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Family Business Succession Planning [Top Pitfalls and Best Techniques]

Fact Checked by Jason Herring & Barry Brooksby
Licensed Agents & Life Insurance Experts.
Insurance and Estates, a strategic life insurance provider composed of life insurance professionals, is committed to integrity in our editorial standards and transparency in how we receive compensation from our insurance partners.

Family Business Succession Planning Is Extremely Important.  Without It, A Small Business May Be Thrown Into Chaos Or Forced To Shut Down If A Key Person Dies Or Becomes Disabled.

The topic of business continuity and succession planning is becoming very popular because a vast number of baby boomer business owners are aging.   This is an arena where business planning, asset protection planning and estate planning are all interconnected and a good estate planner and insurance professional will knit the various components together to form a coherent strategy.

What is family business succession planning?

Family Business succession planning asks the simple question of how the business will continue to operate if the key person (generally dad or mom) is unable to continue operating the company or otherwise serving in a leadership role.

Fortunate families may have a capable son or daughter who not only works within the family business but also has reached a level of sophistication where he/she can step in and lead.

Leading and working are two very different things so the process of training a future leader is an important concern. When adult children are either not involved in the business or not yet able to assume a substantial leadership role, issues can arise which threaten the stability of the business.

If there are partners involved in the business who are outside of the family, it can be difficult for them to deal with inexperienced heirs who suddenly want to work in the business, including being involved in decisions about the direction of the company.  Worse yet, entitled heirs often only want to collect money from the business.

You can imagine the difficult buy out negotiations that can erupt and a business may even be forced to shut down if no agreement can be reached.

Planning for estate taxes and liquidity

Most business are a principal asset in the family estate, and most are large enough to generate substantial federal estate taxes which is essentially a “death tax” that may be 45% of the estate.  To avoid the death tax, the entire business can be passed to a surviving spouse under the unlimited marital deduction.

However, if the surviving spouse doesn’t work in the business, this strategy may only delay the inevitable because taxes will follow upon his/her passing.

It may be better to transfer the business interest immediately if there is a son OR daughter who is actively working to grow the company because if the company grows in value, then taxes will be higher.

But, the next question is whether there is enough liquidity in the estate to pay the estate taxes and other estate settlement costs such as probate legal fees.  Liquidity is a common concern for family businesses where all assets and capital are tied up in operations and expansion.

A business interest such as a corporation may by back shares of stock in order to provide liquidity for the estate, but this depends on whether the corporation is “liquid” enough to do so.  Lack of liquidity is especially common for heavy asset businesses family farms and car dealerships.

Income taxes also create liquidity concerns because when a corporation repurchases stock from a shareholder (the estate), a taxable dividend to the estate occurs and this is an income taxable event.

Of course, a third party could be solicited to purchase part of the company.  IRS rules favor this option because the monies generated are capital gains AND there is a step up in basis upon death so there may be little to no income taxes owed.

Nevertheless, a purchaser may  be reluctant or unwilling to pay a premium due to the instability created by the death of a key person.

Also, most business people will be reluctant to purchase only a portion of a family business, so it may be difficult for the family to keep any ownership within the family in this scenario.

Thankfully, Section 303 of the Internal Revenue Code (IRC) does allow the estate to redeem a certain amount of business interest as if it were a 3rd party purchaser provided certain conditions are met.

Planning for business continuation

Some basic options for continuing the operations of a company upon the death of a key person are:

  1. Position a key employee or employees to either manage or buy out the company.  A key employee may be replaced and positioned to manage the business OR buy out arrangements may be made.  Funding through a key man insurance policy that names the company as beneficiary can make these options possible AND these kinds of arrangements are also often embodied in buy-sell” agreements which are discussed in detail below.
  2. Pursue an outside acquisition of the company. This would involve empowering someone such as the board and/or the surviving spouse with the power to have the company evaluated and marketed to potential acquisition candidates.

Linking your business succession plan together with proper estate planning techniques is essential to facilitate a smooth transition.

You must take certain estate planning steps to assure that there is no confusion in executing your business succession plan.

First, the estate planning documents such as the revocable living trust and powers of attorney need to specify who will have the authority to operate the business in the event of disability. The revocable living trust should specify who has operational authority in the event of death.

Second, estate planning documents should specify what will happen in the event of the death or disability of one of the key persons who operate the company.  These directions should be included in any trust as well as the last will and testament, and should also be described in a separate “buy sell agreement” or as a “buy sell provision” within the operating agreements of the company.

The estate planning documents AND the corporate governing documents, as well as a buy-sell agreement, should include transfer upon death or buyback provisions for shares in the event of disability or death.  For transfers upon death, the revocable living trust may need to be specified as the transferee upon death.

As always, these measures need to be part of a clear business succession plan that is consistent between the various documents discussed above, and thus typically, this planning requires the skills of a competent business and estate planning attorney as well as an experienced competent life insurance strategist with experience in estate and business planning.   The above involves some additional considerations as follows.

Well Thought out Revocable Living Trust

As a business owner, you need a well written Revocable Living Trust Agreement to addresses your business concerns.

A Revocable Living Trust must first include the necessary authorization within the “Trustee Powers” section in order to allow your Successor Trustee to manage your business affairs.

Depending upon the nature of your business, this could be the authorization in the Revocable Trust to allow for the management of corporate stock, a closely held business or subchapter “S” stock which is called a “Qualified Subchapter S or QSST” Trust.

Other powers such as “farm and ranch” powers may need to be included to fully empower the Successor Trustee to take care of business.

How Should Your Business Entity be Held or Titled

Proper titling of your assets is essential. Another way that your Revocable Living Trust coordinates with your business continuation plan is in how your business entity is held or “titled”.

For example, you might own your corporate shares or LLC membership interest as the Trustee of your Revocable Trust rather than in your individual name.

Alternatively, your corporate or LLC documents should include a “Transfer Upon Death” section that allows the shares (or membership interest) to automatically transfer to the Trust upon your death.

Warning: If the business entity is not held by the Revocable Trust upon the owner’s death, then the Trust has no immediate authority to execute your wishes or operate the company.  A probate may be required to properly give this authority to the Successor Trustee.

Buy Sell Agreement or Cross Purchase Agreement

You will need a Buy Sell Agreement or Cross Purchase Agreementdepending upon the specific business continuation plan and the type of insurance decided upon for the company.  For example, there are two basic types of insurance strategies which for the buyout of a business which are “entity purchases” and “cross purchases”.

An entity purchase is where the company (corporation, LLC, LLP…) is the owner of the policy and the beneficiary upon the death of the insured.

A cross purchase is where the individual owners are named as the beneficiaries for policies that cover their partners or co-owners.

Another name for business continuation insurance is “Key Person” or key man insurance, which covers the loss of a person who is critical to the operation of the company.

Where Key Person Insurance Fits In

Key person insurance could either fall into an entity purchase or cross purchase category. However, it is most commonly an entity purchase plan because the company will need funds (1) to make up for the loss of the key person and (2) to fund the hiring and training of a replacement.

Which is why…

…understanding the above concepts demonstrates why a well written entity purchase or cross purchase agreement is critical.

Perhaps most important, is to designate in the agreement who the beneficiaries are and to provide a valuation formula if the life insurance funds are being used by one partner, shareholder or member to “buy out” the deceased partner’s interest.

This kind of planning is an important way to avoid becoming a business partner to the deceased person’s family member or Trustee who may have no experience in the business.

Using Life Insurance in Family Business Succession

The type of coverage you choose is vital to your plan. Using properly structured cash value life insurance is one key ingredient.

Further, as a family business owner, your life insurance policies, coverage amount, and beneficiary designations need to match the stated intent of your business succession planning and estate planning documents.

When you purchase an insurance policy, you designate the beneficiary of the policy upon the death of the insured.

So, if an entity purchase agreement is being used, the company (C Corp or S Corp, LLC, LLP, etc.) should be designated as the beneficiary of the policy.

Similarly, with a cross purchase agreement, the partner or partners who are beneficiaries should be specified.

Also, your coverage should be based upon the business valuation formula in your buy sell agreement as discussed in the preceding section.

Essential Family Business Planning

Understand that the above general recommendations are your essential basic level family business planning recommendations.

There are other more complex family business planning strategies such as a charitable lead trusts or charitable remainder trusts that also could coordinate with your business continuation life insurance as part of a tax deferment and savings strategy.

All of the above is critical estate planning because it can save your company, employees and loved ones from a total financial collapse and preserve your life’s legacy.   So, I encourage you now to take the steps necessary to create a complete family business succession plan.


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