To view searchable, printer-friendly Memorandum, press here: Business Succession Planning Involving Family Members.wpd

Business succession planning involving family members presents  unique challenges, since liquidity needed to pay estate tax or to fund a legacy for nonparticipating family members may exceed that which the business generates. A buy-sell agreement can establishing the price at which participating family members may purchase the business, or a mechanism in which the interest of nonparticipating family members may be redeemed by the entity. If negotiated at arms-length, the price determined under a buy-sell agreement may control for estate tax purposes.

Permissible transferees under a buy-sell agreement may also include other owners of the entity. If a “cross-purchase” agreement is used, the continuing owners will acquire the withdrawing owner’s interest at a price determined under the agreement. A significant advantage to a cross-purchase agreement is that under IRC § 1012, the basis of the surviving owner’s interest is increased by the price paid. Under a “redemption agreement,” the entity itself redeems the owner’s interest at a price determined under the agreement. A management agreement, which defines the rights, powers and responsibilities of each equity owner, often supplements a buy-sell agreement.

Business equity may pass equally to all children, or only to children active in the business, with equalizing transfers of non-business assets to nonactive children. Determining the amount of the equalizing transfer may be difficult, as nonactive children may feel that dividing assets based upon values as finally determined for estate tax purposes may be unfair. Even if fair equalizing values can be determined, nonbusiness assets may be insufficient to provide equal shares to nonactive children. In this case, all or part of the business could be sold to active children, or business equity could pass equally to all children with built-in redemption provisions enabling nonactive children to “put” their business interest to the company at a future time. The put right could be triggered upon a change in ownership or a change in control.

At times, the owner may wish to cede management of the business during his lifetime to family members without disposing of his equity in the company. Future economic benefits could be retained by establishing a mandatory dividend or distribution policy with respect to a retained membership interest or stock ownership. Corporations other than S corporations could have two classes of stock with the class retained by the retiring owner possessing preferential dividend and distribution rights. An S corporation could engage in a tax-free recapitalization creating voting and non-voting interests without violating the single-class-of-stock rule. By selling non-voting interests, the retiring owner could continue to exercise control over dividends and distributions. IRC § 2036 would not apply to a bona fide sale for adequate and full consideration.

An owner with business expertise could enter into a consulting or non-compete agreement with the business which would provide continuing income to the retiring partner. Payments under a consulting agreement are deductible by the business. Unless the retiring owner is an independent contractor, compensation received would be subject to self-employment tax. If employment tax liability arises, the IRS is likely to be indifferent to the level of compensation. Therefore, an owner willing to provide continued services can be divested of ownership interest in the company for legal and estate tax purposes, while continuing to receive a steady stream of income. Payments under a non-compete agreement are amortizable by the business over 15 years under IRC § 197 and although includible as ordinary income, are not subject to employment tax.

An executive bonus plan could be used to fund a nonqualified private pension, such as a life insurance policy. Since such a plan is not tax-advantaged, it could discriminate in favor of any employee. For income tax purposes, the premium payments would be treated as bonuses (or guaranteed payments in the case of a partnership or LLC). Such payments would be deductible by the business and includible as compensation by the owner.

Various trust arrangements may facilitate a plan of business succession. By selling an ownership in the business to a grantor trust, the retiring owner can remove the value of the business, as well as its appreciation, from his estate with no adverse gift or income tax consequences. The promissory note issued by the trust as consideration for the business interest purchased could provide for a low rate of interest at the applicable federal rate. If a self-canceling feature were employed, nothing would be included in the seller’s estate at his death; however, the rate of interest used would have to be higher to compensate for the self-canceling feature.

To appease family members who continue to participate in the business and want no interference from nonparticipating family members, the equity of nonparticipating members could be transferred to a voting trust, which would issue new trust certificates representing the transferred interest. Voting rights would become vested in the trustee. Other inter vivos trust arrangements may be used to hold and pass equity among family members. For example, a revocable trust agreement may specify how the business equity will be distributed should the owner becomes incapacitated.