The Tax Impact at an Owner’s Exit
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:
- At retirement, business owners usually want to enjoy their leisure time or pursue other opportunities. After giving up control, they don’t want to worry about the health of a company they have left behind.
- An owner’s heirs may lack the expertise or interest to manage the business. At the owner’s death, they would like to receive cash to increase their own personal financial security, and perhaps also to meet income and estate tax obligations.
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.
Three Key Questions
One starting point for business succession planning is to ask and answer three questions:
- What is the business worth now on a “fair market value” basis? Fair market value is the amount that a willing buyer would pay a willing seller in an arm’s-length negotiated transaction. A business appraisal conducted by a qualified professional can help to answer this question.
- What will the business be worth when the owner exits? Any future growth in revenues or profits should increase business value. Owners also can increase value by making provisions to groom one or more successors.
- How will heirs obtain a fair value for the business when the owner exits? A solution called a buy-sell agreement pre-determines the terms of a sale (including transaction price) and also provides the cash necessary to complete the sale and pay expenses and taxes.
Terms of a Buy-Sell Agreement
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.
Valuing the Business
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:
· Comparable recent transactions – Business value is based on the terms of sales or mergers involving companies of comparable size in the same industry or market area.
· Multiple of revenue or book value – Business value may be pegged to a multiple of gross revenues in the year or two just before the owner exits. For example, many service-oriented businesses sell for about one to two times annual gross revenues. Or, the value may be pegged to an audited balance sheet as a multiple of “book value.”
· Discounted cash flow—The value is based on total cash flow that the business is projected to generate for a period of years (typically three to five) after the owner’s exit, discounted by a cost of capital.
Hire an Attorney to Draft a Legal Agreement
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.
Provide Funding to Assure that the Agreement is Carried Out
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:
· Quick and convenient cash for heirs – Life insurance solves the problem of turning an illiquid asset (the business) into liquid cash for heirs or estate settlement.
· Tax advantages – Life insurance pays a death benefit that is free of federal income taxes. In buy/sell arrangements, the benefit is usually paid to the party who has the obligation to buy the shares: the surviving shareholders, outside buyer, or the death benefit does not create estate tax consequence for the estate of the deceased.
· Affordable, level premiums – Permanent life insurance can be purchased at affordable level premiums, especially when the insured person is fairly young and in good health.
· Cash value—The cash value of a permanent policy can provide buyout funds if an owner exits at a trigger event such as a divorce or normal retirement. Most agreements include provisions for terminating the buy/sell by mutual consent or if specified events occur. In this case, the policy’s owner can recoup part of the premium cost from cash value.
Planning for a Long-Term Disability
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.