One of the reasons so few family businesses survive into the second generation is because the owners fail to adequately plan for their succession. Many owners simply wait too long to do business succession planning, so the business must be liquidated to pay estate taxes which are generally due nine months after death.

You may think that you and your partner can work out succession details when the time comes. However, you need to understand that the death, disability, or retirement of a partner or co-shareholder creates different objectives for each party. For instance, a retiring shareholder may want to cash in the value of his interest in the business for the maximum dollars possible. But the remaining owner who continues to operate the business may want to minimize payments to the departing partner in order not to drain the cash flow generated by the business.

Failure to plan ahead for the transfer of ownership upon the death of a co-owner can also lead to conflict. Without a business succession plan, the executor and heirs of the deceased owner may be forced into a sale of the business at an undesirable price. The heirs are unlikely to know the value of the company, and if the surviving shareholders want to purchase the stock of the deceased, they may have a personal interest in keeping the sales price low. Similarly, an outside purchaser of the deceased owner's shares who is aware of the distressed nature of the sale will also have a bargaining advantage over the heirs.

Even if your attorney has drafted a buy-sell agreement to handle issues of ownership and management upon a future transfer of your business, the agreement could contain unknown traps. The transfer plan that was originally designed for your fledgling business may no longer be appropriate for your current successful operation.

Suppose, for instance, that you and your co-owners run an incorporated business. And let's say that upon the death of any co-owner, your buy-sell agreement requires the corporation to purchase the stock from the estate of the deceased shareholder. The corporation also owns life insurance on each shareholder in order to have sufficient funds to buy the shares. This is known as a "stock redemption" agreement.

One of the problems with this arrangement is that the surviving shareholders do not get the benefit of an increase in the tax basis of their shares when the company buys the deceased shareholder's stock. This will be an issue if the surviving shareholders eventually sell their shares in the company.

But if the buy-sell agreement had been set up so that the surviving owners personally purchased the stock from the deceased shareholder's estate (rather then using the corporation to buy the stock), the survivors would get a "step up" in tax basis in the purchased stock. Under this arrangement, called a "cross purchase" agreement, the higher basis will mean a smaller capital gains tax when they later sell the stock. For example, suppose each owner of a two-owner business had invested $25,000 in the Company ten years ago, and the business is now worth $2 million. At the death of an owner, the surviving owner is obligated to purchase the decedent’s interest at fair market value, under their buy-sell agreement. The surviving owner takes a $1 million cost basis in the purchased shares, so that he now owns 100 percent of the business, with a total basis of $1,025,000. If he then sells the business for $2 million, a 20 percent capital gains tax will be due on $975,000, for a tax liability of $195,000.

Compare that to the scenario in which their Company buys the decedent’s shares with the life insurance proceeds under a redemption agreement. The surviving owner still ends up owning 100 percent of the Company, but his cost basis remains at $25,000. If he then sells the business for $2 million, a 20 percent capital gains tax will be due on $1,975,000, for a tax liability of $395,000 -- $200,000 more than if he had purchased the shares himself.

Another tax problem with the stock redemption agreement is that the death proceeds received by the corporation may be subject to the alternative minimum tax (AMT). The AMT rate for corporations is 20 percent of its “alternative minimum taxable income.” Corporations paying the AMT may be eligible for a tax credit that may be used in later years to offset regular taxable income in excess of the AMT in those years. Starting in tax years beginning after 1997, certain small corporations will be deemed to have a tentative minimum tax of zero and thus will be exempt from the AMT. If the corporate AMT applies, payment of the AMT in the year of the stock purchase could significantly affect cash flow and inhibit the corporation's ability to survive.

There are, of course, many other tax and non-tax reasons to consider in determining what kind of business succession plan makes the most sense for you. Whatever arrangement you set up, be sure to review it periodically with your attorney and financial consultant.

Published: May 12, 2003

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