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Business succession planning and when it should begin

Business succession planning is an umbrella concept that estate planners use to refer to the issues raised when a business owner—like a shareholder in a corporation, partner in a partnership, or member of an LLC—decides to exit the business, either voluntarily (e.g. retirement, sale) or involuntarily (e.g. death, dissolution of the business).

A business owner should think early on in his career about business succession planning. While the majority of his or her time should be focused on growing the business itself, smart planning also requires keeping an eye to the future of the business, retirement, disability, or dissolution of the business.

Each of these “exit strategy” options requires careful planning. Depending upon your long-term plans, you may or may not need planning now. However, as a general matter, the earlier business succession matters are addressed, the better positioned you will be.

For example, it is often better to negotiate a buy-sell agreement with your business partners before you consider exiting the business; negotiating earlier may give you more bargaining power and leverage, better positioning yourself upon your exit.

A business owner, shareholder, partner, or LLC member should consider business succession planning when that business interest comprises a major asset in his estate. There are many reasons for saying this, but part of those reasons stems from the various legal issues that a business raises—issues that, more often than not, the business owner is not even aware of.

For example, one of the legal issues that business owners typically are not aware of is that the valuation of his business interest is often difficult to determine upon his or her death. This is especially true when the business is a “closely held” one, which is a business that is held by a relatively small number of people (e.g. a family rather than the general public).

From a tax perspective, this matter is important for at last two reasons. First, an over-valuation of your business can result in larger taxes to your family after you pass away (e.g. estate taxes), if your estate is large enough. Second, even if your estate is under the so-called estate tax “exemption amount” (presently $5.25 million, indexed for inflation), property valuation planning is important to minimize possible capital gains taxes upon the eventual sale of the business interest. When a person passes away holding an asset, his interest that he passes to his heirs will receive a “step-up” in tax basis. This basis determines the tax consequences of a sale. In light of the new estate tax rules (post-2013 rules), many of the planning concepts previously implemented should be revisited to ensure they still achieve the client’s goals. Due to the $5.25 million estate tax exemption amount, rather than “estate tax” planning, many clients should “re-tool” their succession planning so it is “income” tax smart. For many, a post-2013 environment presents an income tax play, rather than an estate tax one.

Another issue business owners often overlook is the need for liquidity upon exiting the business. A business interest is not typically liquid—meaning, one cannot typically sell it quickly for cash at its fair market value.

However, an exiting partner may desire to sell his interest to the business, or other business partners. How will the business pay for it? Related, how will the deceased business owner’s family pay for the taxes resulting from one’s death? These are some of the questions addressed in business succession planning.

Consider a third overlooked issue. When the business owner (including minority interest holders) passes away while he is still actively engaged in the business, how will his salary income be replaced? How will his family carry on after his (or her) death? Related also is the question of how the business itself would carry on without one of its key employees.

These are some of the questions addressed in business succession planning. Each business situation is, of course, unique, and there is no “cookie cutter” solution that fits everyone. Smart business succession planning requires an attorney to look under the hood for a proper diagnosis.

In summary, there are at least three reasons to engage in business succession planning: (1) to take advantage of tax favorable planning, either estate/gift taxes for those with “taxable estates,” or income taxes for those who do not; (2) to provide liquidity to the owners or, alternatively, for the business seeking to buy out an owner; and (3) to provide the exiting business owner’s family with sufficient income—in other words, to provide for the needs of family members, beneficiaries, and key employees of the business. Related to this is to ensure that the business can continue seamlessly (e.g. in management and investment) after an owner is gone.