Keeping The Family Business Alive
Family firms comprise 80 to 90 percent of all business enterprises. Less than half of these family-owned businesses survive into the second generation. And only 12 percent will still be viable into the third generation, with three percent of all family businesses operating at the fourth-generation level and beyond, according to research done by Joseph Astrachan, Ph.D., editor of Family Business Review.
For many business owners, their business is their largest asset. They’ve worked hard to build a successful business and fulfill their dream of creating a legacy and economic driver for their family and community. While creating a formal strategy to exit your business may seem daunting, there are dangers of not having a strategy to deal with a sudden death, disability, or retirement of the owner(s).
A well-structured business buy-sell agreement can address these issues. A buy-sell agreement outlines how business ownership will change hands and how the transfer will be paid for in case of a co-owner’s death, disability or retirement. Generally, the agreement provides for the purchase of the departing business owner’s interest by the surviving co-owners or the company itself.
The most common buy-sell agreements use a cross-purchase or a stock-redemption arrangement. With a cross-purchase agreement, the owners agree among themselves to buy a deceased owner’s interest. A stock-redemption agreement is an agreement between a corporation and its shareholders under which the corporation redeems stock in the event of a shareholder’s death.
Cross-purchase agreements have several advantages. For example, the surviving owners receive a “stepped up” income tax basis in the stock bought from the deceased’s estate, which can reduce capital gains taxes if they later sell the stock. Additionally, the insurance proceeds from a policy used to fund a cross-purchase agreement aren’t subject to the corporate alternative minimum tax. Nor are they subject to the claims of corporate creditors.
Unfortunately, cross-purchase agreements can be hard to administer, especially when the business has many owners. For instance, since the business owners carry insurance policies on each of their fellow owners often 20 separate insurance policies would be needed for a business with five owners.
Stock redemption agreements can be a better choice when a corporation has multiple owners, some of the owners are considerably older or younger than the others, the size of the ownership interests vary significantly, or the corporation is in a lower tax bracket than the owners. Despite the clear advantages, stock redemption plans have a couple of drawbacks. First, the life insurance proceeds received by the corporation may be subject to the corporate AMT (alternative minimum tax). Second, the surviving shareholders do not get the benefit of an increase in the income tax basis of their shares when the corporation redeems the stock.
One common mistake business owners make is not considering the possibility of an owner becoming disabled or divorcing. In the event of divorce, for example, an ex-spouse could end up as an unwanted partner in the business. Often times business owners who aren’t responsible for day to day operations may not be concerned about disability. In the event the owner becomes disabled additional revenue must be generated to hire a replacement, causing extra stress on the bottom line.
Other easy-to-overlook events that could adversely affect your business include the departure of a minority owner and the personal bankruptcy of one owner. When you structure your agreement, you should consider all the events that could cause an ownership change.
Perhaps the biggest mistake business owners make with their buy-sell agreements, though, is not keeping their business valuation up to date. Unless you have your business revalued regularly, the buyout amount in your agreement may quickly become outdated, leaving the business vulnerable to serious disputes should a buyout become necessary. At the death of an owner, the IRS may value your business at much more than you think it’s worth, making your estate potentially liable for estate tax. Your family may be forced to sell the business if there is not enough cash to cover the estate tax.
These are just some of the factors to consider when developing a business succession plan to keep a business alive for future generations. Every business has unique circumstances. A certified financial planner, legal advisor and tax advisor can help you identify the various issues and considerations that specifically affect your business and determine what type of buy-sell agreement and other planning strategies make the most sense for you.
Autumn Chalker Soltysiak, CFP® is a registered representative of Lincoln Financial Advisors, a broker/dealer, member SIPC, and offers investment advisory service through Sagemark Consulting, a division of Lincoln Financial Advisors Corp., a registered investment advisor, in Traverse City. This information should not be construed as legal or tax advice. You may want to consult a tax advisor regarding this information as it relates to your personal circumstances.