange of information or opinion occurs. Often there is an emotional context to the conversation.

It is very common to find that owners either avoid critical conversations or have difficulty conducting effective critical conversations. It is a skill which much be learned to plan effectively.

In Chapter 3 of Business Succession Planning there is an explanation of the methodology of conducting the critical conversation. Once this skill is mastered – and it does take some practice – owners can engage in critical conversations as a part of making good decisions in planning.

If It Were Not Mine, Would I Buy It?

The aspect of change is intimidating especially to the owners of a successful business. “If it ain’t broke, don’t fix it” is a mantra for many owners. Advisors will perceive opportunities for increased profitability, need for strategic planning, and deficiencies in entity maintenance leaving exposure to liability, and owners will have difficulty in appropriating resources and responding to these perceptions.

One of the best techniques to challenge the owner who is reluctant to change is to ask: “If this were not your business, as a savvy business purchaser, would you want to buy it? If not, why not?”

Perhaps the owner’s quick answer might be “Of course I would buy this business - it is a successful business with a good cash flow.” The follow up is to remind the owner what sophisticated purchasers do – they conduct a diligence investigation. Challenge the owner to conduct a diligence investigation and then answer the question.

It helps of course if you have a diligence checklist that provides the elements of a competent diligence investigation. As is known from most people’s personal experience, often things are in their best shape right before they are sold. Cars get detailed. House get painted and even remodeled to bring the desired sales price.

One of the best ways to manage a business is to prepare it for sale. To ask why a business would not be desirable to a purchaser is to begin on a valuable diligence investigation. It is an investigation most owners are not motivated to begin. But if they do the investigation, they find it is a valuable tool and motivator for executive management.

As advisors, we often perceive and indicate to owners certain areas of opportunity and deficiency to find that owners do not respond. There may be a variety of reasons for this, but we would be equally willing, and in fact enthusiastic, to respond to owner-perceived opportunities and deficiencies. Suggesting that the owner conduct a diligence investigation of the owner-managed business can be a good technique to stimulate the otherwise complacent owner.

Owners

Owners of an owner-managed business frequently do not prioritize planning and implement planning as a regularly scheduled activity. Moreover, they do not look at planning as a group activity.

Chapter 2 of Business Succession Planning deals with the planning process and how it involves the owners of a business. Most importantly it deals with how the advisor must control the owner’s expectation of what the planning process will produce.

Advisors

The first paragraph of Chapter 1 of Business Succession Planning states:

"The locus of points of the business succession universe may be visualized as being spherical – circular in all directions - multiple in tiers and dimension. One who would advise the business owner on succession must be familiar with the orbital issues involving business, estate planning, tax, valuation, and strategic planning. There is no one profession that may claim the universe as inherently its own or under its control. Each path influences the other. A change in one point necessitates a change in other points. The depth and complexity of the subject begs for collaboration. At the center of it all and most important, is the planning process."

The universe of business succession planning is not the domain of one profession - it is not even under the influence or guidance of one profession over any other. There is no one person who can be "quarterback." There must be a team of advisors, and, to be as effective as possible, they must work together with the owners as a team.

Business Succession Planning was written for all advisors interested in business succession planning. That is also the intent of this blog - to reach out to all those advisors.

About the Book

This book provides all the necessary elements needed during the business succession planning process. The focus will be on the business, legal, and tax implications that need to be addressed. A CD-ROM will accompany the book that contains documents to enforce the plan with an emphasis on buy-sell agreements.

Did you know?
• 37% of all Fortune 500 companies are family owned;
• 60% of all public companies in the US are family controlled;
• 39% will change leadership in the next 5 years;
• 42% of CEOs who plan to retire in less than 5 years have not chosen a successor;
• 55% of CEOs 61 years or older have not chosen a successor;
• 36% have bought out a family member; and
• 37% have a written strategic plan.