by Barbara Gill, CLU, ChFC, CFBS
& Dale J. Seymour, CLU, ChFC, CFBS
Seymour and Associates
Retiring from the family business?What does one do?Sell to other family members?Sell to an outsider?Perhaps retain the family business and gift portions annually to other family members.What about an installment sale or private annuity?Is an ESOP an alternative?What about charitable remainder trust?How does one structure the deal so that the buyer can afford to buy and the seller can afford to retire?Fortunately, there are many creative planning opportunities available to assist the family business owner who desire to create an exit strategy.Planning in advance becomes the key.
Without question, there are many choices to be made regarding business transfers during a lifetime.One option the family business owner always struggles with is whether or not to sell the family business to family members or an outside third party.In the event of structuring a sale with family members, several particular questions should be addressed.
First, are all of the family members interested in buying a proportionate share of the business?Secondly, should all the family members be involved in the business?If not, how do we treat those who don’t buy a proportionate interest?Should they receive a minority position in the business anyway?Of course, one could alternate the bequests for non-involved family members if sufficient assets are available.
Irrevocable life insurance trust planning is always an option.In this instance, life insurance can be used as an option.In this instance, life insurance can be used as an estate creating tool to provide an “alternative estate” for non-involved family members. Do the children have sufficient funds to buy the business?Separate funds may be available.Usually, it is the future earning of the business that will likely end up as the major source of funds for any such purchase.
A charitable trust could certainly be an option to facilitate the transfer of the business interest.If the family members are not ready to assume a leadership role, perhaps a charitable lead trust can be used as an interim step in passing the family business.
It may be possible to receive favorable tax leverage for the senior generation, as well as helping to free up accumulated earnings in the business as a source of retirement funds for the senior generation with minimal adverse tax impact.This technique, known as the charitable stock bail out will be discussed later in this writing.
In the consideration of a sale to an outside third party, different issues must be addressed.For example, finding the right individual to purchase the business, as well as examining the source of funds.The structure of the arrangement will also likely differ from the sale to a family member.This includes, but isn’t limited to, the consideration of security interests and liens, as well as condensing the payment period.Usually, the sale to a family member will allow for a payment period much longer than one to an unrelated third party.
Another opportunity is to retain the business and gift portions to family members. This can be done via the transfer of stock or partnership interest to the younger generation. The younger generation can make use of the annual exclusion in unified credits, otherwise available to minimize the tax impact. This approach doesn’t take into account the inflationary growth that may occur in the remaining shares, or what happens in the event of a premature death of the senior generation family members. Any effective gifting plan generally requires a lot of time.
The overall effectiveness may well be limited by increasing business value, or the premature death of senior generation family members. Any potential estate tax liability (or the business reversals that may be attendant to the loss of the senior generations management expertise and experience) can otherwise be offset by life insurance owned by the children in an irrevocable trust.
An additional planning technique to be considered is the family limited partnership.The use of these types of partnership interests can facilitate transfers to younger family members while retaining control amongst the senior generation.Substantial discounts for lack of marketability and minority interests may be available in certain circumstances as it relates to estate planning valuations.Additionally, as a result of the structure of the family limited partnership, there is a built in incentive to keep the family business in the family.
If the business is to be sold or otherwise transferred to other family members (or outside third parties), it is important to remember that present owners need to receive “full value” for their business interests.Sources of retirement income might include installment payments from an installment sale, periodic payments under a private annuity arrangement, and annual payments due under any charitable trust arrangement.Additionally, deferred compensation payments, if such a program has been included as an ad-on feature to any buy-out agreement, as well as monies received as distributions from business sponsored qualified plans.
A buy-sell agreement may be arranged to help facilitate the lifetime disposition of the business interest in one of two ways.A stock redemption might be used whereby the corporation purchases stock back from the owner who wishes to sell. Alternatively, a cross purchase agreement might be utilized, whereby remaining shareholders purchase the stock.
The use of the installment sale has always been a widely used technique. The family business owner would sell their business interest to their children or other third parties for installment payments and interest.The installment payments provide a stream of retirement income, as well as provide a capital gains “stretch out” for the seller. Life insurance is necessary to insure the unpaid balance of installments for the benefit of the buyer’s family (to guard against his or her premature death). Life insurance may also be used as an asset replacement device to provide an alternative inheritance to children where the business might be sold to an outside third party.
In addition to the buy-sell agreement and the installment sale purchase, a private annuity may be used. In the typical scenario, the parent would sell their business to the children, and the children would promise to pay the parent an income stream for life.Each payment would be made up of capital gains, interest income, and non-taxable recovery of basis. The obligation of the children “transferee’s” must be unsecured.This is opposite the installment sale purchase where the seller can be given a security interest or lien on the business asset.
Because of the unsecured nature of the promise, these arrangements work best where all parties are related family members.Life insurance can minimize the hardship on the buyer’s estate in the event of his or her death before the death of the annuitant’s parents.Additional insurance could be purchased for the buyer’s family to pay estate taxes caused by the inclusion of the property in the buyer’s estate.
A separate opportunity referred to earlier in this writing was the charitable stock bailout. In this scenario, the business is generally owned by more than one shareholder. There is usually significant retained earnings and liquid assets. Often times, the primary shareholder wishes to retire, but does not want the business to pay dividends. One of the owners of the closely held business would establish a charitable remainder trust. This owner would donate all of their stock in the closely held business to the CRT, receiving an income tax deduction based on the value of the shares transferred, the income stream retained, and current life expectancy. The business would redeem the stock owned by the trust–using the funds in retained earnings, which are subsequently reduced.
The CRT would invest the redemption proceeds and pay the income stream to the former business owner for their life.Successor generation, or co-shareholders would become owners of the business without the requirement of continuing payments to the retiring stockholder.The retiring stockholder has removed the assets from their estate and held on to the income stream from the trust.If family members are successor shareholders, the business is transferred without gift or estate tax. Life insurance may be used as an asset replacement vehicle to provide an alternative estate to family members not otherwise benefiting from the transferring of business interest through the CRT.
The last opportunity for consideration is the employee stock ownership plan (ESOP). An ESOP is a qualified plan which is subject to ERISA non-discrimination rules. They are designed to acquire stock in the employer company. Since all employees generally must be included as participants, the result could be some dilution of family control as the ESOP acquires more shares of the family business. For this reason, ESOP’s probably work best where involvement in the business by non-family members is minimal.
The development of an effective solution requires coordination of several aspects of estate and business planning. This is best accomplished by a team of professionals: your accountant, attorney, banker, and financial services professional.
Barbara Gill, CLU, ChFC, CFBS, is engaged in a financial services practice, as well as serving as the Director of Education and Training for Seymour & Associates.She has recently received her certification from the American College in Bryn Mawr, Pennsylvania as a Certified Family Business Specialist–part of her Masters Degree Curriculum in Financial Services.
Dale J. Seymour, CLU, ChFC, AEP, CFBS, has practiced in financial services for 26 years.He has served numerous individuals and family businesses during that time.He, along with Barbara, are two of the first 36 graduates of The American College Certified Family Business Specialist program in the nation.