Business Succession Strategies Buy-Sell Agreements: Considerations and Common Mistakes

Business Owner Market  The small business administration defines a small business as an enterprise having fewer than 500 employees  There are more than 28 million small businesses in the U.S.*  Approximately 543,000 new business are started each month*  More will close their doors for good* *Statistics provided by the U.S. Census Bureau and are through 2011

Business Owner Market  Family owned businesses ‒ 30 percent survive into the second generation ‒ 12 percent are viable into the third generation ‒ Only 3 percent operate into the fourth generation and beyond  Nearly half do not have a succession plan in place  Wealth transfer planning ‒ only 61 percent of business owners surveyed think they have sufficient resources to divide assets among family members

Business Owner Market  Business Protection ‒ 62 percent said they have not made any provisions for dealing with a shareholder or key employee who becomes sick or dies

Where Do We Go From Here?

Business Succession Planning  Exit Planning - Buy-Sell Agreements  Business Protection Planning  Business Owner Retirement Planning  Key Non-Owner Planning

Buy-Sell Agreements  Restrict transfers  Avoid conflicts  Business Continuity - Create a market for owner’s business at certain triggering events - Facilitate smooth transition of management & control - Provide mutually agreeable price & conditions - Provide liquidity - Sets value for estate planning purposes Purpose and Benefits of a formal agreement

Buy-Sell Agreements  Articles of incorporation  Operating agreement  Partnership agreement  Loan documents  Franchise agreements  Deferred equity compensation agreements Consider Existing Restrictions & Agreements

Buy-Sell Agreements  Rights and obligations following a triggering event  Valuation issues  Funding issues  Financing terms  Consider future potential shareholders (especially minor children)  Right to purchase life insurance policies Key Provisions to Consider

Buy-Sell Agreements  Consider the Right Plan - Cross Purchase

Cross Purchase  Arrangement in which each surviving owner agrees to buy out the interest of any departing or deceased owner  Owner, beneficiary and premium payer are typically the same person (NOT a spouse)

Cross Purchase Advantages  Simplicity for 3 or fewer owners  Purchasing owners receive step-up in basis  Life insurance proceeds received income tax-free & do not increase the value of the business Disadvantages  May require several policies with > 2 owners  Owner may unintentionally let policy lapse  Premiums may or may not be deductible

Buy-Sell Agreements  Consider the Right Plan - Cross Purchase - Entity Purchase

Entity Purchase  Arrangement between business entity and its owners  Business redeems interest of an owner in case of death, disability or retirement  Business is owner, beneficiary and premium payer of life insurance policy

Entity Purchase Advantages  Simplistic for > 3 owners  If funded with life insurance, only one policy per shareholder is required Disadvantages  Surviving/remaining shareholders do NOT receive a step up in basis on the deceased/departing owners shares*  Assets held to fund plan may increase value of corporation  Life insurance subject to corporate creditors

Entity Purchase for S Corps Surviving/remaining shareholders of an S Corporation CAN receive a step up in basis on the deceased/departing owners shares if…..  S Corp uses cash basis accounting instead of accrual  S Corp is taking advantage of the short year tax election

Buy-Sell Agreements  Consider the Right Plan - Cross Purchase - Entity Purchase - One Way

One Way  Providing an exit strategy for one-owner businesses  Established between owner and key employee  Creates a buyer for small business owners with no partners or co-shareholders  Buyer receives a step-up in basis  Allows for business continuation

Buy-Sell Agreements  Consider the Right Plan - Cross Purchase - Entity Purchase - One Way - Wait & See

Wait & See  Sets forth triggering events, purchase price and payment terms w/o identifying the purchasers until the event occurs  Corporation typically has first option to purchase share of deceased or exiting shareholder  Remaining shareholders have option if corporation doesn’t exercise its option  Corporation is required to purchase any shares not purchased under first two options  Provides greatest flexibility  Provides greatest risk

Buy-Sell Agreement Funding Methods Cash on Hand - Very liquid, but most business owners put their money to work in the business Sinking Fund - Funds may be inadequate if a business owner dies prematurely - Corp may be exposed to an accumulated earnings tax problem Borrow Funds - The loss of a key person might impair the business’s credit worthiness - Interest costs may be excessive and interest expense may not be deductible Installment Plan - Risk of business failing and payments to seller cease

Buy-Sell Agreement Funding Methods Life Insurance - Complete financing is guaranteed from the beginning - Death proceeds are free from income tax - Generally the most economical as premiums are a fraction of the death benefit - Business credit position is strengthened - If a cash value policy is purchased, equity in the policy can be used for buyout due to retirement or disability

Buy-Sell Agreements  Improper selection of type of Buy-Sell  Improper selection of triggering events  Failure to coordinate related properties  Failure to consider tax issues  Forgetting that minority shareholders / owners have substantial legal rights  Failure to put it all together  Failure to update Common Mistakes

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