If you are the owner of a closely held company, the consequences of not thinking about retirement, disability, or your estate can be greater than you ever imagined. One of the most vivid results of poor planning by a business owner is forced liquidation of the company at less-than-market prices to pay estate taxes. However, the problems related to transferring ownership or control usually are not so dramatic and can easily be avoided
Ideally, your business will provide income during retirement or a period of disability, and maximum benefits to your spouse and children. What is needed is a clear and orderly plan for succession. Most business owners seek to retain control of their companies even as they pass along some of the benefits to others. In some cases, this can be accomplished. Assuming your main goal is to assure that the business continues in good health, there are three plans to consider:
Recapitalization allows you to reorganize the company's capital structure to reflect both a preferred and a common stock. In many states, the preferred stock could be issued as a voting class of stock, thereby enabling the owner to retain some control if so desired. At the date of recapitalization, the entire value of the corporation is assigned to a new class of preferred stock, with only a minimum value attached to the common. At that point, the owner of the closely held business keeps the preferred shares and makes a gift of common stock to the family member or members, or whoever else is taking over. Since the common stock would have little value at the time it was given, the gift tax liability is minor.
The benefits of recapitalization can be significant for both the owner and the family members or key employee. For the owner, recapitalization fixes the value of the business in his or her estate in the form of the preferred stock. But it also guarantees current and future income for the owner through preferred dividends.
Redemption of the owner's common stock after making a gift of some of it to a family member or key employee provides another way of transferring the closely held business. It can be done at any time. Since the owner's redemption -- whereby the corporation acquires the stock -- must be 100% in order to qualify for lower capital gains tax treatment, this gives the relative or key employee sole control over the company.
There are two main disadvantages in this method compared with recapitalization. First the original owner forfeits control of the business and also loses the future source of income. And second, redemption creates a taxable transaction to the extent that the proceeds exceed the taxable basis of the stock. The result would be additional income tax liability at the capital gains rate of 20%.
Buy-sell agreements are the most common means of providing for succession when the business is jointly owned. They can be arranged in one of two ways: through a buy-out by the corporation or a cross-purchase agreement with the co-owner. A corporate buy-out is actually a form of redemption, as described above, except it takes place at a predetermined time as specified in the agreement -- usually upon retirement, disability, or death of the owner.
In terms of tax liability, the two types of buy-sell agreements are equal, and the choice of method depends on such circumstances as whether the other owner has the capital to buy you out. If he doesn't have the capital, a corporate buyout would permit the company to finance the transfer through the purchase of life insurance for the owners. Under this plan, the company would be the beneficiary and would use the proceeds from the life insurance policy to buy out the stock of the deceased. The company could also fund the transfer by periodic contributions to a special sinking fund, which could buy the stock upon an event called for in the buy-sell agreement.
A buy-sell agreement of either type permits you to establish a formula for valuing your stock for estate tax purposes. By setting the formula now, rather than at the time of death, you will be better able to control the value of that stock. Drawing up an agreement while you are still active will help you address three key concerns: succession in the business, how to generate a continued source of income for retirement or during disability, and the provision of funds to pay estate taxes upon death.
Among the elements that must be included in any buy-sell agreement are restrictions on the sale of the stock to outsiders. The agreement should also stipulate the circumstances under which it is to become effective and the price to be paid for the stock. Without these restrictions, Internal Revenue Service regulations state that the agreement won't be binding for estate tax purposes.
Setting the price for the stock is typically done using one of several methods: the book value at date of death, the fixed price provided by agreement, the price fixed by appraisal after death, or a self-adjusting formula based on such factors as the company's standing in its industry, book value, earning capacity, the percentage of interest being transferred, and intangibles, such as goodwill.
Assuming your goal is to value the stock as conservatively as possible for estate purposes, the self-adjusting formula method is the most desirable because it permits you to weight factors you choose, allowing you to emphasize those aspects that give the least value to the stock. However the formula is constructed, it will determine the fair-market value of the business at the appropriate date.
Resolving these critical questions in the future of a business, while requiring time and thought, cannot be considered optional by anyone owning a closely held company. The rewards are fundamental: assurance of income during retirement and minimization of estate taxes for your heirs.