A Blueprint for Business Succession Planning
The equity in a small business owners’ companies is a valuable asset. But in a privately held company, how can equity be converted to cash when the owner exits the business? Creating an exit plan – commonly called a “succession plan” – is an integral part of strategic business planning. This article will help business owners understand: 1) why a succession plan is important; 2) how to begin the process; and 3) how to put the plan into action.
The Tax Impact at an Owner’s Exit
Succession planning, which involves passing ownership to an heir or selling the company, aims to achieve an optimal outcome for the business, which includes converting business equity into cash. This goal is important for two reasons:
1. At retirement, business owners usually want to enjoy themselves or pursue other opportunities. After giving up control, they don’t want to worry about the health of their business.
2. An owner’s heirs may lack the knowledge or interest to manage the business – and may prefer to liquidate it. The value of a business passed to heirs is included in the owner’s estate at death and could be subject to federal estate taxes. These taxes must be paid in cash, and the filing deadline for federal estate taxes is nine months after the date of death, unless an extension is requested.
Valuing the Business
After a successor is identified, the next step is to determine the buy-out value. Although small business owners have some flexibility in setting the price of a buy-out transaction, the IRS and courts require a valuation that represents fair market reality. Some valuation methods include:
• Comparable recent transactions – Business value is based on the terms of sales or mergers involving companies of comparable size in the same industry.
• Multiple of revenue or book value – Business value may be pegged to a multiple of gross revenues in the year or two just before the owner exits. For example, some service-oriented businesses may sell for about one to two times annual gross revenues.
• Discounted cash flow – The value is based on total cash flow that the business is projected to generate for a period of years after the owner’s exit, discounted by a cost of capital.
Drafting the Legal Agreement
The next step is to formalize the buy-sell agreement in writing with the help of a succession planning attorney. An important section of the agreement defines “trigger events” that will require ownership to change hands. Common trigger events include an owner’s death, disability, retirement or divorce.
Funding the Buy-Sell Agreement
Permanent life insurance is often used to fund buy-sell agreements. This is because coverage can continue, and premiums remain constant. Funding these agreements with permanent life insurance also has other benefits:
• Quick and convenient cash for heirs – Life insurance solves the problem of turning an illiquid asset (the business) into cash.
• Tax advantages – Life insurance pays a death benefit that is generally free of federal income taxes. In buy-sell agreements, the benefit is usually paid to the party who has the obligation to buy the shares, so the death benefit does not create estate tax consequences.
• Cash value – The cash value of a permanent policy can provide buyout funds if an owner exits at a lifetime triggering event. Most agreements include provisions for terminating the buy-sell agreement. In such instances, the policy’s owner can recoup part of the premium cost from the cash value.
Successful business owners rarely stop working long enough to ask why they are working so hard. But ultimately, most are striving to achieve a certain level of security for themselves and their loved ones. With the right succession planning, small business owners can help to ensure both the long-term success of their business – and greater financial security for themselves and their family for many years to come.