Introduction

If you are an owner of a business, either you or state law will determine how your business interest will pass to someone else if you were to become incapacitated, decide to retire from the business, become insolvent, die or decide to sell your interest in the business. Business succession planning refers to planning for changing ownership of a business interest. There is no one document used for business succession planning. Instead, it requires the coordination of several documents, including:

each owner's will or revocable trust;
entity documents such as articles of incorporation, articles of organization, by-laws, operating agreement, partnership agreement, etc.; and
buy-sell agreements

If there are no governing documents, state law will determine the outcome of the change in ownership, sometimes with court involvement. Therefore, it is in everyone's best interest in the business to agree in advance what rights each owner has and what restrictions should apply with respect to transferring business interests.

Planning Objectives

The first step to any succession planning process is to identify the goals of the owner. There are a number of questions that need to be addressed in order to do proper planning.

Do you want the business to remain in the family or to pass to key employees?
Do you want to sell the business and then invest the net proceeds?
What are your cash flow needs and income tax objectives?
Is the estate tax a concern?

Planning Tools

There are a number of tools that can be used to plan for business succession.

Wills and Trusts. If the primary objective is transferring your business at death, a will or a revocable trust is an essential tool to determine who will get what interest and on what terms and conditions. If the estate tax is an issue, a critical concern will be how the estate taxes will be paid. If non business assets are insufficient to pay the estate tax on the business interests, the business interests may have to be sold or borrowed against in order to pay estate taxes.
Buy-Sell Agreements. One of the most frequently used planning tools for transferring business interests is the buy-sell agreement. It may be referred to as a shareholder's agreement or a redemption agreement, and sometimes terms of the buy-sell agreement are incorporated in partnership agreements, limited liability operating agreements, by-laws and other agreements.
Gifting. One of the most common ways to shift business interests to family members is to make gifts. Gifts of interests in any family business are usually subject to valuation discounts because of lack of voting control and the lack of marketability. By making lifetime gifts, it is often possible to reduce an owner's interest to a minority share, entitling the estate to a valuation discount for estate tax valuation purposes.
Installment Notes. By selling your business for an installment note to a child, the value that will be included in your estate is fixed. If the note is paid off, the value that is included in your estate will decrease over time. If you are given a self-canceling installment note, it is possible to exclude the entire value from your taxable estate at your death.
Private Annuities. A private annuity is an arrangement whereby you agree to sell your interest in the business in exchange for periodic payments for a fixed period of time or until your death. The use of a properly drafted private annuity will ensure that you receive income for the rest of your life and that the value of the business will not be included in your taxable estate. While proposed regulations undermine the utility of private annuity sales for appreciated property, exchanges of assets with little or no appreciation generate minimal taxable gain and remain useful estate planning tools.

Buy-Sell Agreements

Preparing Buy-Sell Agreements. There are a number of issues that need to be addressed when preparing buy-sell agreements.

� Triggering Events. The purchase and sale of a business interest may be triggered by a number of events, such as an owner's incapacity, death, insolvency, retirement, divorce or receipt of an offer from a third party. A buy-sell agreement need not cover all these situations, but the more triggering events that are addressed in the agreement the less likely there will be a controversy.

� Obligation vs. Right of Refusal. A buy-sell agreement may provide for a mandatory buy-out so that upon the occurrence of a triggering event, an owner must sell and the company or the other owners must purchase the selling owner's interest. An alternative is a right of refusal that says that only one of the parties may sell or purchase and that the other party has to abide by that decision. For example, the agreement may provide that if an owner wants to sell shares to a third party, he is required to sell to the other owners or to the company for the same price and the same terms, but only if the other owners and/or the company elect to purchase his interest.

� Redemption vs. Cross Purchase. The buy-sell agreement might require the company to purchase the selling owner's interest in a redemption or it might require the other owners to purchase the interest under a cross-purchase agreement. Many agreements use both provisions, giving the other owners the right to purchase if they choose to do so and requiring the company to purchase if the other owners do not do so. The cross-purchase arrangement will increase the other owner's income tax basis on their equity interest whereas a redemption will not.

� Insurance. When a triggering event can be covered by insurance, such as disability or death, a buy-sell agreement can specify whether such insurance is mandatory or optional, how it is paid and how the proceed are to be applied. If insurance is not provided for or is inadequate, the agreement should provide for an alternative method of payment, usually in the form of a long-term note that allows the purchaser to make affordable payments with an agreed upon payment schedule and interest rate.

� Purchase Price. One of the most important provisions in a buy-sell agreement is the method for setting the purchase price. One method is to merely pick an agreed upon price, but that can become quickly outdated and an outdated price is usually unfair to at least one of the parties. The best method may be to provide for a qualified appraiser to determine the price, but some businesses can be valued using a formula based on asset values, net income within the past few years, and other factors. When the estate tax is an issue, it is important that the buy-sell agreement be designed so that the Internal Revenue Service will accept the price under the agreement as the value of the business interest for estate tax purchases. Generally, for a buy-sell agreement to be binding on the IRS, the agreement must be a bona fide business arrangement, not a device to transfer the property to members of the owner's family for less than adequate consideration and it must have terms that are comparable to similar arrangements entered into persons in an arms length transaction.

Conclusion

For a smooth transfer of a business, it is important to plan ahead. It is particularly important to consider the transition in a number of different scenarios, including receipt of a third party offer, disability, retirement, insolvency, death or divorce. While a will or revocable trust can be used for transfers at death, there are a number of other important tools that should be considered. Chief among these are buy-sell agreements, installment notes and private annuities. Effective business succession planning can be accomplished only after taking into consideration the unique circumstances of the business and its owners, and often involves a team approach consisting of the owners, their family, their accountant and lawyer in order to design the proper plan.