Over the past couple of years, I've been involved with the Jacksonville Women's Business Center and the Jacksonville Chamber of Commerce Small Business Center as a sponsor, presenter and mentor.  I have found it to be a wonderfully satisfying experience and quite rewarding to help others grow their small businesses.

    Among the many things in which I participate, I often have questions and about which I provide information to small business owners involves business succession planning and buy-sell agreements.

     If you are a business owner you probably have experienced at least some, if not all of, the following:  Are you the first one to arrive in the morning, as well as the last one to leave in the evening? Have your employees ever taken home paychecks while you sacrificed your paycheck to the bottomless pit called accounts payable? Have you ever paid your mortgage on a credit card? 

    Over the years, you probably have worked through physical, mental and financial pain that would have caused other folks to close shop and look for a job elsewhere. As a business owner you have survived untold challenges. If your business is a family business, then you face some additional unique challenges to protect and preserve your business, your wealth, and your family.

Some Interesting Family Business Statistics

     It would be an understatement to say that family businesses are the backbone of the American economy. Approximately 90 percent of all businesses in this country are either family-owned or family-controlled. They come in all shapes, sizes and colors, representing all sectors of our economy. From agriculture, to services, to 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. Interestingly, 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 do not tend to outlive their founders. At any given moment, 40 percent 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 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.

Business Succession and the Family

     The family element in every family business can mean the difference between its success or failure during the transfer process. Common triggering events include the retirement, disability or death of the business owner. Tough questions must be asked and answered. Otherwise, a business that took you decades to build can be destroyed overnight. For example, who will run the business after you? Will it be your spouse, one of your children or a non-family member key employee? If not your spouse, will your spouse be financially dependent on the business or financially independent of the business? What arrangements have you made for an alternative inheritance for your business-inactive children? Have you in-law proofed your estate? Thinking ahead to the second-generation transfer of your business, what provisions have you made to encourage thrift and industry among your grandchildren?

     Aside from the people planning issues, what effect will estate taxes have on the survival of your business?

Estate Tax Uncertainty?    

    Despite the fact that there is currently no estate tax for 2010, what if Congress fails to take action, and in 2011 the estate tax reverts to an exemption from taxes of only $1 million, and a maximum estate tax rate of 55%?

     The only certainty about the federal estate tax is its long-term uncertainty with each change in Congress and the White House. Additionally, many states have imposed their own estate taxes, independent of any federal estate taxes. 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 family business just to meet an estate tax cash call (just nine months after the date of death).

The Need for Liquidity

     Unless you carefully coordinate your financial plan with your estate plan and your business succession plan, there may not be enough cash to fund your ultimate objectives. An appropriately funded estate plan can help 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 liquidity needs.

Buy-Sell Financing

     True or false: Most family business owners want their businesses to be liquidated when they retire, become disabled or die. If you answered false, then you are correct. Next we will talk about the fundamental key to the survival of a family business – a Buy-Sell Agreement (BSA).

Buy-Sell Agreements

     A BSA is a lifetime contract providing for the transfer of a business interest upon the occurrence of one or more triggering events as defined in the contract itself. For example, common triggering events include the retirement, disability or death of the business owner. An interest in any form of business entity can be transferred under a BSA, to include a corporation, a partnership or a limited liability company. Also, a BSA is effective whether the business has one owner or multiple owners. As a contract, a BSA is binding on third parties such as the estate representatives and heirs of the business owner. This feature can be 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.

Importance of Buy-Sell Agreements

     To illustrate the importance of a buy-sell agreement requires only that I look at our currently active probate files.  In those files is the case of Jim (not his real name).  Jim and his wife came to us through a referral from his financial advisor about a year and a half ago.  Our review of his estate matters revealed that he owned 50% of a corporation through which his business was conducted.  He had one partner who owned the other 50% of the corporation.  Their business provided services and manufactured goods to a major industrial operation.  Jim indicated that his business was worth $10 million, but because of the income it generated, that neither he nor his partner would want to sell it for that amount, but would require something more than that.  There was no buy-sell agreement in place, and no business succession plan provide for the death or disability of either of the principals of the business.

     Jim agreed to discuss with his partner a business succession plan for the business and the terms of a buy-sell agreement.

     Approximately four (4) months after Jim and his wife signed their basic estate planning documents, his wife called to notify us that Jim had been diagnosed with brain cancer.  He died four months later, without having reached an agreement with his business partner regarding the business succession plan and the terms of the buy-sell agreement.

     We are now probating Jim's estate.  After almost a year of negotiations, and a threat by the former partner to close the business and reopen it elsewhere, Jim's wife has agreed to take less than $1 million for Jim's interest in the business — less than 20% of its minimum fair market value before his diagnosis!

Three Types of 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. Conversely, under a Cross-Purchase BSA, the business owners agree to purchase one another’s interests. The Wait-And-See BSA gives the entity a first option to purchase the interest before the remaining business owner(s).

     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. 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 funding plan. Like a beautiful automobile without fuel in the tank, a BSA without cash to fund the purchase is going nowhere (except to the trial lawyers, perhaps).

Funding a Buy-Sell Agreement

     Common options to fund the purchase obligation under a BSA include the use of personal funds, creating a sinking fund in the business itself, borrowing funds, installment payments and life insurance. Of these options, only the life insurance option can guarantee complete financing of the purchase from the beginning. Accordingly, a proper BSA will include both disability buy-out insurance and life insurance. 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.  Or, as in Jim's case, a quite significant loss of value for one's family in the event of death or disability.

 Bottom Line

     The bottom line is clear.  Without a properly funded, well thought out, buy-sell agreement, your family business, or any other closely held business, will likely not survive you or your disability.  If you are one of the many business owners without a business succession plan, with a properly funded buy-sell agreement, you should immediately discuss with your team of advisors (your CPA, your life insurance agent, and your estate planning attorney) the appropriate terms for such a plan for your own business.  

     Obviously, we at The Coleman Law Firm are available to assist in such planning, and appreciate the value that is derived from having your advisor team work together to devise a plan that most completely meets your specific, and individual, needs.