If you are a business owner, health care practitioner, or farmer, you'll have to contend with special challenges as you work to preserve your assets for your heirs. To simplify our discussion, we will refer to anyone who falls into any of these three categories as a business owner. As a business owner, you're probably so involved in the day-to-day demands of running your business that you haven't really thought about succession planning. Unfortunately, too many people don't plan properly, and as a result, the value of their business is seriously diminished. A couple of typical cases show how important advance planning can be.

Case Study 1

Bill Johnson Sr., a divorcee, owned a small precision manufacturing company that had an estimated value of $6 million. He had spent his entire career building this successful company, which represented the bulk of his net worth. He was grooming his son Billy to take over the company when he retired. Bill Sr. also had two daughters who were not involved in the business. Unfortunately, he died suddenly, leaving his estate to the three children equally. Billy Jr. was now in business with his two sisters, and he was a minority stockholder. Although Billy's sisters had little interest in the business, they felt they deserved an income from it because, after all, Billy received a nice salary. Together, the two sisters owned a majority of the voting stock, and they were able to successfully demand the income they felt they deserved. Because they did not work in the business, these income payments were not deductible by the business. This story does not have a happy ending: the infighting and cash-flow problems eventually caused the company to fail. The sisters blamed Billy. After all, he was running the company.

A number of steps could have alleviated the problems in this case. One strategy would have been to have the daughters receive their share of the estate of Bill Sr. from assets other than the business. To accomplish this, Bill Sr. would have had to buy life insurance owned by a trust for the daughters' benefit or have arranged for the daughters to own the policies individually. If insurance was not a possibility, he could have considered two classes of stock—voting and nonvoting. In this way, he could have given the daughters nonvoting stock while giving Billy voting stock. All of the children would have had equal ownership in the company, but Billy would have had voting control. Another option would have been for Bill Sr. to sell the company to Billy Jr. for an installment note. At Bill's death, the children would have had an equal interest in the note.

Case Study 2

Dr. Steve Stein's dental practice has provided him and his family a good income for 35 years. Now, at age 64, he has noticed that his patient load is declining significantly each month. That is likely to continue because his current patients are all in their mid to late 60s. Also, an increasing number of his current patients are moving to retirement communities out of town, while others are dying. He seems to be surrounded by younger dentists who have thriving practices while his profits are dropping month by month. He is ready to retire but cannot afford to because there is little value left in his practice. He has no choice but to continue to run an increasingly deteriorating practice. Finally, at age 75, he shuts his doors and sells his equipment for pennies on the dollar.

We have had an opportunity to work with numerous health care professionals over the years and one of our primary objectives is to make sure that we built value in their practices. Dr. Stein should have brought in a younger dentist to the practice. Not only would the younger dentist have provided valuable new blood, but he or she would have been the perfect buyer.

Case Study 3

Horace and Martha James owned a working farm that had been in the family for two generations, and it was their desire that the farm remain in the family. Although the farm income had allowed them to raise and educate their two children, they always had to pay attention to their cash flow. Consequently, they didn't expect the farm to be worth very much and have not concerned themselves with any estate planning. However, when the Jameses both passed away, their children were in for a rude awakening. The farm was rich in timber, and the IRS valued the land at four times the Jameses' estimate. This resulted in substantial estate taxes even though the children didn't have the cash to pay the taxes. Despite the special tax provisions for farmers, the children were unable to pay the taxes, and the farm had to be sold to raise cash.

Business owners, particularly farmers, tend to underestimate the value of their businesses. This is a big mistake. For better or worse, the IRS seems particularly inclined to challenge the business values of deceased business owners. There is a lot of money at stake, and the IRS wins more than its share of these cases. The Jameses' best defense would have been a good offense. First, they could have reduced the value of the farm by using discounting strategies such as the family limited partnership (FLP) or the limited liability company (LLC). Next, they should have considered using their annual gift tax exclusion to begin transferring undivided interests in the farm to their children at that time. Finally, they needed to monitor the value of the land and then develop a game plan that provided the liquidity to meet any potential estate tax obligation. To do this, they would have had to get aid from a qualified appraiser. This is another instance where planning ahead could have achieved the desired objective.

Special Estate Tax Benefits for Farmers and Closely Held Business Owners

One major problem shared by farmers and small business owners is that the farm or business typically represents the majority of the value in their estate. Under normal circumstances, estate taxes are due within nine months after the date of death. Because businesses and farms are by their nature highly illiquid enterprises, there is rarely cash to pay these estate taxes. Fortunately, Congress has provided a variety of special tax provisions to make it easier for the small business owner and farmer to meet their tax obligation and thus pass the assets to family members. These special provisions include the following:

• Installment payment of estate taxes.
• Special-use valuation of certain business property.

Valuing Your Business or Farm

Most business and farm owners have a poor sense of the value of their business. This may be because as a profession, farming can yield small profits for a lot of work. However, the IRS doesn't consider work when it puts a value on your property; you should note what the IRS thinks is very important. Upon your death, it is the IRS that may challenge the values your executor places on the farm. In many instances, the IRS will assume that you are going to try to undervalue the business or farm. To counteract this assumption, you will need to have qualified appraisers establish the fair market value and be prepared to defend their results. You should get a ballpark estimate now so that you can do your advance planning. Figure a worst-case valuation and then develop a plan that addresses the estate tax and succession issues. In previous chapters, we discussed many ways to create discounts for valuation purposes. Other chapters outline strategies that you can use to begin transferring portions of the business or farm each year. The important thing is to develop a plan early. You don't want to die and then have your heirs in a crisis-management mode that often results in higher taxes and a greater burden on your loved ones.

Succession or Sale?

Two potentially distinct issues must be considered when thinking about the family business, the first of which has to do with keeping it in the family. If there are family members who are both interested and capable of carrying on the business, you will want to make sure that you design a transfer that gives that person or persons appropriate control of the business. You will also want to ensure that he or she receives the business in a sound financial condition.

If you don't intend to pass the business to family members upon your death or retirement, you should structure the business in such a way as to receive its maximum value. Your decisions here will help determine the strategy that is best for you and your family.

Succession Planning: Keeping the Family Business in the Family

Take a long look at your business. Are there family members who are able and interested in continuing it? If you have a child or children who are interested in the business and others who are not, do you have a way of dividing your estate so that all are treated fairly? You definitely want to avoid engineering a successful transfer of the family business only to have it divide the family. Let's assume that you want your business to be under your children's control. Some of the planning issues to consider are as follows:

• Management training. We often find situations where children are working in the family business but the parent is still making all the key decisions without any input from the children. This isn't training. If you intend to leave the business to a child, he or she has to be in the loop of business decision making.
• Control. If you have children who are not involved in the business, it is essential that the children who are running the business have voting control. As in the case of the Johnson family, the best solution is to make sure that the children not working in the business receive their fair share of your estate from assets other than your business interest. Although these conversations can be difficult, you should discuss these issues openly with your children so that each of them understands why you are dividing your estate the way you are.
• Financial condition. Take an objective look at your company. Is it financially sound, or is it overleveraged? In the hands of capable management, financial leverage is an important tool for growing a business. Are you the key person in that management team? How would your son or daughter fare if he or she had to suddenly step in your management shoes because of your death or disability? Make sure that you have a plan for transferring the business to your children in sound financial condition, which should be defined in terms of their capabilities, not yours. This may be as simple as providing adequate life insurance on your life and a disability income insurance plan.
• Estate taxes. You need to determine what the business is likely to be valued for estate tax purposes. Will there be adequate liquidity to pay estate taxes? Many succession plans have failed because of failure to plan for this eventuality. Consider using some of the many strategies we have discussed in this book for reducing and transferring the value of your business and other assets.
• Documentation. Remember, for your business interest to be transferred, you have to have proper documentation. Do not assume that you will get around to it someday. Do it now! This can be done through your will, or it can be accomplished with buyout agreements. Consult with your tax adviser for the best method in your situation.

Maximizing Your Business's Value through a Sale

If you do not plan to leave your business to a family member, you will want to take steps to maximize its value upon your death or retirement. If you're assuming someone else will be willing to pay top dollar for your business, you have to do a lot of planning. Here are some of the issues you should consider:

• When to sell? Do you plan to sell your business while you are living or do you plan to wait until you die? This may sound like a strange question, but many people plan to work their entire life. Your strategy for selling during life might be very different from your strategy if you plan to wait until you die.
• Finding a buyer. Business owners sometimes shrug their shoulders and mutter something about someone selling their business upon their death when they're asked about what they intend to do with it. When we press a little harder for an answer, the owner often suggests that his or her spouse is probably the person who would end up dealing with the problem. Sometimes they know an adviser whom they feel they could count on to help with the sale. The truth is that none of these people are likely to be in a position to sell the business for its highest value. You are the only one who intimately understands the business, and you're in the best position to develop a plan for selling it. One solution is to find a buyer now and draw an agreement for sale in the event of your death. This may be easier than you think. Look around your business and see if any key employees would be capable of running it. Employees are often an excellent solution for a business sale. Not only do you have a ready buyer whom you can groom to take your position one day, but knowing that they may own the business one day is a very motivating factor. These employees are not likely to leave. Consider the case of the key employee who purchased and paid for insurance on the life of the business owner. The business owner had his attorney draw a buyout agreement that compelled the key employee to buy controlling stock in the company at the owner's death. The agreement also required the company to sell the stock. The owner is now giving the key employee additional management responsibilities so that he can run the company more effectively in the owner's absence. Much to the owner's surprise, the employee's management skills exceed his. He now has a ready buyer in the event of his death as well as a much more loyal and motivated employee.
• Sell to a competitor. What if you are not lucky enough to have a capable key employee who could buy the business at your death? Next you might consider a competitor. If one of them is reasonably friendly, you may be able to draw an agreement or at least a letter of understanding now. At the very minimum, you should sit down and write out a plan for your spouse or adviser to follow upon your death. List the people whom you think are the potential buyers, describe how to best determine the fair market value of the company, and include any other details that you feel would be useful in helping to sell your business.
• Selling during life. Perhaps the best way to receive full value for your business is to sell while you are still active in it, which usually allows you to receive the maximum value because you are there to assist with the transition. This does not have to be an all-or-nothing deal, particularly if you have key employees. By selling a minority interest in your company to them, you can create a loyalty that otherwise is difficult to achieve. The employees are now owners and will likely shun offers to work for competitors. You can also prepare them with both financial and management skills to take over when you retire or die. Be sure to develop an appropriate exit strategy that will allow you to get their stock back should they cease to be employed by your business. Minority shareholders can cause you a lot of problems.

Structuring Your Buy-Sell Agreement

Once you have found the right buyer for your business, you will need to structure a formal agreement that outlines all the terms. Whether your buyer is a family member or not, buy-sell agreements offer several advantages:

• If one of your goals is to make sure the family business stays in the family, a buy-sell agreement is an appropriate tool. The agreement can be structured such that all sales must be first be offered to existing stockholders (other family members) or the corporation before they can be sold or transferred to a nonfamily member.
• If structured properly, the buy-sell agreement can establish the value of your company for estate tax purposes. The purchase price for most buy-sell agreements is established by way of a formula or fixed price or is based on a required appraisal. The price must be established based on an arm's-length transaction, which means that the price should be one to which two unrelated parties would be willing to agree. The IRS looks closely at deals between family members to make sure that no bargain sales take place.
• The buy-sell agreement provides a ready market for the sale of the owner's interest in his or her business. Knowing the value that your family will receive for your business interest allows you to better plan your estate.

Types of Buy-Sell Agreements

Buy-sell agreements are typically classified as either entity purchase agreements (sometimes referred to as redemption agreements), cross-purchase agreements, or hybrid agreements.

Funding the Buy-Sell Agreement

Having a buy-sell agreement is important, but your family or employees may not have the funds to buy your business interest. In a family-owned business, rarely do the shareholders or key employees have the cash to buy out the interest of a major owner. This problem is most often solved with life insurance. Premiums for permanent or cash-value life insurance can be expensive, but this is often a better solution than term life insurance, which is inexpensive initially but can become prohibitively expensive as you get older. If there are several owners who need to be insured, you may want to consider establishing a partnership to be the owner and beneficiary of the life policies. Without a partnership (or corporation), a company with four owners would need 16 separate life policies to fund a cross-purchase agreement.

Life insurance will not solve all your funding problems. For example, if the triggering event is your disability, life insurance may be of little initial value as a funding vehicle. Any cash values are likely to be inadequate to fund a buyout caused by the disability of the owner. One solution to this problem is to purchase disability buyout insurance. This is a special type of disability policy that provides a lump-sum payment to buy the stock of a permanently disabled business owner. The exact definition of incapacity of a business owner is a complicated issue that needs to be addressed with your professional adviser.

Certain other tax and cash-flow issues are critical to the ongoing financial health of your company. For example, if you were to become disabled and your company continued to pay your salary, those payments might not be deductible by your company, which would create an added drain on its resources. One solution would be to implement a qualified sick pay plan that establishes a company policy for providing income to disabled employees. Another problem caused by a key person's disability is that someone will likely need to be hired to complete his or her duties. This obviously creates further cash drain where the company is paying one person who is not working and another person who is.

Life insurance may also be of little value if you are selling because of your retirement. One possible solution here would be to establish a sinking fund whereby your company sets aside money monthly or yearly for this purpose. In the corporate world this is known as accumulated earnings and can create tax problems for C corporations. Accumulating corporate earnings for the purpose of buying out a majority owner's stock can cause the imposition of the accumulated earnings surtax, which is based on the maximum tax bracket of the individual.

Often, the best solutions are to purchase insurance where you can afford it and then plan to use financing arrangements to fund the balance. For example, your agreement may indicate that insurance will be used up to a certain dollar amount (the face of the policy) and that the balance will be paid over 5 to 10 years in monthly installments at a competitive interest rate. One danger with using installment payments is that they are made with after-tax dollars. The source of these payments is typically company salaries, bonuses, or dividends from the pockets of those people purchasing your stock. If the corporation increases salaries to cover the installment payments, the IRS may declare that the owner/stockholders are receiving what it considers unreasonable compensation, and the portion that is considered unreasonable is then reclassified as dividends for income tax purposes. Dividends are not deductible by the corporation, which results in double taxation. Successfully structuring the sale of a substantial business interest can be a very complicated matter that will require thoughtful effort on your part as well as on the part of experienced professional advisers.

One Final Strategy—The Employee Stock Ownership Plan

Another viable alternative for selling your stock is to establish an employee stock ownership plan (ESOP). An ESOP is similar to a qualified profit-sharing plan except that the company contributes company stock instead of cash. Some crucial details about ESOPs include the following:

• Employer contributions. Just as with a profit-sharing plan, contributions to an ESOP are limited to a maximum of 25 percent of compensation. Contributions may consist of shares of company stock or cash.
• Limitations regarding diversification. An ESOP does not have any limit on the amount of company stock held in the plan. This differs from a typical profit-sharing plan where diversification is a fiduciary duty. One exception concerns employees age 55 or older who have 10 years or more of service with the company: They must be offered a diversification option into any of three alternative investments. The election must be offered annually over a six-year period. During the first five years, transfers may be made up to a cumulative total of 25 percent of the employee's account balance. In the sixth year, this 25 percent limit is increased to 50 percent.
• Forfeitures. As with most retirement plans, an ESOP typically has a vesting schedule. In other words, contributions made on behalf of an employee are not fully vested in their names until they have been in the plan for a certain period of time. If an employee terminates employment prior to becoming fully vested, his or her nonvested portion is typically reallocated among the remaining participants.
• Financial leverage. The rules regarding ESOPs allow a company to borrow money to buy company stock to fund the plan's contributions. The interest on these loans is a deductible expense by the corporation.

One of the primary advantages to the ESOP is that it can provide you with a ready market for your stock. If the company is a C corporation, the tax on capital gains from the sale may be avoided by reinvestment in marketable securities (stocks and bonds) within 12 months. This advantage is not currently available to owners of S corporation stock. An ESOP owning shares (even 100 percent) of an S corporation will pay no income taxes on corporate profits.

Also, under an ESOP, if the company lacks the cash flow to make a contribution, there is no requirement to do so. Because the employees ultimately will end up owning the company, the ESOP may provide additional employee motivation. Finally, using borrowed money to make stock contributions can be an effective way of raising capital for a company. One added advantage is that the stock may be sold over a number of years or in a lump sum.

Owning and running a business can be a time-consuming and demanding proposition. You put years of your life into making your business a success. To maximize the return on your efforts, you will need to develop a plan to reap the full value of your business at your death or retirement.

One common concern that we all have is protecting our assets from legal judgments. A corporation, FLP, or LLC can provide you with a certain level of protection from would be creditors. For a full discussion of asset protection, read Chapter 15, “Asset Protection Strategies.”