A Partnership From Hell
Failing to stabilize and protect estate values is one of the classic errors in most estate plans. Avoid this situation by consulting your tax, financial and legal advisors.
A partnership from hell — thats what it must feel like to suddenly be in business with your best friends spouse. Worse yet, finding yourself forced to work through his/her attorney, and it could be catastrophic to own a business with the ex-wifes new husband and his attorney. How does this happen? If your succession plans do not include the possibility of death, disability or retirement for the owners of a closely held business, then you are faced with just this scenario. (If you think this situation is bad, imagine a partnership with the IRS, a consequence of a poorly designed estate plan.) While the Chrysler Corporation can have Lee Iacocca step down and not disrupt the companys profitable outlook, not many closely held or family businesses have the same degree of continuity.
When a small business owner-employee steps out of the picture, the surviving partners and surviving spouse usually have differing goals. The business owner usually wants to continue operations and put any profits back into growing the business, while the surviving spouse wants income and minimal risk. The logical solution is for the surviving partner or the business to buy out the deceased owners interest, but that entails coming up with cash. Where does an owner look for funding to maintain control? There are only four sources of funding to provide value to heirs, and they are cash in the business, sale of assets, borrowed funds and insurance products.
Each of these sources of capital has advantages and disadvantages, so decisions are based on personal needs and economic evaluations.
1. Use cash in the business or personal funds to buy out the surviving spouse. By accumulating after-tax funds on a steady basis, its possible to set aside adequate capital to purchase those business interests. These sinking funds work well enough if there is adequate time, but the risk is absorbed by the partners if something happens too early and derails the plan. In a 33% tax bracket, one needs to earn $1.50 to have $1 available for this purchase. Also remember that funds set aside in a corporation may be subject to excess accumulation penalties. Even businesses with significant cash flow may not be able to sustain required payments with a principal player who contributed to the profitable operation out of the picture. Uncertainty and unfavorable tax leveraging are the major disadvantage of this method.
2. Assets sold under pressure rarely bring more than discounted garage sale prices. As long as they are not the major income producing assets of the business, maybe you can do without them. However, most nonessential assets will not bring their full market value, so the best assets must be offered for sale instead. Business liquidators report that a 40% loss in value is typical, so that option would appear to be undesirable.
3. If borrowing credit is still intact after the loss of a major rainmaker in the business, maybe a lending institution will loan the survivor the funds. Of course, the money needs to be repaid with interest using after-tax dollars. Even if the heirs finance an installment sale, the business will eventually have to purchase itself more than once. In this case, the surviving heirs must assume the risk that the business will continue to be profitable enough to provide a steady source of income with a restructured management team.
4. Properly structured insurance products within a buy-sell agreement have the potential to provide necessary tax-free cash when the event (death, disability or retirement) that triggers the need for funding exists. There are a number of strategies available to purchase these special insurance contracts with tax advantaged premium payments. Some of todays most popular discretionary perks now include using life insurance products in creative ways to pay for personal needs with corporate dollars. Recent changes in tax laws now make these discretionary programs more appealing, making them one of the few tools available that favor the small business owner.
Buy-sell agreements form much of the basis for continuity in business operations, whether it be for sole proprietors, partners or corporations. A well-drafted agreement ensures the family that the business will be either retained or disposed of fairly. The contract also establishes an upper limit for the IRS as a market value for estate tax purposes. If there is a closely held business interest in your estate, it would be a good idea to sit down with your estate planning team and explore the various options to preserve value and control. Good planning can reduce uncertainty, expenses, tax liabilities and improve both the clients and heirs income potential.
For creative ways to preserve corporate value, protect heirs active in the business, resolve excess accumulation issues and generate retirement income for the founding business owner, look at an IRC Section 664 trust as a powerful transition tool. For more information, e-mail us.
Vaughn Henry deals with planned giving and estate conservation work and is a member of the Central Illinois Chapter of the International Association for Financial Planning.
- Business Continuity Planning
- Closely-held Businesses Passed Down With Tax Leveraged Options
- Family Farm Operations Preserved
- Multi-generational Estate Planning
Contact us for suggestions on planning options to preserve your family business.