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How to Plan For Your Business – Begley Report

by: Begley Law Group

By:  Thomas D. Begley, Jr., Esquire, CELA

CASE STUDY 1:  INADEQUATE BUY-SELL AGREEMENT LEADS TO LITIGATION

Three physicians are in practice together.  Their corporation was formed 15 years ago, at which time articles of incorporation were filed, a buy-sell agreement was signed, stock certificates were issued, and all basic corporate formalities were followed.  The buy-sell agreement provides a cross-purchase arrangement, which stipulates that, in the event of the death of one of the parties, the remaining physicians will purchase from the deceased’s estate that party’s interest in the practice.  The agreement provides that the purchase price will be $40 per share and that the price will be reviewed every three years.  Since the initial incorporation, the physicians have not reviewed the buy-sell agreement or revisited the $40 per share price, and they have failed to hold annual meetings.  No provision has been made for disability or retirement.

One of the physicians now has cancer and has spent much of the past year in treatment that has left him incapacitated and unable to practice medicine.  The physician has stopped receiving his salary from the corporation, and his wife, acting as his agent under a general durable power of attorney, has decided that he should exit the practice.

She approaches the other physicians to attempt to withdraw her husband from the corporation.  The cross-purchase agreement does not apply to cases of disability.  The two remaining physicians agree to buy the third physician out at $40 per share, even though, at the time of the physician’s incapacity, the corporation’s net worth is about $200 per share.  The incapacitated physician has mounting medical expenses and limited investments outside of the corporation.

Since the cross-purchase agreement fails to adequately provide for the terms of the buyout, litigation is required to resolve the dispute.

CASE STUDY 2:  LACK OF PLANNING LEADS TO FAMILY DISCORD AND LITIGATION

Jim is married to Mary.  They have two children, Frank and Susan.  Jim has spent his entire work life running a small tool store he inherited from his father.  When Frank finishes his education, he begins working in the business.  Over the years, Frank grows into a very competent manager, expands the business to a second location, and insists that a corporation be formed to operate the business.  Although Jim is very proud of the job that Frank has done, he refuses to relinquish control of the business.  Jim has not executed a will, a power of attorney, or an advance medical directive, nor has he made any plan providing for his exit from the business. Jim has no other assets except for the home in which he and his wife Mary have lived.

Jim develops mild cognitive impairment that worsens over a period of years.  In the past six months, he has become completely incapacitated and has been moved to a locked Alzheimer’s unit in a local nursing home.  Mary is still competent, but she is elderly.  

Tired of caring for her husband, she has moved into an assisted living facility.  The business may have to be sold to pay for Jim’s care.  Frank wants to inherit the business that he has spent his adult life working for and improving.  He also wants to ensure that the business will provide for his mother.  Susan has completed her education and lives in New York.  She now claims that she wants half of the business since it is the only asset for her to inherit.  The company’s shareholders have seldom held annual meetings, stock certificates have never been issued, and minutes have not been kept up to date.  Jim’s failure to properly plan has resulted in discord among the family members.  Frank is considering opening his own business.  Susan is considering litigation.

WHAT TYPES OF PLANNING ARE CRITICAL WHEN FORMING A BUSINESS?

When starting any business, it is important to plan for both the management of that enterprise and its eventual transfer to a successor. With the guidance of an attorney and other professional advisors, business owners need to:

  • Choose an appropriate business entity.
  • Choose employee benefits.
  • Develop a succession plan.
  • Coordinate that succession plan with their personal estate plans.

PLANNING FOR THE MANAGEMENT OF THE BUSINESS

♦ What Type of Business Entity is Best for the Business? One of the first steps a business owner must take is to decide on a suitable business entity.  Each type of entity has advantages and disadvantages, and the right choice for a particular business will depend on a variety of factors.  In particular, a business owner should ensure that the chosen entity will allow for adequate management and control, both today and in the future.  The entity selected should enable the business owner to maintain control for as long as desired and to transfer the business at the chosen time, according to his or her wishes.

An attorney can assist the business owner in choosing an appropriate entity and in considering its impact on estate, gift, and income taxes. Business entity choices include the following:

  • Sole Proprietorship
    • Advantages:  Simplicity and control
    • Disadvantage:  Liability
  • Corporation
    • Advantages:  Limited liability; potential tax benefits; ability to retain or transfer control
    • Disadvantages:  Filings required; possibility of double taxation with an ordinary corporation
  • Limited Liability Corporation
    • Advantages:  Limited liability; potential tax benefits; ability to retain or transfer control
    • Disadvantage:  Filings required
  • Partnership
    • Advantages:  Limited liability; potential tax benefits; ability to retain or transfer control
    • Disadvantage:  Filings required
  • Limited Liability Partnership
    • Advantages:  Limited liability; potential tax benefits; ability to retain or transfer control
    • Disadvantage:  Filings required

♦ What Documentation is Required for a Business Entity? Certain documentation is required for most business entities.

  • Entity Selection. After a business entity has been selected, appropriate documentation must be filed with the state office having jurisdiction over the enterprise.  A sole proprietorship is not required to do this, but should consider filing a fictitious name certificate.
  • Internal Documentation. Depending on the type of entity chosen, a business must have internal documentation, such as an operating agreement, a partnership agreement, or by-laws.  These documents should not only provide for the day-to-day management of the business, but also include a succession plan with provisions such as a buy-sell agreement.
  • A Buy-Sell Agreement. This is an agreement between or among business owners as to how the business will be valued and what will happen in the event of the death, disability, or retirement of one of the owners.  A buy-sell agreement should address:
    • Issuance and endorsement of shares, membership certificates, or partnership units.
    • Restrictions on transfers.
    • Determination of valuation.
    • Mandatory purchase at the death of the shareholders.
    • Optional purchase upon termination of employment for reasons other than death.
    • Stock pledges.
    • Personal guarantees of corporate obligations.
    • Modification and termination of the agreement.
    • S corporation status.
    • Miscellaneous provisions.
    • Provisions relating to life insurance.
  • An Employment Agreement. This stipulates the compensation and duties of a business owner employed by the business entity.  The agreement also should address:
    • Vacations.
    • Termination.
    • Employer’s authority.
    • Records.
    • Expenses.
    • Reimbursement of disallowed compensation and expenses.
    • Military service and disability.
    • Term.
  • Medical Reimbursement. If the business entity adopts a medical reimbursement plan, an agreement to that effect should be prepared.
  • A Written Succession Plan. A business plan should include a succession plan that provides for how the owner will leave the business either at retirement or upon his or her death or disability.

♦ What Team Should a Business Owner Develop? From the onset, a business owner should develop a team of professional advisors to assist in business plan development and maintenance.  This team should consist of the following:

  • An attorney.
  • A CPA.
  • A financial advisor.
  • A family business consultant (if the business is large and the emotional issues are complex).

♦ What Employee Benefits Should Be Offered? A new business should make it a priority to choose the basic benefits that will be offered to employees.  These benefits may include, but are not limited to, the following:

  • Life insurance (in particular, life insurance to fund a buy-sell agreement).
  • Disability insurance.
  • Medical insurance.
  • A retirement plan.

♦ What Issues Are Unique to Family-Owned Businesses? Family-owned businesses have unique issues and considerations.  Family business owners rank the issues that confront them in the following descending order of importance:1

1.   Organizational structure of the business.

2.   Capable and supportive key management.

3.   Motivation of successors and management.

4.   Accommodation of family members.

5.   Estate planning.

6.   Retirement planning for current management.

7.   Retaining competent professional advisors.

8.   Operating with a board of outside directors.

SUCCESSION PLANNING

♦ What is the Role of Business Succession Planning? Business succession planning enables a business owner to decide how an enterprise will be transferred upon his or her death, disability, or retirement.  Succession planning should be considered at the time a business is formed, and provisions for executing that plan should be included in the original business entity documents.  As illustrated in Case Study 1, it is also critical for the succession plan to be reviewed and updated annually.  This can help avoid negative consequences, such as failing to plan for disability or retirement, or leaving shareholders vulnerable to a poor valuation, with litigation as the only recourse.

A properly executed succession plan defines certain events, such as death, disability or retirement, that will trigger the sale of a business interest.  The succession plan and related documents provide a mechanism for the purchase of the business interest of an owner when such events occur.  The succession plan can stipulate that the business interest may be purchased by the business entity or by other owners.  If there are no other owners, the plan can outline what efforts will be taken to find a buyer for the business.

♦ What Needs to be Considered When Developing a Succession Plan? The first step in developing a succession plan is to envision the entity’s future.  Will the business grow or stay the same size?  Will children or other owners or employees take over, or will the business be sold to a third party?  Will the business continue into the future, or will it end upon the death, disability, or retirement of the owner?

Equally important is an understanding of how business income fits into the business owner’s personal financial plan.  Is it a significant source of retirement income for the business owner and his or her spouse?  Is it the sole asset in the business owner’s estate?

♦ What is the Nexus Between Business Succession Planning and Estate Planning? Since a succession plan is a key aspect of a business owner’s estate plan, it is very important to ensure that one is properly coordinated with the other.  Failure to do so can result in an unsatisfactory disposition of assets, or expensive litigation and fractured family relationships.

As illustrated in Case Study 2, a succession plan must answer such business and estate planning questions as:  If a son takes over the business during his lifetime, how will the owner’s wife be taken care of?  If the father dies and leaves all his assets to the wife, how will the son’s place in the business be preserved?  How will the father provide for his daughter if he leaves the business to his son?

Business owners should review both their succession plans and estate plans on a regular basis to ensure they remain up to date.  This is particularly important as business owners near retirement or become aware of an impending disability.

♦ How Can Succession Planning be Accomplished When a Business is the Main Source of Income for the Business Owner and/or His or Her Spouse? There are a number of alternatives:

  • A Salary Continuation Plan. In this arrangement, the business agrees to pay some of the owner’s salary in the future.  When this is done over a number of years, it can provide the owner with a reasonable salary during retirement.  The agreement is an enforceable contract, but may be evidenced with an unsecured promissory note.
  • A Retirement Plan. A qualified pension, profit-sharing plan, SIMPLE, SEP IRA, or KEOGH can provide a business owner with reasonable retirement compensation at a favorable tax basis, while allowing the company to take a tax deduction for the contributions it made when the plan was established.  Since the plan is not a taxpayer, income on contributions is earned tax free and is taxed only upon distribution.
  • A Structured Payout. A business owner who plans to sell his or her business may consider a structured payout over a period of years.
  • Separate Business Entities. In this arrangement, one business entity holds the business, and the other holds the real estate and leases it back to the business.  This allows a business owner to retire from the business, but keep the entity with the real estate to help fund his or her retirement.

♦ How Can Succession Planning be Accomplished When the Business Has Multiple Owners? There are several options for transferring a business with multiple owners. They include:

  • A Buy-Sell Agreement. As illustrated in Case Study 1, the best way to plan for a business owner’s death, disability, or retirement when there are multiple owners is a buy-sell agreement.  There are three common types of buy-sell agreements: a redemption agreement, a cross-purchase agreement, and a hybrid of the two.
    • A Redemption Agreement.  This is a contract between all of the owners and the business, in which the owners agree to sell their interests back to the company at an agreed-upon price (usually based on a formula rather than an exact figure).  If an owner wishes to sell to a third party, the redemption agreement generally requires that he or she first offer the interest to the company.  If the company refuses to buy, the interest can then be sold to a third party.
    • A Cross-Purchase Agreement.  This generally is a contract between owners in which the exiting owner (or his or her estate) offers to sell his or her interest to the remaining owners at a specified price (again, typically based on a predetermined formula).
    • A Hybrid Agreement.  This agreement is usually between the entity and the owners, and it provides for either of them to purchase the exiting owner’s interest.  In many cases, the agreement requires that the owner (or his or her estate) first offer the interest to the company.  If the company refuses the purchase, then the other owners may purchase the interest.
  • Life Insurance. If the company or the owners have illiquid assets, life insurance may be used to fund the agreement.
  • Installment Sale. Life insurance may not be a satisfactory way of purchasing the business interest from a disabled or retiring business owner.  In such cases, an installment sale may be required.  In an installment sale, the remaining business owners pay a lump sum to the exiting owner shortly after the disability or retirement, with periodic payments thereafter.

♦ How is a Succession Owner/Manager Selected? If the business owner has a specific individual in mind to take over the business, whether a child, other relative, or extraordinary employee, it is important to begin planning and grooming that person for succession immediately.  The business owner should consider transferring control of the business to the desired successor during his or her lifetime and assuming an advisory position for himself/herself.  This can help the chosen successor become accustomed to running the business while benefiting from access to the founder’s knowledge and experience.

The individual chosen to assume ownership of the business may not be the best choice to manage the business.  The business owner may need to consider these two roles separately and decide on the best choice for each.

♦ What Happens When Some Children Participate in the Business and Others Do No? As illustrated in Case Study 2, this is a significant issue for both succession planning and estate planning.  Often, a business is the primary asset in a family.  One child may have worked for years in that business and expects to inherit it and take over at some point in the future.  Other children who haven’t worked in the business may feel they are owed a portion of it since the family lacks other assets to pass on.

One solution is to purchase a survivorship, or “second-to-die,” life insurance policy that pays out at the death of the second parent.  This type of policy rewards the child who has worked in the business for his or her “sweat equity,” while still providing equal amounts to other children in the family.

♦ What Housekeeping is Required? To help ensure that a succession plan will be upheld and properly carried out, it is critical for business owners to follow all business formalities.  This includes filing annual reports with the State Corporation Commission, paying annual dues, filing a tax return, and holding annual meetings to ensure that the original plan is reviewed and updated as required.  Specifically, a business entity should:

  • Hold annual meetings of shareholders, members, or partners.
  • Take minutes of these annual meetings.
  • Hold Board of Directors’ or Managers’ meetings.
  • Take minutes of these Board of Directors’ or Managers’ meetings.
  • Adjust any valuation agreement, if the buy-sell agreement so provides.

Failure to perform corporate formalities may be considered evidence that there is not a formal business, which calls into question such issues as the valuation of the business or any favorable tax positions.  It may also leave business assets open to individual creditors.  As shown in Case Study 1, failure to update a succession plan periodically can leave the business owner and his or her family in a precarious position.


1 “Business Succession Planning That Meets the Owner’s Needs,” Daniel H. Markstein, III, Estate Planning Magazine, July 2006, Vol. 33, No. 7, p. 22.