Succession Planning for Closely Held Businesses
Many closely-held business owners have not considered or are uncomfortable with planning for the succession of their businesses after their death or retirement. Failure to do so, a however, can be disastrous to the long-term future of a business. Analysts have estimated that a very large percentage of closely-held businesses fail in the year following the departure of the company’s founder.
A carefully designed plan for the succession of a business can go a long way toward avoiding such a failure. When creating such a plan, the owner should consider such items as the economic needs of the owner and his or her family, whether an adequate successor is available for management of the company either in the family or outside it, the future prospects of the business, and when the owner is willing to transfer control of the business.
Depending upon the specific circumstances, a number of techniques may be available. However, a common element in many successful plans is use of an agreement between the shareholders commonly known as a “buy-sell” agreement.
A buy-sell agreement can serve many functions. It can protect the business from disputes between shareholders on such matters as management rights, dividends, and voting deadlocks. Additionally, a buy-sell agreement often allows continuing stockholders or the company to purchase the shares of a stockholder who retires, becomes disabled or dies, or desires to sell shares to a third party. The agreement also provides a source of funds to the selling shareholder or his or her estate.
Once the decision to use a buy-sell agreement has been made, the terms of the agreement should be structured in order to avoid a number of potential problems. For example, tax laws aimed at so-called “estate freeze” transactions provide that, in order to have the purchase price set forth in the agreement respected for estate tax purposes, various requirements must be met. An agreement among family members which uses a formula or book value method of establishing the purchase price will not generally meet those requirements.
Another problem with many buy-sell agreements results from a relatively little known tax law provision, under which insurance proceeds collected by a “C” corporation may be taxed. The problem arises from the “tax preference” under the corporate alternative minimum tax (“AMT”) for the excess of current book income over taxable income. Since life insurance and disability buy-out insurance are items of corporate book income, but generally do not constitute taxable income, a buy-out agreement in which a corporation will redeem stock with such proceeds may subject the corporation to the AMT. However, if the problem is recognized in advance, certain remedial actions can be taken to avoid the AMT.
Many buy-sell agreements also do not specifically address the divorce or bankruptcy of a shareholder. This omission can have the surprising effect of allowing an owner’s former spouse or creditors to become shareholders in the business. By structuring the agreement properly, however, the remaining shareholders can be protected from this to the extent legally possible.
In short, careful succession planning is essential for the continued success of closely-held businesses. A buy-sell agreement is a technique which is often used successfully to provide for the transfer of ownership of a business upon death or retirement. However, care should be taken to ensure such an agreement is properly structured.