What Does the Future Hold for Your Business? Funding the Buyout Under the Buy-Sell Agreement
Part 4 of a 5 Part Series
by Kim Coogan (February 25, 2013)
You know you need to establish a succession plan for your business; you've identified and continue to develop individuals to whom the management, executive decision-making, and ownership of your business will pass. You recognize the importance of documenting your intentions for the future ownership of your business using a "buy-sell agreement."
Now you have to ask yourself the not-so-simple question, "If I pass away or retire and my interest is sold, how will I, or my family, be paid?" Or, "If my partner dies or wants out, how will I pay him or her, or his or her family, if I have to buy out his or her interest?" The answers to these questions will be different if the buyout occurs during lifetime as opposed to upon the death of an owner.
The buy-sell agreement should set forth the terms of payment of the purchase price, which will be determined in accordance with the valuation provisions of the agreement. In the event of the departure, retirement, disability or other lifetime buyout event of an owner, typically the agreement will allow for a promissory note evidencing the obligation to pay the purchase price over time. The term of the note may be principal and interest payments over 5, 10, or more years. The interest rate will be set at the time of the buyout, based on an index, e.g. prime rate, or the applicable federal rate, as published by a specific source. The note will most likely be secured by the pledge of the business interests being purchased.
Upon the death of an owner, the buyout may be funded either in the same manner as a lifetime buyout, or more commonly, with the proceeds from a life insurance policy on the life of the deceased owner. If the buy-sell agreement is a redemption agreement, whereby the business entity buys out the interest of the deceased owner, then the business entity will own the life insurance policies on the lives of the business owners. Upon the death of an owner, the business entity will pay out the agreed purchase price to the business owner's estate, or trust, depending on how the business interests were owned. The business interests will be transferred by the deceased owner's successor in interest to the business entity.
If the buyout is a cross purchase, then the surviving business owners will pay the agreed purchase price to the deceased owner's successor in interest. If there are two owners, then each would own a life insurance policy on the life of the other. In the case of a business with multiple owners, insurance can become more complicated. For example, with three owners, each would have to buy life insurance on two other owners. In total, there would be six life insurance policies. This can become somewhat cumbersome. An alternative might be a trusteed buy-sell agreement, whereby one life insurance policy on each of the owners is owned by an escrow agent (or "trustee"). Upon the death of an owner, the trustee collects and pays out the insurance proceeds to the deceased owner's successor in interest in exchange for the shares in the business. The escrow agent then allocates the shares among the surviving owners.
Congratulations! You've consulted with your professional advisors; you've done the hard work of considering who will carry on your vision for your business after you step away from it; you've laid the groundwork for management, leadership and ownership succession; and you've documented all of this in a well-written buy-sell agreement. You've obtained the proper life insurance or other mechanism to fund a potential buyout. You are doing great! But your work isn't done. It's a work in progress. You should revisit your business succession plan annually, and re-evaluate your management and leadership to ensure your plan is on track, and make any necessary adjustments. Your attorney, accountant, and insurance professional should work together with you to make sure your plan is the best it can be for you and your business.
What Does the Future Hold for Your Business? Every Business Owner Should Have a Buy-Sell Agreement
Part 3 of a 5 Part Series
by Kim Coogan (February 12, 2013)
In Part 1, we recognized the need to establish a succession plan for your business; and we discussed the importance of identifying and developing individuals to whom the management, executive decision-making, and ownership of your business will pass. Whether you determine that the business should pass to family members, key employees, or will be sold to a third party, it is critical that you document your intentions in a document often referred to as a "buy-sell agreement."
A buy-sell agreement is an agreement among the owners of a business, or between the sole owner and certain key employees, which sets forth the conditions under which ownership interests in the business may be transferred. One of the goals of such an agreement is to prevent the entity ownership from landing in the hands of the spouse of a deceased owner, the ex-spouse of an owner, or children who are not involved in the business. The agreement lists certain events, e.g. death, disability, departure or retirement of a business owner, the desire to sell to a third party, or the entry of a divorce or bankruptcy court order, which would trigger a buyout by the remaining owner(s) or key employee(s).
The agreement may be in the form of a redemption agreement, under which the business entity itself buys the business interest from the transferring owner. Alternatively, it may be a cross-purchase agreement, under which the remaining owner(s) buy the interests of the transferring owner; or it may be a hybrid agreement, which allows either the entity or individual owners to buy the interest. The agreement may provide for rights of first refusal, or a mandatory buyout by one party of the other party's interests in the business. There may be put and call options, giving an owner the right to require the other owner(s) to buy his or her interest, or sell their interests to the calling owner. The buy-sell agreement should also address the conditions under which an owner may transfer his or her interests by gift or sale to his or her descendants, or to a trust for their benefit, without triggering a buyout by the other party to the agreement.
A critical component of the buy-sell agreement is the valuation mechanism used to determine the purchase price for the business interest. There may be a specific formula included, or a provision that a valuation will be obtained from a professional valuation expert. Different methods of valuation may be applied, depending on the circumstances of the buyout. For example, book value might be used in a divorce or bankruptcy situation, and fair market value might be used for a death or disability situation. There might be a discount on the buyout price for a "put" and a premium on a "call." The parties should review the valuation provisions annually to ensure they remain appropriate, given changes in the industry, the market, and the business' financial condition.
Another critical question that must be considered is how the buyout will be funded. We will address funding in the next installment of this series on business succession planning. Note, however, that the method of funding and the design of the buy-sell agreement must be coordinated, so it is important to consider these issues concurrently.
Estate and Gift Tax Update
by Carrie Buddingh (January 10, 2013)
Crisis averted! Well, for the time being at least. As you probably know, on January 1, 2013, Congress passed the American Taxpayer Relief Act of 2012 (“ATRA-2012"), which prevented our nation from going over the “fiscal cliff.” You may now be thinking, “What does this new law mean to me and my estate?” “Has anything changed at the state level?” Or even, “I thought the gift and estate tax law just changed in 2010. What changed this time?” You are in luck! Below please find a concise description of the current changes in the law that took effect January 1, 2013:
• The estate, gift, and generation-skipping transfer (“GST”) tax exemptions have been permanently increased to $5 million (adjusted for inflation). That means that the exemption amount for 2013 is now $5.25 million. However, the top estate, gift and GST tax rates have also been increased to 40%.
• For decedents who pass away in 2013 or later, the Illinois estate tax exemption has been increased to $4 million. Please note that Illinois does not currently tax any gifts (regardless of their size) made by an individual during his or her lifetime.
• The "portability" provisions introduced under the 2010 Tax Relief Act have become permanent as well. Portability allows a surviving spouse under certain conditions to elect to use the unused portion of the predeceased spouse’s federal exclusion amount for estate or gift tax purposes. Please note, however, that no such provisions apply under Illinois law.
• ATRA-2012 extends the provisions that allow individuals age 70 ½ and older to make tax-free IRA distributions directly to a charity up to $100,000 in lieu of taking a required minimum distribution (“RMD”) in such amount and paying the resulting income tax. This is often called qualified charitable rollover (“QCR”).
• In addition, for a limited time, Congress is allowing individuals to reclassify gifts made to a qualifying charity as a 2012 QCR if such gift is made prior to February 1, 2013. Thus, for example, if an individual took an IRA distribution after November 30, 2012 and then paid it to a qualified charity before February 2013, then the individual can claim such payment to the charity as a QCR for 2012.
• Not part of ATRA- 2012, but effective January 1, 2013 under the pre-existing gift tax law, the gift tax annual exclusion is $14,000 per donor per donee. The GST tax annual exclusion is also $14,000 for “direct skip” outright gifts to grandchildren or others more than one generation removed from the donor.
• The “step-up” upon death of the cost basis of a decedent’s assets continues to apply.
What Does the Future Hold for Your Business? Management Succession - Perhaps the Most Critical Piece of the Puzzle
Part 2 of a 5 part series
by Kim Coogan (September 29, 2012)
So you’ve taken a moment to step back to survey the successful business enterprise you’ve built, and you realize you need to create a plan for the succession of your business. At some point you’ll want to retire, or you’ll pass on, as all of us eventually will. What would be your number one concern if suddenly you were unable to run the business? If you plan for your business to provide value to you in your retirement, or to continue to provide value to your family after you’re gone, likely your biggest concern is management succession. Who will provide leadership in your absence? Who will manage your employees? Who will maintain your customer and vendor relationships? If, like many business owners, you are the one filling all of these critical roles, you will need to consider developing people to fill your shoes when you step away.
The best place to start this process is to break your business down into components and evaluate who the key employees in each area are. What are their skills; what critical functions do they serve? Do they have the experience and skills to successfully lead the company? Are they respected by the other employees, and do they have the characteristics necessary to be an effective leader? If this examination reveals certain areas of the business operations that rely solely on you for leadership and direction, you will need to consider developing a layer of support. Are there individuals who are already part of your organization, who have the ability and aptitude needed to make the kinds of analyses and decisions you make? Do they have the depth of understanding of the industry, and the foresight needed to guide the company in the future?
One issue that commonly arises in closely-held business situations is the involvement of family members in the succession plan. It may be difficult to communicate to a family member that he or she is not entitled to take over running the business based on ancestry alone. It is critical, if a family member is to succeed to the business, that he or she is qualified and committed to continuing your vision in the best interests of the business and its employees.
Day-to-day operations are important, but long-term business strategy will determine the ongoing success of the business. If you don’t have a board of directors, or a board of managers if you are an LLC, you may want to think about forming a board. Ideally, a board of directors or managers is comprised of individuals with knowledge of your industry and your business. Think of individuals who would be helpful in creating a business plan for the company, as market conditions, technology and the economy change over time. The board members may not have any involvement with the day-to-day operation of the business, but would keep tabs on its financial health, and make decisions outside of the ordinary course of the business. Building a reliable board while you are still around to share your ideas will help to ensure that your vision for the future of your business will be carried forward.
While the directors’ or managers’ role is to make high level decisions and to keep the business moving in the right direction, the officers’ role is to govern the day-to-day operations. The officers have more hands-on responsibility for ensuring that the strategies and decisions laid out by the directors are being implemented. If you are the President, you may consider naming one or more Vice-Presidents, and grooming your replacement by involving him or her in some of the higher level operational decisions.
Your professional advisors, i.e., your attorney, accountant, and banker can be valuable resources who may guide you in developing a management succession plan. Additionally, there are small business consultants available who may help you to work through some of the more emotional aspects of formulating a plan. These can be very difficult decisions, which may take a considerable amount of time and mental and emotional energy to discern and to implement. It is important to start this process long before a management succession plan becomes necessary, to maximize the potential for a seamless transition of your business.
What Does the Future Hold for Your Business? Getting Started on a Business Succession Plan
Part 1 of a 5 Part Series
by Kim Coogan (August 5, 2012)
As a business owner, you have at least a half million things to focus on at any given moment. Somewhere down the list is creating a plan for the succession of your business upon your eventual retirement or death. Who will run the business when you decide to step back? Who will succeed to the ownership of your business when you're gone? These are tough questions that need to be carefully considered, and it will likely take some time to work through and develop answers.
It can take years to develop an organization that is well-situated to carry on the business effectively, after you- the founder, the visionary, the source of the elbow grease that has built the business into the successful entity it is today-decide it is time to enjoy the fruits of your labor by pursuing other meaningful endeavors that perhaps have had to take a back burner while you ran the business.
Some of the key issues involved in business succession planning are:
- Transition of day-to-day management of operations to knowledgeable, key personnel in the organization;
- Transition of executive decision-making power to one or more competent, decisive leaders who will navigate through short- and long-term changes in the business, industry marketplace, and economy;
- Transfer of ownership, both control and economic value, to key employees, next generation of family members, or a third party.
Family business owners have the additional challenge of determining whether members of the next generation have the skills and inclination to continue the business successfully. Sharing common genes does not necessarily mean sharing the same interests, aptitudes and vision.
In a perfect world, you would be assured the luxury of time to map out and execute your business succession plan. Whether you decide that the best solution is an outright sale to a third party, or transition of the business to certain employees or family members, you will need time to implement your plan. The groundwork necessary to accomplish this should be laid over several years prior to your anticipated exit date. This will make the transition of the business as successful, tax-efficient, and seamless as possible. Planning ahead will also maximize the potential return to your family from the many years of sweat equity you have invested to make it the successful business it is today.
Since our world isn't always perfect, until the business transition is complete, you should have an emergency plan that may be implemented in the event of an unforeseen event such as your untimely death or disability. Your emergency plan should be communicated to your trusted advisors, giving them guidance as to how to proceed to assist your family and key employees with the business transition in such a situation.
The most important step is the first one-contacting an attorney to start the business succession planning discussion. Your attorney and other business advisors will be able to listen to your goals and concerns, and present you with options for your succession plan. It may take some time for your ideas to take shape, but taking the time to contemplate the future of your business after your departure will be well worth it in the long run.