Take Control Of Your Operation’s Succession Planning Process

Take Control Of Your Operation’s Succession Planning Process

Sarah Harwood

Sarah Harwood

George Malis

George Malis


There comes a time when every business owner must consider the future of his or her business upon retirement or death. It is prudent to consider your goals and implement a plan sooner rather than later. Proper business and estate planning with your intentions clearly expressed can ensure that your goals are met. It can also avoid unnecessary tax liability, loss of control of the business and unnecessary fighting within the controlling members or shareholders.

You should first consider your goals for the business. Common goals of small business owners include preserving the business and assets for future

generations, ensuring that the younger generation currently engaged in the business have a vested interest, maximizing liquidity, minimizing taxes and establishing a plan for the younger generation to take gradual control.
There are multiple ways to meet your goals. Each business is different and requires its own specialized plan, but here are some options to consider:

Lifetime Gifting. One way for a business owner to transfer value in the business to the next generation is by making gifts of stock or membership interests in the business during your lifetime. An owner may make tax-free gifts of up to $14,000 per person, per year, and if combined with gifts from a spouse, this amount can be doubled to $28,000 per person, per year.

The advantage of lifetime gifts is that they remove future appreciation from the business owner’s estate and are income tax free to the recipient. One drawback is that generally the income tax basis for the gifted property is the donor’s basis in that gifted property. Thus, to the extent there is a large unrealized gain on the gifted shares of stock in the business, the gain is passed to the donee and will be recognized upon the future sale of the business. However, that potential must be weighed against the benefit to the business owner of removing future appreciation out of his or her estate. Loss of control does not have to be a concern, since there are methods for gifting interests in the business while maintaining control.

Buy-Sell Agreements. Another option for managing the ownership and control of a small business is the Buy-Sell Agreement. If you own a limited liability company, check your operating agreement, as some operating agreements have these provisions incorporated within them. While there are various options for a Buy-Sell Agreement, many small businesses prefer the “Wait-and-See Buy-Sell Agreement.” Basically, this type of agreement establishes the terms for the sale of a member’s or shareholder’s interest in the business upon specific triggering events, such as death, disability, retirement and termination of employment. The agreement is called Wait-and-See because nothing happens until a triggering event occurs.

The agreement will also set the price of the sale, or a method for establishing the price and the terms of payment. In addition, this type of Buy-Sell Agreement typically offers the first option to purchase the interest in the business to the company itself. If the company or business decides not to purchase the available interest, then the option goes to the other non-selling/current members or shareholders. The first option to the business has the advantage of “non-dilution” to the other shareholders or members, and the selling party only looks to one buyer for payment. In the event the option passes from the company to the other non-selling shareholders or members, all of the other business owners must exercise their option or a non-exercising owner runs the risk of dilution of their ownership interest in the company.

While there are certain restrictions that vary by state, for example, prohibitions against a business purchasing shares if it will render the company insolvent, a Buy-Sell Agreement is a good method to ensure control and continuity in the ownership of the business.

Selling the business to a family member. The sale of the business to family members is a good method for removing the value of the business from your estate, and beginning the process of a transfer of ownership. Sales within a family are allowed and avoid the gift tax as long as the sale is for fair market value. Sellers will have to pay income tax (typically at capital gains rates), but keep in mind that these taxes are lower than both gift and estate taxes. Sales can be structured in installments and when doing so, any income taxes are also paid over time as the seller receives the installment payments.

There are also methods to structure the sale so the seller maintains control of the business. In these scenarios, the seller retains voting control and only sells non-voting shares. Also, an installment sale essentially acts as a freeze on any potential appreciation in the company. Because of the sale, the buyer will benefit from the appreciation. A Buy-Sell Agreement can be used (as discussed above) to transfer control upon a triggering event, such as death, disability or retirement of the seller.

The Intentionally Defective Irrevocable Trust. In the case of high worth business owners (typically those with an estate valued over $5,340,000 for an individual or $10,680,000 for a married couple —check the Internal Revenue Code for yearly adjustments — the Intentionally Defective Irrevocable Trust may be a good option for transferring your interest in the business while minimizing or lowering gift and/or estate taxes. The transaction is also structured so you maintain control of the business. The trust is funded by you with cash of at least 10 percent of the contemplated purchase price. The trust then purchases for fair market value your interest in the business.

The effect of this is to transfer the value of the business out of the business owner’s estate to the trust in a similar manner as the installment sale described above. However, because the trust has a special status for income tax purposes, all distributions and income from the business are received by the trust and grow income tax free, because for income tax purposes, the (former) business owner is taxed on the business income. Thus, the owner of the business continues to pay the income taxes (which further reduce his or her estate value) on the profits from the business, and the trust can grow “income tax free.” Generally, the trust beneficiaries are your children and grandchildren.

Whatever Your Plan, Don’t Ignore Fair Market Value

There are multiple estate and business succession planning methods. This article contains a few options to consider. And buried within each concept described is the use of bona fide fair market value opinions. “Fair market value” is an important concept in business and tax planning and cannot be overlooked in any bona fide transfer planning. Since each business is unique, business owners should discuss their options with their lawyer and/or accountant in more detail.