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    Why engage in business succession planning?

    The four basic reasons to engage in business succession planning are as follows:

    1. To minimize and plan for the financial burden of estate and gift taxes;
    2. To provide liquidity to the owners;
    3. To provide for the continuity in the management of and investment in a business;
    1. To fairly and adequately provide for the needs of family members, beneficiaries and interested parties (i.e. Key Employees).

    Fundamental question: Should the interest in the business just be sold rather than attempting to pass it on to the surviving family members or interested third parties through business succession planning?

    There are multiple issues that are capable of creating a rift in the business succession process. These include problems with family relationships, unpreparedness of the individuals receiving the business, and taxes related to the transfer of the business. Therefore, it is important to understand family dynamics as early as possible during the succession planning process and be able to identify and address issues that could cause problems later on.

    One study showed that 95% of businesses that fail upon being inherited by the next generation are related to three major factors:

    1. Problems in family relationships account for 60% of the subsequent business failures;
    1. The Heirs not being sufficiently educated, experienced and emotionally prepared to run the business account for 25% of the subsequent business failures;
    1. Issues related to transfer taxes only account for 10% of subsequent failures and traditionally this is where estate planners place the majority of their focus.

    Defining the family business

    A family business does not necessarily have to be an ongoing business utilizing an operating entity. It can consist of a mere pool of capital that is controlled or managed by a single family, members of an extended family, or multiple families.2 Family businesses can also contain real estate or other types of real property. Each family business should be managed and/or controlled differently depending upon the particular dynamics of that individual family.

    When dealing with the succession of a family business it is important to understand how

    1 12 J. Bus. Venturing 385

    2 Dreux & Goodman, Business Succession Planning & Beyond (1997).


    the family operates that business and how they operate as a family together. Most notably, it is important to understand the testator(s) and what he or she expects or understands about the different members of his or her family and what roles the members of the family will be expected to play in the continuing business via the succession plan.

    The expectations a testator has for his or her family has the potential to create problems, especially if the family does not entirely get along and arguments over financial matters can create problems where there were none previously. Thus, helping a family face and resolve or minimize these problems ahead of time is probably the most important step to ensuring the success of the succession planning process because it may lead to finding where future family relationship problems are likely to arise (i.e., negative behaviors and feelings about the family business), and finding an adequate solution that will help the heirs fit into their new roles in the continuing family business through the succession plan or lead to a sell decision that is in the best interest of the family.

    Sell Decision

    It is of paramount importance to understand whether the testator wants to keep the business in his or her family or wants to sell the business. If the testator wants to sell the business, it is less important to understand the dynamics of the family and how each member will or will not be fitting into the business plan. The sale will create the necessity to understand what will happen when the business is sold:

    1. How will the family business be valued?
    2. If the testator has passed, who will be empowered to negotiate the sale terms?
    3. How will the estate and income tax consequences of such a sale be dealt with?

    Understanding the Family Business

    Before beginning to plan for transferring the family business, it is necessary for the succession planner to understand all the working aspects of the business. He or she should review all important and necessary documentation relating to that business. First, the succession planner should review any ownership documents, including stock books, articles of incorporation, bylaws and any other agreements relating to ownership and or voting. In addition, any document that relates to the history of the business including financial statements, contracts in place including employment contracts should be reviewed thoroughly. The succession planner should also be aware of any mortgages or loans that encumber the business, as well as any other agreements or contracts that could lead to problems of ownership during transition of the business from one generation to the next. All of these documents will help the succession planner to understand the structure of the business and whether it will need a new structure for it to successfully pass to the next generation.


    There are several steps that are necessary to help facilitate the business succession planning. First, make sure you have a contract with the testator, which provides a review of the approach that will be used to help him or her accomplish his or her goals. It is important that the testator understand the process that they will need to go through during the planning process. Next, the succession planner should make sure to have family meetings so he or she can better understand each family member and any attribute or attitude of entitlement that may detract from the testator’s goals.

    The succession planner also needs to act as a mentor to the family. He or she needs to be able to guide and assist the family with their new roles with the company. Further, this can help in situations where the testator dies before the beneficiaries have been prepared.

    A.      When the Business is Transferred to the Beneficiary in Full

    When transferring the business there are variables that should be considered when determining the appropriate technique include the following: Types of assets held by the business; financial resources of the business; the dynamics of the family; the type and marketability of assets held; the economic position of the client and/or the financial resources of the business; the business owner’s need for cash flow during retirement; the number of business owners and their relationship; incentives in place to prevent loss of key employees, the type of existing business entity; and different income and estate tax considerations.

    There are two major classifications of techniques used to deal with transfer taxes when transferring a business between generations:

    1. Techniques that utilize valuation discounts
    2. Techniques that utilize timing

    Both of these techniques to strategically transfer a business’s value from one generation to the next with the lowest transfer tax burden can be combined to get the most beneficial outcome for the testator. A simple example of a technique utilizing a valuation discount is taking one spouse’s separate property and changing the title to community property. Since both spouses must consent to sell a community property asset a small valuation discount could be applied to argue for a lower fair market value for the asset than would be achieved if the asset were valued as separate property.

    A simple example of a timing technique would be to transfer title of an asset expected to substantially appreciate as a lifetime gift rather than letting the asset transfer at death after it has highly appreciated.

    Family Trusts

    Family trusts that become irrevocable at the time of the testator’s death or incapacity are often used as a vehicle for the testator to transfer control of an entity, the management rights and/or the economic benefits of the business. Irrevocable and revocable are the two types of family trusts.


    Revocable trusts are treated as a grantor trusts during the testator’s lifetime and thus the income of the trust is taxed to the grantor.3 Revocable trusts come in a multitude of varieties but the most common flavors include AB trust and ABC trusts. In a typical AB trust arrangement a single trust containing all of the assets of a couple is split at the death of the first grantor into the A trust (bypass or exemption trust) which subjects trust assets to the estate tax up to the full extent of the first to die’s exemption amount without incurring any estate tax and then funds the remainder of the estate to a B Trust (martial trust) utilizing the marital exemption found under IRC Section 2056(a) to avoid any estate tax on the first to die’s estate. The C trust is typically utilized to transfer Qualified Terminal Interest Property (QTIP) where the first to die has children from a prior marriage. Ordinarily the surviving spouse is given the use of the income from the QTIP trust for life with any remainder interest passing to the first to die’s children from a prior marriage.


    Assets are often put into irrevocable trust for the benefit of a settlor’s family members and other beneficiaries. Funding an irrevocable trust is considered a completed gift and generally effectively removes an asset from a settlor’s estate. The term irrevocable means that the grantor cannot rescind the trust or utilize the assets funded to the trust for his or her own benefit. In order to effectively remove an asset from the grantor’s estate, the grantor must not retain any beneficial interest in the trust. Income generated by assets in an irrevocable trust will either be taxed to the beneficiary(s) of the trust or to the trust itself.4 Irrevocable trusts are generally utilized when a business owner does not want to individually gift stock or membership interests to his or her successors, or if he or she wants to protect the heirs’ interest from creditors or the impacts of divorce.

    Intentionally Defective Grantor Trusts can be utilized to continue to subject the settlor to income tax on assets contributed to an irrevocable trust but get assets out of the settlor’s estate for transfer tax purposes.

    Techniques Applicable to Potential Transferees

    There are multiple categories of people to whom the business owner may want to transfer the business or the economic benefits of the business.

    Family Members

    When the testator/business owner wants to transfer the ownership of the business to family members so as to keep the wealth within the family the process often is expensive and difficult because of the necessity to have the funds available when the associated transfer taxes become due. Thus transferring techniques typically include some or all of the following: creating a new, or reorganizing the existing business entity to utilize valuation discounting; transferring the interests to the business entity; and providing a funding mechanism that will provide for the estate tax usually through life insurance.

    3 IRC §§ 676 & 671
    4 IRC §§ 641 & 678

    Family Limited Partnerships (FLP’s) are often used to facilitate a valuation discount and also to provide other benefits such as continuity of management and limited liability. Grantor Retained Annuity Trusts (GRAT) can be utilized to facilitate a valuation discount where a grantor retains an annuity interest in the assets contributed to the trust with a remainder interest benefiting the grantor’s beneficiaries.

    Note: Beware that excessive valuation discounts have been systematically targeted and can lead to unanticipated gift or estate tax obligations often at a time where insufficient assets are likely to exist to provide for them. Discounts in excess of 30% often lead to an audit and transfers via interfamily sale can also result in retroactive revaluation.


    A transfer to employees may be a transfer of control or economic benefits or both. The transfer can be to the employees in general, or to a limited group of people. For example, voting shares of a company can be given to family members and non-voting shares can be given to employees if the settlor wishes to have his beneficiaries retain control of the company while passing on economic benefits to the employees.

    Incentive stock option and non qualified stock option plans can be used as mechanisms to keep younger successor employees in the business and continue to work towards building it during the settlor’s lifetime. Under these plans, employees can receive equity from the company (LLCs and partnerships) in the form of capital or profit interests.

    Existing Co-Owners

    The buy-sell or shareholders agreement is an essential tool for succession if the business has more than one owner. When an owner is departing from the company, or another triggering event occurs, the buy-sell agreement will set the valuation method and terms for purchasing that owner’s interest in the company. See below for expanded coverage.

    Outside Buyers Who Will Continue or Liquidate Business

    Rarely do outside buyers seek to acquire the stock of a business because of unknown business liability and off balance sheet risks like pending lawsuits and everyday product liability for example. For this reason most business sales are classified as asset sales. An earn-out agreement can be utilized to partially or fully finance an asset sale where the owner receives a deferred payment based on a formula linked to the company’s future sales performance or profitability. Retention bonuses can be used to retain key employees to enhance the company’s value to the purchaser and compensate the key employees for their loyalty to the original owner.

    Charitable Entities or Trusts

    A charitable contribution of business assets may be something the client is interested in if he or she has already sufficiently provided for his or her natural heirs or does not have any. The business owner can give business assets to advance the charity’s purpose or give investment assets that the charity can later liquidate for cash. These gifts can offset income taxes during the life of the business owner and offset estate taxes at their death often through the use of charitable lead trusts and charitable remainder trusts.

    B.       Buy-Sell Agreement Basics

    Purpose of Buy-Sell Agreement

    Buy sell agreements function to provide certainty and order where a transition in ownership of a business entity becomes necessary because of the occurrence of a previously agreed upon set of events. The parties to a buy sell agreement contractually attempt to anticipate conflicts and circumstances that would upset the normal functioning of the business entity to the extent a party to the agreement would be forced to sell his or her ownership interest in the entity. Typically the buy sell agreement lists items like thefollowing;

    • Under what circumstances or events may an owner sell his or her interest in a company;
    • Under what circumstances or events will an owner be contractually forced to his or her interest in a company;
    • Who qualifies as an allowable buyer;
    • How will a valuation of the company be performed to value the portion of the company sold;
    • Buy sell agreement benefit the owners by reducing to writing the following items at a time when the owners are getting along: Such an agreement benefits the entity and its owners by;
    • Preventing a transfer of an ownership interest to an ineligible shareholder to protect an S Corporation election;
    • Providing for job stability existing minority owners and key non-owner employees;
    • • Planning for the liquidation of an owner’s interests because of their death, disability, retirement, or other agreed events (can be voluntary or mandatory);
    • • Documenting a plan to allow for continuity of management and control after a change in ownership;
    • Creating liquidity for the shares of selling owners;
    • Creating liquidity to fund estate taxes and settlement costs;
    • Establishing a valuation methodology for estate and gift tax filings;
    • Giving the owners control over whom they do business with and how control will be shared;
    • Providing a mechanism to prevent those that have conflicts of interest from obtaining an ownership in the businesses, i.e. Competitors, Disgruntled employees, Heirs of a decedent;
    • • Planning for the level of involvement of retired or non-performing owners.

    Buy-sell agreements are usually drafted as stand-alone documents. They also can be incorporated into an operating agreement. The buy-sell agreement and the operating agreement must be drafted in such a manner as they do not conflict. A poorly drafted buy-sell agreement is likely to result in a dispute regarding one or more of its provisions and the accompanying possibility of a malpractice claim where the document did not work to your client’s advantage.

    Events commonly triggering a buy out;

    The following list are events that commonly trigger a buyout; Expulsion or termination of employment, Declaration of Bankruptcy, Loss of professional license, Breach of operating agreement, Breach of fiduciary duty to business entity, Criminal conviction, Dissolution of marriage.

    C.     Business Structure Conversion

    Often, the client is doing business through an existing entity before consulting an succession planner about business succession planning. Even though the bottom line objectives of the business succession plan can ordinarily be accomplished with any type of entity (corporation, partnership, or LLC), the unique tax and non-tax attributes of the available types of business entities can dramatically impact the business succession plan. Therefore, early in the planning process the advisor should evaluate the current form of the business to determine its suitability for use in the business succession planning process. An analysis must be undertaken as to whether any modifications to the entity structure are indicated. The entity structures changes can be minor such as adding preferred stock or amending an operating agreement to as major as converting to a completely different business entity structure depending on the goals sought in the planning process.

    Many older businesses were formed as C corporations which may have at some point elected S status. Unfortunately, for most family-owned businesses, the most advantageous form of entity for business succession planning purposes is an LLC. Accordingly, succession planners dealing with a client doing business through a C or S Corporation should seriously consider converting to an LLC especially in situations where the business succession client effectively controls the entity. However, the income tax implications of a conversion to a different form of business entity needs to be closely examined before making a conversion.

    Business Succession planners like LLC’s because of the estate planning opportunities these entities present surrounding valuation discounts and the availability of limited liability for the owners. For similar reasons succession planers frequently utilize family limited partnerships. Both family limited partnership and LLC’s permit (1) profits and losses to flow through to the individual level (2) management flexibility, and (3) the ability to limit transfers of business interests outside the family.

    FLPs are often used to give away assets utilizing the client’s annual gift and estate tax exclusion. Transfer tax savings are realized through the use of valuation discounts and by transferring the future appreciation of the business out of the client’s estate. Assets besides an operating business can also be gifted away through these entities. For example, real property and securities can be contributed to a FLP by a married couple in exchange for the general and limited partnership interests. Non-taxable lifetime gifts up to the exclusion amount (currently $14,000) can be made of the limited partnership interests to the children of up to $28,000 per year per child utilizing the husband and wife’s individual $14,000 exclusion. The couple continues to enjoy and control the assets though their general partnership interests.

    The income tax consequences of the conversion of a C Corporation into an LLC taxed as a partnership or family limited partnership (FLP) to be aware of are the capital gains and ordinary income that arise as a result of a deemed liquidation of the C Corporation and subsequent contribution of its assets to an LLC or FLP that can result in two levels of taxation, once at the corporate level and once at the individual level. In an S Corporation conversion to an LLC or FLP, the planner needs to be aware of the potential for built in gains tax if the S Corporation converted from a C Corporation with the 10 previous tax years. Additionally, the liquidation can result in taxable dividend treatment if the S Corporation has undistributed earnings and profits from a C Corporation year.

    In California it is simple and straight forward to convert from one form of business entity  to another. The California Secretary of State lists the requirements for conversion on its website.

    D.     Minimizing Tax Burden in Transferring Ownership

    As stated previously most techniques to minimize transfer taxes include either:

    1. Techniques that utilize valuation discounts
    2. Techniques that utilize timing

    Both techniques focus on the fact that at death, an estate is taxed on the amount of taxable lifetime gifts and death bed gifts that exceed a then applicable exclusion amount. Techniques that utilize valuation discounts usually involve fractionalizing an asset and thus creating valuation discounts. Techniques that focus on timing ordinarily accelerate the timing of the transfer. For example, an asset expected to significantly appreciate can be sold via an installment note with payment being deferring over time based on the pre appreciated current value which is thus effectively removed from the estate. Similarly, an asset can be gifted while retaining an income stream sufficient to support a valuation discount for transfer tax purposes while enjoying a fixed income stream for a period of years via a GRAT.

    Installment Sale

    Installment sales are utilized in succession planning as follows; the client sells a percentage interest in the family business to an irrevocable trust for the benefit of his or her children and documents the sale via a promissory note. The sale will ensure that any future appreciation in the value of the interest sold will be removed from his or her estate and inure to the client’s children. Simultaneously the value of the promissory note becomes fixed as to the estate of the selling client. In order for the sale to be respected, the installment sale must be for full and adequate arm’s length consideration and provide an adequate rate of return (interest). Any subsequent disposition within the following two years by the client’s children may trigger gain recognition by the client under the related party rules found under IRC §453(e). A subsequent disposition of the installment obligation by the client other than by death, can also cause immediate recognition of the original unrecognized gain on the installment sale under IRC §453B.


    A GRAT is an irrevocable trust in which a client is granted an annuity interest in the underlying trust assets for a specific period of time and the remainder interest benefits the client’s junior beneficiaries at the end of that term. GRATs are beneficial in that the value of the gift that is contributed to the trust is discounted. The GRAT strategy capitalizes on the fact that IRS actuarial tables often result in a perceived undervaluation of the remainder interest. Complications can arise if the grantor dies during the annuity term of the GRAT where the retained interest can become subject to the estate taxes.

    Self-Canceling Installment Note (SCIN)

    A SCIN combines the fixed payment term of an installment note with a cancellation-on-death of the seller feature. Additional consideration must be paid for the cancellation feature usually via a higher interest rate or through a mortality risk factor added to the principal balance of the installment obligation. The advantages of using a SCIN are that it immediately removes the value of the portion of the business sold from the seller’s estate, and on cancellation of the note on the seller’s death there is no value attributable to the cancelled note to include in the seller’s gross estate. A SCIN transaction must be sufficiently documented to avoid inclusion of any remaining gain yet to be paid by the seller’s estate under IRC §691(a)(5)(A)(iii). Inclusion of the unpaid gain can arguably be avoided by structuring the SCIN transaction as a contingent payment arrangement where each payment under the installment note is made contingent on the seller’s being alive on

    the payment date.

    The above techniques can be combined as well. For example property can first be contributed to a limited partnership which supports a valuation discount for limited partnership interest transfers to a trust established for the benefit of the client’s beneficiaries where the client is predicting significant cash flow and appreciation on the underlying assets.

    E.     Business Valuation and Sale

    Estate tax audits often result in unanticipated and unplanned for estate tax obligations often at a time when insufficient assets are available to pay the additional tax. The vast majority of estate tax audits result from the use of aggressive valuation discounts. Thus, valuation is of prime importance in considering intra-family transfers.

    Valuation Overview

    Of prime importance to any successful business succession plan is determining what the business is worth. This is complicated by the fact that the client’s business is often the largest and least liquid asset they own. A business valuation expert can establish solid ground on which to construct a client’s business succession planning strategy. The valuation process may also unearth methods to increase the business’s bottom line and thus ensuring its continuing marketability. In many ways business valuation is art and not science. Placing a value on a closely held company where there is no established market inherently involves a great amount of uncertainty. To complicate matters further there is no universally accepted methodology to establish a value for a closely held company. Business valuation experts have identified over 600 factors that influence a valuation to varying degrees. However, no uniform method exists to determine the weight to be given each factor. Additionally, valuation experts are forced to consider the purpose of the report, the underlying nature of the industry, the specifics of the type of business being valued, and all current on-point economic and tax factors. Consequently, valuations can fluctuate widely based on the valuation professional’s interpretations of these factors or from the choice of an inappropriate valuation method.

    Choosing a Valuation Professional

    Business valuation is a specialty and thus a competent business valuation expert should be retained as early in the business succession planning process as is practical. The goal is to choose the business valuation expert that will arrive at a value for the business is defensible in federal and state courts and before the taxing authorities. Clients often have problems seeing the value in obtaining a valuation report, and must be educated to understand that a formal valuation report is absolutely necessary when and if their business succession plan falls under the scrutiny of the taxing authorities. Moreover, the valuation report often identifies methods of enhancing the business prior to its ultimate sale or transfer, which often occur after it is transferred to the client’s beneficiaries.

    IRS Penalties May be Incurred if a Valuation Expert’s Report is Unsupported

    A 20-percent penalty attributable to underpayment of tax caused by a “substantial estate or gift valuation understatement” is possible under IRC §6662(g) and a 40-percent penalty is possible where a “gross valuation misstatement” is established under IRC 6662(h).

    Overview of Common Valuation Approaches

    Cost or asset approach: This method consists of adding up the values established for each business tangible and intangible assets at each asset’s current fair market value.

    Market approach: This method relies on comparable market data to arrive at a value of a closely held company. The valuation professional analyzes available data of similarly situated businesses. The comparable data often involves recent acquisitions of similar companies. Price-earnings, price-cash flow, price-revenue, and price-book value multiples of comparable companies are also analyzed for applicability to the business being valued.

    Income approach: This method focuses on return-on-investment and a company’s earning power. A company’s historical earnings are analyzed as being indicative of the company’s current earning power. Each approach is not necessarily mutually exclusive to the other approaches.

    Valuation Premium and Discount Basics

    In determining the fair market value of a business, valuation adjustments can be made that either increases the businesses’ value (premiums) or reduce its value (discounts). Typical discounts surround the degree of control or lack of control the person has over the business through minority interest discounting. Discounts are also taken for the perceived degree of illiquidity of a business because of the lack of a market for it through lack of marketability discounting.

    A key person discount reflects the reality that the loss of a key individual can hurt a businesses’ profitability. Examples are a salesperson who accounts for a large portion of a company’s sales revenue, an executive with highly specialized skills and industry knowledge, or an employee that aggressively recruited because of their reputation.

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