coordinating-estate-plans-with-business-succession — estate and legacy planning

Business owners face unique estate planning challenges. The business often represents a significant portion of total wealth, is illiquid, and requires continuity planning to preserve value. Coordinating estate plans with business succession ensures that ownership transfers efficiently while providing fair treatment to all heirs and adequate liquidity to pay estate taxes.

Buy-Sell Agreements: Foundation of Business Succession

A buy-sell agreement is a legally binding contract that governs what happens to a business interest when an owner dies, becomes disabled, retires, or wants to sell. Properly structured, it provides certainty, liquidity, and a predetermined valuation method.

Trigger Events

Buy-sell agreements typically activate upon:

Death of an owner
Total disability (usually defined as inability to work for 12-24 months)
Retirement at a specified age
Voluntary withdrawal
Divorce (to prevent ownership transfer to an ex-spouse)
Bankruptcy of an owner
Termination of employment (for S corporation shareholders who are employees)

Cross-Purchase Agreements

In a cross-purchase arrangement, the remaining owners personally purchase the departing owner's interest.

Structure: Each owner enters into an agreement with every other owner. If there are three partners, each has two separate agreements—resulting in six total agreements.

Tax treatment: The purchasing owners receive a stepped-up basis in the acquired interest, equal to the purchase price paid. This higher basis reduces future capital gains when those owners eventually sell.

Disadvantages:

Complexity increases with more owners (n owners require n × (n-1) agreements)
Owners must personally fund the purchase
Disparate ages among owners create unequal insurance premium costs
Young owners may lack funds to purchase interests from older owners

Best suited for: Partnerships and LLCs with 2-4 owners of similar ages.

Entity Redemption Agreements

In an entity redemption (also called a stock redemption for corporations), the business itself purchases the departing owner's interest.

Structure: The entity enters into a single agreement obligating it to purchase any owner's interest upon a triggering event.

Tax treatment: Remaining owners do not receive a basis increase. Their percentage ownership increases, but their cost basis remains unchanged.

Disadvantages:

No basis step-up for remaining owners
Corporate-owned life insurance may be subject to alternative minimum tax
For C corporations, redemption proceeds may be taxed as dividends rather than capital gains if certain tests are not met

Best suited for: Businesses with multiple owners, especially when ages vary significantly, or when owners prefer simplicity.

Hybrid Agreements

Hybrid arrangements combine elements of both approaches. The entity has the first right (or obligation) to purchase a departing owner's interest. If the entity declines or cannot complete the purchase, the remaining owners have the right to purchase personally.

This structure provides flexibility and allows optimization based on circumstances at the time of the triggering event.

Wait-and-See Agreements

Wait-and-see agreements defer the decision of whether to structure the transaction as a cross-purchase or redemption until the triggering event occurs. This allows the parties to evaluate tax implications and funding availability at that time.

Life Insurance Funding

Life insurance provides the liquidity necessary to fund buy-sell obligations at death without requiring the sale of business assets or outside financing.

Calculating Coverage Needs

The death benefit should equal the anticipated purchase price of the owner's interest:

Current business value × ownership percentage = base coverage
Consider projected growth and adjust coverage periodically
Account for any existing owner loans to the company

Ownership Structure for Life Insurance

Cross-purchase funding: Each owner purchases and owns policies on the other owners' lives. Owner A owns a policy on Owner B, and Owner B owns a policy on Owner A.

Entity redemption funding: The business owns and pays premiums on policies covering each owner. Proceeds are payable to the business.

Insurance LLC or Partnership: For cross-purchase arrangements with multiple owners, an LLC can own all policies, simplifying administration. Upon death, the LLC distributes proceeds to surviving members who then purchase the deceased's interest.

Premium Considerations

Life insurance premiums are not tax-deductible, regardless of who pays them. For entity-owned policies on owners who are employees, premium costs are not considered compensation. The death benefit is generally received income-tax-free, though corporate-owned life insurance may trigger alternative minimum tax liability.

Valuation Discounts for Business Interests

Business interests held by decedents may qualify for valuation discounts, reducing the taxable estate value.

Lack of Marketability Discount

Closely held business interests cannot be sold on a public exchange. Finding a buyer takes time and effort, and buyers demand price concessions for illiquidity. Discounts typically range from 15% to 35%.

Lack of Control (Minority Interest) Discount

Minority owners cannot direct business operations, force distributions, or liquidate the company. This lack of control reduces value. Discounts typically range from 15% to 40%.

Combined Discounts

When both discounts apply, they are applied multiplicatively, not additively. A 25% marketability discount combined with a 30% minority discount results in:

Remaining value after minority discount: 70%
Remaining value after marketability discount: 70% × 75% = 52.5%
Total effective discount: 47.5%

Documentation Requirements

To support valuation discounts, obtain qualified appraisals from accredited business appraisers. The IRS scrutinizes aggressive discount claims, and documentation must support the specific facts of the business and ownership structure.

Key Person Considerations

Businesses dependent on specific individuals may see reduced value upon that person's death. Buy-sell agreements should address how key person risk affects valuation.

Key person life insurance, owned by the business, provides funds to:

Recruit and train replacement personnel
Compensate for lost revenue during transition
Reassure customers, creditors, and suppliers
Fund any repurchase obligations

ESOP as a Succession Tool

An Employee Stock Ownership Plan (ESOP) is a qualified retirement plan that invests primarily in employer stock. ESOPs can facilitate business succession while providing tax benefits and employee retention incentives.

How ESOPs Work

The company establishes a trust that purchases shares from existing owners. The ESOP borrows funds (if necessary) to make the purchase, and the company makes tax-deductible contributions to the ESOP to repay the loan. Employees receive allocations of shares based on compensation or other formulas.

Tax Benefits

For selling shareholders: If the company is a C corporation and the ESOP owns at least 30% of the company after the sale, the selling shareholder can defer capital gains by reinvesting proceeds in qualified replacement property (domestic securities) within 12 months. This is known as a Section 1042 rollover.

For the company: Contributions to the ESOP (including principal and interest on ESOP loans) are tax-deductible. An S corporation owned entirely by an ESOP pays no federal income tax (though this benefit has been limited by anti-abuse rules).

ESOP Considerations

Minimum company size typically $5 million or larger in value to justify costs
Requires annual independent valuations
Department of Labor fiduciary requirements apply
Repurchase obligation: company must buy back shares from departing employees
Complexity and ongoing administrative costs

Worked Example: $6M Business with 3 Partners, 1 Retiring

Facts:

ABC Manufacturing LLC, valued at $6,000,000
Three equal partners: David (62, retiring), Michael (52), and Sarah (48)
Each partner owns 33.33%, valued at $2,000,000
David wishes to retire over 3 years and transfer his interest
Michael and Sarah want to continue operating the business
LLC taxed as a partnership

Analysis of Options

Option 1: Entity Redemption

ABC Manufacturing purchases David's interest for $2,000,000.

David receives $2,000,000 in exchange for his interest
David's tax: Gain taxed at capital gains rates on amount exceeding his basis
Michael and Sarah's ownership increases from 33.33% to 50% each, but basis remains unchanged
ABC Manufacturing may need to finance the purchase or use operating cash

Option 2: Cross-Purchase

Michael and Sarah each purchase half of David's interest ($1,000,000 each).

David receives $2,000,000 total
Michael and Sarah each receive a $1,000,000 basis increase in the acquired interest
Michael's ownership: 33.33% + 16.67% = 50% with basis of (original basis + $1,000,000)
Sarah's ownership: 33.33% + 16.67% = 50% with basis of (original basis + $1,000,000)
Higher basis benefits Michael and Sarah upon future sale

Option 3: Installment Sale

David sells his interest over 3 years to spread his tax liability.

Installment terms:

Year 1: $666,667 (plus interest)
Year 2: $666,667 (plus interest)
Year 3: $666,667 (plus interest)

Assuming David's basis is $500,000 and the sale price is $2,000,000:

Gain: $1,500,000
Gross profit percentage: 75%
Each year's taxable gain: $666,667 × 75% = $500,000

David spreads $1,500,000 of gain over three years instead of recognizing it all at once, potentially reducing his marginal tax rate.

Recommended Structure

Given the facts, a cross-purchase with installment payments provides optimal results:

David's interest is purchased by Michael and Sarah over 3 years
Each buyer makes annual payments of $333,333 to David
Interest at the applicable federal rate (AFR) is paid on outstanding balance
Michael and Sarah each receive $1,000,000 basis increase
David spreads gain recognition over the installment period

Funding the Purchase:

Michael and Sarah each need $333,333 annually for 3 years
Options: personal savings, bonus payments from ABC, personal loans, or bank financing secured by business assets
If David had died instead of retiring, life insurance would have provided funds

Documentation Required

Amended Operating Agreement reflecting ownership changes
Purchase Agreement specifying price, terms, and conditions
Promissory notes from Michael and Sarah to David
Security agreement (if any collateral pledged)
Updated buy-sell agreement for remaining two owners

Post-Transaction Structure

After completion:

Michael: 50% owner, basis = original + $1,000,000
Sarah: 50% owner, basis = original + $1,000,000
Michael and Sarah should execute new buy-sell agreement
Life insurance policies reviewed and updated for new ownership percentages

Estate Tax Considerations

When a business owner dies, the estate must value the business interest and potentially pay estate tax.

Section 6166 Installment Payments

If a closely held business interest exceeds 35% of the adjusted gross estate, the estate may elect to pay estate tax attributable to the business over 14 years (5-year deferral, then 10 annual installments). Interest accrues at 2% on deferred tax for the first $1,000,000 (indexed) of taxable value.

Special Use Valuation (Section 2032A)

Real property used in farming or closely held businesses may be valued based on its current use rather than highest and best use, reducing estate value by up to $1,310,000 (2024 limit, indexed for inflation).

Coordinating Estate Plans with Business Succession