Serving families throughout Lynnfield, Wakefield, Reading, Peabody, Danvers, Beverly, the Greater Boston, North Shore, and Southern New Hampshire area
Family businesses (either family-owned or family-controlled) make up approximately 90% of all businesses in this country. They come in all shapes, sizes and colors, representing all sectors of our economy. From agriculture to services, technology to manufacturing, family businesses generate an estimated one-half of the U.S. Gross National Product and pay half of all wages earned in this country.
Not all family businesses are traditional small businesses either. In fact, about one-third of all businesses included in the Fortune 500 are family businesses. But not all of the family business statistics are rosy.
Family businesses tend not to outlive their founders. More than 30% survive to the second generation, but only 12% to the third, and 3% by the fourth generation. At any given moment, 40% of family businesses are in the process of transferring their ownership. Unfortunately, two-thirds of all initial transfers fail. Of the one-third that survives an initial transfer, only one-half will survive a second transfer.
Why Family Businesses Do Not Survive
Why such a dismal success rate? The reasons are as varied and unique as the businesses and business owners themselves. Nevertheless, many of the failed transfers can be traced to three causes: people, taxes and cash.
Family Business Owners and Estate Planning for the Family
The family element in every family business can be the difference between success or failure during the transfer process. The retirement, disability or death of the business owner are all common events that trigger a business transfer.
Tough questions must be asked and answered and prior to the triggering event, open communication must occur between family members in order for the business to transition to the next generation. Otherwise, a business that took decades to build can be destroyed overnight.
For example, who will run the business after you? Who will run the day-to-day operations and who will continue on as the entrepreneur who will market, manage, and facilitate the vision of the business? Will it be your spouse, one of your children or a non-family member key employee? If your spouse will not run the business, will he or she still be financially dependent on it… or can you make arrangements to ensure they are financially independent of it? Will it be in the best interest of the family to sell the business at its highest value and ensure the value of the business is not diminished by your death?
What arrangements have you made for the inheritance of your children who are not active in the business? Do you want them to be treated equally or fairly? Have you protected your estate in the event of a child’s divorce?
What instructions have you created to ensure the continuation of your business is consistent with your values and vision, so the next generation is encouraged to work hard, be thrifty, and continue your legacy?
Estate Tax Uncertainty and Monitoring the Value of the Business
The only certainty about the federal estate tax is its uncertainty with each change in Congress and the White House. Additionally, some states now impose their own estate taxes, independent of any federal estate taxes. Massachusetts has a separate and distinct estate tax, which may result in the payment of estate taxes within 9 months of your death. In the event a substantial part of your gross estate is the value of a business, planning is needed to ensure enough liquid assets are available to pay both federal and state estate taxes at the time of your death.
Accordingly, careful monitoring of the economic, political and legal climate is required. Why? Without proper estate-liquidity planning, your family may have to sell the business just to meet an estate tax cash call. Annual reviews of both the value of the business and the estate is needed to monitor the liquidity needs at death.
Many businesses create a one-time business and estate plan based on the value of the gross estate and the business as of the date of the initial planning. They very rarely review or monitor the change in value. Many clients are surprised to find out that a buy-sell agreement created years ago will not pass the business as they intended. The business plan and estate plan must be monitored and maintained so the plan will work, the business will transition as intended, and your family and business is taken care of when it really matters.
Coordinating, Monitoring, and Updating Your Financial and Estate Plans
If your financial and estate plans are not carefully coordinated, monitored, and updated, there may not be enough cash to fund your objectives. An appropriately funded estate plan where assets are aligned, verified, and tracked can meet all of your people-planning objectives and provide liquidity for estate taxes (and business debts). Life insurance, owned in the proper amount, type and manner, may be effectively used to fund such money matters.
We are not licensed to sell insurance, nor do we receive commissions, but we often recommend life insurance as a valuable tool. Life insurance can often provide liquidity to an estate or business to prevent a forced estate sale to pay taxes or to hire those needed to help maintain the value of your business after your death.
The Business Buy-Sell Agreement (BSA)
A buy-sell agreement (often called a BSA) is a contract documenting how an interest in a business will transfer upon the death, disability, or retirement of a business owner. These are often called “triggering events” and are defined in the contract. An interest in any form of business entity can be transferred under a BSA, to include a transfer of corporate stock, a transfer of a partnership, or a limited liability company interest. Also, a BSA is effective whether the business has one owner or multiple owners. As a contract, a BSA directs the estate representatives, trustees, or heirs holding the interest at the time of death as to the transfer of that interest.
Proper planning is needed so the sale of the transfer of the interest is not delayed as a result of an executor or administrator needing to be appointed to sign the transfer papers and complete the transfer dictated by the BSA. A trust or escrow agent can hold the business interest and have the authority to execute and fulfill the terms of the BSA without court intervention. We are often surprised that many professionals miss this step and believe that a BSA will prevent probate court intervention.
Think about it: if you own your business interest in your name alone and you pass away, no one has legal authority to sign the papers that bear your name. Only the executor or administrator appointed by the probate court will be allowed to sign the business interest transfer papers and collect the proceeds from the sale. Careful planning in the BSA and your living trust-based plan, along with the proper alignment of the business interest with your trust, can avoid probate intervention even in a BSA.
This type of coordinated planning using trusts, escrow agents, and BSAs is invaluable when the business owner wants to ensure a smooth transition of complete control and ownership to the party that will keep the business going. Subject to certain Family Attribution Rules under Internal Revenue Code § 318, a BSA can help establish a value for the business that is binding on the IRS for federal estate tax purposes as provided under Internal Revenue Code § 2703.
Entity Buy-Sell, Cross-Purchase Buy-Sell and Wait-and-See Buy-Sell Agreements
A BSA is commonly structured in one of three general formats: An Entity BSA, a Cross-Purchase BSA or a Wait-And-See BSA. Under an Entity BSA, the business entity itself agrees to purchase the interest of a business owner. This is commonly called a redemption agreement (stock redemption, partnership or LLC interest redemption agreement). Conversely, under a Cross-Purchase BSA, the business owners agree to purchase one another’s interests. When there are very few owners, this cross-purchase agreement can be very valuable, as it will provide the surviving owner with an income tax step-up basis on the business entity purchased. The Wait-And-See BSA gives the entity a first option to purchase the interest before the remaining business owner(s). The wait and see approach is a valuable tool to give a second look at what may be the most efficient manner to pass or transfer a business interest.
In addition to these three general formats, a One-Way BSA may be used when there is one business owner and the purchaser is a third party. This is very useful if a third party purchaser can be identified and the business owner can determine the details of the agreement during life.
The selection of the appropriate BSA format is critical for a variety of tax and non-tax reasons beyond the scope of this discussion. However, no BSA is complete without a proper means of providing liquidity for the purchase of the business (i.e. proper funding).
Funding or Providing Liquidity for a Buy-Sell Agreement
Some common options to fund or provide cash for the purchase obligation under a BSA include the use of personal funds, creating a sinking fund in the business itself, borrowing funds, installment payments (promissory notes), and life insurance. Of these options, only the insurance option can guarantee complete financing of the purchase from the beginning. Since the health of the business owner determines their insurability, any delay in acquiring appropriate coverage could be fatal to the success of the BSA and, with it, the survival of the business itself.
Any well-drafted BSA will provide for a promissory note to be used to make up for any deficiency in cash available at the time of transfer. Care must be taken in the agreement so the terms of the promissory note can be supported by the cash flow of the business. That way the purchaser does not default on the note obligation or drain the business of the cash flow needed to maintain it. When a promissory note is used to fund a BSA, it is in the best interest of both the purchaser and the deceased owner’s heirs that the business remain profitable and that there is enough cash flow and liquidity to maintain the business and pay the promissory note obligations.
Please contact us for more information, as the various estate, tax, and business issues must be coordinated so both the business and your family are taken care of when it really matters.