Page 1


LifeFocus.com T. Young info@lifefocus.com www.LifeFocus.com

Planning for Business Succession

March 28, 2010


LifeFocus.com

Page 2 of 103

Table of Contents Planning for Succession of a Business Interest ................................................................................................ 8 Business succession planning--what is it? ...............................................................................................8 Transferring your business interest with a buy-sell agreement ................................................................8 Sell your business interest ....................................................................................................................... 8 Transfer your business interest through lifetime gifts ...............................................................................9 Transfer your business interest at death through your will or trust .......................................................... 10 Choosing the right type of succession plan ..............................................................................................10 Short-Term Contingency Planning .................................................................................................................... 11 What is a short-term contingency plan? ...................................................................................................11 Why should you have a short-term contingency plan? ............................................................................ 11 What should you include in your contingency plan? ................................................................................ 11 Effect of your sudden death on the business--table .................................................................................12 Training Successor Management ..................................................................................................................... 13 Why should you be concerned about training successor management? .................................................13 Ensure the smooth transition of responsibilities .......................................................................................13 Where to begin .........................................................................................................................................13 Keeping Your Business in the Family ............................................................................................................... 15 What are some of the issues concerning keeping the business in the family? ........................................ 15 Emotional issues--Family succession ...................................................................................................... 15 Income & liquidity planning ...................................................................................................................... 15 Partial cashout from business .................................................................................................................. 16 Other potential demands on business cash ............................................................................................. 16 Possible solutions for continued success of the business ....................................................................... 17 Selling Your Business to Family ........................................................................................................................18 What is special about selling your business to family? ............................................................................ 18 Special financing techniques available .................................................................................................... 18 Selling Your Business to Nonfamily .................................................................................................................. 20

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 3 of 103

What is special about selling your business to nonfamily? ...................................................................... 20 Sales considerations ................................................................................................................................ 20 Other Transfer Strategies and Considerations ..................................................................................................22 Other transfer options .............................................................................................................................. 22 What is a grantor retained trust? ..............................................................................................................22 What are the different types of grantor retained trusts? ...........................................................................22 Installment sale ........................................................................................................................................ 23 Retained interest ...................................................................................................................................... 23 After-sale considerations ..........................................................................................................................23 Gifting Your Business ....................................................................................................................................... 25 Why would you want to give away your business? .................................................................................. 25 Are there different ways to make gifts? ....................................................................................................25 Determining the Value of Your Business .......................................................................................................... 27 What is valuation? ....................................................................................................................................27 What is the importance of determining taxable value? ............................................................................ 27 Why a valuation might be needed ............................................................................................................27 Valuation issues ....................................................................................................................................... 28 Different definitions of value .....................................................................................................................29 How do you determine the taxable value of your business? ....................................................................30 Minimizing Taxable Value of Business (Estate Freeze) ....................................................................................32 What is minimizing the taxable value of your business? ..........................................................................32 A quick lesson on the estate tax system .................................................................................................. 33 How does an estate freeze minimize taxes? ............................................................................................34 What are your options? ............................................................................................................................ 35 How do you choose which option is right for you? ................................................................................... 36 Transferring Your Business Interest with a Buy-Sell Agreement ...................................................................... 37 What is a buy-sell agreement? .................................................................................................................37 Why would you want one? ....................................................................................................................... 37 Personal considerations ...........................................................................................................................38

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 4 of 103

Business considerations .......................................................................................................................... 39 Does size matter? .................................................................................................................................... 39 What are the tradeoffs of having a buy-sell agreement? ......................................................................... 40 What should you do to set up a buy-sell agreement? .............................................................................. 41 Is there anything you should try to avoid? ................................................................................................42 Common errors ........................................................................................................................................ 42 Choosing the right type of buy-sell agreement .........................................................................................43 Questions & Answers ...............................................................................................................................43 Funding Your Buy-Sell Agreement with Tools Other than Insurance ................................................................45 What are the alternatives to using insurance? ......................................................................................... 45 Why consider any of these options? ........................................................................................................ 45 What could go wrong? ............................................................................................................................. 46 Conclusion ............................................................................................................................................... 47 Funding Your Buy-Sell Agreement with Life Insurance .....................................................................................48 What does it mean to fund a buy-sell agreement with insurance? ...........................................................48 When can it be used? .............................................................................................................................. 48 Strengths ..................................................................................................................................................48 Tradeoffs .................................................................................................................................................. 49 Considerations by type of buy-sell agreement: entity purchase agreement ............................................ 50 Considerations by type of buy-sell agreement: cross purchase agreement ............................................ 51 Can we use our group life insurance to fund the buy-sell? ...................................................................... 51 How much insurance is needed? ............................................................................................................. 52 What happens if the insurance proceeds differ from the value of the business interest? ........................ 52 How to do it .............................................................................................................................................. 52 Income tax considerations ....................................................................................................................... 53 Questions & Answers ...............................................................................................................................54 Funding Your Buy-Sell Agreement with Disability Insurance ............................................................................ 55 What is disability insurance? ....................................................................................................................55 How can disability affect your business? ................................................................................................. 55

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 5 of 103

How can you use disability insurance with your buy-sell agreement? ..................................................... 56 What are the benefits to using disability insurance with your buy-sell agreement? ................................. 56 What are the drawbacks to using disability insurance with your buy-sell agreement? ............................ 56 What could go wrong using disability insurance with your buy-sell agreement? ..................................... 57 Are there any alternatives to fund a disability buy-out under your buy-sell agreement? ..........................58 Equalizing Estate Distributions to Your Children ...............................................................................................59 Why equalize distributions to children? ....................................................................................................59 When does equalizing distributions become a problem? .........................................................................59 What are the primary planning solutions? ................................................................................................59 What are the factors to consider when reviewing planning solutions? .....................................................61 Business Succession Planning Alternatives ..................................................................................................... 62 Select Options for Preserving a Family Business for Children ..........................................................................63 Overview of Buy-Sell Agreement Forms ........................................................................................................... 65 Buy-Sell: Cross Purchase vs. Entity Purchase vs. Wait and See ..................................................................... 66 Buy-Sell: Cross Purchase vs. Entity Purchase vs. Section 303 Stock Redemption ......................................... 69 Buy-Sell: Cross Purchase vs. Entity Purchase vs. Trusteed Cross Purchase .................................................. 72 Buy-Sell: Cross Purchase vs. Entity Purchase vs. One-Way ............................................................................75 Buy-Sell: Cross Purchase vs. Entity Purchase vs. Section 302 Stock Redemption ......................................... 78 Comparison of Buy-Sell Funding Methods ........................................................................................................81 Beneficiary Designations for Buy-Sell Agreements Funded with Life Insurance .............................................. 82 Planning for Succession of a Business Interest ............................................................................................... 83 Cross Purchase: During Lifetime ...................................................................................................................... 84 Cross Purchase: At Death .................................................................................................................................85 Entity Purchase Buy-Sell: During Lifetime ........................................................................................................ 86 Entity Purchase Disability Buyout: During Lifetime ........................................................................................... 87 Wait and See Buy-Sell: During Lifetime ............................................................................................................ 88 Wait and See Buy-Sell: At Death ...................................................................................................................... 89 Business Valuation Diagram ............................................................................................................................. 90 Transferring Your Family Business ................................................................................................................... 91

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 6 of 103

You and your estate may get some relief under the Internal Revenue Code .......................................... 91 Selling your business interest outright ..................................................................................................... 91 Transferring your business interest with a buy-sell agreement ................................................................91 Grantor retained annuity trusts or grantor retained unitrusts ................................................................... 92 Private annuities .......................................................................................................................................92 Self-canceling installment notes ...............................................................................................................92 Family limited partnerships ...................................................................................................................... 92 Funding a Buy-Sell Agreement with Life Insurance .......................................................................................... 93 How funding with life insurance works ..................................................................................................... 93 Advantages of using life insurance .......................................................................................................... 93 Disadvantages of using life insurance ......................................................................................................93 How to set up different types of buy-sell agreements .............................................................................. 93 The buy-sell agreement should be fully funded ....................................................................................... 94 The value of the business could change over time .................................................................................. 94 Should group life insurance be used? ......................................................................................................94 Possible negative tax consequences ....................................................................................................... 94 Keeping track of your buy-sell agreement ................................................................................................94 Funding a Buy-Sell Agreement with Disability Insurance ..................................................................................95 How disability income insurance works ....................................................................................................95 Coordinate the disability policy with your buy-sell agreement ..................................................................95 Different types of buy-sell agreements .....................................................................................................95 Disability income funding can ensure you a fair price .............................................................................. 95 What are the drawbacks of using disability insurance? ........................................................................... 96 What happens if you recover from your disability? .................................................................................. 96 Monitoring your buy-sell agreement .........................................................................................................96 Can I transfer my business through my will? .................................................................................................... 97 What is a buy-sell agreement? ..........................................................................................................................98 How can I determine what my business is worth for estate and gift tax purposes? ..........................................99 How can I keep my business in the family? ...................................................................................................... 100

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 7 of 103

What is a family limited partnership, and will it help reduce estate taxes? ....................................................... 101 I own a business. Are there any creative ways I can use life insurance in my business? ................................ 102

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 8 of 103

Planning for Succession of a Business Interest Business succession planning--what is it? One of the important decisions a business owner must face is when and how to step out of the business--in other words, business succession planning. Do you expect to retire from your business? Do you have a plan in place? What would happen to your business if you were to die today? Do you have children you hope to bring into the business? These are questions only you can answer, and your answers will lead you and your financial and legal advisors to a course of action. When you develop a succession plan for your business you have two basic choices: you can sell your business, or you can give it away. Once you choose to either sell or gift, you can structure your plan to go into effect during your lifetime or at your death.

Transferring your business interest with a buy-sell agreement You can transfer your business interest with a buy-sell agreement, a legal contract that prearranges the sale of your business interest. It allows you to keep control of your interest until the occurrence of an event specified in the agreement, such as your death, disability, or retirement. A buy-sell agreement can help you to solve the problems inherent in attempting to sell a closely held business. When you structure your agreement, you can tailor it to your needs. With a buy-sell agreement, you choose the events requiring a sale When you draft your buy-sell agreement, you establish the triggering events, meaning those events under which the sale can or must happen. Common triggering events include death, disability, or retirement. Other events like divorce or bankruptcy can also be included as triggering events under a buy-sell agreement. A buy-sell agreement provides a ready buyer for your interest At the occurrence of the triggering event, the buyer is obligated to buy your interest from you or your estate. The buyer can be a person, a group (such as co-owners), the business itself, or a combination. You (or your family or estate) are spared the task of trying to find a buyer when you are ready to sell. Price and sale terms are prearranged A major function of the buy-sell agreement is the establishment of the pricing mechanism for the sale of the business interest. The payment method is typically also determined at the time the agreement is drafted. The major sale negotiation is conducted at a time when there is no pressure to sell. This eliminates the need for a fire sale when you retire, become ill, or die; and it may result in greater overall fairness in the deal. A buy-sell agreement can interfere with other estate planning Once you are bound under a buy-sell agreement, you can't sell or give your business to anyone except the buyer named in the agreement without the buyer's consent. This could restrict your ability to reduce the size of your estate through lifetime gifts of your business interest, unless you carefully consider and coordinate your estate planning goals with the terms of your buy-sell agreement.

Sell your business interest The major benefits when you sell your business interest are control and cash: you keep control of your interest or business assets until you are ready to let go, and you decide how much or how little you want to sell.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 9 of 103

Selling allows you to receive cash (or convertible assets) and choose the timing When you sell your business interest or assets, you receive cash (or assets you can convert to cash) that can be used to maintain your lifestyle or pay your estate expenses. You can choose when you want to sell--now, at your retirement, at your death, or at some point in-between. You can sell your interest during your lifetime, and receive cash to use for your retirement, a new business venture, or that trip around the world you've been putting off. When done at your death, an asset sale can provide cash for your estate to use in paying your final expenses or for distribution to your beneficiaries. A limited market means a sale could be difficult There is often no market for the sale of a closely held business, which could make finding a buyer for your interest difficult. Some assets, such as equipment, may have a specialized use or a short time frame of technological usefulness. If your business is a service business, it may be hard to find a buyer for intangible assets such as your customer list. The level of competition in your geographic area or business field could also affect your ability to find a buyer. When the sale occurs after your death, your family or estate may be at a distinct disadvantage when negotiating with a potential buyer. The interested buyer can be expected to try to take advantage of your family's need for cash to settle your estate expenses and offer a price that is below a fair market value. A buy-sell agreement might be the solution to prevent this from happening, because it guarantees a buyer for your interest. Size of business interest, estate could make sale difficult The larger the size of your business interest, the more difficult it may be to find a buyer with access to sufficient cash or credit on short notice. In addition, the larger the size of your business relative to your entire estate, the greater the need for cash to settle your estate expenses. Again, transferring your business interest with a buy-sell agreement might help you to solve these potential problems. Smaller business interests are not without their own problems. Buyers may be reluctant to purchase a minority interest because such an interest doesn't carry with it the ability to control the business.

Transfer your business interest through lifetime gifts You can transfer your business interest through lifetime gifts by doing just that--making gifts during your lifetime. You can choose to make smaller gifts of portions of your business interest over a period of time or make a gift in total at your retirement. Lifetime gifting reduces the value of your estate and could lower your estate taxes A lifetime gifting program removes the value of the business from your estate as you make gifts to the recipient. The benefit to you is a reduction in the value of your total estate, thus the possibility of lower estate taxes at your death. Not only do you remove the value of the gift itself from your estate, but you also remove the future appreciation on the gift and taxes that would be associated with the gain. Lifetime gifting allows you to take advantage of the annual gift tax exclusion, which may help you reduce total gift and estate taxes You could make gifts of unrestricted stock over a period of time by arranging the gifting program to maximize the annual gift tax exclusion, which allows you to (currently) gift up to $13,000 per donee per year without incurring federal gift tax (although you may have to pay state gift tax). The benefit to you is a tax-free, systematic reduction in the size of your estate. When you make gifts of portions of your stock, you ultimately pay less total gift tax than if you made one large gift, thanks to the valuation discount. Lifetime gifting requires you to give up part or all of your business As you make gifts of your business interest, you might also be giving up some of your ownership control over the business, while the recipient of the gift gains control. If you have co-owners, your relative percentage of control will diminish. If you are the majority stockholder, it might take a long time before you are in a position of

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 10 of 103

significantly less control. If you hold equal ownership with co-owners, it may not take long before you become a minority shareholder.

Transfer your business interest at death through your will or trust If you wish to keep control of your business until your death and transfer your interest to someone at that time, you could transfer your business interest at death through your will or trust. This method of business succession can be effective when the intended receiver of your bequest is currently active in your business and would be able to carry on the business activities. Will provisions can authorize the continuation of your business A will provision can direct the executor of your estate to continue your business for a specified period of time or purpose, thus granting permission to carry out activities that otherwise may not be allowed. If the business is continued, the executor may be held personally liable for losses of the business. Caution should be taken by authorizing the executor to incorporate the business, which may limit liability to the activities of the continued business. After your death, the business can be maintained until your family can take control and continued income from your business can be provided to your family and heirs. With a living trust, you can see your continuation plan in action A living trust would allow you to make a revocable transfer of your business interest, providing you with the opportunity to see your continuation plan in action while you are alive. You can see your successor management operating the business while you are afforded continued control and input. This gives you the chance to be completely satisfied with your decision before it becomes irrevocable at your death. A living trust can provide income to you or your heirs Depending upon the structure of your living trust, you may receive an income from the trust during your retirement until your death. At your death, the business may provide income to your family or heirs or the business can be maintained until your family or heirs can take over. Use of a trust can be efficient and private When you establish a living trust, it requires you to organize your property during your lifetime. In doing so, your assets are transferred at death in an orderly fashion as you intended and not at the discretion of the court. The use of a trust will be less expensive overall, because your assets pass from the trust directly to the people you designate to receive them, avoiding the costly probate court process. This would be considered a private transaction, keeping the transfer free of any publicity.

Choosing the right type of succession plan The various succession strategies can be used to achieve specific goals for your business interest. Depending upon your particular situation, one or more of these tools may be appropriate for you. The tricky part is, how do you decide? Take a look at our decision tools which were created to help you analyze and compare the various business succession strategies. Once you have narrowed down your choices, meet with your attorney and tax or financial planner to develop your personal business succession plan.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 11 of 103

Short-Term Contingency Planning What is a short-term contingency plan? A short-term contingency plan is a strategic guide that can be used by your business to deal with your sudden, unexpected absence from the business, as in the case of disability or death. Your contingency plan should map out a procedure for the continuation of business operations that can be followed until longer-term plans are established. Even if you have made arrangements for succession of ownership of your business interest through your will or a buy-sell agreement, you still need a plan for succession of management. A short-term contingency plan can provide for the transfer of duties and continued business operations during the transitional period leading to the transfer of ownership. Tip: You should also have a disaster recovery plan in place for dealing with data and records recovery in the event of a fire, an earthquake, a flood, or other disaster, and for alternate suppliers should something happen to a major trading partner.

Why should you have a short-term contingency plan? A proactive contingency plan can mean the difference between the survival and the failure of your business after your death. It can allow your successors in the business to focus on the fundamental purpose of the business, instead of trying to develop an action plan while in the midst of a crisis. The plan can be used to minimize downtime, preserve the customer base, and continue delivery of the product or service in an effort to maintain cash flow. The more aspects of the business that you directly control, the more critical a contingency plan may be for your successors.

What should you include in your contingency plan? Your contingency plan should map out plans for management and core operations. The more direct control you presently have over specific tasks, the greater the need for a detailed plan of action for others to follow. The following questions will guide you in formulating your contingency plan. • Management Who will be in charge in your absence? • Is this person or group adequately prepared to step into your role? • Is this person aware of the contingency plan and the location of important documents? • Have you executed a durable power of attorney? • Is this person or group acquainted with key business contacts? • Are the key business contacts familiar with the designated employee or group? • Core operations What are the critical functions of the operation, and how many are you directly responsible for? • How will the functions generally controlled by you be covered in your absence? • Is there someone prepared to step in and immediately assume duties presently carried out by you (e.g., sales, marketing, banking)? • Is there a back-up plan in place for accessing company funds for payroll, payables, and other expenditures?

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 12 of 103

• Who are the key contacts for banks, suppliers, and customers, and how can they be reached? • Will records and data disks stored off-site be accessible to your successor?

Effect of your sudden death on the business--table The following table explains how the business may be affected by your sudden death. Loss of Sales

If you are the main force behind sales in your company, your death may mean the immediate loss of sales, and possibly the end of the business.

Loss of Goodwill

If you are the main contact for suppliers and customers, you may be the very reason why they choose to do business with your company. Your absence could result in the defection of key trading partners to your competition.

Decreased Production Are you directly responsible for the production of the company product? Are you the only person who knows how the process works? Your absence could mean slowdowns. Restrictions on Credit

Uncertainty about the future stability of the company after an owner's death has caused many lenders to insert language in loan agreements that makes the loan immediately due upon the death of the owner (or other specified key people), causing an immediate cash concern for the business.

Loss of Talent

The talent, ideas, and vision you provide to your business are irreplaceable. When you die, the talent you contribute also dies. If there is no one with training to back up your position in the company, the company will suffer as a result.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 13 of 103

Training Successor Management Why should you be concerned about training successor management? Many business succession plans focus on the succession of ownership but neglect to address the issue of management succession. Whether you expect the management team that will follow you to the corner office to come from inside or outside the company, you should consider training one or several people to serve as interim or successor management. This can serve multiple purposes. First, having trained successor management in the business can work into your short-term contingency plan established to cover your unexpected absence from the business (due to death, for instance). Second, trained successor management can serve as interim management during the transition period during and after your withdrawal from the business at your retirement, while your interest is being transferred after your death, or when you head out for that long vacation you have been yearning for.

Ensure the smooth transition of responsibilities When you take a proactive position and train one or more people to assume management responsibilities, you can provide valuable coaching in the business itself and the industry in which it operates. You will be able to explain the nuances of running your business. If you plan to keep your business indefinitely, a successor manager can be groomed over a period of time leading up to your retirement or withdrawal. If you plan to sell your business, successor management can be invaluable during the transition period when ownership changes hands.

Where to begin Evaluate candidates You may want to evaluate all potential candidates and identify strengths and weaknesses. In evaluating potential candidates, you will need to identify the skills and traits that are required of the individual filling a specific role. You will also want to measure the extent to which any potential candidates currently possess certain skills in the areas shown in the table below. Gaps between skills needed and skills possessed indicate areas for training and development. Skill

Description

Business competency Competency skills and requirements will vary by business and competitive market environment and include technical and administrative skills Business commitment Commitment to the business is exhibited by a high energy level, high standards of excellence, and discipline Personal character

Character is often demonstrated by integrity, high ethical standards, compassion for employees, and the trust of others

Leadership ability

Leadership skills include the ability to build teams and promote teamwork, adapt to changing business environments, develop long-term vision, and challenge others to succeed

Choose a successor manager or team You may have decided already who will take over your company (e.g., your child). But what if your child is still a minor when you die or lacks the experience to assume the management role? You probably have one or more key employees in the business--those people who are instrumental in producing, marketing, or selling your product or service. Their knowledge and experience can be called upon and these individuals can be groomed to

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 14 of 103

act as interim management should the need arise. If your child chooses a career path outside your business, your key employees might even become the buyers of your business. Train successor management There are options available for training successor management, as shown below. • Formal in-house training program--Such a program could include specific goals and timetables for completion. Rotation among different areas of the company and increased responsibilities can provide exposure to all the aspects of the company. If your business is a family business, it is important to allow your successor manager the opportunity to develop leadership skills and to gain the respect of employees using his or her own abilities and talents rather than through family relationships. • Outside development--If your child is your chosen successor manager, it might be a good idea to arrange for training outside of your business. Such a plan might include formal education in college or graduate school programs. Employment in another company can be valuable, as it allows the child to grow and mature outside the family business environment (and also make any early career mistakes elsewhere!).

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 15 of 103

Keeping Your Business in the Family What are some of the issues concerning keeping the business in the family? You may want to keep your business in the family, as opposed to selling it to an outside party or another business. If this is your plan, you should be aware of some of the issues that can contribute to the success or the failure of the business as it is transferred to the successor generation. Some of the issues revolve around personality and control, while others have to do with your potential need for future income and the demands it can place on the business. Insight, planning, and open discussion can contribute to the successful transfer and continuation of the family business.

Emotional issues--Family succession Conflicting needs and values Families and businesses commonly have conflicting needs and values. These conflicting needs often overlap in a family business, as family roles and perceptions come into play inside the business. It can sometimes be hard to look beyond the family relationships and see the strengths of a family member as an employee. It is important for the continued success of your family business that family issues and business issues are kept separate. One tool that has been found to be useful is the formation of a family council to establish plans for both business and family goals. Formal succession plans can be used to ease concerns about transferring ownership and to prepare the successors for their new roles. In addition, estate planning is critical for both the family and the business to ensure that the estate goes primarily to your heirs and not to pay taxes. Identity issues There can be identity issues that arise as the business is passed from one generation to the next. The senior generation may be trying to determine whom and what they will be after they leave control of the company. The successor generation may be trying to determine whom they will be and how they will take over the company. There can be personal issues as the younger members attempt to be taken seriously by other family members. It may be hard for family members to realize that the family member who was such a troublesome adolescent has now settled down. It can also be hard for the parents to realize that the children are capable of making sound business decisions. Tip: One way to help ease these issues is to engage in early training of those family members who participate in the business.

Income & liquidity planning Retirement income planning There are retirement planning options unique to business owners. If you have not already engaged in retirement planning for yourself, you might want to do so now. Arrangements can be made for deferred compensation while you are still working. With deferred compensation, you would receive a raise in salary while working but not actually receive the cash until your retirement or withdrawal from the company. If you are ready to retire now and don't have an outside plan, you may still have some options. If you plan to sell the business to your successor family members, financing arrangements such as installment sales, private annuities, and self-canceling installment notes (SCINs) can provide you with income over a period of time. A lump-sum payment can provide you with an amount of cash that you can invest. If you intend to pass the business to your heirs through your will or trust at your death, you may want to consider retirement options such as IRAs, simplified IRAs, simplified employee pension plans, or some of the other retirement plans available.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 16 of 103

Income for surviving spouse A major area of concern may be income for your spouse when you die. If you have derived your living from your business, what will your spouse do when you die and it passes to your heirs? There are various options available that include the use of life insurance or buy-sell agreements to facilitate the sale of the business interest to family members. Your spouse could receive money from the sale of your business. One thing to remember, however, is that generally the business can't continue to pay out your salary to your spouse if you have died. Payment of final expenses If you die while still active in your business, there might be a need for cash to pay your final expenses and estate taxes. If the business is a corporation, your family or estate may be able to sell back an amount of stock equal to your estate taxes and final expenses under a Section 303 stock redemption. You should consult a tax advisor as certain specific conditions apply to such a stock redemption.

Partial cashout from business As part of your plan to keep the business in the family, you might want to engage in a partial cashout. This could work if you don't need to receive full payment for your interest. Your family could buy part of your interest with the remaining interest transferred in the form of lifetime gifts of your business interest or through your will or trust. Another possibility for partial cash is for the business itself to buy part of your interest in a stock redemption.

Other potential demands on business cash Smoothing the transition After you have left your business due to retirement, death, or just a desire to withdraw, certain expenses will continue. While these are not new expenses to the business, it may be more difficult for the business to meet these and other existing expenses when your leadership and skills are no longer present. Compensation for your replacement Let's assume that there is nobody in the company who is prepared to step into your role and take over if you died. The business may have to recruit, train, and compensate a replacement hired from outside the family or business. This could represent an additional cash drain on the business. Very often, someone from outside the family may demand a higher salary than you were paying yourself. The financial burden of this potential situation can be reduced or eliminated through use of a key person life insurance policy on your life. Compensation to children remaining in the business Another expense that will continue is compensation to those children who are active in the business. If their roles in the business are expanded with your departure, it may warrant an increase in compensation. The loss of your leadership may result in a slowdown of sales and/or profits as customers face uncertainty about the stability of the business. There are two ways to smooth this transition. By training successor management, you increase the chances of the business's continued success by avoiding a management crisis at your withdrawal from the business. Cash flow can be eased through use of key person life insurance on yourself (or other key employees). Profits to family members retaining ownership interest You may have family members who are not active as employees in the business but who hold ownership positions. As owners, they may expect to receive profits from the business. In addition to a cash outflow, this passive ownership interest might also represent a potential for conflict between those family members actively managing the business who want to reinvest profits back in the business. Should the family members who are owners wish to sell their interest back to the business, it would represent another drain on the business if it attempts to repurchase the stock.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 17 of 103

Tip: You can plan ahead for such a possible ownership buyout. Possible ways to provide cash include the use of buy-sell agreements funded with life insurance or the use of a key person life insurance policy. Cashing out some family members Certain family members may not wish to remain with the business after you are gone, while others may have different goals. Owners who are not active in the business as managers or employees generally have a different set of needs and desires than those who are active participants in the business. If cash is available to repurchase the ownership interests of those members who want to leave the business, many potential conflicts could be eliminated. One potentially damaging conflict is that between the active owners who may want to use profits to expand the business and nonactive owners who may want profits to be distributed. Tip: Buy-sell agreements between owners can facilitate the sale of shares, as long as the agreement has been funded. Life insurance on a key person can provide cash to buy out parties wishing to sell.

Possible solutions for continued success of the business You can take strategic steps to increase the chances of the business succeeding after you pass it to your family. With some advance planning, these steps can strengthen the business and its employees now and for the future. One way to smooth the transition of management and ownership is to have a short-term contingency plan in place. The following table illustrates some of the possible obstacles to the continued success of your business after your withdrawal, as well as possible solutions: Potential Obstacle

Potential Solution

Conflicting needs of family and business

• Family council to engage in strategic planning for both the business and family needs

Identity issues

• Defined roles within business • Training of successor management

Retirement income needs

• Retirement plans appropriate for self-employed/sole proprietorship/partnership • Retirement plans most appropriate for corporations • Sell your business to family

Final expenses, estate taxes

• Section 303 stock redemption • Life insurance coverage on a key employee

Compensation for outside replacement

• Life insurance coverage on a key employee

Compensation for family members remaining in business

• Life insurance coverage on a key employee

Profits for family member owners

• Life insurance coverage on a key employee

Desire of some family owners to cash out of business

• Buy-sell agreement funded with life insurance • Life insurance coverage on a key employee

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 18 of 103

Selling Your Business to Family What is special about selling your business to family? Certain financing methods available When you are considering selling your business, you may have possible buyers within your own family. You may want to withdraw from the business but still keep the business within the family, and you might have children or other relatives who work in your business with you who might be ideal potential buyers. When selling your business to family, there are certain financing arrangements available that you probably wouldn't consider when selling to someone outside the family. There are also tax considerations that apply specifically to transactions within the family--some favorable, some not. May be subject to IRS scrutiny One possible downside to conducting business transactions with family members is that the IRS will more closely examine such transactions. There is the unfortunate potential for the IRS to question the price or valuation method used. As long as the sale of your business can be shown to be for fair market value (FMV), you should be on firm footing. It is to your benefit to call on the services of professional financial and tax advisors, as well as a qualified business appraiser. By anticipating the worst when you structure a sale to a family member, you can avoid unpleasant surprises later, such as a gift tax assessment by the IRS if your valuation is contested or the inclusion of the business in your estate when you thought you had transferred it out.

Special financing techniques available When you sell your business to a family member, there are financing methods available to you and your buyer beside a lump-sum cash transaction. These can be especially valuable when the family member buying your business doesn't have the cash or access to enough cash to make the purchase. Financing can be structured so that you receive a stream of income in exchange for your business while spreading out your gain on the sale over the payment period. Private annuity Private annuities are often used with family transactions. Under this arrangement, the payments for your business interest are spread out over the rest of your life. The payment amount is calculated using a life expectancy table. If you die before reaching the calculated life expectancy, the buyer gets your business for less than the full price, and if you live longer, your buyer pays more than anticipated. The major benefit to you is the removal of the value of the business (and the future appreciation) from your estate (i.e., less potential estate tax). Installment sale An installment sale might be a suitable financing arrangement when you are willing to accept payments over time, want the additional security of a promissory note or collateral, and want to be sure you (or your estate) receive the full price for your business. Unlike the private annuity, the buyer using installment payments must continue making payments to you or your estate until the full price is paid. The major tax difference to you is that any balance still due at your death must be included in the value of your estate for estate tax purposes. If you meet all requirements, you can spread your gain on the sale over the installment payment period. Self-canceling installment note (SCIN) A self-canceling installment note (SCIN) is a special form of installment note that is a hybrid of the private annuity and installment sale. It is sometimes referred to as a death-terminating installment sale. Like a private annuity, the payments end at death, and like an installment sale, the obligation can be secured with a note or collateral without jeopardizing the tax treatment.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 19 of 103

Caution: SCINs are sophisticated tools with major gift and estate tax consequences. Consult an attorney or tax advisor before establishing this financing method. Using a buy-sell agreement with a family sale You may want to consider using a buy-sell agreement if you are planning to sell your business to a family member. Buy-sell agreements let you arrange the terms of the sale today for a sale at some point in the future. You can lay all the groundwork for the sale at a time when there is no pressure to sell. Buy-sell agreements can be structured to provide potential buyers through the use of options or guaranteed buyers through purchase obligation clauses. Coordinating sale with gifts It is possible to coordinate the sale of your business with a gifting program to reduce potential estate taxes. Gifting allows you to systematically reduce the size of your estate. When you make gifts of portions of your business interest, you can still maintain control of the business until you are ready to fully let go. Under the federal gift tax rules, you are currently allowed to make gifts up to $13,000 per recipient per year free from federal gift tax. If you are married, you and your spouse can make gifts up to double the annual gift tax exclusion free from gift tax, as long as you are both U.S. citizens and make the gifts jointly. This strategy can provide you with the opportunity to ease your successor into the business by granting smaller ownership portions up until the time of sale. Once you are ready to give up control, you can go ahead with the sale of your business using one of the financing methods discussed or any other method that is acceptable to you and your buyer.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 20 of 103

Selling Your Business to Nonfamily What is special about selling your business to nonfamily? When you sell your business to a family member, your objective may be to keep the business within the family and make it as easy as possible for your relative to make the purchase. When you sell your business to nonfamily, however, your primary objective may be to get the highest possible price for the sale while delaying recognition of capital gain for as long as possible by maintaining a stock position in the acquiring company. When you sell to nonfamily, you may not be subject to the same level of scrutiny the Internal Revenue Service (IRS) applies to transactions between related parties.

Sales considerations Selling shares or assets One negotiating point is whether the sale of your business is to be a sale of shares (stock) or of assets. Each option has tax consequences for both parties, and there are reasons why you may favor one transaction over the other at any given point in time. When the business is sold in a stock deal, the buyer assumes ownership of the assets and liabilities of the corporation. Unknown or contingent liabilities could cause concern for the buyer and affect the sales price. In an asset sale, the buyer acquires tangible property or equipment but the liabilities remain with the seller. With a sole proprietorship, the only possible arrangement is to sell assets, because the business itself is not a separate entity. Using a buy-sell agreement when selling to nonfamily A buy-sell agreement is a legal contract you can enter into today to arrange for the future sale of your business. You can set the terms for the sale of your business at a time when there may be no pressure to sell. Because it is a legal contract, the courts can be called upon to enforce the contract if either party fails to perform as agreed. Once you enter into a buy-sell agreement, you can't sell or give your business to anyone other than the buyer named in the agreement, so you need to coordinate the agreement with any estate planning you may be conducting. Selling to another corporation Another corporation might be a potential buyer of your business, especially in these days of mergers and acquisitions. The acquiring company may offer you cash for your business or may propose a stock swap whereby you exchange stock in your own company for that of the acquiring company. When you receive cash, you will have to recognize a gain or loss on the sale transaction. If the transaction is a stock swap, you may be able to avoid recognition of gain on the sale by holding the stock of the acquiring corporation until your death. Structuring tax-free sales When the buyer of your business is another corporation (usually a large publicly held corporation), a stock swap can result in a tax-free sale. This can be especially favorable to you if your business has appreciated in value since you initially invested, because you can avoid capital gains tax. Federal securities regulations may require you to hold the stock of the acquiring company for a specified length of time before you can resell it, and the value of the stock may decrease before you are allowed to sell. You might defer your capital gain indefinitely by holding the stock of the company until your death. However, your estate must include the value of the stock, subjecting it to estate tax. Structuring taxable sales A taxable sale can be structured by selling assets to the purchasing corporation. Specific assets for sale must be identified, and any gain or loss must be determined for each. Assets are classified in one of three categories:

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 21 of 103

capital assets, Section 1231 assets, and all other assets. The asset classification determines whether the gain or loss is treated as either capital or ordinary. Certain tax rules apply if the business is liquidated after the sale of assets, and S corporations may be subject to the built-in gains tax under Internal Revenue Code Section 1374. Using charitable remainder trusts A charitable remainder trust is a special planning technique that can allow you to establish an irrevocable trust and use your business to provide an income stream to benefit you and/or your spouse (or another person), with a remainder interest to a qualified charity as beneficiary. Example(s): You contribute your business stock to a charitable remainder trust and receive a charitable deduction. The trust sells the stock, invests the proceeds, and pays an income stream. At the end of the payment term, the remainder of the trust passes to the charitable beneficiary. You are receiving a charitable deduction and supporting the qualified charity of your choice. The major tradeoff is that the charitable remainder trust must be irrevocable, meaning you can't change your mind once it is set up. There are different types of charitable remainder trusts, and the IRS publishes a list of qualified charities. Of course, you should consult an experienced legal practitioner to assist you in setting up any such trust.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 22 of 103

Other Transfer Strategies and Considerations Other transfer options In addition to selling your business outright or gifting your business to your heirs, there are other strategies and options that you can use to transfer your business to your heirs. These options include transferring your business into a grantor retained trust, selling your business through an installment sale, or recapitalizing the equity structure of the company and retaining an interest. You should consult your attorney to determine the benefits and drawbacks of each of these options, as these will differ depending on the circumstances of your particular business and your own personal circumstances.

What is a grantor retained trust? A grantor retained trust is a type of irrevocable trust. An individual (called the grantor) transfers assets into a trust and then retains an interest for a period of time. The retained interest may be the right to receive income or may be the right to use the property in the trust. At the end of the retained interest, the property in the trust will pass to the beneficiaries of the trust. Grantor retained trusts are valuable estate planning tools because the value of the initial transfer into the trust can be discounted for federal gift tax purposes. The size of the discount will depend upon the length of the retained interest and the applicable federal interest rate that must be used to discount the gift. Furthermore, if the grantor outlives the term of the retained interest, then the assets, including any appreciation in the assets, is not included in his or her taxable estate. Thus, transferring assets into a grantor retained trust can be an excellent way to remove assets (especially appreciating assets) from your estate while allowing you to receive a benefit from those assets for a certain period of time.

What are the different types of grantor retained trusts? There are three types of grantor retained trusts: Grantor retained annuity trust A grantor retained annuity trust (GRAT) is an irrevocable trust into which you transfer assets (such as cash, stocks, bonds, and real estate) and then retain an income interest for a set period of time. With a GRAT, the income you receive will be a fixed amount of principal and interest. The payments from the trust can be made to you either once a year or more often, if you desire. At the end of your retained interest (which can last for as long or short a period of time as you like), the assets in the trust will pass to the beneficiaries of the trust. The beneficiaries will typically be your children or grandchildren. The initial transfer of assets into the GRAT is considered a taxable gift. However, for federal gift tax purposes, you can discount the value of the gift. The size of the discount will depend upon the length of the retained interest and the applicable federal interest rate. The longer the retained interest, the more the gift can be discounted. You can also use your applicable exclusion amount (formerly known as the unified credit) to protect some or all of the gift from the federal gift tax. If you outlive the term of the retained interest, the assets in the GRAT, including any appreciation in the assets, will not be included in your taxable estate. If you do not outlive the term of the retained interest, the full value of the assets in the trust at the time of your death will be included in your taxable estate. Grantor retained unitrust A grantor retained unitrust (GRUT) is an irrevocable trust into which you transfer assets (such as cash, stocks, bonds, and real estate) and then retain an income interest for a set period of time. With a GRUT, the income you receive will be a fixed percentage of the value of the assets in the trust. The assets will then be revalued each year. Thus, if the value of the assets in the trust increases, the payments to you will increase as well. The payments from the trust may be made to you once a year or more often, if you desire. At the end of your retained interest (which can last for as long or short a period of time as you like), the assets in the trust will pass to the

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 23 of 103

beneficiaries of the trust. The beneficiaries will typically be your children or grandchildren. The initial transfer of assets into the GRUT is considered a taxable gift. However, for federal gift tax purposes, you can discount the value of the gift. The size of the discount will depend upon the length of the retained interest and the applicable federal interest rate. The longer the retained interest, the more the gift can be discounted. You can use your unified credit to protect some or all of the gift from the federal gift tax. If you outlive the term of the retained interest, the assets in the GRUT, including any appreciation in the assets, will not be included in your taxable estate. If you do not outlive the term of the retained interest, the full value of the assets in the trust at the time of your death will be included in your taxable estate. Grantor retained income trust A grantor retained income trust (GRIT) is an irrevocable trust into which you transfer property (or other assets) and then retain the right to use or hold that property for a set period of time. A GRIT differs from a GRAT or GRUT because the creator of the GRIT does not usually retain an income interest. Rather, the grantor of the trust retains the right to simply use or hold the property for a certain period of time. The grantor may transfer a piece of artwork into the trust, for example, and then retain the right to hang that artwork in his or her home for a period of time. Like a GRAT and a GRUT, the transfer of the property into the trust is considered a taxable gift. However, the value of the gift can be discounted. Furthermore, if the grantor outlives the term of the retained interest, the assets in the GRIT will not be included in that person's taxable estate.

Installment sale An installment sale is a transaction in which you sell your business to another individual and the payments are spread out over two or more years. To qualify for installment treatment, at least one payment must be made in a year after the year of the sale. Other than this one requirement, you have a great deal of flexibility in how the payments can be structured. They can begin and end whenever you (and the buyer) want them to. For example, you may want to receive the payments in years when you will be in a lower income tax bracket. Another advantage to an installment sale is that the taxable gain on the sale of a cash-basis taxpayer business can be spread over the term of the installment payments, and you do not have to pay the entire tax at the time of the sale. With the sale of an accrual method business, however, you are required to pay the full tax on the gain at the time of sale. There may also be estate tax savings--at the time of your death only the present value of the unpaid installment payments must be included in your taxable estate. Finally, unlike a private annuity, you may retain a security interest in the business during the term of the installment payments.

Retained interest A retained interest involves a recapitalization of your business (in a tax-free reorganization) by dividing the common stock of the company into two classes of stock--voting and nonvoting stock. Once the two classes of stock have been created, you retain the voting stock and then gift away the nonvoting stock to your children and heirs. You can then maintain control of your company while gifting away some of the equity to your heirs. The gift to your heirs may qualify for the annual exclusion from the gift tax. You may also be able to discount the value of the gift because of the lack of marketability and the minority interest. By using the annual exclusion and the valuation discount, you can transfer a substantial amount of the nonvoting stock to your heirs without incurring a gift tax. The value of that stock, including any appreciation in that stock, will then not be included in your taxable estate.

After-sale considerations Many of the transfer techniques discussed above involve a payout of the sale price of your business over a period of time. You may be concerned about protecting yourself in the event the buyer defaults on payments due to you or has financial troubles. You might even be concerned about a default if the buyer is a family member. However, there are several steps you can take to protect yourself when you sell or transfer your business to a new owner. Your lawyer can draft many of these protections right into the purchase and sale agreement. You can do the following: require the new buyer to maintain certain financial ratios (debt-to-equity, cash flow percentages, etc.); have the buyer personally guarantee the payments; have the new owner sign a noncompetition agreement; restrict additional financing; have a third party secure the financing; and retain some voting rights in the company.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 24 of 103

Cash flow and balance sheet requirements One way to give yourself some protection against the buyer defaulting on payments is to require the company to meet certain financial goals during the term of the payments. For example, you could require that the company meet certain debt-to-equity ratios. You could require that the company maintain a certain cash-flow ratio. If the company failed to meet any of these financial ratios, that would constitute a default by the buyer. Guarantees, caps, and dividend limitations Another way to protect yourself is to require the buyers to personally guarantee the payments to you. You may even want to have the buyers pledge personal assets to secure the payments. You could also put a cap on how much the new owners can pay themselves (either in salary or in bonus). Finally, if the company is an S corporation, you could require that the company limit the dividends that it pays on the S corporation stock. Noncompetition agreements Another technique to provide some protection is to require the new owner to sign a noncompetition agreement, restricting the ability of the new owner to set up a competing business should the business you sell to him or her fail. You don't want to be in the position of providing training for the new owner at your expense. You may also want to restrict the right of the new owner to sell off assets or even parts of the business. Restrictions on additional financing Another protection strategy is to restrict the new owner from taking on additional financing during the term of the payout to you. You don't want the company to be saddled with additional debt while payments are still being made to you. Third-party security You may also require the new owner to have a third party --a bank, for example--collateralize or secure the payments to you. The bank could issue a letter of credit, guaranteeing that the payments will be made to you if the buyer should default. However, a letter of credit and other third-party security arrangements can be quite expensive. A new owner may be very hesitant to incur this expense. Retained voting rights A final option is to retain some sort of voting rights in the company. For example, instead of selling or transferring 100 percent of your stock in the company, you might only sell 80 percent. Prior to the sale, you could amend the company's bylaws to require that any major action by the company require an 81 percent vote of the stockholders. You would then have a veto over any major actions that the company might take. In this way, you could protect your interest in the business.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 25 of 103

Gifting Your Business Why would you want to give away your business? Sometimes better to gift than sell due to tax law There may be personal (nontax) reasons why you would want to gift some or all of your business interests. There is also a good reason built into the tax code. Gifting some or all of your business interest allows you to reduce or remove the value of your business from your estate, which could mean lower estate taxes that may be due at your death. Not only is the value of your gift removed from your estate, but also any gift taxes you paid when making the gift. If you sold part or all of your business during your lifetime, you might be subject to capital gains tax. If your estate sells your business soon after your death, the sale price may determine the value of the business included in your estate for estate tax purposes. Caution: Gifts made within three years of death (along with any corresponding gift taxes) may have to be added back into the estate. Consult an attorney or tax advisor. Gifting can be used when value of your business is large or growing rapidly If the value of your business is large, gifting can be used to move income within your family or to shift ownership of the business out of your estate. When you make a gift of some or all of your business interest, the value of the gift as well as the future appreciation is removed from your estate. You may be subject to gift taxes on the gift, but you will have frozen its value, meaning you won't be subject to tax on any future appreciation. This can be a valuable strategy when you expect the value of the business to continue growing. If the value of your business is large, you might consider making a gift up to the size of the $1 million gift tax applicable exclusion amount (formerly known as the unified credit) during your lifetime instead of waiting until your death in order to remove a larger portion (and its future appreciation) from your estate now.

Are there different ways to make gifts? Lifetime gifts--direct from you to the recipient You might choose to make lifetime gifts of your stock or business interest. When you decide to make lifetime gifts, you can give away a little or a lot to whomever you choose, and you can control the timing of the gift. Lifetime gifts of your business interest may allow you to relinquish control according to your own timetable, and they can be done privately if you so choose. An added benefit to gifting your business is the removal of the value of the gift from your estate, along with any future appreciation. Tip: You might consider a systematic plan whereby you make small gifts of your business interest to one or more recipients eash year over a period of time. If the value of each individual gift is equal to or less than $13,000 per recipient (current figure), the gifts are federal gift tax free under the annual gift tax exclusion. You can give $26,000 per recipient if you and you spouse make the gift jointly. Using trusts Gifting your business using a trust can be more difficult and requires documentation and transaction fees, but it still provides several benefits. You can structure the trust so that you keep control of the business for as long as you want. A living trust will allow you to keep your business interest out of probate, test the performance of the receiver before giving up complete control, and offers some protection from creditors during your lifetime. You can also establish a retained income trust --such as a grantor retained annuity trust--that will provide you with an income for a specified period of time and move your business out of your estate at a discount.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 26 of 103

Charitable remainder trusts A charitable remainder trust is a special planning technique that can allow you to establish an irrevocable trust and use your business to provide an income stream to benefit you and/or your spouse, with a remainder interest to a qualified charity as beneficiary. For example, you could contribute your business stock to a charitable remainder trust and receive a charitable deduction. The charitable trust then pays you and/or your spouse an income stream. At the end of the payment term, the remainder of the trust passes to the qualified charity. You receive a charitable deduction and support the charity of your choice. The major tradeoff is that the trust must be irrevocable, meaning you can't change your mind once it is set up. There are different types of charitable remainder trusts, and the IRS publishes a list of qualified charities. Transfer using another entity You can transfer your business interest using another entity, such as a family limited partnership (FLP), S corporation, or limited liability company. A family limited partnership is an entity formed to manage and control your jointly owned family business. All the requirements for a limited partnership must be met, and personal service businesses (e.g., lawyer, plumber, photographer) don't qualify. Usually, the parents are named general partners, retain control of the business itself, and receive an income, while the children are limited partners. By transferring the business to an FLP, the general partners (parents) may be able to use valuation discounts and substantially reduce the value of the business and perhaps any potential estate tax liability through annual gifts to the limited partner children. The FLP is flexible and can be modified to meet changing family or business needs. Transfer your business interest at death through will or trust You may choose to make a gift of your business at your death. To ensure that your business is actually distributed to those people you want to receive it, you should have a valid will or a trust in place. Gifting your business through your will can be effective when the intended receiver of your bequest is currently active in your business and is willing and able to carry on the business activities. The absence of a will or a trust could mean court distribution of your business interest to beneficiaries who you never intended to receive it.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 27 of 103

Determining the Value of Your Business What is valuation? Assignment of price or dollar value The basic concept of valuation is to determine a justifiable dollar value or price for a total or partial interest in your closely held business. It is the process of answering the question, " How much is your closely held business worth? " Business valuation plays a critical role in determining gift and estate tax liability and/or the appropriate selling price for an interest. Because valuing a business is so important, you should be very careful when selecting an appraiser.

What is the importance of determining taxable value? Business valuation key component to estate or succession planning Business valuation is a critical component to your estate or business succession planning. Your business may be your largest asset, and if you plan to engage in either one of these types of planning, at some point you will need to determine the taxable value of your business interest. An incorrect value (i.e., one that is underestimated) could cause you to miss out on tax-saving strategies, while a value that is inflated could result in an investment of time and money in unnecessary planning. The IRS is very interested in taxable value Perhaps a key reason to be concerned about the taxable value of your business is the Internal Revenue Service (IRS), which is always on the lookout for sales at below and even above fair market value. If you sell something for less than fair market value, the IRS could deem the transaction a combination sale and gift and charge you gift tax on the difference between the value you received and the value the IRS calculated. Likewise, a sale at above fair market value could be deemed a gift (subject to gift tax) from the buyer to you. Your tax liability depends on it The value applied to your business bears an important and direct relationship to the amount of tax you will owe, whether it be capital gains tax resulting from a sale, gift tax on shares you have given away, or estate tax on property you own at your death. If the value determined by the IRS is different than the value your tax was calculated on, you (or your estate) could be liable for additional tax.

Why a valuation might be needed May be no active market to set price The valuation of large, publicly traded companies such as those found on the New York or the American Stock Exchanges is usually set by the buyers and sellers in the market through active trading. This price is generally accepted as the fair market value. With a closely held business, however, there isn't an active market for the stock, so valuation becomes much more challenging. A determination of the value of your business should be conducted for gift or estate tax purposes or to engage in the sale of your business. Determine capital gain When you sell your business, the difference between your basis and the price you receive is your capital gain. Your gain must be reported and is subject to capital gain tax. A properly conducted business valuation can ensure that the price at which your interest is sold represents fair market value and that your tax liability is correct.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 28 of 103

Sale of business to family member You may be selling your business interest to a family member. You should be aware that the IRS tends to carefully examine this type of sale in search of disguised gifts. If the IRS determines a higher value for your business than the sale price you used, you might very well be liable for gift tax on the difference between the two values. Further, it usually takes a couple of years before the IRS challenges the value, and your additional tax liability may be compounded by accrued interest and penalties. A valuation by a qualified appraiser could avoid this potential problem. Sale of business to outsider If you are planning to sell your business to a nonfamily party, you may want to receive the highest amount possible. An independent evaluation may help you to achieve this objective while at the same time assuring the buyer that the price being paid is fair. Without a valuation from an independent, qualified appraiser, it might be harder to attract buyers due to the perception that the business is being overvalued by the seller. The timing and circumstances of the sale will also have an impact on the value. A forced liquidation or sale (one where the money is needed fast) will generally result in a lower valuation and price received. Transfer of business under buy-sell agreement If you have a buy-sell agreement for your business, you already have a buyer for your interest upon the occurrence of certain events. If correctly done, your buy-sell may have been specially drafted to establish taxable value. The terms of your buy-sell may require a periodic valuation of the business. When an interest changes hands under the agreement, a valuation is needed for the price exchanging hands, which sets the tax basis for the buyer and the capital gain of the seller. Transfer of interest by gift Part of your estate planning strategy may be to transfer your business interest by gift. Gifts of a certain size are not subject to gift tax. In order to determine if you must pay gift tax (and, if so, how much), you need to know the value of the gift. Any time a business interest is transferred by gift, a valuation should be conducted to document the gift tax value and reduce the risk of the IRS changing the value of the gift upon a later audit. Tip: Do the valuation as closely as possible to the date of the gift. Estate tax purposes A business valuation may be required when an owner dies. A valuation at this point can ensure that all applicable discounts are reflected in the value. It is also of major importance in determining the estate tax liability. The last thing your estate needs is to be subjected to an IRS audit and have poor (or no) documentation of the business valuation used in the estate tax return. If the business has a buy-sell agreement, a valuation may be needed to calculate the price at which the interest will be sold to the buyer named in the agreement.

Valuation issues Appraisal versus value An appraisal is the process of determining value and represents an opinion. The result of the appraisal analysis is the assignment of a value based on a specific point in time. There is no one process and generally no one definitive value for a business. It is possible for a business to have different values, depending on the purpose of the evaluation and the interpretation of the criteria examined. Because there is no single method or definition, it is important that the appraisal report contain a specific definition of value and the assumptions used in the analysis. Multiple approaches to determining value There is more than one way to approach a business valuation. The nature of the business itself may indicate that one way is more appropriate than another, and while there are general rules, it is still more art than science.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 29 of 103

Furthermore, appraisers are at their own discretion in determining if intangibles, fair market values or liquidation values will be used. Appraisers using the same named approaches may use different techniques to determine the value. As a result, sometimes multiple, independent valuations are conducted, and an average result is used. The table below shows three common valuation methods: Method

Methodology

Income approach Value is based on expected income generation Asset approach

Value is determined on basis of business assets

Market approach

Value is based on past sales of shares of this or a similar business

Valuation may be discounted The value of certain ownership interests may be discounted (reduced), depending on certain conditions. Sometimes, a minority stock interest in a closely held corporation is granted a discount for estate tax purposes when it is included in the owner's gross estate. The discount is granted because the minority interest itself carries no ability to influence corporate decisions or policy, which in turn reduces its marketability to anyone but the controlling shareholders. A minority interest that cannot influence policy but is large enough to represent a swing vote could have a valuation discount disputed by the IRS. Valuation can be disputed A lot of factors can affect the value of a business. Disputes between taxpayers and the IRS involving the valuation of property occur relatively frequently. To complicate things, even the IRS acknowledges that there is no one, true, fair market value for a closely held business, so the area is open to interpretation. Moreover, not only might the valuation be subject to dispute, but inaccurate valuations for tax purposes could be subject to civil and criminal penalties. Timing is important Transactions are valued by the IRS on the date of the transfer. To reduce the chance of the IRS calculating a value that differs greatly from the value you paid tax on, your valuation should be determined (and documented) as closely to the transaction date as possible. Event

Valuation Date

Type of Tax

Gift

Date of completion of gift transfer

Gift tax

Sale

Date of sale

Capital gains tax

Death Date of death OR alternate valuation date six months after death Estate tax Tip: It is important to get an accurate appraisal of the value of a business interest any time the business is transferred as a result of lifetime gift, sale, or bequest.

Different definitions of value Fair market value Fair market value (FMV) is the price at which property would change hands between a willing buyer and a willing seller (who are independent, nonfamily members), where both parties have reasonable knowledge of the relevant facts, and neither party is under any compulsion to buy or sell. This is the definition frequently used by the IRS.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 30 of 103

Fair value Fair value is different from fair market value, and as used here, it is different from the accounting definition. In business valuation, fair value is a statutory standard generally applied in cases involving dissenting shareholders and sometimes in suits involving corporate dissolution, merger, sale, or auction. The determination of fair value is usually applied to minority interests when the minority shareholders believe they won't receive full consideration for their shares under the merger, sale, or dissolution. The minority shareholders have their shares appraised and receive an amount of cash equal to the fair value in exchange for the shares. Investment value Investment value is specific to an owner (or prospective owner) and includes consideration of factors such as the owner's knowledge, abilities, related business interests, and expectation of earning potential and risk. A business will likely have different investment values to different people, depending on specific factors (i.e., the value is in the eyes of the beholder). Intrinsic or fundamental value Intrinsic value is a term that carries different meanings to different professionals. In some cases, it is used to refer to fair market value, fair value, investment value, or even some other type of value. Sometimes it is used to refer to the analysis of an investment banker, security analyst, or financial manager or analyst. The point is, this term has several meanings and interpretations, so it is very important that any valuation including this term have a very specific definition of its usage. Going concern value A going concern value considers factors specific to the business, both physical and intangible. Consideration is given to the existing infrastructure, goodwill, reputation, trained workforce, licensing, and/or plant capabilities of the business. The valuation is based on the assumption that the business will continue to be a viable operating entity and as such should bear a higher value than the sum of the values of its collective assets. Liquidation or breakup value Liquidation value is a determination of the proceeds (net of selling costs) realized if a company ceased operating and sold off the assets. There are two types of liquidation, and the specific situation will affect the valuation. An orderly liquidation involves the sale of assets over a period of time to maximize proceeds. A forced liquidation, on the other hand, means selling the assets as quickly as possible (often by auction) and often at a lower value than might otherwise be achieved if more time were available. Book value Book value is an accounting term that can apply to a specific asset or an entire company. An asset's book value equals the historical cost minus any allowances for depreciation, amortization, or unrealized losses. The book value for a company is the shareholders' equity, calculated from the balance sheet as the excess of total assets over total liabilities.

How do you determine the taxable value of your business? Find a qualified appraiser Determining the value of your business is not something you should attempt on your own, especially in light of the fact that the IRS could challenge your valuation. There are appraisers who specialize in determining the value of businesses. Your CPA may even be one of these specialists or know someone who is.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 31 of 103

Don't use an old appraisal You may have had your business appraised in the past for another purpose. As tempting as it might be, don't use an old appraisal now. The purpose of the appraisal can affect the valuation assigned, and time can change the factors that go into the appraisal calculation.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 32 of 103

Minimizing Taxable Value of Business (Estate Freeze) What is minimizing the taxable value of your business? Estate taxes can erode value of your business As a business owner, you may be concerned about what will happen to your business after you die. Most business owners want to ensure that their businesses pass on to their children intact, but with high funeral costs and other final expenses, this may not happen unless they plan ahead. If you do not provide for adequate liquidity (i.e., your estate must have enough cash) to pay these costs, your business may have to be sold or otherwise disposed of, and your heirs may not receive what you intend for them to have. For example, when you die, a variety of taxes may be imposed on the assets in your estate, including state death taxes, the state gift tax, the federal gift and estate tax, the state generation-skipping transfer tax (GSTT), and the federal GSTT (collectively referred to as estate taxes). Planning for estate taxes is essential because this could be one of the largest expenses your estate will pay. Estate is valued In order to plan for estate taxes, you must have some understanding of how they work. Estate taxation works much like income taxation, except that, of course, estate taxes are imposed on your estate, not on your income. Generally speaking, your estate is defined as: • Property owned by you (or deemed to be owned by you) at the time of your death ( gross taxable estate), and • Certain gifts you made during life ( taxable gifts) Basically, this is what happens: A value is established for the assets that are included in the gross taxable estate and taxable gifts. These values are added together, resulting in the gross taxable value of your estate. The subsequent application of certain allowable exemptions, exclusions, and deductions results in the net taxable value. The net taxable value is then multiplied by the appropriate tax rate, resulting in the tentative tax owed. Allowable credits are then subtracted from the tentative tax to compute the net tax owed. The lower the taxable value of your estate, the lower the tax. Estate tax liability illustrated The following table illustrates the calculation: 1. Gross Taxable Estate + Taxable Gifts = Gross Taxable Value 2. Gross Taxable Value

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 33 of 103

Applicable Exemptions/ Exclusions/Deductions = Net Taxable Value 3. Net Taxable Value x Applicable Tax Rate = Tentative Tax 4. Tentative Tax Applicable Credits = Net Tax Owed If your business is the largest asset in your estate, the greatest portion of estate taxes that may be imposed on your estate will be based on your business ownership interest. It is especially important for you to understand the strategies and techniques available that may help reduce the taxable value of your business and thus help to reduce any estate taxes that may be owed. Possible to reduce taxable value of business There are strategies that you can implement now while you are still living that may reduce the taxable value of your business. These are called inter vivos strategies. There are also techniques that can be used after your death, such as special use valuation or deferred payment of estate taxes (Section 6166). These are called post-mortem techniques. The following discussion does not concern post-mortem techniques and refers to inter vivos techniques only. Estate freeze There are many inter vivos strategies that reduce the net taxable value of your estate (e.g., maximizing the available tax exemptions, exclusions, deductions, and credits). But probably the most obvious strategy is simply to remove an asset from your estate while you are living so that it is not included in your estate at death. This reduces the gross taxable value of your estate. This strategy is called an estate freeze. An estate freeze places a ceiling on the value of your business and controls your estate's tax liability. In addition, the estate freeze may also result in income tax savings. It is, therefore, a powerful estate planning tool that allows you to ensure adequate liquidity to preserve your business and pass it on to your children.

A quick lesson on the estate tax system To understand the strategies and techniques available to help minimize the taxable value of your business, it is useful to have some understanding of how the estate taxation systems work. What follows is a quick lesson.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 34 of 103

Federal taxes Federal taxes are imposed on wealth that you transfer to others either during your life as gifts (gift tax) or at your death through bequests (estate tax). Together, gift tax and estate tax are referred to as transfer taxes. This is how the federal transfer tax system works: Generally, taxable gifts are reported, and any gift tax owed is paid annually (generally, you must file a gift tax return, Form 709, and pay gift tax due, if any, by April 15 of the year following the year in which you make a taxable gift). Upon death, taxable gifts are added together with your gross taxable estate for estate tax calculation purposes, even though a gift tax return may already have been filed and gift tax paid (gift tax paid is deducted from estate tax owed). The value of gifts brought back into your estate is the gift property's fair market value(FMV) at the time the gift is made. Or, in other words, the property's value is frozen when the gift is made. The federal transfer tax system works this way so that (1) you can't avoid estate tax by giving your wealth away before you die, and (2) you pay tax on the cumulative amount of wealth you give away (this pushes your estate into a higher tax bracket). Example(s): George owned property valued at $200,000. He gave $100,000 to his friends, paying gift tax on $100,000 in the amount of $1,800 (assume no other variables). George kept the other $100,000. Two years later, George dies, and the $100,000 he kept is now worth $125,000. The IRS adds the gift George made to George's current assets to compute his taxable estate. George's taxable estate is $225,000 ($100,000 + $125,000). The tentative estate tax owed on $225,000 is $4,050. The gift tax George paid at the time of the gift is subtracted from the tentative tax, so George's estate owes $2,250 in estate tax ($4,050 - $1,800). There is also a transfer tax called the generation-skipping transfer tax (GSTT). This is an additional flat tax (at a rate equal to the highest current estate tax rate) that is imposed on transfers you make (either during life or at death) to skip persons--persons who are two or more generations below you (e.g., your grandchildren). State taxes Your estate may also be subject to state gift tax and/or state death taxes. These tax systems vary from state to state. Generally, you pay gift tax on lifetime gifts (currently, only a handful of states impose gift tax), and your estate pays estate tax (called death taxes) only on property in your estate at the time of your death (all states have some form of death tax). Some states also impose a GSTT.

How does an estate freeze minimize taxes? Removing assets from your estate before death may not avoid taxes altogether, but it may help to minimize these taxes. This may be accomplished in several ways. Eliminates future appreciation from your estate Probably the biggest tax savings result from removing future appreciation from your estate. This happens because gifts that are brought back into your estate for estate tax purposes are valued at the gift property's FMV at the time the gift is made (its frozen value). Generally, businesses increase in value over time. Removing the business today keeps the appreciated value out of your estate later. The amount subject to tax will be less today than it will be in the future. Example(s): Darcy purchased improved real estate for $150,000. Five years later, the property is now worth $300,000, and she expects that it will double in value during the next five years. Darcy wants to give the property to her daughter Ellen. If Darcy wants to save estate tax, she should make the gift now instead of later. Now, $300,000 will be subject to gift tax. In five years, $600,000 will be subject to gift tax. The following table further illustrates this point: Darcy's Property

Value Today Value in Estate in FiveYears

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 35 of 103 Real estate (gifted)

$300,000

Real estate (not gifted) $300,000

$300,000 (FROZEN) $600,000 (APPRECIATED)

Takes advantage of the annual gift tax exclusion The annual gift tax exclusion currently allows you to give $13,000 per donee to an unlimited number of donees per year without incurring federal gift tax. Generally, married couples can double the exclusion amount. This exclusion allows you to distribute your property tax free and potentially put your estate into a lower tax bracket. Tip: Some states may have the equivalent of the federal annual gift tax exclusion. Takes advantage of the applicable exclusion amount and GSTT exemption The applicable exclusion amount (formerly known as the unified credit) offsets lifetime gifts and bequests (death-time gifts) (assuming there is an estate tax). The GSTT exemption works like the applicable exclusion amount for gifts made to skip persons. You may want to use the applicable exclusion amount and the GSTT exemption during your lifetime instead of waiting until your death because of the time value of money (i.e., money is worth more today than it will be tomorrow). Tip: Some states may also have the equivalent of the GSTT exemption and/or the applicable exclusion amount. Shifts income to a lower income tax bracket Because the income tax rate schedules are graduated, your total federal and state income tax burden may be reduced if income-producing assets are distributed among several family members rather than being concentrated in your hands only. Caution: Be careful if you are distributing business interests into the hands of minor children, however. Your potential federal income tax savings of transferring income-producing property to your minor children may be reduced by the kiddie tax. Shifts capital gains to a lower income tax bracket Federal and state capital gains tax on the sale of appreciated property may be reduced by transferring the property to a family member who is in a lower income tax bracket or who has losses to offset the gain.

What are your options? There are many inter vivos techniques that can be used to implement an estate freeze in order to ensure adequate liquidity and preserve your business for your children. Family limited partnership (FLP) A family limited partnership (FLP) is currently a very popular technique for reducing the taxable value of your business. An FLP is a limited liability business entity created and governed by state law and is generally limited to members of a family. Besides the tax-saving results discussed previously, an FLP also qualifies for certain significant discounts. In addition to the tax-saving benefits, an FLP (1) lets you keep control of the business and (2) provides liability protection for all the limited partners. However, an FLP is a relatively complex form of entity, and it should be organized with care. In addition, because an FLP is a separate entity, all formalities of existence must be carefully followed and maintained.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 36 of 103

Private annuity A private annuity is the sale of property in exchange for a promise to pay you income for the rest of your life. You (the seller or annuitant) transfer complete ownership of the property to the other party (the purchaser or obligor). A private annuity avoids transfer taxation because it is classified as a sale, not as a gift. Property removed from your estate through a bona fide sale is not subject to transfer taxes, although the sale may be subject to capital gains taxes. A private annuity is a good technique if you have no other source of income and need the income from the business to support yourself. Buy-sell agreements A buy-sell agreement is a legal contract common in closely held businesses. It is an agreement you can enter into now that provides for the future sale of your business interest. Under the terms of a buy-sell agreement, the buyer may be legally obligated to buy your interest in the business from you (or your estate), and you (or your estate) may be legally obligated to sell your business interest at the occurrence of a specified triggering event. When the triggering event occurs, there is a ready buyer for the share of the business. The buy-sell agreement may, under the right circumstances, set the FMV of an interest in the business when the agreement is executed. When the agreement is structured properly, the IRS will accept the taxable value as FMV as long as certain conditions are met. Gifts A gift is simply the act of transferring your business interests to another party without receiving something of at least equal value in return, no strings attached. You can gift your business outright or in a trust. As well as enjoying tax savings, gifting your business to your children can result in many personal rewards (e.g., seeing your children enjoy your generosity). However, giving away your business also means giving up control, so you must be prepared to let go of the business.

How do you choose which option is right for you? You should consider your personal goals in conjunction with your tax-saving goals in order to choose which option may be right for you. Some of the things you might want to think about include the following: • Will your estate have enough cash to pay for your funeral and other final expenses? • Do you want to reduce income taxes? • Are you uncomfortable about giving up control of your business? • Are your children capable of managing the business on their own? • Do you need income from the business to support yourself? • Do you trust your heirs to make annual payments to you? • Do you mind formalities? • Do you want to keep the cost of implementation down? • Do you want to protect your business assets from the claims of creditors? • Do you want to see your children enjoy the benefit of your generosity?

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 37 of 103

Transferring Your Business Interest with a Buy-Sell Agreement What is a buy-sell agreement? Business succession tool Events like the death, disability, or retirement of an owner don't have to mean the end of the business. Business succession planning can provide for an orderly transition of ownership and business management, during lifetime or at death. One tool used in business succession planning is the buy-sell agreement. A properly designed buy-sell agreement can allow you to keep control of your business until death, disability, retirement, or other specified event. This discussion will provide an overview of buy-sell agreements in general, reasons why you might want to have a buy-sell agreement, and a brief description of each specific type of buy-sell agreement. Legal contract A buy-sell agreement is a legal contract, common in closely held businesses. It is an agreement you can enter into now that provides for the future sale of your business interest. A buy-sell agreement is also referred to as a business continuation agreement, a stock purchase agreement, or a buyout agreement. Establishes buyer for your business interest A buy-sell agreement identifies a buyer or potential buyer of your business interest and the conditions under which a sale will occur. The buyer could be an individual or an entity, and there can be more than one buyer. Typically, once you are bound under a buy-sell agreement, you can't sell your interest in the business to any party except the buyer named in the agreement. More frequently, the agreement involves rights of first refusal, so the potential to sell to a third party is possible. Defines events triggering sale of business interest Under the terms of a buy-sell agreement, the buyer may be legally obligated to buy your interest in the business from you (or your estate), and you (or your estate) may be legally obligated to sell your business interest at the occurrence of a specified triggering event. You, your advisors, and the other parties to the agreement will determine the triggers appropriate for your business situation. Possible triggering events include those shown in the following table: Typical Triggering Events Other Possible Triggers • • • •

Death Long-term disability Retirement Divorce

• Personal insolvency or bankruptcy • Conviction of a crime • Loss of professional license • Withdrawal prior to retirement • Termination of employment

Why would you want one? There are several benefits to having a buy-sell agreement. Some of these benefits affect you, your family, or your estate, while others affect the business itself in terms of stability and how it is viewed by outside parties, such as bankers. When an owner of a closely held business dies and there is no continuation plan, the seller (for instance, your estate) is generally at a disadvantage and may be forced to accept a low price for the business interest, assuming a buyer can be found. A properly designed buy-sell agreement can protect your heirs by

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 38 of 103

eliminating the possibility of a forced sale or the need for your family to rely on the business for income. The buyer and sale price are prearranged under the buy-sell agreement. What happens when an owner dies? Corporate law dictates that certain forms of business organizations terminate at the death of an owner. A buy-sell agreement can prevent the termination of your business at your death. The following table lists the common business forms, and what would happen at the death of an owner if there is no buy-sell agreement in place: What Happens When an Owner Dies? Business Form

Law Says

Sole Proprietor

• Business enterprise terminates by operation of law at death of owner • Employees have no authority to continue operations • Executor can continue business but is not allowed to benefit from activities needed to continue business and may be personally liable to estate beneficiaries for losses incurred during continuation

Partnership

• Partnership dissolves upon death of a partner (business may continue) • Surviving partner responsible for dissolving and liquidating business, if appropriate

Professional Corporation • Many states limit ownership to members of same profession--heirs or personal representative could not assume ownership of stock Corporation

• Business entity does not terminate (but is generally disrupted by loss)

Personal considerations Provides a guaranteed buyer for your business interest (or how to avoid a fire sale) When you die, your estate does not have to search for someone who is willing to buy your share of the business. Your estate will not be forced to sell your business interest at an unfairly low price to get the cash needed if your estate must pay estate taxes. Under the terms of the agreement, when any of the triggering events occur, there is a ready buyer for the share of the business. A buy-sell agreement spells out exactly who will buy your interest in the business, under what circumstances, and at what price. Tip: For this to work, you must fund the buy-sell agreement. Provides liquidity for the payment of estate taxes and other estate settlement expenses (but only if the agreement is funded) Estate taxes, if owed, are due to the federal government nine months after death. In some states, the death taxes are due even sooner than that. The buy-sell agreement not only provides a buyer for the business interest but also specifies the value or valuation method, if the payment will be in a lump sum or installment, and when it will happen. If your estate is large and subject to estate taxes, your family will need enough cash to pay them. You want to be sure that they will be able to convert your portion of the business into cash quickly and at a fair price. Under a buy-sell agreement, the sale of the business interest can occur quickly, and your family can be spared the panic of just how to pay the estate taxes. Caution: If the buyer does not have the cash or access to cash when needed for the buyout, the agreement won't serve any useful purpose. Make sure that the agreement specifies the plan tofund the buy-sell agreementand, even more importantly, that the funding takes place. Tip: The applicable exclusion amount (formerly known as the unified credit) exempts a certain amount of your gross estates from federal estate tax liability. In addition, businesses meeting the definition of a qualified family-owned business interest may be allowed a deduction. (The qualified

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 39 of 103

family-owned business interest deduction is available only to the estates of persons dying after December 31, 1997 and before January 1, 2004.) If this is you, you probably won't owe estate taxes, and the benefit of a buy-sell agreement to provide liquidity for estate taxes may not be of much importance to you. Even if your estate is exempt from federal estate taxes, you still may want the benefits of a buy-sell agreement such as a guaranteed buyer. Avoids potential conflicts of interest between surviving owners (if any) and your heirs At your death, there is a natural conflict of interest between your surviving co-owners (if any) and your heirs. Generally, it is in your heirs' best interest to receive the largest amount of cash possible from the business. Likewise, it is generally in the surviving co-owners' best interest to continue the business operation without interruption and to keep liquidation costs to a minimum. Without a prearranged agreement, the differing needs of your heirs and your surviving co-owners are likely to result in a dispute. A buy-sell agreement can ensure that your plans for your business and for your heirs are carried out as you intended and are not met with resistance. Can establish the value of the business for estate tax purposes, if structured properly The buy-sell agreement may, under the right circumstances, set the fair market value (FMV) of an interest in the business when the agreement is executed. When the agreement is structured properly, the IRS will accept the FMV as the taxable value if certain conditions are met. Caution: Buy-sell agreements between family members or related parties can be subject to close scrutiny by the IRS. The definition of "family member" includes your spouse, parents of you and your spouse plus their lineal descendants including spouses, and any other "natural objects of the transferor's bounty."

Business considerations Maintains stability of business operations The buy-sell agreement specifies exactly who will continue as owners in the business. The agreement can be used to ensure that the people who have been running the business can continue to do so. It can ensure that the surviving co-owners will not be forced to accept outsiders into the business. Improves creditworthiness of the business A buy-sell agreement may increase the probability of the business continuing successfully after the death or withdrawal of an owner. From a creditor's viewpoint, the continued existence of the business means the continued ability to meet outstanding loan payments. Creditors may view the business as more stable and the owners as responsible businesspeople, and may be more likely to extend credit to the business. Maintains legal status of your S corporation, partnership, or professional corporation (if relevant) A buy-sell agreement can protect S corporation status by preventing ineligible shareholders from buying shares of the corporation, preventing ownership by more than the maximum allowable number of shareholders, and complying with the one class of stock requirements. It can protect partnership status by avoiding liquidation at the death of a partner. In most states, nonprofessionals are not allowed to be stockholders in a professional corporation. Use of a buy-sell agreement can prevent a nonprofessional from becoming a stockholder in your business in violation of the law.

Does size matter? Buy-sell agreements can be set up for companies with one owner or many. The size of your company will affect your choices in setting up your specific form of buy-sell agreement and may cause one form to be more appropriate than another, but it would not generally prohibit you from having a buy-sell agreement. Just as there are different business ownership arrangements, there are different forms of buy-sell agreements. One of the distinguishing features between the different buy-sell agreement forms is the buyer to the transaction. The buyer

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 40 of 103

could be any or all of the current co-owners, an outside third party, or the business entity itself. There can be more than one buyer. The following table illustrates the various types of buy-sell agreements that are commonly found, the typical buyer, and what forms of business organization and size each form is best suited for. Within the basic forms of agreement, you can custom-fit your buy-sell agreement to your particular business through the use of various clauses, options, and requirements. Overview of Buy-Sell Agreement Forms Agreement Form

Buyer

Works Well With

Unsuitable For

Wait and See

Business entity, co-owner, Business with two or more Sole proprietor and single or both owners shareholder corporation

Trusteed Cross Purchase

Co-owner Transaction overseen by trustee

Business with two or more Sole proprietor and single owners Simplifies plan shareholder corporation when large number of owners

Entity Purchase (Stock Redemption)

Business entity

Business with two or more Sole proprietor and single owners shareholder corporation

Section 302 Stock Redemption

Business entity

Business with two or more Sole proprietor and single owners shareholder corporation

Section 303 Stock Redemption

Business entity

Business with two or more Sole proprietor and single owners, especially family shareholder corporation business

Reverse Section 303 Stock Redemption

Business entity

Business with two or more Sole proprietor and single owners, especially family shareholder corporation business

Cross Purchase (Crisscross) Agreement

Co-owner

Business with two or more Sole proprietor and single owners shareholder corporation Large number of owners (gets complicated with four or more)

Option Plan

Business entity, co-owner, Business with any number Any scenario where or any eligible third party of owners, including sole guaranteed sale is proprietorship and single needed Sale not guaranteed shareholder corporation

One-Way Buy-Sell

Business entity, co-owner, Business with any number Sole proprietor with no or any eligible third party of owners, including sole willing buyer proprietorship and single shareholder corporation

What are the tradeoffs of having a buy-sell agreement? In exchange for the guarantee of a buyer for your business interest, you must accept certain restrictions on your ability to transfer your interest to parties outside the agreement. Careful structuring of your buy-sell agreement and coordinating it with your personal estate and tax planning goals can minimize and possibly eliminate the impact of the following tradeoffs.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 41 of 103

Restrictions can affect personal estate planning Gifting strategies are important estate planning tools for owners of closely held businesses. Lifetime gifts of your interest in the business to your children could be part of your estate planning strategy to pass your business interest to your heirs and reduce the total value of your estate. Restrictions in the buy-sell agreement could prevent you (and your co-owners) from passing all or part of your interest in the business as a gift. The parties to the agreement, therefore, must consider whether to restrict transfers by gift. Tip: If the ownership group decides to allow gift transfers, the group of permissible donees should generally be defined. The donee group should probably be subject to the terms of the buy-sell agreement. Restrictions could limit your access to outside credit Restrictions within the buy-sell agreement could prohibit you from pledging your own interest in the business as collateral for outside credit, or could require the consent of the other owners. Without the ability to pledge your business interest, the lender might turn you down for a loan. Tip: If the buy-sell agreement is set up to include a right of first refusal, the owners would be allowed to pledge their individual business interests as loan collateral. If a foreclosure occurs, the stock acquired by the creditor would have to be offered for sale to the other parties to the agreement before it could be sold to a third party. Under the right of first refusal, the buyer under the agreement would have the right to buy (or refuse to buy) the shares held by the creditor. The lender must be notified the shares are subject to a right of first refusal, and the loan could not exceed the shares' fixed purchase price. This restriction should be indicated on the stock certificate (many states have laws requiring this). Restrictions may be unenforceable under state law State property laws favor the right of business owners to transfer their interest in a business to whomever they want, whenever they want, at whatever terms they want. Restrictions in a buy-sell agreement that are extreme will generally be viewed as unreasonable and therefore unenforceable. For instance, a restriction that may be viewed as extremely prohibitive (and therefore unreasonable) is one that permanently and absolutely bans lifetime transfers of shares of a business's stock, along with a mandatory resale of the shares to the corporation at death for the original purchase price. A restriction like this could be viewed as a forfeiture; unreasonable, and therefore unenforceable. If the only condition for a profitable transfer of stock is a pure right of first refusal that requires the offer of the stock at the same price to the other parties, it does not restrict the transfer of stock, only the persons who may buy the stock. In this case, the restriction is not extremely prohibitive and would almost always be enforceable. In general, if the terms of the restrictions were reasonable when the agreement was executed, such as rights of first refusal and rights to buy interests in the business based on a formula set price, then the restrictions would be enforceable. Whenever a buy-sell agreement is ambiguous, the courts will not uphold the enforceability of the restrictions. However, a carefully drafted, clearly outlined buy-sell agreement containing reasonable terms of restriction should be able to avoid any issues with state law.

What should you do to set up a buy-sell agreement? Decide what you want to happen to your share of the business You should consider all of your financial, tax, and estate planning goals. Think about the questions in our seperate Buy-Sell Planning Questionnaire. Get help Setting up a buy-sell agreement can be very complex because it involves legal and tax issues. Don't try to tackle this alone--get professional help from your attorney, tax advisor, and/or financial planner. Each party to the

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 42 of 103

agreement should have his or her own attorney and advisors. Periodically review the agreement Once you have drafted your buy-sell agreement, don't just put it away and forget about it. You and your buy-sell participants should review the agreement on a regular basis, perhaps yearly. You want to be sure that the agreement still meets your objectives. The valuation provisions may specify an annual valuation of the business.

Is there anything you should try to avoid? Probably the biggest error that might be made in structuring your buy-sell agreement is thinking that your agreement has to look like another company's buy-sell agreement. The nature of your business and your ownership structure and relationships should be considered when drafting your buy-sell agreement. One size does not fit all! The key is to analyze the ownership of your business. The following table shows some common characteristics of business ownership: Ownership Characteristics

Participation in the Business

Active--Owners hold equal percentages

All owners are active in the business

Active--One majority owner, one or more minority owners

Majority owner controls business Minority owners have no significant control

Passive ownership

All owners are "outsiders" and none work in the business

Combination of passive and active ownership

Some owners work in the business

Family owned

All or most of the owners are family members

Common errors Errors and oversights can occur when drafting a buy-sell agreement. Some of these can be the result of trying to treat all owners equally, when they may not be equal. Other errors might come about as a result of an accidental oversight. Common errors include: Equal application of rights and restrictions In an attempt at fairness and equality, the buy-sell agreement might apply the same level of rights and restrictions to all owners. But should a majority shareholder be subject to the same restrictions as an owner who has contributed far less to the business? Rights and restrictions under a buy-sell agreement can be structured to cover different ownership ratios and do not have to apply equally to all owners. Sometimes, a buy-sell agreement that attempts to treat all shareholders as equals has the unintentional result of unfairly restricting a majority shareholder who is forced to give up control and flexibility. It could also unduly burden a minority shareholder who may need to come up with a large amount of cash to fund the obligation. Using an inappropriate valuation The valuation of the business under the buy-sell agreement is of great importance. The agreement is a legal contract, and the price (or method of determining price) specified will lock in the sale price. When done correctly, the buy-sell agreement will set a sale price that will be accepted by the IRS as the fair market value (FMV). The IRS is not obligated to accept the sale price as the FMV for taxation. When the value set in the agreement is determined to be less than FMV, there can be an unfortunate and expensive consequence--the selling estate will be taxed on the difference between the sale price and the FMV. Consult your attorney or tax advisor for more information.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 43 of 103

Failure to conduct a valuation update Another potential problem in the business valuation under the buy-sell agreement is neglecting to update the agreement. Buy-sell agreements are often written to provide for periodic updates of the value of the business, the intention being to reflect changes in the business. The potential problem can arise when the revaluation is not done, the triggering event occurs, a sale must take place, the price ends up being declared too low by the IRS, and the seller has to pay a big tax bill. Tip: One solution is to provide a backup method of valuation in the agreement, with the conditions under which it will be used. This can provide a safety net in case the periodic valuation isn't done. Your tax advisor can help you set this up. Failure to include enough triggering events A buy-sell agreement specifies triggering events, generally including death, disability, retirement, divorce, bankruptcy, criminal activity, or loss of professional license. When an event specified in the agreement happens, it triggers a sale of the owner's business interest. Some buy-sell agreements limit the triggering events to death, failing to provide for a sale after another disruptive event such as an owner's divorce, where the courts could award part of an ownership interest to a spouse. An event such as disability can cause an owner's withdrawal from the business and create a liquidity problem as the business tries to provide income to the owner or buy out the owner's interest. Failure to provide funding Too often, the triggering events named in a buy-sell agreement are believed to be far off in the future, when the company is wildly successful and experiencing no cash flow problems. Sadly, the events often happen much sooner than expected and may catch a company before it has taken the steps to fund the buy-sell agreement. The method of funding the buyout should be established at the same time the agreement is drafted.

Choosing the right type of buy-sell agreement A buy-sell agreement can be a powerful tool in a business continuation plan. When coordinated with your estate and tax planning, a buy-sell agreement can provide a smooth transfer of your ownership interest. In addition to looking at your own personal goals for estate and tax planning, you must consider factors specific to your business before you can decide on a particular type of buy-sell agreement. For instance, the number of owners in your business may make some types of buy-sell agreements cumbersome or even impossible. The form of business organization may point to one ideal solution or several good solutions. Work with your attorney and tax advisor to draft an agreement that meets your goals, covers the necessary bases, and works with your estate and tax plans.

Questions & Answers Can you use a buy-sell agreement if your irrevocable trust owns the shares of your business? If your estate planning includes the use of an irrevocable trust that owns your business interest, you must coordinate the trust ownership of your business interest with your buy-sell agreement. The trust would be bound by the terms of the buy-sell agreement. Can the buy-sell agreement be changed? Generally, the buy-sell agreement can be amended, as long as all of the parties agree to the changes. Do you have to write another buy-sell agreement when one of the owners dies? That depends on the type of buy-sell agreement. If your business has more than two shareholders, and you want the agreement to continue beyond the first death, use of an entity purchase (stock redemption) buy-sell

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 44 of 103

agreement can allow this to happen more easily than a cross purchase (crisscross) agreement. What if the number of shareholders increases? If you anticipate an increase in the number of shareholders and want to be able to include the new shareholders in the buy-sell agreement, the entity purchase (stock redemption) agreement can allow this to occur more easily than a cross purchase (crisscross) agreement. What can be done if one of the parties to the buy-sell agreement refuses to carry out the obligation previously agreed to? A buy-sell agreement is a legal contract. The courts can grant specific performance of the contract, forcing the reluctant party to comply with the terms.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 45 of 103

Funding Your Buy-Sell Agreement with Tools Other than Insurance What are the alternatives to using insurance? Although life insurance is considered the most popular funding method for a buy-sell agreement, there are alternative funding methods available. These can be used instead of or in conjunction with life insurance. The life insurance alternatives include: • Cash • Borrowings • Installment payments • Private annuity • Stock redemption • Sale-leaseback • Appreciated property bailout • Deferred compensation

Why consider any of these options? You (or your estate) may be able to spread your gain over a period of years When you sell your business interest, the transaction is subject to capital gains tax. If you receive a lump-sum payment for the lifetime sale of your business interest, you must pay tax on the capital gain all at once. If you sell your business interest during your lifetime (for instance, at your retirement) and accept installment payments, you may be allowed to spread the gain on your sale over the installment period. The following funding methods for your buy-sell agreement would allow you to spread your gain from the lifetime sale of your business over time: • Installment payments (with limitations) • Private annuity • Deferred compensation Funding method may not require any cash payment right now Most of the alternatives to insurance funding don't need a down payment or initial premium. Chances are good that you or your company won't have to spend any money today if one of the noninsurance alternatives is chosen. However, depending upon the specific cash accumulation plan chosen, there may be some initial deposit to a fund, with regular, periodic deposits following. Generally the intent behind the other options is to wait until the event triggers the buy-sell agreement transaction, and then get the funding. Method

Cash Payment Needed Now?

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 46 of 103 Cash

Maybe

Borrowings

No

Installment payments

No

Stock redemption

No

Sale-leaseback

No

Appreciated property

No

Deferred compensation No Private annuity

No

Funding payments may be all or partially tax deductible Although insurance premium payments in general are not tax deductible, several of the noninsured funding methods may provide a way in which part or all of the payment is deductible to the buyer. Although there will be no tax consequences for the seller, this issue may be important in the context of the sale of a family business. Method

Deductible

Conditions

Cash

No

• No deduction for payment • Interest earned on invested cash for funding is taxable

Borrowings

Interest may be deductible

• Interest on loans used for business purposes is generally deductible

Installment payments

Interest may be deductible

• Determined by status of buyer--active participant or passive investor • Beware of rules regarding low interest rates

Deferred compensation

Part or all of payment may be deductible

• Portion of payment attributable to deferred compensation is deductible

Appreciated property bailout No

• Could result in corporate capital gain tax on value of property exchanged

Private annuity

No

• Private annuity payments are generally not deductible

Sale-leaseback

Part or all of payment may be deductible

• Lease payments are generally considered deductible business expense

Stock redemption

No

• Generally no deduction for repurchase of company stock

What could go wrong? No cash when you (or your estate) want to sell your share of business A significant drawback in using an alternative to insurance for funding your buy-sell agreement is that there will not be any cash available to buy your share of the business. This could happen as a result of several things, but the key factor is that none of the alternative methods guarantees that there will be cash when you die, retire, or

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 47 of 103

become disabled. Changes in the economy or your business could have made borrowing difficult or impossible. You may have set aside all the needed cash in a sinking fund but, due to circumstances, your creditors may have gotten their hands on it.

Conclusion As you can see, you do have options for funding your buy-sell agreement, but you should carefully consider the risk inherent in each method. Consult your tax and legal advisors to choose the funding method for your buy-sell agreement that works best with your circumstances and those of your business, as well as your tax and estate plans.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 48 of 103

Funding Your Buy-Sell Agreement with Life Insurance What does it mean to fund a buy-sell agreement with insurance? The general function of life insurance is to create a sum of money payable at the death of the insured in order to replace the economic loss resulting from the person's death. When used to fund your buy-sell agreement, life insurance will create a sum of money at your death that will be used to buy your business interest from your family or estate. Using life insurance in a buy-sell agreement requires all the procedures involved in buying personal life insurance. An application must be completed, including a completed medical history, and life insurance underwriting procedures must take place.

When can it be used? You are a party to a buy-sell agreement You can use life insurance funding if you are one of the parties specified in a buy-sell agreement and are obligated by the terms of the agreement to purchase all or a part of the business interest held by another buy-sell participant at the other person's death. This obligation provides an insurable interest, one of the requirements for an insurance company to issue a policy. You are insurable For insurance funding to work with your buy-sell agreement, you must be able to get life insurance, which often involves a physical examination. If you are in poor health, you might be considered uninsurable by the insurance companies. If this applies to you, see Alternatives for the Uninsurable for some optional funding methods. You can still use insurance with your buy-sell agreement even if some of the parties are uninsurable. You would need to structure alternate financing for the uninsurable shareholders. Who owns the life insurance policy? Although certainly not an ironclad rule, the general arrangement is for the partners, partnership, stockholders, or corporation (whoever is the purchaser specified in the agreement) to pay the premiums. The party paying the premiums is also generally the owner of the policy and receives the proceeds of the policy at the death of the insured, whose interest in the business is to be purchased. There are many possible variations to this scenario. See the discussions Premium Payment, Beneficiary Designation, and Choosing the Policyowner for more information. Strengths and tradeoffs of life insurance in a buy-sell agreement There are strengths and tradeoffs that apply to the use of life insurance in funding a buy-sell agreement in general. These are discussed in this section. There are also some considerations specific to the type of buy-sell agreement, which are addressed separately in paragraphs below.

Strengths Low-cost alternative The total cost of the annual premiums on a life insurance policy is generally far less than the amount of cash that would need to be reserved and held aside to fully fund the purchase of a share of the business. The use of life insurance allows full funding of the buy-sell agreement, using an amount of cash that is less than the full purchase obligation.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 49 of 103

Only means of guaranteeing event that creates need for cash (death) also provides cash for it The death of a shareholder can cause a strain for the company resulting from the loss of talent, disruption of business, and the accompanying loss of revenue. Such an event could lead to temporary difficulty in getting loans or other funding. The use of life insurance funding with the buy-sell agreement will likely assure that cash will be available to purchase the deceased owner's share of the business, eliminating the need to find financing at the time of the event. Policy cash values can be used to fund lifetime sale When your buy-sell is funded with a permanent (cash value) life insurance policy, the accumulated cash values can be accessed and used to fund a lifetime sale resulting from retirement or disability. The policy can remain in force or be surrendered when the cash is needed. Caution: There may be tax consequences and fees associated with a policy surrender. See Tradeoffs. Life insurance proceeds paid quickly after death--possible to close buy-sell deal quickly Life insurance is designed so that the proceeds are paid quickly after your death. This characteristic ensures that the buy-sell transaction can be settled quickly. The use of life insurance proceeds to fund the buy-sell agreement can provide your estate with the cash needed to fulfill state and federal estate tax obligations. Life insurance proceeds received income-tax free. The proceeds received from the policy generally do not constitute taxable income to the beneficiary of the policy when the beneficiary is an S corporation, the shareholders, or a third party. Caution: A C corporation may be subject to the alternative minimum tax (AMT) when it receives proceeds from a life insurance policy. Simple to explain and implement Most people have some understanding of the concept of insurance. The process of getting life insurance for a buy-sell agreement is the same as that for any other life insurance. Even if someone has never had insurance before, it is still not difficult to explain the concept and put the policies in place.

Tradeoffs Life insurance premiums not deductible expense In general, policy premiums are paid with after-tax dollars and are not a deductible expense. This applies regardless of who pays the premiums--the corporation, the shareholders, or a third party. Uninsurable shareholders present a problem It is possible that a shareholder may be deemed uninsurable, although few individuals are actually refused insurance because of age or physical health. Most insurers may agree to cover almost any age up to the mid-70s (and even 80 with some policy types). People with illnesses may be insured with the application of a rating (or a flat extra premium, depending upon the severity of the illness). The rating that may apply to a high-risk insured will raise the cost of the premiums on that individual and equates the premium to the total level of risk for the insurance company. The additional cost of insurance for a high-risk shareholder may make other options more appealing. For more information on funding for uninsurable shareholders, see Alternatives for the Uninsurable.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 50 of 103

Payment of policy premiums represents ongoing expense Policy premiums represent an ongoing expense. In an entity purchase buy-sell with several shareholder participants, the annual policy premiums could, in some cases, even result in cash flow problems for the corporation. Not only is cash needed for the payments, but the premiums are not a deductible expense. Tip: Even though the payment of policy premiums can result in a cash drain, it is not anything like the cash outflow that would result at the time of an obligation to purchase the entity under a buy-sell agreement if no insurance was used! In addition, if a shareholder dies soon after a policy is issued, the purchase will have been funded with minimal cash outlay. Could create transfer-for-value problem If life insurance policies are used to fund the agreement, the death of one owner could cause a transfer-for-value problem with the policies insuring the remaining owners. When a shareholder dies, the estate becomes the owner of the policies covering the other shareholders under the agreement. If these policies are transferred to the remaining shareholders to fund future obligations under a cross purchase buy-sell agreement, a transfer-for-value may occur. If a transfer-for-value is deemed to occur, any proceeds received from the transferred policy will be taxable. Policy cancellation may be taxable If the policy is canceled (surrendered) for cash (for instance, to fund a lifetime buyout under the buy-sell), the gain on the policy is subject to federal income tax. The gain on a canceled policy is calculated by adding the net cash value and the balance of any outstanding loans and subtracting the policy basis. Caution: The policy may also carry surrender charges. Check your policy. Caution: Policy fees and expenses are usually charged against the policy in the first few years. As a result, policy surrenders during the first few years of the policy may provide little cash value. Caution: If the policy is surrendered while there is a policy loan balance outstanding, the transaction could be subject to income tax on the amount of the loan.

Considerations by type of buy-sell agreement: entity purchase agreement The alternative minimum tax (AMT) may apply when policy owned by C corporation The proceeds received by a C corporation under an entity purchase (stock redemption) buy-sell agreement may be subject to the alternative minimum tax (AMT). In addition, any buildup in cash surrender value of life insurance policies held by a C corporation may also subject the corporation to--or increase its existing exposure to--the AMT. The corporate AMT is not an issue when the proceeds are received by an S corporation, a partnership, or the co-shareholders or partners of the insured. Value of insurance proceeds increase value of business When the business is the beneficiary of the insurance policy, the value of the proceeds received becomes company property and increases the value of the business. This scenario, which is sometimes referred to as the "ballooning" problem, could result in inequity in the treatment of the deceased and the surviving shareholders. If the purchase price does not include the value of the insurance proceeds, the family of the deceased shareholder does not benefit from the increase in the value of the business resulting from receipt of the insurance proceeds and the cash values of the company-owned policies on the other shareholders. Example(s): Wayne, Bruce, and Robin are equal shareholders in a business valued at $300,000, with an entity purchase agreement fully funded by life insurance. Wayne dies. The company owns a $100,000 policy on Wayne's life and collects the proceeds as beneficiary, increasing the value of the business to $400,000. The $100,000 proceeds are transferred to Wayne's estate in exchange

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 51 of 103

for his stock. Bruce and Robin now each hold 50 percent interests in the company, which is valued at $300,000 plus the cash values on the existing policies on their own lives. Wayne's estate doesn't receive any benefit from the increase in the value of the business due to the receipt of the proceeds on Wayne's life or the cash values in the policies on the lives of Bruce and Robin. Tip: A practical solution might be for the sale price in the entity purchase agreement to reflect the cash values of all policies funding the buy-sell. The deceased shareholder would then receive a benefit (through the sale price) from cash value accumulations in the policies.

Considerations by type of buy-sell agreement: cross purchase agreement Life insurance has no adverse effect on working capital or credit position of the company The company is generally not a buyer under a cross purchase agreement, which is an agreement between the individual shareholders. As a result, the company will not have to reserve large amounts of cash in a sinking fund in advance of a stock purchase, nor will it need to use company funds or take on debt to fund the buy-sell transaction. Can require large number of policies Under the cross purchase (crisscross) form of buy-sell agreement, each participant holds a policy on the life of every other participant under the buy-sell agreement. If there are a large number of participants, many policies will be needed. For more information on the number of policies required, see Calculate the Number of Policies Needed with Cross Purchase Buy-Sell Agreement. Disparity in ages or ownership percentages can cause inequities in premium payments Under a cross purchase buy-sell agreement, each owner pays the premiums on the policies owned on the other shareholder's lives. If the ages of the shareholders vary widely, younger shareholders will have to pay higher premiums on the lives of the older shareholders. The younger owner may find it difficult or impossible to pay the higher premiums. (The counterargument is that younger shareholders may have a shorter payment period. Of course, there is no guarantee that this will be the case.) Likewise, if the ownership percentages are not equal, more insurance will be needed to cover the buyout cost of the larger interests, resulting in higher premium costs for those who hold smaller ownership interests.

Can we use our group life insurance to fund the buy-sell? This is not advisable for several reasons: 1. Generally, group life insurance premiums are deductible to the company. However, an employer may not deduct premiums it pays for group insurance coverage on an employee when the employer is a beneficiary either directly or indirectly. 2. Many states have group insurance statutes that prohibit an employer from being the beneficiary of group insurance on its employees. 3. If group life insurance is used for funding a cross purchase agreement, the corporation cannot deduct the group life premiums. The premiums could be considered constructive dividends to the shareholders. 4. The reciprocal transfers of policies between the shareholders could be considered a transfer-for-value by the IRS. The proceeds from the group insurance would be taxed as ordinary income to the surviving shareholders. 5. It is possible that the shareholders might agree collectively that the amount received from the group policy by the beneficiary spouse or family of a deceased shareholder would be the consideration for the stock. In this case, the surviving shareholders would not receive an increase in the stock's basis,

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 52 of 103

resulting in a larger gain if the business interest is sold in a lifetime transfer. 6. If the policy ownership is not transferred, and the shareholders simply name each other as beneficiaries, then both the business interest and the insurance proceeds would be included in a stockholder's gross estate.

How much insurance is needed? Ideally, the buy-sell agreement should be fully funded. The insurance coverage should be arranged so that your life is insured for an amount equal to the value of your ownership interest. When you die, there will be enough cash from the policy proceeds to pay your estate in full for your share of the business. It is important to note, however, that even partial funding of the agreement is far better than no funding at all. If all that is affordable is insurance coverage for part of the value of your interest, you might want to go ahead and fund that amount. You may be able to get more insurance or take on additional funding methods later. For additional types of funding, see Funding Your Buy-Sell Agreement with Tools other than Insurance.

What happens if the insurance proceeds differ from the value of the business interest? Proceeds less than value of interest The insurance proceeds could be less than the value of your business interest due to growth of the business (or other reasons). Your buy-sell agreement should specify what will happen when the value of the business is larger than the amount of the proceeds from the insurance company. One possible option is for the buyer to make installment payments for the difference. Your buy-sell agreement should specify how the proceeds/valuation difference will be handled. Proceeds greater than value of interest The proceeds from the life insurance policy funding your buy-sell agreement could exceed the value of your business interest when you die, as a result of cash value buildup in the policy. Often, it is specified within a buy-sell agreement that the insurance proceeds represent the minimum price for the business interest and that the full amount of the insurance will be paid to the deceased's family or estate. Another option is to provide that any proceeds in excess of the value of your interest at death belong to the party who paid the premiums on the insurance. Your buy-sell agreement should address this potential situation up front and should specify whether the funds would be used by the business, the surviving shareholders, or to provide an additional benefit to the family or estate of the deceased.

How to do it After the buy-sell agreement stating the purchase price, terms, and funding arrangements is drafted, the following steps should occur: Obtain the life insurance policies For an entity purchase (stock redemption) buy-sell agreement, the business should apply for separate life insurance policies on each of the shareholders. A common arrangement is for the business to pay the annual premiums and be the owner and beneficiary of the policies. For a cross purchase (crisscross) buy-sell agreement, each shareholder applies for individual life insurance policies on each of the other shareholders. Each shareholder pays the annual premiums on the policies on the other shareholders and is the owner and beneficiary of the policies. For a wait and see buy-sell, there are three purchase options available for the life insurance policies: The business can buy the policy on each of the shareholders, as in the stock redemption; the individual shareholders can buy the policies, like in the cross purchase plan; or a combination of these can be used. When the time comes to make the purchase, the individuals who own the policies can loan the proceeds to the company for the purchase, if a purchase by the

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 53 of 103

company is desired at that time. Tip: Include a schedule of the insurance policies as part of the buy-sell agreement. List the names of all buy-sell participants, the insurance company, policy numbers and face amounts, and the policyowners, beneficiaries, and premium payers. Monitor annual policy premium payments Each year, the premiums on the policies must be paid, or the insurance will lapse. Your buy-sell agreement should include a feature requiring proof of policy premium payment. Review amount of insurance regularly The insurance coverage may have to be increased periodically to reflect increases in the value of the business. It might be a good idea to include the insurance review as part of the annual year-end closing of the company's books. If additional insurance is not possible, another funding method, such as a cash reserve, could be established to help cover the increase in the business value. Monitor insurance company Periodically check on your insurance company. Is the company maintaining its ratings, or has it suffered from a financial downturn? There are several ways you can easily check out how your insurance company is performing. Financial and ratings information is available from several reputable sources and is often available at your local library, by subscription, or on the Internet.

Income tax considerations Policy premiums are not deductible expenses Amounts paid for life insurance premiums are not deductible. It makes no difference if the policy you own under the buy-sell is on the life of another shareholder or your own life. Caution: If the stockholders attempt to use company-paid group life insurance to fund the buy-sell agreement, the company may be denied a deduction for its premium payments. If the stockholders reciprocally name each other as beneficiaries of their insurance or reciprocally agree to apply the proceeds to the purchase of their stock, the proceeds may be taxable under the transfer-for-value rule. Tip: It is possible, however, to pay the cost of the premium to the policyowner in the form of a bonus. This would make the amount of the premium deductible by the business as compensation to the policyowner, but the amount of this bonus together with the policyowner's other compensation must not exceed reasonable compensation. The bonus may need to be "grossed up" so that the after-tax bonus amount is sufficient for the premium payment. Premiums could be considered taxable dividends Premiums paid by an associate shareholder are not taxable to the insured. However, if the corporation pays the premiums on life insurance to fund a buy-sell agreement between the individual shareholders ( cross purchase buy-sell agreement), the premium payments may be treated as taxable dividends to the stockholders. Tip: It is possible, however, to pay the cost of the premium to the policyowner in the form of a bonus. This would make the amount of the premium deductible by the business as compensation to the policyowner, but the amount of this bonus plus any other compensation paid to the policyowner must not exceed "reasonable compensation." The bonus may need to be "grossed up" so that the after-tax bonus amount is sufficient for the premium payment.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 54 of 103

Death proceeds are generally received income-tax free (except C corporation) Proceeds received at the death of the insured are generally not subject to income tax for the beneficiary. The notable exception to this treatment is when the proceeds are received by a C corporation, which could face an alternative minimum tax (AMT) liability when it receives insurance proceeds.

Questions & Answers How many policies are needed to fund a buy-sell with life insurance? It depends upon the type of buy-sell agreement and the number of participants under the agreement. With an entity purchase agreement, the general arrangement is for the business itself to own the insurance policies. One policy would be required for each shareholder under the agreement, so if there are 6 participants, the company would buy 6 policies. With a cross purchase agreement, the shareholders buy policies on each other. Six participants under a cross purchase agreement would need a total of 30 policies. Each shareholder would buy 5 policies, one on each of the other 5 participants. See Calculate the Number of Policies Needed with Cross Purchase Buy-Sell Agreement for the calculations. If you use a trustee with the buy-sell agreement, the trustee could buy one policy for each participant.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 55 of 103

Funding Your Buy-Sell Agreement with Disability Insurance What is disability insurance? Disability insurance is an insurance policy that pays a benefit in the event of a long-term illness or injury. The policy contains specific definitions of what constitutes a disability and the time frame (waiting period) between the disabling event and the first benefit payment.

How can disability affect your business? Higher likelihood of owner disability than death for given period The scary fact is, the likelihood of you or one of your co-owners becoming sick or injured for 12 months or longer before age 65 is much higher than the likelihood of any one of you dying. This means a higher likelihood of the buy-sell agreement being triggered by disability than death for any given year. The chances of at least one disability lasting 12 months or longer in a group of two, three, or four owners with an average age between 27 and 52 are shown in the following table: Chance of Disability before Age 65 Number of Owners Average Age 2

3

4

27

26.3% 36.7% 45.7%

32

25.6% 35.8% 44.7%

37

24.5% 34.5% 43.1%

42

23.0% 32.4% 40.7%

47

20.7% 29.4% 37.1%

52

17.4% 24.9% 31.7%

Disabled owner still needs income and the business may be unable to continue paying salary If you become sick or hurt, you would still need income to cover your living expenses. Health insurance may cover all or most of your medical needs, but it can't do much for your mortgage, your car payment, shoes for your kids, or your grocery bill. The business may not be able to pay you a salary for not working without the payments being considered dividends. Generally, companies are allowed to pay dividends only under certain circumstances, and the money must come from surplus funds. Tip: A disability salary continuation agreement established before an event of disability would allow the company to continue paying salary to a disabled owner for a specific period of time. The agreement can be structured to apply to certain individuals or groups, without covering all employees. Co-owners may be unhappy paying nonproductive owner Your co-owners will probably be reluctant to continue paying you if you cannot work. Even if the company is able to do it, continuing to pay out your salary will probably cause a cash drain on the company as well as extra work

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 56 of 103

for the remaining co-owners who are trying to fill your duties while you are out of work. Business may be directly affected by your absence Your business may be adversely affected by your sudden absence due to disability. Depending upon your role within the business, your absence due to disability could result in a slowdown or even a loss of sales; replacement costs incurred in attempting to find and train a replacement; possible slowdowns in production; and the possible loss of goodwill with customers and trading partners.

How can you use disability insurance with your buy-sell agreement? Disability insurance can be used in addition to the funding method you have decided on for the purchase of a business interest at an owner's death or retirement. It provides the buyer with money to pay for your interest when you become sick or injured for a long time. If the buy-sell agreement is an entity purchase plan, the business generally owns, pays for, and is the beneficiary on the disability policy. With a cross purchase agreement, the individuals bound under the agreement generally own, pay for, and are the beneficiaries on the policies on each other. When you become sick or hurt, a waiting period (usually 12 to 24 months) begins. At the end of the waiting period, the policy pays the benefit in either a lump sum, installment payments, or a combination of the two.

What are the benefits to using disability insurance with your buy-sell agreement? Income protection for you and your family The disability clause in your buy-sell agreement and disability insurance funding provide income protection for your family. Your buy-sell agreement establishes the buyer for your interest as well as the conditions under which they must buy. When you become sick or hurt, the disability insurance provides the buyer with the money to pay for your share of the business. Increase chances of receiving fair price if you have to sell If you become sick or injured and are unable to participate in your business, you may be forced to sell your interest. If your buy-sell agreement is funded for a purchase only at your death but you are alive and disabled, the buyer under your buy-sell agreement may not have all the cash to pay for your interest (for instance, if funding was arranged for a buyout at death). You could be at a negotiating disadvantage if you are allowed to try to find a buyer outside the buy-sell agreement. Chances are high that you will not be able to get a fair price for your share of the business if you are forced to sell quickly due to disability. Disability defined Disability insurance policies contain a definition of disability (which can vary between policies), an explanation of what happens in the event of a recurring disability, and the time period before benefit payments begin. This frees the company or shareholders from trying to define the conditions of disability. It frees the sick or injured person (maybe you?) from having to prove to co-owners an inability to work. It becomes the responsibility of the insurance company to monitor the disability. Tip: Coordinate the terms of your buy-sell agreement disability clause with the policy definition of disability. When your buy-sell has the same definition of disability as your insurance policy, any potential for confusion or disagreement is eliminated.

What are the drawbacks to using disability insurance with your buy-sell agreement?

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 57 of 103

You may be uninsurable If insurance companies consider you uninsurable, you will not be able to get disability insurance. Factors that could make someone ineligible for disability insurance include a history of certain health problems, high-risk hobbies such as skydiving or auto racing, or employment in certain occupations. Can't be used to fund buy-out of retiring or withdrawing healthy owner Although disability insurance can be used effectively to fund the purchase of your business interest when you are sick or injured, there is no policy benefit available if you are retiring or withdrawing from the business when you are healthy. Unlike life insurance, a disability policy can't be surrendered in exchange for a payment from accumulated cash values. Benefits payable to corporation could trigger alternative minimum tax (AMT) If your business is a C corporation, disability policy benefits paid to the corporation under an entity purchase agreement could trigger the AMT. When the company receives disability insurance proceeds, the amount received will increase an existing AMT liability or create a new exposure to the (very complicated) tax. If the business is subject to additional tax as a result of receiving disability proceeds, there will be less cash available to pay you. Insurance premiums not tax deductible The premiums for disability insurance to fund your buy-sell agreement are not deductible. It makes no difference if the payments are made by the business itself or the individual owners.

What could go wrong using disability insurance with your buy-sell agreement? You could recover after the sale of your business interest It is possible (though maybe not probable) that you could recover from your illness or injury after you sold your business interest under the disability clause of your buy-sell agreement. If this happened, you would find yourself without your business and possibly forced to start all over again in a new business or career. Tip: Disability insurance policies contain a waiting period before benefits are paid. It is generally advisable to use a long waiting period (e.g., 24 months) for the disability insurance and trigger date for the buy-sell agreement. By using a long waiting period, you reduce the chances that you will recover after you have sold your interest. In addition, longer waiting periods reduce the policy premiums. Tip: Make sure that your buy-sell agreement and your disability policy address what will happen if you do recover after the transfer of your interest has taken place or begun. It should specify whether you would be eligible to get your interest back should you recover after the waiting period. Conflict between policy terms and buy-sell agreement terms Perhaps the biggest (but completely avoidable) problem you could run into using disability insurance with your buy-sell agreement is a conflict between the terms of the insurance policy and the terms of your agreement. For example, your buy-sell agreement might state that the waiting period between the time you become disabled and the time your interest is bought is 12 months, but the disability insurance policy might have a waiting period of 24 months. You may be under the assumption that you will be able to sell your interest to the buyer named in the buy-sell agreement after a full year of sickness or injury, only to find out that you have another year to wait before there is any money.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 58 of 103

It is important to make sure that the terms of the disability policy and the buy-sell agreement disability clause are the same. The following table shows the areas to pay particular attention to when setting up the disability clause and the policy: Coordinate Disability Insurance Policy Terms with Buy-Sell Agreement Disability definition

What is disabled? Unable to perform own job, or any job?

Waiting period

How long after disability occurs before benefit is paid?

Trigger date

When does sale of the interest become mandatory?

Recovery

If you recover after the buy-sell transaction has begun, can you get your shares back?

Recurring disability What if your disability returns when you appeared to have recovered? Payment terms

Will the payment be made in a lump sum, installments, or a combination of the two?

Policy allowed to lapse--no benefit when needed It is an unfortunate possibility that the premiums on the disability policy may not be paid, causing the policy to lapse. If this happens, there will be no insurance benefit when you become sick or disabled. Tip: Monitor the premium payments, and make sure they are paid. This way, you can avoid the unpleasant surprise of discovering there is no disability insurance to pay for your business interest after you have sustained a major illness or injury.

Are there any alternatives to fund a disability buy-out under your buy-sell agreement? Alternatives for funding the disability clause of your buy-sell agreement, along with the benefits to you as the seller, are shown in the following table: Funding Alternatives for Disability Buyout Funding Method

Seller Advantages

Seller Disadvantages

Lump-Sum Cash

Seller gets money up front

Seller may not get money if buyer doesn't have it

Private Annuity

Often used in family transfers when business owner in poor health

Seller becomes unsecured creditor of buyer

Borrowings

Seller gets money up front

Seller may not get money if buyer doesn't have access to credit

Installment Payments Seller can set favorable interest rate Gain can be spread over time

Seller becomes creditor of buyer

Sale-Leaseback

Seller gets money up front

No guarantee sale-leaseback transaction will occur

Life Insurance

Seller gets money up front from policy accumulated cash value

Cash value may not be large enough for total buyout Cash value may not be available

Disability Insurance

Seller can "cash out" of business after disability

Seller could recover from disability, no longer have a business

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 59 of 103

Equalizing Estate Distributions to Your Children Why equalize distributions to children? Equal distribution of wealth usually considered fair An equal distribution of wealth is usually considered a fair distribution. When each of your children receives an equal share of your wealth, it is difficult to argue that any child has been treated unfairly. An equal distribution eliminates hurt feelings, jealousy, bitterness, and family discord. Sometimes equal isn't necessarily fair Under certain circumstances, an equal distribution may not be a fair distribution. Suppose a child has contributed a significant amount of time and effort to the success and profitability of your closely held business. This child has helped you to acquire your wealth. It may be fair to leave this child more than an equal share of your wealth when you are gone, especially if your other children have not contributed to the success of the family business. Value of an asset may vary depending upon who receives it If you are trying to divide your assets into equal shares, you may find that the value of a particular asset to a particular child may vary from the value of that same asset in the hands of another child. For the child who has always worked in the family business, succession may be equal to job security, status, and opportunity. For the child who has never worked in the business, succession may be equal to little more than the liquidation value of the company. Equality of distributions is still up to you There is no law that requires you to equalize distributions to children. It is legal to disinherit a child if you like. However, most parents seek to achieve a distribution of their assets that is at least equitable. When a closely held business is involved, this task can be challenging.

When does equalizing distributions become a problem? Equalizing distributions to your children may become a problem when some of your children participate in your closely held business and others do not. The participating children may be in the best position to take over and own or manage the business. However, if they succeed you as owners, you may have insufficient nonbusiness assets to ensure that your other children receive an equal share of your wealth.

What are the primary planning solutions? If you plan to sell your business, then you do not have an equalization problem. Cash proceeds are easily divisible. If, however, one or more of your children will succeed you in the family business and you have few nonbusiness assets, then you may be facing an equalization problem. If you decide you want to achieve a more equal distribution between your participating and nonparticipating children, you should consider the following planning solutions. Two or more of these plans can be combined or modified to help you achieve your goals. Joint ownership Joint ownership, also known as joint tenancy, is one of the ways two or more people, called joint tenants, can own something together. As joint tenants, each owns the whole property and is entitled to use it as he or she sees fit. Joint tenancy allows you to avoid probate, which can be time consuming and costly. If one joint tenant dies, the property automatically passes to the surviving joint tenant.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 60 of 103

You can equalize distributions to your participating and nonparticipating children by granting them joint ownership of your closely held business. As joint owners, they each own an undivided and equal interest in the entire business. Example(s): Hal owns a home heating oil business worth $200,000 and nonbusiness assets worth $120,000. He has two children, Bob and Ken. Assuming that Bob and Ken want to be involved in the business, Hal can divide his nonbusiness assets equally between them and leave his business to them as joint owners. As joint owners, they share ownership of the company. Each will possess an undivided one-half interest in the entire company and have an equal distribution of the company.

Caution: Granting joint ownership of your closely held business may be a taxable gift, subject to gift tax. Nonvoting stock Nonvoting stock is stock that is issued without voting rights. It allows your nonparticipating children to share ownership of the business without having any control over business decisions and operations. Example(s): Ken works in the family business. Nellie-Mae does not. Ted can create voting stock that will be left to Ken and nonvoting stock that will be left to Nellie-Mae. Ken will have control of the business, free from any interference from Nellie-Mae. Nellie-Mae can sell her stock back to the company for cash or keep it and collect dividends, assuming dividends are generated. Minority position with buy-sell over time A minority position with a buy-sell over time is a way to pass control of the business to your participating children and draw cash out of the business for distribution to your nonparticipating children. The cash is generated by forcing the company to repurchase your shares of stock upon your death using a buy-sell agreement. Example(s): Ted transfers stock to Ken to make him a minority shareholder. Ted, Ken, and the company agree that, upon Ted's death, the company will repurchase Ted's remaining stock by making payments over a period of time. The payments will go to Nellie-Mae. Spin-off A spin-off is a way to leave a portion of your business to your participating children and sell off the remaining portion. Proceeds from the sale will provide cash for your nonparticipating children. Example(s): Ken works in the installation and service department of the family business. Ted can create a new company by spinning off his installation and service department. He can then transfer the new company to Ken and sell the remaining portion of the original business. The proceeds from the sale will be available for distribution to Nellie-Mae. Life insurance This is a way to leave the family business to your participating children and leave life insurance proceeds of equal value to your nonparticipating children. Example(s): Ted's business purchases a life insurance policy that will pay Nellie-Mae $80,000 upon Ted's death. Ted will also leave $120,000 of nonbusiness assets to Nellie-Mae. Ted will leave the business, valued at $200,000, to Ken. Each child will receive assets worth $200,000. Shareholder agreement A shareholder agreement can be used to leave equal amounts of stock to each child, ensure that the stock remains in the family, and allow children an option with respect to their inheritance. Participating children have the opportunity to buy their siblings' stock, while nonparticipating children have the option to sell their stock, but only

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 61 of 103

after offering the participating children the first option to buy. Example(s): Ted arranges to have appropriate rules and restrictions regarding future transfers placed on the stock. He will leave equal shares of stock to both Ken and Nellie-Mae. If Ken chooses, he can repurchase Nellie-Mae's stock according to the rules. Similarly, Nellie-Mae can sell her stock but must give Ken the first option to buy. Will or trust with equalization clauses A will or trust with an equalization clause directs your executor to equalize treatment among children before making final distributions of your wealth. This works only if you have sufficient nonbusiness assets to distribute to the nonparticipating child. Example(s): Ted adds an equalization clause to his will or trust, instructing his executor to ensure that Nellie-Mae receives a distribution that is equal in value to the value of the business received by Ken.

What are the factors to consider when reviewing planning solutions? How much control each child has over business Several factors will likely play a part in your decision to adopt any of the aforementioned planning solutions. You may want to consider who will control the family business and whether that control should be shared. When you transfer business assets to your nonparticipating children, you may also be transferring a degree of control to them, so you will want to determine whether this is appropriate and plan accordingly. What sources of funding are available Another factor is funding. Many planning solutions require funding. Often an equalization plan provides that stock must be repurchased or redeemed. The source of funding might be a life insurance policy, future profits of the business, a partial sale of business assets, or the personal savings of your children. The source and availability of funds may be a factor in determining which planning solution you adopt. Whether timing of distributions will affect children Timing of the distribution is also a factor. Several planning solutions provide that nonparticipating children receive a stream of payments over a period of years rather than a lump-sum inheritance. Some planning solutions may require participating children to temporarily share ownership of the family business until a future date. Timing considerations should be evaluated in accordance with your family's needs. Whether business is likely to remain liquid Finally, the success of several planning solutions is contingent on the future success of the business. Some of your children may be relying on the performance of other children for their inheritance. The degree to which you are comfortable with such an arrangement may help you in choosing a strategy for equalizing distributions.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 62 of 103

Business Succession Planning Alternatives

If you want to:

Lifetime gifts Bequest

Lifetime sale

Estate sale

Buy-sell agreement

Not appropriate

Not appropriate

You may be able to sell your business outright-but there is no guarantee

Your estate may be able to sell your business outright-but there is no guarantee

Buy-sell agreement can be used to guarantee the sale of your business

You can control the timing and size of the gifts

You control the size of the gift through your will

Not appropriate Not appropriate

Not appropriate

Can be used in conjunction with sale

Not appropriate

You can control timing of sale-but sale is not guaranteed

Buy-sell can be used to guarantee your child's option to buy your interest

Can be used to reduce the value of your estate and maximize gift tax exclusion

Will not minimize value of your estate

You can control Value of business timing of must be included sale-but sale is in your estate not guaranteed

Sell your business interest

If you want to: Give business to your children

If you want to: Sell business to your children

If you want to: Minimize value of your estate

Your child could buy from your estate-but sale is not guaranteed

Value of business must be included in your estate, but the buy-sell can help establish that value

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 63 of 103

Select Options for Preserving a Family Business for Children Family Limited Partnership

Private Annuity

Self-Canceling Grantor Installment Retained Note Annuity Trust

Lifetime Gifts

Provides liquidity?

No

Yes

Yes

Yes

No

Minimizes federal gift tax?

• To the extent of the annual gift tax exclusion and the lifetime gift tax exemption • Value of gifts may be discounted

Yes, to the extent the fair value of the business does not exceed the present value of the annuity

Generally, yes

Yes, to the extent the fair value of the business does not exceed the present value of the annuity

To the extent of the annual gift tax exclusion and the lifetime gift tax exemption

Minimizes federal estate tax?

Shifts future appreciation to children

Yes, but not to the extent payments are received back into your estate

Yes, but not to the extent payments are received back into your estate

Yes, but not to the extent payments are received back into your estate

Shifts future appreciation to children

Minimizes federal income tax?

Shifts FLP income to children, who may be in lower tax brackets

• Generally, • Payments payments are are return of return of basis, capital basis and/or gain, and/or interest interest (ordinary (ordinary income) income) • You pay • You pay income tax income tax on interest on interest income income

• You pay no Yes income tax on annuity payments • You pay taxes on all income earned by the trust

Minimizes Yes, but federal capital children do not gains tax? receive a "step up" in cost basis for gifted interests

No, generally, for exchanges made after October 18, 2006

Capital gain can be reported over the period payments are received

Yes, but children do not receive a "step up" in cost basis

Yes, but children do not receive a "step up" in cost basis

Lets you retain control of the business?

Yes

No

No

Yes

No

Provides lifetime income?

To extent you receive FLP income

Yes

Yes

Provides income for stated term of years only

No

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 64 of 103

Protection against creditors?

• Yes, if general partner is a corporation • Limited partners have no personal liability for business debts

Payments received are subject to creditors

Payments received are subject to creditors

Payments received are subject to creditors

• Your creditors cannot reach gifted interests • Gifted interests are subject to your children's creditors

Any risk?

No

• You may die before receiving full payment • The buyer's obligation is unsecured

You may die before receiving full payment

No

No

Formalities?

Many

• Transfer title • Execute agreement

• Transfer title • Execute note

• Transfer title • Execute trust

Transfer title

Costly?

Yes

Can be costly

Can be costly

Can be costly

No

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 65 of 103

Overview of Buy-Sell Agreement Forms Agreement form Wait and see

Trusteed cross purchase

Buyer Business entity, co-owner, or both

Co-owner Transaction overseen by trustee

Works well with

Unsuitable for

Business with two or more owners

Sole proprietor and single-shareholder corporation

Business with two or more owners

Sole proprietor and single-shareholder corporation

Simplifies plan when large number of owners

Entity purchase (stock redemption)

Business entity

Business with two or more owners

Most expensive type

Section 302 stock redemption

Business entity

Business with two or more owners

Sole proprietor and single-shareholder corporation

Section 303 stock redemption

Business entity

Business with two or more owners, especially family business

Sole proprietor and single-shareholder corporation

Reverse Section 303 stock redemption

Business entity

Business with two or more owners, especially family business

Sole proprietor and single- shareholder corporation

Cross purchase (crisscross) agreement

Co-owner

Business with two or more owners

Sole proprietor and single-shareholder corporation Large number of owners (gets complicated with four or more)

Option plan

Business entity, co-owner, or any eligible third party Sale not guaranteed

One-way buy-sell

Business entity, co-owner, or any eligible third party

Business with any number of owners, including sole proprietorship and single-shareholder corporation

Any scenario where guaranteed sale is needed

Business with any number of owners, including sole proprietorship and single-shareholder corporation

Sole proprietor with no willing buyer

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 66 of 103

Buy-Sell: Cross Purchase vs. Entity Purchase vs. Wait and See Nineteen questions you should consider when choosing a buy-sell agreement Factors to consider

Cross Purchase

Entity Purchase

Wait and See

What is the form of business entity?

Any business with multiple owners

Any business with multiple owners

Any business with multiple owners

Who is the buyer?

Co-owner

Business entity

Business entity Co-owner Both

Who is the seller?

Shareholder Family or estate of shareholder

Shareholder Family or estate of shareholder

Shareholder Family or estate of shareholder

Can life insurance be used to fund agreement?

Yes, generally each shareholder is applicant, owner, payor and beneficiary of life insurance on other shareholders

Yes, generally business entity is applicant, owner, payor and beneficiary of life insurance on each shareholder

Yes, each shareholder could buy life insurance on each other, the business could buy, or both

How many policies will be needed?

Multiple policies needed Formula used is: n(n-1)

Number of policies is minimal Only one policy per shareholder needed

Depends on who is buying the life insurance-business or shareholders

n = number of shareholders Are the premiums deductible?

Premiums are not tax-deductible expense to shareholders

Premiums are not tax-deductible expense to business

Premiums are not tax-deductible expense to shareholders or business

Are death proceeds taxable?

Received by surviving shareholders tax free

Received by business entity tax free Alternative Minimum Tax (AMT) may apply

Received by surviving shareholders or business entity tax free Alternative Minimum Tax (AMT) may apply

Are death proceeds subject to claims of creditors?

In most states, death proceeds on personally owned policies are exempt from claims of creditor Some states limit amount of proceeds exempted

Corporate creditors can usually claim against cash value and proceeds of life insurance owned by the business

Corporate creditors can't reach proceeds of personally owned policies, but they can claim against proceeds of life insurance owned by the business

Does business have a right to death proceeds?

Proceeds available to business only if surviving shareholders willing to make loan or capital contribution

Business entity has right to death proceeds when it is policy beneficiary

Business entity has right to death proceeds when it is policy beneficiary Proceeds payable to shareholders available to business only if individuals willing to make loan or capital contribution

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 67 of 103

What happens to stock basis of remaining shareholders?

Basis increases by amount equal to price paid by shareholder for stock

No increase in shareholder's basis Value of stock owned by remaining shareholders increases when corporation retires stock or holds as treasury stock

Basis increases by amount equal to price paid by shareholder for stock No increase in shareholder's basis for stock bought by business entity

What if co-owners are related and business is a corporation?

Not an issue

Attribution rules apply when stock is purchased by business entity In family corporation redemption of stock usually results in dividend

Attribution rules apply when stock is purchased by business entity

What if there is a need to change from one type of insurance funded buy-sell to another?

Transfer of existing insurance policies to corporation may be an exception to Transfer-for-Value Rule

Transfer of corporate owned policies to shareholders violates Transfer-for-Value Rule unless an exception applies

Transfer-for-Value Rule applies unless an exception

Which plan has most flexibility?

Agreement with multiple shareholders can be cumbersome when funded with life insurance Adding new shareholders to plan may be complicated

Can't be used by a corporation with only one shareholder or a sole proprietorship Can add new shareholders to plan with unanimous consent to amend agreement

Maximum flexibility, options Can't be used by corporation with only one shareholder or a sole proprietorship

Is value of insurance included in estate of decedent shareholder?

Value of policies owned on other shareholders included in estate Proceeds of policies on own life are generally not included in estate

Value of proceeds payable to business may indirectly increase decedent's estate by increasing the value of corporation

Value of policies owned on other shareholders included in estate Proceeds of policy on own life not included, but business owned policy proceeds may inflate value of corporation

Are ownership amounts or percentages affected?

Remaining shareholder's ownership percentages can remain same or change, depending on amount of stock purchased by each

Ownership ratios of remaining shareholders increased pro rata by the amount of stock redeemed by business entity

Remaining shareholder's ownership percentages can remain same or change, depending on stock purchased and previous ownership

Does state law apply?

If professional corporation state law restricts sale to other professional

State corporate law allows a corporation to buy its own shares only from surplus funds Redemption prohibited if would make a corporation insolvent

Local law, corporate charter and by laws must be examined for possible restrictions

Can add new shareholders to plan with unanimous consent to amend agreement

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 68 of 103

Could there be a problem when transferring the policies which decedent owned on surviving shareholders?

Potential Transfer-for-Value problem at shareholder's death when decedent's interest in policies is transferred to surviving shareholders

If policies are owned by corporation, there is no need to transfer at decedent's death

Potential Transfer-for-Value problem when decedent's policy interest is transferred to surviving shareholders No need to transfer if policy is corporate owned

What happens if business earnings accumulate to fund buy-sell?

No corporate funds used Usually no Accumulated Earnings Tax issue

Business funds accumulated in advance of shareholder death for purpose of stock redemption may be subject to Accumulated Earnings Tax unless business purpose can be proven

If no corporate funds used usually not an issue If business purpose for accumulation can be proven may not be an issue

Are there any estate tax effects to shareholder?

If the estate is bound to sell and certain conditions are met, the agreed price typically will control for Federal Estate Tax purposes Sale price included in estate

If the estate is bound to sell and certain conditions are met, the agreed price typically will control for Federal Estate Tax purposes Sale price included in estate

If estate is bound to sell and certain conditions are met, the agreed price typically will control for Federal Estate Tax purposes Sale price included in estate

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 69 of 103

Buy-Sell: Cross Purchase vs. Entity Purchase vs. Section 303 Stock Redemption Nineteen questions you should consider when choosing a buy-sell agreement Factors to consider

Cross Purchase

Entity Purchase

Section 303 Stock Redemption

What is the form of business entity?

Any business with multiple owners

Any business with multiple owners

Any business with multiple owners especially family corporation

Who is the buyer?

Co-owner

Business entity

Business entity

Who is the seller?

Shareholder or family or estate of shareholder

Shareholder or family or estate of shareholder

Family or estate of shareholder

Can life insurance be used to fund agreement?

Yes, generally each shareholder is applicant, owner, payor and beneficiary of life insurance on other shareholders

Yes, generally business entity is applicant, owner, payor and beneficiary of life insurance on each shareholder

Yes, business could be applicant, owner, payor, and beneficiary of life insurance on each shareholder In family corporation family members could own policy

How many policies will be needed?

Multiple policies needed Formula used is: n(n-1)

Number of policies is minimal Only one policy per shareholder needed

Number of policies is minimal Only one policy per shareholder needed

n = number of shareholders Are the premiums deductible?

Premiums are not tax-deductible expense to shareholders

Premiums are not tax-deductible expense to corporation

Premiums are not tax-deductible expense to business or family member

Are death proceeds taxable?

Received by surviving shareholders tax free

Received by business entity tax free Alternative Minimum Tax (AMT) may apply

Received by business entity tax free Alternative Minimum Tax (AMT) may apply

Are death proceeds subject to claims of creditors?

In most states, death proceeds on personally owned policies are exempt from claims of creditor Some states limit amount of proceeds exempted

Corporate creditors can usually claim against cash value and proceeds of life insurance owned by the business

Corporate creditors can't reach proceeds of personally owned policies, but they can claim against proceeds of life insurance owned by the business

Does business have a right to death proceeds?

Proceeds available to business only if surviving shareholders willing to make loan or capital contribution

Business entity has right to death proceeds when it is policy beneficiary

Business entity has right to death proceeds when it is policy beneficiary Proceeds payable to family available to business only if family member willing to make loan or capital contribution

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 70 of 103

What happens to stock basis of remaining shareholders?

Basis increases by amount equal to price paid by shareholder for stock

No increase in shareholder's basis Value of stock owned by remaining shareholders increases when corporation retires stock or holds as treasury stock

No increase in shareholder's basis Value of stock owned by remaining shareholders increases when corporation retires stock or holds as treasury stock.

What if co-owners are related and business is a corporation?

Not an issue

Attribution rules apply when stock purchased by business entity In family corporation redemption of stock usually results in dividend

Attribution rules specifically do not apply to this type of transaction

What if there is a need to change from one type of insurance funded buy-sell to another?

Transfer of existing insurance policies to corporation may be an exception to Transfer-for-Value Rule

Transfer of corporate owned policies to shareholders violates Transfer-for-Value Rule unless an exception applies

Transfer of corporate owned policies to shareholders violates Transfer-for-Value Rule unless an exception applies

Which plan has most flexibility?

Agreement with multiple shareholders can be cumbersome when funded with life insurance Adding new shareholders to plan may be complicated

Can't be used by a corporation with only one shareholder or a sole proprietorship Can add new shareholders to plan with unanimous consent to amend agreement

Authorizes partial redemption of decedent's stock with favorable tax treatment Amount of stock redeemed is limited

Is value of insurance included in estate of decedent shareholder?

Value of policies owned on other shareholders included in estate Proceeds of policies on own life are generally not included in estate

Value of proceeds payable to business may indirectly increase decedent's estate by increasing the value of corporation

Value of proceeds payable to business may indirectly increase decedent's estate by increasing the value of corporation

Are ownership amounts or percentages affected?

Remaining shareholder's ownership percentages can remain same or change, depending on amount of stock purchased by each

Ownership ratios of remaining shareholders increased pro rata by the amount of stock redeemed by business entity

Ownership ratios of remaining shareholders increased pro rata by the amount of stock redeemed by business entity

Does state law apply?

If professional corporation state law restricts sale to other professional

State corporate law allows a corporation to buy its own shares only from surplus funds Redemption prohibited if would make a corporation insolvent

State corporate law allows a corporation to buy its own shares only from surplus funds Redemption prohibited if would make a corporation insolvent

Could there be a problem when transferring the policies which decedent owned on surviving shareholders?

Potential Transfer-for-Value problem at shareholder's death when decedent's interest in policies is transferred to surviving shareholders

If policies are owned by corporation, there is no need to transfer at decedent's death

If policies are owned by corporation, there is no need to transfer at decedent's death

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 71 of 103

What happens if business earnings accumulate to fund buy-sell?

No corporate funds used Usually no Accumulated Earnings Tax issue

Business funds accumulated in advance of shareholder death for purpose of stock redemption may be subject to Accumulated Earnings Tax unless business purpose can be proven

Business funds accumulated in advance of shareholder death for purpose of stock redemption may be subject to Accumulated Earnings Tax unless business purpose can be proven

Are there any estate tax effects to shareholder?

If the estate is bound to sell and certain conditions are met, the agreed price typically will control for Federal Estate Tax purposes Sale price included in estate

If the estate is bound to sell and certain conditions are met, the agreed price typically will control for Federal Estate Tax purposes Sale price included in estate

If estate is bound to sell and certain conditions are met, the agreed price typically will control for Federal Estate Tax purposes Sale price included in estate

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 72 of 103

Buy-Sell: Cross Purchase vs. Entity Purchase vs. Trusteed Cross Purchase Nineteen questions you should consider when choosing a buy-sell agreement Factors to consider

Cross Purchase

Entity Purchase

Trusteed Cross Purchase

What is the form of business entity?

Any business with multiple owners

Any business with multiple owners

Any business with multiple owners

Who is the buyer?

Co-owner

Business entity

Co-owner

Who is the seller?

Shareholder or family or estate of shareholder

Shareholder or family or estate of shareholder

Shareholder or family or estate of shareholder

Can life insurance be used to fund agreement?

Yes, generally each shareholder is applicant, owner, payor and beneficiary of life insurance on other shareholders

Yes, generally business entity is applicant, owner, payor and beneficiary of life insurance on each shareholder

Yes, trustee could be applicant, owner, payor, and beneficiary of life insurance on each shareholder

How many policies will be needed?

Multiple policies needed Formula used is: n(n-1)

Number of policies is minimal Only one policy per shareholder needed

Number of policies is minimal Generally one policy per shareholder when trustee is policyowner

n = number of shareholders Are the premiums deductible?

Premiums are not tax-deductible expense to shareholders

Premiums are not tax-deductible expense to business

Premiums are not tax-deductible expense to trustee

Are death proceeds taxable?

Received by surviving shareholders tax free

Received by business entity tax free Alternative Minimum Tax (AMT) may apply

Received by trustee tax free Alternative Minimum Tax (AMT) may apply

Are death proceeds subject to claims of creditors?

In most states, death proceeds on personally owned policies are exempt from claims of creditor Some states limit amount of proceeds exempted

Corporate creditors can usually claim against cash value and proceeds of life insurance owned by the business

Depending upon structure of the trust, trustee owned life insurance may be exempt from claims of creditors

Does business have a right to death proceeds?

Proceeds available to business only if surviving shareholders willing to make loan or capital contribution

Business entity has right to death proceeds when it is policy beneficiary

Proceeds available to business only if surviving shareholders willing to make loan or capital contribution

What happens to stock basis of remaining shareholders?

Basis increases by amount equal to price paid by shareholder for stock

No increase in shareholder's basis Value of stock owned by remaining shareholders increases when corporation retires stock or holds as treasury stock

Basis increases by amount equal to price paid by shareholder for stock

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 73 of 103

What if co-owners are related and business is a corporation?

Not an issue

Attribution rules apply when stock purchased by business entity In family corporation redemption of stock usually results in dividend

Not an issue

What if there is a need to change from one type of insurance funded buy-sell to another?

Transfer of existing insurance policies to corporation may be an exception to Transfer-for-Value Rule

Transfer of corporate owned policies to shareholders violates Transfer-for-Value Rule unless an exception applies

Transfer of existing insurance policies to corporation may be an exception to Transfer-for-Value Rule

Which plan has most flexibility?

Agreement with multiple shareholders can be cumbersome when funded with life insurance Adding new shareholders to plan may be complicated

Can't be used by a corporation with one shareholder or a sole proprietorship Can add new shareholders to plan with unanimous consent to amend agreement

Use of trustee reduces number of policies and administrative effort needed

Is value of insurance included in estate of decedent shareholder?

Value of policies owned on other shareholders included in estate Proceeds of policies on own life are not included in estate

Value of proceeds payable to business may indirectly increase decedent's estate by increasing the value of corporation

Proceeds payable to trustee are not included in shareholder estate Value of interest in policies owned on other shareholders included in estate

Are ownership amounts or percentages affected?

Remaining shareholder's ownership percentages can remain same or change, depending on amount of stock purchased by each

Ownership ratios of remaining shareholders increased pro rata by the amount of stock redeemed by business entity

Remaining shareholder's ownership percentages can remain same or change, depending on amount of stock purchased by each

Does state law apply?

If professional corporation state law restricts sale to other professional

State corporate law allows a corporation to buy its own shares only from surplus funds Redemption prohibited if would make a corporation insolvent

If professional corporation state law restricts sale to other professional

Could there be a problem when transferring the policies which decedent owned on surviving shareholders?

Potential Transfer-for-Value problem at shareholder's death when decedent's interest in policies is transferred to surviving shareholders

If policies are owned by corporation, there is no need to transfer at decedent's death

Potential Transfer-for-Value problem when decedent's interest in policies held by Trustee is transferred to surviving shareholders

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 74 of 103

What happens if business earnings accumulate to fund buy-sell?

No corporate funds used Usually no Accumulated Earnings Tax issue

Business funds accumulated in advance of shareholder death for purpose of stock redemption may be subject to Accumulated Earnings Tax unless business purpose can be proven

If no corporate funds used, usually no Accumulated Earnings Tax issue

Are there any estate tax effects to shareholder?

If the estate is bound to sell and certain conditions are met, the agreed price typically will control for Federal Estate Tax purposes Sale price included in estate

If the estate is bound to sell and certain conditions are met, the agreed price typically will control for Federal Estate Tax purposes Sale price included in estate

If estate is bound to sell and certain conditions are met, the agreed price typically will control for Federal Estate Tax purposes Sale price included in estate

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 75 of 103

Buy-Sell: Cross Purchase vs. Entity Purchase vs. One-Way Nineteen questions you should consider when choosing a buy-sell agreement Factors to consider

Cross purchase

Entity purchase

One-way

What is the form of business entity?

Any business with multiple owners

Any business with multiple owners

Business with any number of owners including sole proprietorship

Who is the buyer?

Co-owner

Business entity

Business entity, co-owner, key employee, or any eligible third party

Who is the seller?

Shareholder or family or estate of shareholder

Shareholder or family or estate of shareholder

Shareholder or family or estate of shareholder

Can life insurance be used to fund agreement?

Yes, generally each shareholder is applicant, owner, payer, and beneficiary of life insurance on other shareholders

Yes, generally business entity is applicant, owner, payer, and beneficiary of life insurance on each shareholder

Yes, buyer under agreement could be applicant, owner, payer, and beneficiary on policy on life of seller

How many policies will be needed?

Multiple policies needed Formula used is: n(n-1) n = number of shareholders

Number of policies is minimal Only one policy per shareholder needed

Number of policies is minimal Only one policy per shareholder needed

Are the premiums deductible?

Premiums are not tax-deductible expense to shareholders

Premiums are not tax-deductible expense to business

Premiums are not tax-deductible expense to buyer

Are death proceeds taxable?

Received by surviving shareholders tax free

Received by business entity tax free Alternative minimum tax (AMT) may apply

Received by beneficiary tax free Alternative minimum tax (AMT) may apply if proceeds received by business

Are death proceeds subject to claims of creditors?

In most states, death proceeds on personally owned policies are exempt from claims of creditor Some states limit amount of proceeds exempted

Corporate creditors can usually claim against cash value and proceeds of life insurance owned by the business

Corporate creditors can't reach proceeds of personally owned policies, but they can claim against proceeds of life insurance owned by the business

Does business have a right to death proceeds?

Proceeds available to business only if surviving shareholders willing to make loan or capital contribution

Business entity has right to death proceeds when it is policy beneficiary

Business entity has right to death proceeds when it is policy beneficiary Proceeds payable to individual available to business only if individual willing to make loan or capital contribution

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 76 of 103

What happens to stock basis of remaining shareholders?

Basis increases by amount equal to price paid by shareholder for stock

No increase in shareholder's basis Value of stock owned by remaining shareholders increases when corporation retires stock or holds as treasury stock

Basis increases by amount equal to price paid by individual for stock No increase in shareholder's basis for stock bought by business entity

What if co-owners are related and business is a corporation?

Not an issue

Attribution rules apply when stock is purchased by business entity In family corporation, redemption of stock usually results in dividend

Attribution rules apply when stock is purchased by business entity

What if there is a need to change from one type of insurance funded buy-sell to another?

Transfer of existing insurance policies to corporation may be an exception to transfer-for-value rule

Transfer of corporate-owned policies to shareholders violates transfer-for-value rule unless an exception applies

Typically the plan would not change

Which plan has most flexibility?

Agreement with multiple shareholders can be cumbersome when funded with life insurance Adding new shareholders to plan may be complicated

Can't be used by a corporation with one shareholder or a sole proprietorship Can add new shareholders to plan with unanimous consent to amend agreement

If buyer dies before seller, seller has no obligation under agreement terms

Is value of insurance included in estate of decedent shareholder?

Value of policies owned on other shareholders included in estate Proceeds of policies on own life are not included in estate

Value of proceeds payable to business may indirectly increase decedent's estate by increasing the value of corporation

Proceeds of policy on own life not included, but business-owned policy proceeds may inflate value of corporation and decedent's estate

Are ownership amounts or percentages affected?

Remaining shareholder's ownership percentages can remain same or change, depending on amount of stock purchased by each

Ownership ratios of remaining shareholders increased pro rata by the amount of stock redeemed by business entity

Buyer's ownership percentage can remain same or change, depending on amount of stock purchased and previous ownership

Does state law apply?

If professional corporation, state law restricts sale to other professional

State corporate law allows a corporation to buy its own shares only from surplus funds Redemption prohibited if it would make a corporation insolvent

If professional corporation, state law restricts sale to other professional or business entity itself

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 77 of 103

Could there be a problem when transferring the policies that decedent owned on surviving shareholders?

Potential transfer-for-value problem at shareholder's death when decedent's interest in policies is transferred to surviving shareholders

If policies are owned by corporation, there is no need to transfer at decedent's death

Typically not an issue since buyer is usually only owner of policy on seller

What happens if business earnings accumulate to fund buy-sell?

No corporate funds used Usually no accumulated earnings tax issue

Business funds accumulated in advance of shareholder death for purpose of stock redemption may be subject to accumulated earnings tax unless business purpose can be proven

If no corporate funds used, usually not an issue If business purpose for accumulation can be proven, may not be an issue

Are there any estate tax effects to shareholder?

If the estate is bound to sell and certain conditions are met, the agreed price typically will control for federal estate tax purposes Sale price included in estate

If the estate is bound to sell and certain conditions are met, the agreed price typically will control for federal estate tax purposes Sale price included in estate

If estate is bound to sell and certain conditions are met, the agreed price typically will control for federal estate tax purposes Sale price included in estate

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 78 of 103

Buy-Sell: Cross Purchase vs. Entity Purchase vs. Section 302 Stock Redemption Nineteen questions you should consider when choosing a buy-sell agreement Factors to consider

Cross Purchase

Entity Purchase

Section 302 Stock Redemption

What is the form of business entity?

Any business with multiple owners

Any business with multiple owners

Any business with multiple owners

Who is the buyer?

Co-owner

Business entity

Business entity

Who is the seller?

Shareholder or family or estate of shareholder

Shareholder or family or estate of shareholder

Shareholder or family or estate of shareholder

Can life insurance be used to fund agreement?

Yes, generally each shareholder is applicant, owner, payor and beneficiary of life insurance on other shareholders

Yes, generally business entity is applicant, owner, payor and beneficiary of life insurance on each shareholder

Yes, business entity could be applicant, owner, payor, and beneficiary on policy on life of seller

How many policies will be needed?

Multiple policies needed Formula used is: n(n-1)

Number of policies is minimal Only one policy per shareholder needed

Number of policies is minimal Only one policy per shareholder needed

n = number of shareholders Are the premiums deductible?

Premiums are not tax-deductible expense to shareholders

Premiums are not tax-deductible expense to business

Premiums are not tax-deductible expense to business

Are death proceeds taxable?

Received by surviving shareholders tax free

Received by business entity tax free Alternative Minimum Tax (AMT) may apply

Received by business entity tax free Alternative Minimum Tax (AMT) may apply

Are death proceeds subject to claims of creditors?

In most states, death proceeds on personally owned policies are exempt from claims of creditor Some states limit amount of proceeds exempted

Corporate creditors can usually claim against cash value and proceeds of life insurance owned by the business

Corporate creditors can usually claim against cash value and proceeds of life insurance owned by the business

Does business have a right to death proceeds?

Proceeds available to business only if surviving shareholders willing to make loan or capital contribution

Business entity has right to death proceeds when it is policy beneficiary

Business entity has right to death proceeds when it is policy beneficiary

What happens to stock basis of remaining shareholders?

Basis increases by amount equal to price paid by shareholder for stock

No increase in shareholder's basis. Value of stock owned by surviving shareholders increases when corporation retires stock or holds as treasury stock

No increase in shareholder's basis. Value of stock owned by surviving shareholders increases when corporation retires stock or holds as treasury stock

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 79 of 103

What if co-owners are related and business is a corporation?

Not an issue

Attribution rules apply when stock purchased by business entity In family corporation redemption of stock usually results in dividend

Attribution rules apply when stock purchased by business entity In family corporation redemption of stock usually results in dividend

What if there is a need to change from one type of insurance funded buy-sell to another?

Transfer of existing insurance policies to corporation may be an exception to Transfer-for-Value Rule

Transfer of corporate owned policies to shareholders violates Transfer-for-Value Rule unless an exception applies

Transfer of corporate owned policies to shareholders violates Transfer-for-Value Rule unless an exception applies

Which plan has most flexibility?

Agreement with multiple shareholders can be cumbersome when funded with life insurance Adding new shareholders to plan may be complicated

Can't be used by a corporation with one shareholder or a sole proprietorship Can add new shareholders to plan with unanimous consent to amend agreement

Can't be used by a corporation with one shareholder or a sole proprietorship Can add new shareholders to plan with unanimous consent to amend agreement

Is value of insurance included in estate of decedent shareholder?

Value of policies owned on other shareholders included in estate Proceeds of policies on own life are not included in estate

Value of proceeds payable to business may indirectly increase decedent's estate by increasing the value of corporation

Value of proceeds payable to business may indirectly increase decedent's estate by increasing the value of corporation

Are ownership amounts or percentages affected?

Remaining shareholder's ownership percentages can remain same or change, depending on amount of stock purchased by each

Ownership ratios of remaining shareholders increased pro rata by the amount of stock redeemed by business entity

Ownership ratios of remaining shareholders increased pro rata by the amount of stock redeemed by business entity

Does state law apply?

If professional corporation state law restricts sale to other professional

State corporate law allows a corporation to buy its own shares only from surplus funds Redemption prohibited if would make a corporation insolvent

State corporate law allows a corporation to buy its own shares only from surplus funds Redemption prohibited if would make a corporation insolvent

Could there be a problem when transferring the policies which decedent owned on surviving shareholders?

Potential Transfer-for-Value problem at shareholder's death when decedent's interest in policies is transferred to surviving shareholders

If policies are owned by corporation, there is no need to transfer at decedent's death

If policies are owned by corporation, there is no need to transfer at decedent's death

What happens if business earnings accumulate to fund buy-sell?

No corporate funds used Usually no Accumulated Earnings Tax issue

Business funds accumulated in advance of shareholder death for purpose of stock redemption may be subject to Accumulated Earnings Tax unless business purpose can be proven

Business funds accumulated in advance of shareholder death for purpose of stock redemption may be subject to Accumulated Earnings Tax unless business purpose can be proven

See disclaimer on final page March 28, 2010


LifeFocus.com Are there any estate tax effects to shareholder?

Page 80 of 103 If the estate is bound to sell and certain conditions are met, the agreed price typically will control for Federal Estate Tax purposes Sale price included in estate

If the estate is bound to sell and certain conditions are met, the agreed price typically will control for Federal Estate Tax purposes Sale price included in estate

If estate is bound to sell and certain conditions are met, the agreed price typically will control for Federal Estate Tax purposes Sale price included in estate

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 81 of 103

Comparison of Buy-Sell Funding Methods Funding Method

Seller Advantages

Seller Disadvantages

Lump-Sum Cash

Seller gets money up front

Seller may not get money if buyer doesn't have it

Private Annuity

Often used in family transfers Can lower seller's estate value

Seller becomes unsecured creditor of buyer

Borrowings

Seller gets money up front

Seller may not get money if buyer doesn't have access to credit

Installment Payments

Seller can set favorable interest rate Gain can be spread over time

Seller becomes creditor of buyer

Sale-Leaseback

Seller gets money up front

No guarantee sale-leaseback transaction will occur

Section 303 Stock Redemption

Seller receives cash for estate settlement

Seller not guaranteed cash--company may not be able to redeem stock under local law

Deferred Compensation

Seller receives payments beginning at retirement or withdrawal

Business may not be able to make payments

Appreciated Property Bailout

Seller receives asset in exchange for stock

Seller does not receive cash

Life Insurance

Seller gets money up front

Seller may be uninsurable

Disability Insurance

Seller can "cash out" of business after disability

Seller may be uninsurable Seller could recover from disability, no longer have a business

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 82 of 103

Beneficiary Designations for Buy-Sell Agreements Funded with Life Insurance The general rule is that the party with the obligation to make the purchase of the business interest at an owner's death is the party that should be the beneficiary of the funding life insurance policy. As such, the logical beneficiaries for each form of buy-sell agreement are shown below. Surviving spouse/heir

Business entity

Buyer

Seller's estate

Trustee

Entity purchase agreement

No

Logical

No

No

Can be used, but not common

Cross purchase agreement

No

No

Logical

No

If a trusteed cross purchase

Trusteed cross purchase

No

No

No

No

Logical

Wait and see agreement

No

Maybe

Maybe

No

Maybe

Section 302 stock redemption

No

Logical

No

No

No

Section 303 stock redemption

Maybe

Logical

No

No

No

Reverse Section 303 redemption

Logical

No

No

No

No

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 83 of 103

Planning for Succession of a Business Interest

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 84 of 103

Cross Purchase: During Lifetime

See At Death

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 85 of 103

Cross Purchase: At Death

See During Lifetime

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 86 of 103

Entity Purchase Buy-Sell: During Lifetime

See At Death

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 87 of 103

Entity Purchase Disability Buyout: During Lifetime

See When Disability Occurs

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 88 of 103

Wait and See Buy-Sell: During Lifetime

See At Death

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 89 of 103

Wait and See Buy-Sell: At Death

Business has option to purchase X's stock

If business does not exercise option or purchases less than all of X's stock, Owner Y has a second option to purchase X's stock

Business is required to purchase any of X's stock not purchased

See During Lifetime

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 90 of 103

Business Valuation Diagram

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 91 of 103

Transferring Your Family Business As a business owner, you're going to have to decide when will be the right time to step out of the family business and how you'll do it. There are many estate planning tools you can use to transfer your business. Selecting the right one will depend on whether you plan to retire from the business or keep it until you die. Perhaps you have children or other family members who wish to continue the business after your death. Obviously, you'll want to transfer your business to your successors at its full value. However, with income, gift, and potential estate taxes, it takes careful planning to prevent some (or all) of the business assets from being sold to pay them, perhaps leaving little for your beneficiaries. Therefore, business succession planning must include ways not only to ensure the continuity of your business, but also to do so with the smallest possible tax consequences. Some of the more common strategies for minimizing taxes are explained briefly in the following sections. Remember, none are without drawbacks. You'll want to consult a tax professional as well as your estate planning attorney to explore all strategies.

You and your estate may get some relief under the Internal Revenue Code If you are prepared to begin transferring some of your business interest to your beneficiaries, a systematic gifting program can help accomplish this while minimizing the gift tax liability that might otherwise be incurred. This is done by utilizing your ability to gift up to $13,000 per year per recipient without incurring gift tax. By transferring portions of your business in this manner, over time you may manage to transfer a significant portion of your business free from gift tax. Clearly, the disadvantage of relying solely on this method of transferring your business is the amount of time necessary to complete the transfer of your entire estate. In addition, Section 6166 of the Internal Revenue Code allows any estate taxes incurred because of the inclusion of a closely held business in your estate to be deferred for 5 years (with interest-only payments for the first four years and interest plus principal due in the fifth year), and then paid in annual installments over a period of up to 10 years. This allows your beneficiaries more time to raise sufficient funds or obtain more favorable interest rates. The business must exceed 35 percent of your gross estate and must meet other requirements to qualify.

Selling your business interest outright When you sell your business interest to a family member or someone else, you receive cash (or assets you can convert to cash) that can be used to maintain your lifestyle or pay your estate taxes. You choose when to sell--now, at your retirement, at your death, or anytime in between. As long as the sale is for the full fair market value (FMV) of the business, it is not subject to gift tax or estate tax. But if the sale occurs before your death, it may be subject to capital gains tax.

Transferring your business interest with a buy-sell agreement A buy-sell agreement is a legal contract that prearranges the sale of your business interest between you and a willing buyer. A buy-sell agreement lets you keep control of your interest until the occurrence of an event that the agreement specifies, such as your retirement, disability, or death. Other events like divorce can also be included as triggering events under a buy-sell agreement. When the triggering event occurs, the buyer is obligated to buy your interest from you or your estate at the FMV. The buyer can be a person, a group (such as co-owners), or the business itself. Price and sale terms are prearranged, which eliminates the need for a fire sale if you become ill or when you die. Remember, you are bound under a buy-sell agreement: You can't sell or give your business to anyone except the buyer named in the agreement without the buyer's consent. This could restrict your ability to reduce the size

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 92 of 103

of your estate through lifetime gifts of your business interest, unless you carefully coordinate your estate planning goals with the terms of your buy-sell agreement.

Grantor retained annuity trusts or grantor retained unitrusts A more sophisticated business succession tool is a grantor retained annuity trust (GRAT) or a grantor retained unitrust (GRUT). GRAT/GRUTs are irrevocable trusts to which you transfer appreciating assets while retaining an income payment for a set period of time. At either the end of the payment period or your death, the assets in the trust pass to the other trust beneficiaries (the remainder beneficiaries). The value of the retained income is subtracted from the value of the property transferred to the trust (i.e., a share of the business), so if you live beyond the specified income period, the business may be ultimately transferred to the next generation at a reduced value for estate tax or gift tax purposes.

Private annuities A private annuity is the sale of property in exchange for a promise to make payments to you for the rest of your life. Here, you transfer complete ownership of the business to family members or another party (the buyer). The buyer in turn makes an unsecured promise to make periodic payments to you for the rest of your life (a single life annuity) or for your life and the life of a second person (a joint and survivor annuity). A joint and survivor annuity provides payments until the death of the last survivor; that is, payments continue as long as either the husband or wife is still alive. Again, because a private annuity is a sale and not a gift, it allows you to remove assets from your estate without incurring gift tax or estate tax. Until recently, exchanging property for an unsecured private annuity allowed you to spread out any capital gain realized, deferring capital gains tax. However, this tax benefit has generally been eliminated. If you're considering a private annuity, be sure to talk to a tax professional.

Self-canceling installment notes A self-canceling installment note (SCIN) allows you to transfer the business to the buyer in exchange for a promissory note. The buyer must make a series of payments to you under that note. A provision in the note states that at your death, the remaining payments will be canceled. SCINs provide for a lifetime income stream and avoidance of gift tax and estate tax similar to private annuities. Unlike private annuities, SCINs give you a security interest in the transferred business.

Family limited partnerships A family limited partnership can also assist in transferring your business interest to family members. First, you establish a partnership with both general and limited partnership interests. Then, you transfer the business to this partnership. You retain the general partnership interest for yourself, allowing you to maintain control over the day-to-day operation of the business. Over time, you gift the limited partnership interest to family members. The value of the gifts may be eligible for valuation discounts as a minority interest and for lack of marketability. If so, you may successfully transfer much of your business to your heirs at significant transfer tax savings.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 93 of 103

Funding a Buy-Sell Agreement with Life Insurance As a partner or co-owner (private shareholder) of a business, you've spent years building a valuable financial interest in your company. You may have considered setting up a buy-sell agreement to ensure your surviving family a smooth sale of your business interest and are looking into funding methods. One of the first methods you should consider is life insurance. The life insurance that funds your buy-sell agreement will create a sum of money at your death that will be used to pay your family or your estate the full value of your ownership interest.

How funding with life insurance works When using life insurance with a buy-sell agreement, either the company or the individual co-owners buy life insurance policies on the lives of each co-owner (but not on themselves). If you were to die, the policyowners (the company or co-owners) receive the death benefits from the policies on your life. That money is paid to your surviving family members as payment for your interest in the business. If all goes well, your family gets a sum of cash they can use to help sustain them after your death, and the company has ensured its continuity.

Advantages of using life insurance • Life insurance creates a lump sum of cash to fund the buy-sell agreement at death • Life insurance proceeds are usually paid quickly after your death, ensuring that the buy-sell transaction can be settled quickly • Life insurance proceeds are generally income tax free; a C corporation may be subject to the alternative minimum tax (AMT) • If sufficient cash values have built up within the policies, the funds can be accessed to purchase your business interest following your retirement or disability

Disadvantages of using life insurance • Life insurance premiums are paid with after-tax dollars because the premiums are generally not a tax-deductible expense • Premium requirements are an ongoing expense • One or more co-owners may be uninsurable due to age or illness • If the co-owners' ages vary widely, younger co-owners will have to pay higher premiums on the lives of the older co-owners • If the ownership percentages vary widely, more insurance will be needed to cover the owners with the larger ownership interests, resulting in higher premium costs for those with smaller ownership interests

How to set up different types of buy-sell agreements In an entity purchase buy-sell agreement, the business itself buys separate life insurance policies on the lives of each of the co-owners. The business usually pays the annual premiums and is the owner and beneficiary of the policies. A wait and see (or hybrid) buy-sell agreement allows you to combine features from both the entity purchase and cross purchase models. The business can buy policies on each co-owner, the individual co-owners can buy

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 94 of 103

policies on each other, or a mixture of both methods can be used.

The buy-sell agreement should be fully funded The amount of insurance coverage on your life should equal the value of your ownership interest. Then, when you die, there will be enough cash from the policy proceeds to pay your family or estate in full for your share of the business. But if all that is affordable is insurance coverage for a portion of your interest, you might want to go ahead and fund that amount. Later, the company may be able to increase the amount of insurance or use additional funding methods. In the meantime, the agreement should specify how your family or estate will be paid.

The value of the business could change over time What if the insurance proceeds turn out to be less than the value of your business interest, due to growth in the business? Your surviving family members might end up getting less than full value for your business interest. Your buy-sell agreement should specify how the valuation difference will be handled. Conversely, the insurance proceeds might be greater than the value of your business interest when you die. Your buy-sell agreement should address this potential situation upfront and specify whether the excess funds will belong to the business, the surviving co-owners, or your family or estate.

Should group life insurance be used? Using a company's group life insurance plan to fund a buy-sell agreement is generally not recommended. Normally, group life insurance premiums are tax deductible to the company. But premiums are no longer deductible if the business is the beneficiary.

Possible negative tax consequences • For policies issued after August 16, 2006, the death benefits of life insurance on the life of an employee payable to the employer/policy owner may be subject to income taxes unless an exception applies. • Assume your business is a corporation or is taxed as one. When one of your co-owners dies, his or her estate becomes the owner of the insurance policies covering you and the other co-owners of the business in a cross purchase agreement. If these policies are then transferred to the surviving co-owners to pay for future buyouts, a transfer-for-value (gain) may occur, and a portion of the proceeds received from the transferred policies may be taxable. • If a policy is canceled (surrendered) for cash to buy out your interest while you are living, any gain on the policy is subject to federal income tax for the policyowner. Gain includes all policy loans outstanding at the time of surrender. Also, the policy may carry surrender charges. • The proceeds received by a C corporation under an entity purchase agreement may be subject to the AMT.

Keeping track of your buy-sell agreement Each year, the premiums on the policies must be paid, or the insurance will lapse. So monitor premium payments carefully. Your buy-sell agreement should include a feature requiring ongoing proof of payment. Also, review the amount of insurance regularly. The insurance coverage may have to be increased periodically to reflect increases in the value of the business. If additional insurance is not possible, another funding method should be established. Finally, periodically check the financial rating of your insurance company. The policies funding your buy-sell agreement will do your family no good if the insurer becomes insolvent.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 95 of 103

Funding a Buy-Sell Agreement with Disability Insurance You may have a great buy-sell agreement in place at the company where you are a partner or co-owner--one that clearly stipulates how much your family will be paid for your share of the business interest in the event of your death. It may also cover early retirement and the buyout terms under those circumstances. But what if you become disabled long before you are likely to die or retire? Insurance industry statistics show that the chance of you or one of your co-owners sustaining a long-term illness or injury (over one year) before age 65 is much greater than the odds of any one of you dying prematurely. Disability income insurance may provide a solution.

How disability income insurance works If you were to suffer a severe injury or develop some type of long-term illness, you would probably be unable to earn a paycheck during that time. Disability income insurance is a salary-continuation agreement that replaces a portion of your income while you are injured or ill. Disability insurance with your buy-sell agreement provides the funds to allow your company to continue paying your salary or to completely buy your share of the business if your disability is permanent. Keep in mind that disability insurance is designed to protect you in the event of a long-term illness or injury. So, a disability insurance policy includes an elimination period (i.e., a waiting period between the time you become sick or injured and the time any benefits are paid). Some policies call for waiting periods as long as one or two years, so you will need to depend on your savings and other investments for a considerable period of time. Depending on the type of policy, you can receive benefit payments in either a lump sum, installment payments, or a combination of the two. Disability insurance should generally be used in addition to the funding method you have chosen for the purchase of your business interest at your death or retirement.

Coordinate the disability policy with your buy-sell agreement You should make sure that any conflict between the provisions of your disability income insurance policy and your buy-sell agreement is eliminated at the outset. The buy-sell agreement should contain the same definition of disability as your disability policy. Determine when the agreement requires a complete buyout after you become sick or injured. Also, coordinate the waiting period, how benefits are paid, and how you may be able to buy your shares back if you recover from your illness or injury.

Different types of buy-sell agreements If your buy-sell agreement is an entity purchase (stock redemption) plan, the company itself buys disability policies for each of the shareholders or partners. The company is the owner, premium payer, and beneficiary of the policies. With a cross purchase (crisscross) agreement, you and your co-owners agree as individuals to purchase the business interest of any co-owner who becomes disabled. Under the terms of the agreement, you buy a separate disability policy on each of the other co-owners; in turn, each co-owner buys a policy on you. Each of you is the owner, premium payer, and beneficiary of the policies you have purchased. Be aware that tax consequences may arise if the company pays the premiums on policies under a cross purchase agreement. A wait and see (hybrid) buy-sell agreement allows you to combine features of both an entity purchase and cross purchase agreement.

Disability income funding can ensure you a fair price The greatest advantage offered by using disability insurance with your buy-sell agreement is that you can receive the full value of your business interest if you become disabled before your death or normal retirement. For example, say you become permanently disabled in an auto accident. You are unable to work and want to sell your interest in the business you helped establish, but the company doesn't have the cash to pay you right now. Without disability coverage in this circumstance, you might be forced to go outside the company to sell your business interest. You could end up selling the interest for less than it is worth.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 96 of 103

Funding your buy-sell agreement with disability insurance assures that the other co-owners will buy your interest, names the conditions under which they will purchase your interest, and provides the money to pay you a fair price. If your injury is not permanent, disability insurance will provide income protection for your family while you are recovering.

What are the drawbacks of using disability insurance? • Insurance premiums are not tax deductible. It makes no difference if the payments are made by the business itself or the individual owners. • Insurance companies may consider you uninsurable--ineligible for disability insurance--due to factors such as your age, health problems, high-risk hobbies, or employment in certain occupations. • Disability insurance can be used only if you're sick or injured. There is no policy benefit available if you die or retire from the business when you're healthy.

What happens if you recover from your disability? It's possible that you could recover from your illness or injury after you've already sold your business interest under your buy-sell agreement's disability clause. If this happens, you could find yourself without a business, career, or income. Make sure that your buy-sell agreement addresses whether you'll be eligible to buy your shares back if you recover after the waiting period. The agreement should contain a schedule specifying how your interest will be transferred back to you. Because it is possible that you'll recover from your disability, it is generally advisable to set up a long waiting period before the policy pays salary continuation benefits or triggers the purchase of your share of the company. This reduces the chance that you may recover from your disability after having sold your business interest. In addition, longer waiting periods reduce the policy premiums.

Monitoring your buy-sell agreement Remember that the disability insurance with your buy-sell agreement will provide you with no benefit if the policy is allowed to lapse. Make sure that all required premiums are regularly paid. You don't want to leave yourself and your family unprotected at a time when you're sick or injured. While you're at it, check up on the other funding components of your buy-sell agreement. And if the agreement is not fully funded, push to have this done as soon as it is financially feasible for the company. Finally, as the company grows, it's important to periodically review the buy-sell document and the funding vehicles to ensure that they're keeping pace with the current value of your business.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 97 of 103

Can I transfer my business through my will? Question: Can I transfer my business through my will?

Answer: Yes, you can use your will to transfer your business interest after your death. You can also use your will to specify a long-term succession plan for your business if, for instance, you want one of your children (who may be currently active in the business) to take over and run it when you're gone. Without such a clause in your will, your interest could possibly be distributed equally to all of your children, even though you did not intend that result. A disadvantage of transferring your business through your will is that the full value of your interest will be included in your taxable estate. Unless you have made provisions for additional liquidity (e.g., by using life insurance), your heirs may be forced to sell the company just to pay the estate taxes. Assets disposed of through a will are subject to probate, the court-supervised process of administering a will. Probate can be expensive and time consuming. It could also result in business interruptions, which in turn could result in a loss of customers and employees if confusion develops over who's running the business and how it will continue to operate. The probate process is also public, which may allow others to discover details about your estate that you would rather not disclose. Talk to your lawyer and your financial professional about your business interest and what you would like to happen to it at your death. Transferring your interest through your will is just one method that can be used. Other options (or combinations of options) can also be used to accomplish your wishes. Some methods may allow you to equalize distributions to your heirs without splitting up the business. Some can help you minimize the taxable value of your business interest. A buy-sell agreement can be drafted now to establish a plan for the future succession of your business interest. Trusts may also be used to help accomplish your goals. All of these strategies take time to plan and implement, so the best time to begin planning is now.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 98 of 103

What is a buy-sell agreement? Question: What is a buy-sell agreement?

Answer: A buy-sell agreement is a contract that provides for the future sale of your business interest or for your purchase of a co-owner's interest in the business. Buy-sell agreements are also known as business continuation agreements and buyout agreements. Under the terms of a buy-sell agreement (assuming you are the seller), you and the buyer enter into a contract for the transfer of your business interest by you (or your estate) at the occurrence of a specified triggering event. Typical triggering events include death, disability, and retirement. Ideally, buy-sell agreements are fully funded, and life insurance is frequently used for this purpose. After determining the value of the business, you, your advisors, and the other parties to the agreement will determine the best way to fund the transaction, and the triggers appropriate for your business situation. If you own a business and are concerned about how the death of a co-owner might affect its operation, a funded buy-sell agreement can help by ensuring that you will be able to purchase your partner's share, eliminating any doubts about the continuation of the business. You can also avoid the dilemma of being in business with your partner's survivors. There are also costs and possible disadvantages involved in establishing a buy-sell agreement. One such disadvantage is that the agreement typically limits your freedom to sell the business to outside parties. If you think that a buy-sell agreement might benefit you and your business, consult your attorney and financial professional about the pros and cons of setting one up.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 99 of 103

How can I determine what my business is worth for estate and gift tax purposes? Question: How can I determine what my business is worth for estate and gift tax purposes?

Answer: Determining the value of your business is something you should not attempt to do on your own, especially because the IRS could challenge your valuation. Even the IRS acknowledges that no one true fair market value (FMV) exists for a closely held business. There are appraisers who specialize in determining the value of businesses. Your CPA may be one of these specialists or know someone who is. FMV is defined by the federal estate and gift tax regulations as "the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts." It is the sale price that a hypothetical buyer and seller would reach, not necessarily the price that the actual owner would agree to or the price that an actual buyer might be willing to pay. You may have had your business appraised in the past for another purpose. As tempting as it might be, don't use an old appraisal for a new transaction. The purpose of the appraisal can affect the valuation assigned, and time can change the factors that go into the appraisal calculation. Numerous factors might affect the value of a business. However, the IRS has identified a number of relevant considerations: • Nature of the business and history of the company • Outlook for the economy in general and an industry in particular • Book value and financial condition of the company • Earnings capacity • Dividend-paying capacity • Goodwill/intangible value • Sales of stock and the size of block to be valued • Market value of stock in comparable businesses A number of different methods exist for determining the FMV for a closely held business. Generally, only an appraiser will know how to analyze these factors to reach a conclusion as to the FMV of your business.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 100 of 103

How can I keep my business in the family? Question: How can I keep my business in the family?

Answer: There are several ways to keep your business in the family. The method you choose will depend on whether you wish to keep ownership and control of the business until your death, or begin transferring ownership (and possibly control) to your family during your lifetime. In addition, your options will be affected by the business entity itself. A sole proprietorship, for example, may have different options than a partnership or a corporation. The presence of a buy-sell agreement or another restrictive agreement between current owners may also impact your options. Each of the options for keeping your business in the family bears its own tax consequences and can be affected by your overall estate planning goals. If you wish to maintain ownership until your death, you can transfer your business to family members using your will. Depending on the value of your estate and the year in which you die, your business interest may be included in your estate and subject to estate taxes under this method. However, under certain circumstances, valuation discounts may be available to lower the taxable value of your business interest. See a tax attorney for more information. If you want to begin transferring ownership of the business during your lifetime, you can structure the transfers to occur in such a manner that you retain the controlling interest until you are ready to fully remove yourself from the business. You can make lifetime gifts of interests in your business to your family members. Depending on the amount of the gift and to whom the gift is made, lifetime transfers of your business interest may be subject to federal and/or state gift tax. (See a tax attorney for more information.) Or, you can combine lifetime gifting with an outright sale of your interest. The sale can occur either during your lifetime or after your death. You may want to use a trust to facilitate the transfer of your business, or transfer ownership through the use of another entity, such as a family limited partnership. A buy-sell agreement can be established now to provide for the future sale of your business to one or more family members. Buy-sell agreements are legal agreements that establish a buyer for your business, the price or pricing mechanism to be used, and the events (such as retirement, death, or disability) that will trigger the sale. Be aware that once you are bound under such an agreement, you may not be allowed to make gifts of your business interest or sell to anyone other than the buyer named in the agreement, depending on the terms of the agreement.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 101 of 103

What is a family limited partnership, and will it help reduce estate taxes? Question: What is a family limited partnership, and will it help reduce estate taxes?

Answer: A family limited partnership (FLP) is a partnership created and governed by state law and generally comprises two or more family members. As a limited partnership, there are two classes of ownership: the general partner(s) and the limited partner(s). The general partner(s) has control over the day-to-day operations of the business and is personally responsible for the debts that the partnership incurs. The limited partner(s) is not involved in the operation of the business. Also, the liability of the limited partner(s) for partnership debts is limited to the amount of capital contributed. An FLP can be a powerful estate planning tool that may (1) help reduce income and transfer taxes, (2) allow you to transfer an ownership interest to other family members while letting you keep control of the business, (3) help ensure continued family ownership of the business, and (4) provide liability protection for the limited partner(s). An FLP is often formed by a member(s) of the senior generation who transfers existing business and income-producing assets to the partnership in exchange for both general and limited partnership interests. Some or all of the limited partnership interests are then gifted to the junior generation. The general partner(s) need not own a majority of the partnership interests. In fact, the general partner(s) can own only 1 or 2 percent of the partnership, with the remaining interests owned by the limited partner(s). There are several advantages to organizing your business as an FLP: • Limited partnership interests that are gifted to other family members are generally valued at less than the full fair market value of the underlying assets. That is, reasonable discounts to the value of the limited partnership interests are permitted for lack of marketability and lack of control. This means that by gifting the assets via a limited partnership interest instead of an outright transfer of the business assets themselves, you may be saving gift and estate taxes. • At death, only the value of your ownership interest in the partnership will be included in your gross estate. • The use of the partnership entity allows you to shift some of the business income and future appreciation of the business assets to other members of your family. • You maintain management control of the business while transferring limited ownership of the business to family members. • Restrictions within the partnership agreement limiting the transfer of the partnership interests may help ensure continuous family ownership of the business.

See disclaimer on final page March 28, 2010


LifeFocus.com

Page 102 of 103

I own a business. Are there any creative ways I can use life insurance in my business? Question: I own a business. Are there any creative ways I can use life insurance in my business?

Answer: You can use life insurance in several ways to help your business. You might consider purchasing a key-person life insurance policy that covers the loss of services when a key employee or partner dies. The benefits can be used to cover any lost profit and the cost of replacing the employee or partner. The insurance is owned by your business, which also receives the benefits. Another way to insure against the death of a business partner is through a buy-sell agreement. For example, three partners in a business each own the same amount of stock. One partner, Mr. Clark, dies, and his stock goes to his wife through his will. If the business had written a buy-sell agreement and funded it with life insurance, the surviving partners would have received a life insurance benefit when Mr. Clark died. The partners and Mrs. Clark could then have exchanged the life insurance benefit for the company stock. Split-dollar life insurance is another benefit you can offer your employees while investing in your company. Here, the business purchases a life insurance contract on the life of an employee and shares the cost. If the employee dies, your business receives an amount equal to the premiums paid, and the employee's beneficiary receives the remaining death benefit. If the policy is surrendered for any other reason, your business receives the cash value. Deferred compensation that supplements a retirement plan is another option you might consider. Your company would buy a life insurance policy on the life of a key employee. The business is the owner and beneficiary. If the employee dies, the business receives the death benefit tax free. From the benefit proceeds, your business pays an annual sum to the employee's survivors for a specified period. Providing group life insurance as an employee benefit can also help your business by attracting and retaining employees. Group insurance is less expensive to purchase than individual insurance. Also, no medical exam may be required, depending on the size of your company. Here, the premiums are tax deductible to your business, and the benefits are paid directly to your employee's beneficiary.

See disclaimer on final page March 28, 2010


Planning for Business Succession eBook  

LifeFocus.com T. Young March 28, 2010 info@lifefocus.com www.LifeFocus.com What should you include in your contingency plan? ..................

Read more
Read more
Similar to
Popular now
Just for you