Family biz needs succession plan

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Some years ago, an estate planning attorney introduced me to the owner of a successful manufacturing business and his two sons who worked beside him. I asked the business owner what his plans were for the business and his response was simple: to continue working for a few more years and at some point, hand the reigns over to his children.

I admired him for his plan but mentioned scenarios that I felt had not been addressed. He assured me all was fine and he would talk to his attorney. Unfortunately, prior to the owner reaching his goal of leaving the business to his children, he passed away and the business was left to his surviving wife. Normally this does not create a problem, but in this case the wife was his second and not the mother of the two children in the business.

It was only a short time after the owner’s death that the two children in the business were fired and replaced by the children of the surviving spouse, her children from a prior marriage.

Could this catastrophe have been avoided? The simple answer is yes, by the use of an internal family buy/sell agreement. For the purposes of this article I will surmise that in most instances the surviving spouse does not want the business nor are they in a position to run the business. Most often, what they desire is cash from the sale of the business, and the peace of mind in knowing there are enough assets that will allow them the ability to maintain their standard of living.

Let’s look at the above reference case where the second wife inherited the business and the children were fired. Had the business owner thought out the consequences of his involuntary retirement (death), he would have implemented a buy/sell agreement outlining the following activities in the event of a premature death. The buy/sell would have stated that in the event of the owner’s death, the business would transfer to the surviving spouse.

Upon this triggering mechanism, the children would then be obligated to buy said business from the surviving spouse and surviving spouse obligated to sell said business to the children. Due to IRC Section 1014(a), the beneficiary of an asset received at the death of an owner would receive a full step-up in cost bases, thus eliminating any and all capital-gain taxes on the sale of the business.

Under this scenario, the children end up with the business and the surviving spouse ends up with the cash.

The question is, where does the cash come from that is required for the buyout? The answer is life insurance. If done correctly, the children in the business will purchase a life insurance policy on the life of the owner. Upon his demise, the children will receive the insurance proceeds free of income taxes, capital-gain taxes, estate taxes and alternative minimal taxes. The type of insurance used is up to the family. Term life insurance works well if the business owner wishes to retire and transfer the business to the children within the next few years at which time the policy can be canceled. Cash-value insurance tends to work better if there is no predetermined date of retirement and the cash value can be used by the children to purchase a portion of the business, thus providing additional assets for dad and mom to retire on.

Should you wish to add an element of asset protection to the equation, have the business owner create a trust (not a living trust) and make gifts to the trust on behalf of the children. The children (who are the trustees of the trust) will have the trust acquire an insurance policy on the owner’s life and the trust will make all premium payments. Upon the death of the owner, the trust will receive the death benefit and purchase the corporate stock from the surviving spouse, just as the children had done. The business is now owned by the trust and the children pay themselves a salary, just as they always have. Now, if a child is sued for any reason, or they enter into a divorce with their spouse, the business cannot be part of the lawsuit or judgment. In addition, because the business is not part of the estate of the child, the business will not be subjected to estate taxes upon their demise.

Remember, not having a thought-out succession plan is a plan. It’s a plan that allows others to make your choices for you — whether or not those choices are in line with your goals and desires. 

La Mont is director of advance planning and investments at RB Capital Management LLC in Fresno, Calif.