Business Succession Planning
Are you a small business owner? Do you own a business of any size? If so, then estate planning is extremely important for you!
Business planning, and in particular, business succession planning is required of every business owner to provide a detailed plan and smooth transition of that business to the next generation or to the next owner of that business.
For many business owners, their business is their main asset. Therefore, a common goal of many of our clients is to ensure that the value of the business is maximized and is able to be liquidated to generate the necessary cash flow to fund their retirement. This is one, of just many important reasons to establish a business succession plan.
Planning for Estate Taxes
If you are a business owner, you should make sure that your succession plan is planning for the possibility of paying estate taxes (and more importantly the limiting of those taxes).
In today's tax environment, the IRS taxes estates that are larger than $5.45 million (or $10.9 million for married couples) at death with a top tax rate of 40%. However, for business owners, when a business valuation occurs, it can be very easy for the going concern of a business to reach above that $5.45 million estate tax exemption. In addition, if there is no plan in place and there is an unexpected death, the ability of the surviving family to continue and be successful in the business is usually drastically reduced.
In many situations when an unexpected death occurs, the surviving family is left in a situation of being forced to sell the business to pay the estate taxes (estate taxes are due within 9 months of the date of death). In addition, this transition period will be hard enough on the family and employees of the business then having to worry about the payment of estate taxes.
The best course of action is to have a plan in place to ensure that should this contingency occur, the heirs will be able to continue to operate the business, maintain the value of the business, and not have to worry about performing a quick sale of the business in order to pay taxes. Another option is the use of a life insurance trust to provide the liquid assets necessary at the business owner’s death to avoid a quick sale of the business to pay the estate tax.
Another issue for business owners to consider is the generation skipping transfer tax. This is a tax to family members when an asset transfers to a family member at death more than one generation removed, for example grandchildren. This can be a tax in addition to the estate tax that may be due in some circumstances.
Common Ways that Owners Can Exit a Business
Other than the obvious death of the business owner, there are many different ways that the business owner can exit the business and transition the ownership to the next generation of business owners.
Selling The Business
There are a number of different ways that a business owner may sell their interest in the business. The first, is that the owner may just sell the business. The could include listing the business for sale or having a business broker seek out a qualified buyer. This buyer may purchase the shares of the corporation or the membership interest of the LLC. However, the buyer could also choose to only purchase the assets of the business. The buyer may choose to buy the name, the customer list, trade secrets and other assets of the business. The purchase could be in one lump sum or a structured buy-out that would occur over time.
However, what if it is just not you? What if you have a business partner or multiple business partners? A strongly recommended way to plan the selling of the business is through a Buy-Sell Agreement. This allows and provides peace of mind that the heirs would not be thrown into a court process to gain access to the business interest they just inherited. In addition, most Buy-Sell Agreements are funded with life insurance and setting up a plan that the proceeds will go to the business owner’s spouse or the business owner’s trust. Naming the trust as the beneficiary of the buy-sell agreement that is funded with life insurance is the most common and most powerful planning tool as it prevents situations of the contingent beneficiaries suddenly becoming an owner of the business.
Sale of Business Through Stock Ownership Plans
Another common way that business owners sell their share in a business is through an Employee Stock Ownership Plan. This typically takes the form an Employee Stock Ownership Trust and it allows for the owner to transfer the ownership of the business to the employees in exchange for cash. This cash is typically contributed to the trust and is used to purchase the shares of stock from the original shareholder, i.e., the business owner.
Sale or Outright Gifts of the Business to the Family Members
Perhaps the simplest way to transfer ownership shares of a business to family members is an outright gift. Although, this can create some unfavorable gift tax consequences as the value of the business is typically above $14,000 (or $28,000 for a married couple, the annual gift exclusion amount). Therefore, gifts of the business to family member can be somewhat troublesome.
However, a beneficial way can be through a family loan. Under IRC 7872, the minimum interest rate can be used between the family members purchasing the business. In addition, if the family desires to set an interest rate below what is prescribed by Internal Revenue Code 7872, then that family can do so, and this section of the law states in detail what the gift tax results and the income tax results will be by using an interest rate below what is prescribed by section 7872.
Although, one of the most powerful tools when it comes to selling one’s business interest is through an Intentionally Defective Grantor Trust and the use of an Installment Note. This type of transaction provides the seller with significant control while deferring taxes, or even eliminating taxes.
Grantor Retained Annuity Trusts (GRATs)
This type of arrangement regarding the sale of a business can be very beneficial. A business owner may want to do this when the owner expects to live for several more years, wants to keep the income of the business that he or she created, and expects the business to go up in value over time.
The basic structure of the arrangement is that the owner will retain an interest in the business before it is passed to the beneficiaries of a trust. By structuring the transaction in this manner, the eventual transfer of the business is kept private and the business is protected against future potential creditor claims.
How does a GRAT work? Well, they are complicated! However, I can explain them in the easiest way I know how. The eventual selling business owner will set up a GRAT and then make a gift of company stock to the trust. However, the trust is completely and absolutely irrevocable and cannot be altered or revoked. A trustee is then appointed to manage the trust and the company stock, as well as other assets that may have been transferred to the trust. In addition, the trust will contain provisions that says an annuity will be paid from the trust to the business owner for a certain number of years. The annuity can be set up in a number of different ways. It could be a fixed dollar amount or it could be a percentage of the value of the assets that were initially contributed to the trust, or any number of other ways as well.
At the end of the term that the business owner is receiving income from the trust, also called the retention period, the assets of this trust (which include all the appreciation of the assets), then go to the beneficiary of the trust.
However, if the business owner is alive at the end of the annuity term in the GRAT, then none of the assets that were transferred to the trust will be subject to federal estate tax upon the death of that business owner.
Closing the Business
However, another way to sell the interest in a business is to simply close down the business. This is done by ending all business transactions and selling the assets of the business. Although, it is not as easy as it sounds. There will be several issues that will need to be addressed.
All customers or clients will need to be notified in advance. If there is a website, the website should be shut down. If the business is operating as an LLC or a corporation, a winding down of the business will need to occur.
The winding down process will include filings with the Tennessee Secretary of State’s Office. The State of Tennessee Department of Revenue will also need to be contacted and informed that the business is no longer in existence. Finally, it is always a good idea to open a P.O. Box for mail to be forwarded to the business for the next 6 to 12 months.
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