When thinking about the need to do estate planning, imagine yourself on a trip to Tibet. Then consider -- what if the trip never ended and I never returned? Just as you must consider the impact of your mortality on your family, you must also consider the impact of your death or incapacity on your business.
Many abhor this dreary subject but it requires attention. In this issue, the third in our series of newsletters on business succession, the focus is on planning for the passing of control when a major stockholder or officer dies or becomes too sick to continue.
Although it can prevent a lot of headaches in the long run, few business owners have the foresight to have written control agreements between the founder(s) and the next generation (or underlings) regarding the passing of control. Control agreements can take a number of forms, and may be called redemption agreements or buy-sell agreements.
For example, suppose the stock in a family-owned business is owned by several members of the family and it is the wish of all of them that, in the event of the death of one of them, the deceased's stock be kept in the family. If there is no agreement mandating the sale of the decedent's business interest, then that interest will pass by Will or intestacy (if there is no Will) to "someone." That "someone" may be an estranged spouse who is not a blood relative of the family or an out-of-state relative who previously had no contact with the business.
One way of preventing ownership from passing outside a family or group (say, a group of founders) is to have a redemption agreement between the current owners of the business. A redemption agreement would provide that if any one of the family members dies, the business or the survivors, individually, will buy the interest of the decedent. Such an agreement provides a number of benefits in addition to keeping the ownership in designated hands.
Such an agreement can create a market for the sale of closely held stock or partnership interests when there is no other practical way to sell the interest of a decedent. Often the decedent's immediate family members are not experienced in the business or psychologically ready to carry on the duties of the deceased owner. Such relatives are often better off with cash than with an interest in a closely held business.
Life insurance, if it is available at a reasonable price, can prove invaluable in providing funds to purchase the interest of a deceased family member/stockholder. Furthermore, it allows the family of a decedent to have cash rather than an interest in a closely held business for which there is no market.
If insurance proceeds are not available to help pay for the purchase, few small businesses can pay cash for the entire interest of a decedent. Promissory notes providing for payments over a period of years may be the answer. Promissory notes allow the business time to pay for the interest, while giving the decedent's family a binding commitment from the business to pay, usually with interest added for the time value of the use of money. Such notes can, if agreed in advance, provide the promissory note holders with information about the business. They may also forbid the business from selling major assets or reorganizing unless the note holders are paid in full.
Mandatory sales agreements can also afford another benefit -- avoiding a fight with the IRS over the value of a decedent's interest. If the decedent has a taxable estate, the price stated in a bona fide redemption agreement will usually establish the value of the decedent's interest for estate tax purposes. So, in addition to handling immediate problems such as cash flow for the business and the financial needs of the decedent's family, a mandatory sales agreement, if properly drafted, can help keep the IRS examiners at bay.
What about the duties performed by the deceased business member? Often, in the event of the death of a colleague, the surviving officers are doubly burdened. Now, they have to handle more duties and work harder in order to provide income to the surviving members of the decedent's family. Imagine having to handle a heavier workload while, at the same time, having to deal with a surviving spouse of a deceased business associate who is demanding cash for necessities!
What if major business owner is not dead but is seriously incapacitated? Suitable agreements can provide for mandatory purchases of the interest of a disabled or incapacitated business owner, although such provisions are less common. There is also insurance available for such disabilities but it is much more expensive than life insurance.
A careful reader may have noticed that this newsletter has not addressed one of the toughest issues related to a mandatory sales agreements -- "How do you set the price?" That's our topic for the next issue.
By Tax and Business Professionals, Inc.
9837 Business Way
Manassas, VA 20110
While designed to be accurate, this publication is not intended to constitute the rendering of legal, accounting, or other professional services or to serve as a substitute for such services.
Redistribution or other commercial use of the material contained in Tax & Business Insights is expressly prohibited without the written permission of Tax and Business Professionals, Inc.