Estate of affairs

Entrepreneur, May, 1998 by Joan Szabo

If you've already done long-range planning for your company, you've probably established a way to transfer ownership when you pass on. But do you know what the tax consequences of such a transfer will be? Are you clear about what taxes your heirs or the other owners in your business will have to pay and how they'll pay them? According to tax experts, trouble may lie ahead for small-business owners who don't know the answers to these questions.

Before examining the tax consequences, however, a word about planning. Properly planning for business ownership transfer is as important as writing a will, experts say. The planning process forces you to iron out how ownership will change hands and how to pay for the transfer in the event of death. Putting this information on paper gives you the confidence of knowing you won't be leaving your business partners or family in a bind when you die.

When small-business owners don't understand the tax consequences of a business transfer plan, those who are left behind may be hit with a hefty tax bill they could have avoided if the necessary forethought and planning had taken place. All too often, small-business owners don't plan ahead. "Most small-business owners [think they] will never die," says Bill Fleming, director of personal financial planning services for Coopers & Lybrand LLP in Hartford, Connecticut. "They refuse to acknowledge they will be anywhere except running the business, so they fail to plan."

PASSING THE BUCKS

The most common way for closely held businesses to accomplish a future transfer is with a buy-sell agreement. This arrangement lays out the future ownership of the business in the event that one of the owners dies. Buying life insurance for each owner is a good way to fund the business purchase.

When one owner dies, the buy-sell agreement stipulates that the insurance policy's death benefits are to be paid out to the surviving owners or to the business, giving them the money they'll need to purchase the part of the company the deceased person owned. The agreement provides the surviving owners and family members with a smooth business transition, generally by allowing them to quickly buy the deceased owner's interest. Your family will be secure, having received cash for your shares. The details of ownership transfer, including the obligations of all parties involved and how the business will be valued at the time of transfer, are spelled out in the buy-sell agreement, says Michael E Rogers, an attorney and CPA with the Philadelphia law firm Kauffman, Freeman & Rogers PC. This way, the surviving owners don't have to worry about negotiating a price when one of the co-owners dies. Ironing out all these details beforehand also helps avoid future disputes.

There are two general approaches you can take to a buy-sell agreement. One is known as the entity purchase, in which the company itself buys out your interest in the business when you die. To accomplish this, the company buys life insurance on each shareholder and designates the business as the beneficiary. "It has the illusion of simplicity," says Fleming. "But when there's a death, the surviving owners suddenly face unforeseen problems." Major complications include paying a much higher federal tax bill when the surviving owners decide to sell the business and the possibility that the IRS will insist the life insurance death benefit be included in the company's value.

Rogers points to another tax drawback of using the entity purchase method. If your company is a C corporation, the business may be hit with an alternative minimum tax bill when it receives the insurance proceeds. That particular tax problem would not affect S corporations, however.

The other method is the cross-purchase agreement. With this arrangement, the surviving co-owners buy out the deceased owner's interest using the life insurance proceeds. Of the two methods, a cross-purchase agreement offers the best tax savings. A major one is that business owners buying out the deceased owner's interest in the company receive an increase in the basis (the measuring point for gain) to the market value of the company for the portion purchased. Therefore, when the surviving owners decide to sell the business down the road, they'll face a smaller capital gains tax bill than if they hadn't set up a cross-purchase agreement.

Here's how it works: Take the example of two owners who each contributed an equal amount, say $25,000, to launch a business that's now worth $2 million. One of the owners dies, and the other wants to buy the deceased owner's interest. Under a cross-purchase agreement, the surviving owner uses life insurance proceeds to purchase the other's share of the business. Then he is able to use $1 million (in proceeds from the insurance) as his basis for income tax purposes for the part of the company purchased from the deceased person.

"A higher basis is important for taking losses in the future or if you're going to sell the company at some point," says Fleming. With a cross-purchase agreement, the shares in the business that the deceased person owned are valued for income tax purposes at their current value at the time of the co-owner's death. However, if the surviving owner was required to use the original amount invested as the basis - $25,000 in the above example - any profit realized over the $25,000 would be hit with capital gains taxes when the business was sold. That is also exactly what would happen if the two owners selected an entity purchase agreement instead of the cross-purchase for the buy-sell.