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The equity that small business owners build in their companies represents a valuable personal asset. But in a privately-held company, how can equity be converted to liquid cash when the owner exits the business? Creating an exit plan (or "succession plan") is an integral part of strategic business planning. This article will help business owners understand: 1) why a succession plan is important; 2) how to begin the process; and 3) how to put the plan into action.
Succession planning aims to achieve an optimum outcome for the business (e.g., passing ownership to an heir or selling the company) while also converting business equity into liquid cash when it is needed. This goal is important for two reasons:
The value of a business passed to heirs is included in the owner's estate at death and could be subject to federal estate taxes if not left to the surviving spouse. These taxes must be paid in cash, and the filing deadline for federal estate taxes is nine months after the date of death, unless an extension is requested. So, even if heirs do not need or expect a business to produce immediate cash after an owner's death, federal and state governments require cash to settle taxes. In the worst cases, valuable businesses have been put on the market at "fire sale" prices just to meet estate tax pressures.
Aside from taxes, heirs may need cash for other needs including business debts and obligations, probate and attorneys' fees, the cost of business appraisals, audits, and the cost of closing down the business and paying severance to employees. Almost every business needs a pool of liquid cash to work through a period of transition in ownership. Providing this cash is one of the most important steps in the succession planning process.
One starting point for business succession planning is to ask and answer three questions:
A buy-sell may be formed between co-owners or partners, who each agree to buy out the other's interest. Alternatively, it may involve the current owner and a designated successor owner, perhaps a family member or top manager.
Most buy-sell participants lack the resources to buy a partner or owner's interest in a valuable business. Without planning, they may be capable of completing the transaction only by: 1) borrowing heavily; or 2) paying in installments over time. Since most business owners and their heirs prefer to receive cash at the closing, it is necessary to define the source of the cash well in advance. Often, the primary source is permanent life insurance.
After a successor is determined, the next step is to determine the buy-out value. While small business owners have some flexibility in setting the price of a buy-out transaction, the IRS and courts will insist on a valuation that represents fair market reality, some valuation methods include:
The next step is to formalize the buy/sell arrangement through a written agreement with the help of an attorney experienced in succession planning. Ideally, this attorney also has some proficiency in estate tax planning and business valuation. An important section of the agreement defines the "trigger events" that will require ownership to change hands. Common trigger events include an owner's death, disability, retirement, divorce, or separation from employment. When a buyout is triggered by an event other than death, the legal agreement also may include provisions that prevent the departing owner from competing against the company or disclosing its trade secrets.
Permanent life insurance typically is used to fund buy/sell arrangements because coverage can continue, and premiums remain affordable, at any age. Funding buy/sell arrangements with permanent life insurance also has other benefits:
In addition to an owner's death, another trigger event that can be funded with insurance is an owner's long-term disability. In this case, disability income insurance can be purchased to fund an obligation written into the buy-sell agreement. Subject to the terms of the policy, disability buy-out insurance pays to the business beneficiary or other owner a stated amount of lump-sum or periodic income (after a waiting period) that can be used to fund part or all of a buyout.
In summary, business owners rarely stop working long enough to ask why they are working so hard. But there will come a day when this question will become paramount. Ultimately, a small business may not maximize long-term success for the owner and heirs unless the owner plans ahead to reap the rewards.
Premier Planning Partners does not provide legal or tax advice. Please consult with your attorney, accountant, and/or tax advisor for advice concerning your particular circumstances.