Planning to pass a business to the next generation, or to non-family members, involves a combination of complex issues requiring legal, tax, financial and management planning.Too often, a business owner devotes her entire career to building the enterprise, but fails to plan for the future of the business. When a thorough succession plan is in place, however, the business owner can anticipate and effectively manage change. The process must involve family members, professional advisors, shareholders, partners and key employees. A successful plan will address many issues, the more common of which are: the decision to pass the business to family, or sell the business to outsiders; the death, disability or retirement of the owner or co-owner; tax and estate planning; and the retention of key employees.

Succession planning is an exit strategy that transfers a business from the senior generation to the younger generation, to employees or to outsiders through the sale of the business. If the business will stay in the family, the owner may provide for the disposition of the business as part of his will. For example, an owner may stipulate the specific bequests of business interests; the transfer of his interest to a trust, such as a QTIP trust; the authority for fiduciaries to continue the business; or other arrangements.

Alternatively, the succession of the business can be made during the owner's lifetime. Transferring a portion of the business during lifetime shifts future appreciation out of the parents' estate to the children.

Notwithstanding, whether the business owner transfers the business after death or while alive, there are many considerations that the owner must face. For example, if the successors are the children, are any active in the business? If not, have they shown a desire to be involved in the business and are they capable of running the business? If the children are not capable of, or interested in, managing the business, then the owner may have to sell the business to an outsider.

Further, the business owner must consider whether to retain control of the business for her lifetime, or decide when to step away. The owner must also consider how much income she needs from the business, if there is enough cash to pay the taxes if the owner dies, and whether the business can survive a liquidity crisis.

Planning techniques

The business owner has powerful tools in the succession planning toolbox. Below are some of the options that can be considered when a client decides it is the right time to plan for the future.

* Gifts. One of the easiest and most effective means to transfer business interests to children or other family members is to give stock. Giving business assets to younger family members removes their value from the donor's estate, thereby reducing any applicable estate and inheritance taxes. However, each gift must be complete, without the donor's reservation of control over the asset. Further, the gift tax will apply to a gift if its value exceeds the annual exclusion amount.

Each parent has a $12,000 annual exclusion for gifts to a child or grandchild. One parent can use the other parent's annual exclusion to make gifts of $24,000 annually to a child or grandchild without triggering gift taxes. Transferring a portion of the business during lifetime shifts future appreciation out of the parents' estate to the children. Such gifts may be subject to illiquidity discounts and minority-interest discounts.

* Buy-sell agreements. Perhaps the most important tool in succession planning is the buy-sell agreement. A buy-sell agreement is an agreement between the owners of a business, or among the owners of a business and the entity, to purchase and sell ownership interests in the business at a specified price when one or more specified events occur.

Buy-sell agreement provisions are often incorporated in the terms of a limited liability company operating agreement or limited partnership agreement. For a corporation, a buy-sell agreement is typically created as a separate document, such as a shareholders' agreement.

Buy-sell agreements are used for a variety of purposes by closely held businesses, including the following: restricting the transfer of ownership interest to unwanted third parties; providing a method of funding the buyout of a withdrawing or deceased owner's interest and establishing the terms for the payment; preventing delays in the administration of the estate of a deceased shareholder, since the terms for the sale of the interest are settled; and preventing disputes between the spouse and children of the deceased owner and the remaining owners.

Some common events that trigger the rights and duties under a buy-sell agreement include one or more of the following: the death or disability of an owner, divorce, third-party offers to purchase, separation from service, retirement, and bankruptcy.

In general, there are three types of buy-sell agreements: cross-purchase, stock redemption and hybrid. In cross-purchase agreements, each surviving business owner becomes personally obligated to purchase the departing owner's interest. These agreements are ideal for partnerships and corporations with small ownership groups. The number of policies that each owner must buy is equal to the number of owners minus one, since each owner does not buy a policy on herself. Thus, the total number of policies needed would be the number of owners times the number of owners minus one.

For example, with four owners, the number of policies needed would be 4 x (4-1), or 12. The purchasing shareholder receives a full step-up in basis in the retiring or deceased shareholder's shares that are acquired. Insurance to fund such agreements is cross-owned, is not a corporate asset, and therefore does not effect the valuation of the stock. Since the corporation does not have to redeem the stock, the dividend problems of Internal Revenue Code § 318 are avoided.

With stock-redemption agreements, the entity is required to purchase the owner's interest. A redemption does not give the other shareholders a step-up in basis as a result of their increased ownership interest in the corporation. A redemption can create a potential dividend. Where multiple shareholders are involved, redemption agreements reduce the numerous life insurance policies that are necessary with cross-purchase arrangements.

Hybrid agreements are combination arrangements that usually put the priority for redemption with the corporation, but the shareholders have the option of directly redeeming a deceased owner's shares if the corporation is unwilling or unable to do so.

Valuation issues in buy-sell agreements are the most difficult problems encountered by business owners. In most agreements, book value or the cost method is used, or there is a mutually agreed-upon price between the shareholders. IRC § 2703 provides that the price set for the transfer of property under any agreement - including a shareholder agreement - will be ignored when determining the value of such property for estate, gift and generation-skipping tax purposes, unless the agreement has a bona fide business purpose, does not permit a wealth transfer to the natural objects of the decedent's bounty, and is comparable to similar arrangements negotiated at arm's length.

Where the buy-sell agreement does not satisfy all the above conditions, the price may be disregarded by the Internal Revenue Service. Nonetheless, the use of shareholder agreements by closely held corporations is a valuable tool. A properly drafted agreement can fix the value of the business for federal estate tax purposes, while ensuring the continuity of the business succession. In addition, the agreement can eliminate the risk of losing a corporation's S election.

* The GRAT. A more sophisticated business succession tool is the grantor-retained annuity trust. A GRAT is specifically authorized by IRC § 2702(a)(2)(B) and 2702(b). For federal tax purposes, the trust is treated as a grantor trust.

A GRAT is composed of the annuity recipient, the grantor, and the asset's future owner, the remainder beneficiary. The grantor establishes an irrevocable trust for a term of years, transfers stock in the business to the trust, and retains an annuity payment for the term of the trust. At the end of the trust's term, the remainder interest passes to the designated beneficiaries, such as the grantor's children.

If the grantor dies prior to the expiration of the term of the trust, then the entire value of the trust is included in the grantor's estate for federal estate tax purposes. If the grantor survives the term of the trust, then the assets, such as the stock, will pass to the designated beneficiaries. Upon termination of the annuity term, the children receive the stock, including any appreciation, free of any estate or gift tax. GRATs work best with pass-through entities, such as an S corporation, limited liability company or partnership having enough cash flow to pay the annuity.

* Sale to a defective grantor trust. The sale to a defective grantor trust is an effective estate-freezing technique that keeps the value of a closely held or family business in the owner's taxable estate. Defective grantor trusts allow a grantor to transfer assets with the potential for substantial appreciation out of her estate with favorable estate, gift and generation-skipping tax results.

A "defective" grantor trust means that the trust has been drafted so that income from the trust will be taxed to the grantor of the trust, although the trust's assets will not be included in the grantor's estate for federal estate tax purposes. This is important because transactions that have significance for income tax purposes, such as a sale of assets to the trust, will be ignored for income tax purposes, but respected for estate and gift tax purposes.

The technique works likes this: The business owner forms an irrevocable trust that is treated as owned by the business owner for income tax purposes, purposely breaking one or more of the grantor trust rules of sections IRC § 671 et seq. After the trust is established, an essential first step is to transfer assets via a taxable gift to the trust. The grantor should transfer at least 10 percent of the property's value that will subsequently be sold to the trust, making the trust economically legitimate.

The owner then sells assets such as stock in a closely held or family business to the trust in exchange for an installment note with interest. The trust then uses the cash flow generated by the assets purchased to pay off the installment note to the business owner.

When the grantor dies, only the fair market value of the note is included in her estate. If the note is paid off prior to the owner's death, then nothing is included in his estate. Any increase in value of the sold assets will not be taxed in the estate, and will inure to the benefit of the trust beneficiaries.

This technique works best with a business that is a pass-through entity, such as an S corporation, a partnership or a limited liability company.

* Charitable remainder trusts. Charitable remainder trusts allow a business owner who is philanthropically inclined to obtain a significant income tax charitable deduction, reduce estate and gift taxes, retain flexibility in the timing of income distributions, and supplement retirement income with the potential for long-term income growth.

Using this technique, the grantor transfers highly appreciated stock or a closely held business interest to an irrevocable trust. In exchange for a charitable gift, the CRT pays income to the donor for a fixed period or for life. The income may be paid to someone other than the grantor. At the death of the grantor or any beneficiary who is entitled to receive income during their lifetime, the remaining assets pass to one or more chosen charities.

The CRT is a tax-exempt entity. A CRT may be structured as a charitable remainder unitrust or a charitable remainder annuity trust. In a CRUT, the income beneficiary is entitled to a payment that is a percentage of the value of the trust, as valued each year. Thus, the income payment will increase as the value of the assets increases. Conversely, the income payment will decrease if the value of the trust assets decreases. Additional gifts are permitted without creating a new trust. In a CRAT, the income payments are fixed at the inception of the trust and do not vary, so they have no correlation with the future value of the trust assets.

A succession plan may incorporate a CRT where the business owner wants to receive favorable income tax treatment for the sale of the stock. The owner establishes a CRT and names himself as the income beneficiary of the trust and a charity as the remainder beneficiary. The owner then gives a business interest to the CRT.

The trustee sells the stock at a fair market value price. If the sale of the stock after its transfer to the CRT is impending, then the trustee should not be under an obligation to sell the stock or the IRS may attempt to tax the gain to the grantor, rather than the trust.

After the stock is sold, the owner is paid an income interest for life or some other predetermined period. At the end of this period, the underlying assets pass to the chosen charity. Although the trust will be included in the grantor's estate for federal estate tax purposes because of the retained income interest, a charitable estate tax deduction will offset the inclusion of the trust in the taxable estate. Moreover, the grantor will also receive an income tax deduction for the value of the remainder interest.

The CRT does not work if the business is an S corporation, partnership or limited liability company that is taxed as a partnership. The reason is unrelated business taxable income. UBTI is income from a trade or business that is regularly carried on and that is not substantially related to the exempt organization's purpose. UBTI will cause the CRT to lose its tax-exempt status. Any income from a pass-through entity will be UBTI. Further, CRTs are not among the permissible shareholders of S corporations, as listed in IRC § 1361*(2).

The bottom line

This feature is not meant to be an exhaustive treatise on every possible nuance of the succession planning process. The focus is on some of the tools to consider when working on these types of engagements. Two thirds of family businesses fail in transition of management to the second generation, so the odds are steep. However, if you and the business owner make a concerted effort to plan for succession, the odds of failure will be greatly reduced.

Robert J. Birch, CPA, JD, is a sole practitioner in Lansdale, Pa. Reach him at rjblawyer@comcast.net. Reprinted with permission from The Pennsylvania CPA Journal.

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