Less than one third of the country's 21 million family-owned businesses make it to the second generation, according to the Small Business Administration. Over 85 percent fail to make it to the third generation. The sudden death or disability of the founding owner who has no estate or succession plan in place, is the most devastating yet the most avoidable cause of failure. A succession plan, created with advice from experienced legal and financial professionals, can ensure your family isn't left in a bind and will receive value for your years of hard work.

 Each succession plan has its own set of issues that must be addressed. Fortunately there are plenty of legal and financial tools to address them. It's important to first understand some of the scenarios that can take place in a typical family-owned business situation. Here are some challenges or concerns to consider:

Inheritance by Will or Trust 

·         With Federal and state estate taxes as high as 50 percent, heirs could be forced to sell the business to pay the taxes

·         A surviving spouse who was dependent on income from the business will have only business profits, if any

·         If some heirs are active in the business and other less so, disputes may occur regarding salaries, dividends and profits

Buy-Sell Agreement

·         A buy-sell agreement addresses specific price and payment terms and whether these go into effect at the owner's death only or at some other times

·         A source for money for the purchase price needs to be identified

·         If sale during the owner's lifetime is intended to provide retirement income, the terms for payment must be clear and work for all concerned

Gifting  

·         Gifts of ownership interests in a business during the owner's lifetime must comply with IRS gift tax rules

·         Often, the owner's desire to maintain control must be balanced with the next generation's interests

Here are specific legal and financial tools to address these issues, including:

·         Life insurance, when affordable and owned in a way to avoid or minimize taxes, can be the source of money for payment of estate taxes or funding a buy-sell agreement

·         Family Limited Partnerships and other forms of business organizations can make gifting of stock in a business faster and easier as well as ensure the business stays in the family

·         A thoughtfully written Buy-Sell Agreement, which addresses the interests of the owner and spouse as well as the next generation, can address issues before they become problems

Over the past several months we've been providing updates on the status of the federal estate tax. To recap, under current law there is currently no federal estate tax on estates of people who die in 2010; however on January 1, 2011, the federal estate tax will be imposed on estates over $1 million in value.  In 2009, the federal estate tax was imposed only on estates of over $3.5 million in value.  There has been speculation that Congress will act before the end of 2010 to prevent the $1 million exemption from taking effect on January 1, either by extending the 2009 law (continuing the $3.5 million exemption) or by enacting an even higher exemption amount ($5 million).  To date, Congress has not taken any action despite numerous bills introduced in the House and Senate since January 1, 2009, which attempted to address this issue. 

It now seems certain there will be no action on the federal estate tax until after the November elections.  In September, Senate Democratic leaders announced they would not vote on tax legislation - including provisions to reinstate the estate tax -- until after that time.   Without Congressional action, the federal estate tax will reappear on January 1, 2011, with a $1 million exemption, creating a large federal estate tax obligation for many estates that would have escaped the tax altogether under the higher exemption amounts that had been in effect since 2004.

A question still remains whether Congress will reinstate the federal estate tax for 2010 and apply that tax retroactively to estates of individuals who have died in 2010.  If Congress attempts to apply the estate tax retroactively, many expect this action to be challenged in the courts, which would leave the issue unresolved for years while those cases make their way through the court system.

A recently mentioned possibility is that Congress will offer a choice to estates of those who die in 2010, meaning the estate can elect to either (1) allow the federal estate tax to apply retroactively, pay any federal estate tax that may be due and receive a step-up in basis on all inherited assets, or (2) pay no federal estate tax but forgo the step-up in basis and comply with the 2010 carryover basis rules.  This possibility became more concrete on Sept. 13, 2010, when a group of leading Republican senators introduced a bill that proposes to retroactively impose an estate tax on estates of those who die in 2010, raise the estate tax exemption to $5 million, repeal the carryover basis rules, reduce the top estate and gift tax rate to 35%, and permit a surviving spouse to take advantage of her spouse's unused estate tax exemption.  Significantly, the bill also includes a provision that would allow executors of estates of those who die in 2010 to elect whether to be taxed under this new regime or under the present 2010 rules.

By the time our next newsletter is published in January, we should have much more information.  Stay tuned!