Individuals who own interests in a closely held family business need to address an exit strategy. In many cases, such individuals wish to have a child who is involved in the business takeover its operation at some point, often when the founder retires, becomes incapacitated, or dies.

This can raise a myriad of income tax, estate tax, estate planning, corporate/business, and family issues. Is the designated successor capable of handling the business? How should ownership of the entity be handled and transferred? And should that be addressed in the same manner as control of the entity?

This article describes several of the many ways these transfers can be structured.

Non-Voting Interests

Could succession be as simple as making the founder’s shares non-voting upon death and having those shares pass to trusts for the surviving spouse—then, upon their death, pass to trusts for the children equally? This could also be done by recapitalizing the entity into voting and nonvoting interests and gifting or selling (depending upon estate planning goals and the founder’s financial needs) the voting interests to the child in the business.

One concept behind this approach is to enable all children to share equally in business profits, while ensuring that those not in the business cannot interfere with the child running the business.

The simplistic approach outlined above, however, may not be sufficient to protect the interests of all involved. As but one example, without a specific provision addressing salary, the child in the business could increase their salary and thereby unduly reduce funds available for distribution to all owners.

Death Buyout by Child in the Business

An agreement could be planned so that the child in the business must buy the founder’s shares based on appraised value with terms (e.g., 10% down and the balance with a self-amortizing note over a given term). The payments should be structured to be reasonable for the rest of the family and palatable to the child in the business, while considering the business’s cash flow. This might be documented in a buy-sell agreement for the entity, or might even be contained in the founder’s will or revocable trust.

For example, if a mandated buyout is provided for, the valuation formula should consider the economic impact of the death of the founder on the business’s valuation. If an appraiser is hired to quantify the value and potential impact of the founder’s passing, that same analysis may inform how to price and structure a disability or retirement buyout. If this is deferred until death, the founder will not be present to guide the discussions or decisions. This could increase the risk of conflict amongst surviving family members. The following should be prepared in advance:

  • ▪ A valuation of the business
  • ▪ A valuation of the business without the founder’s involvement (e.g., death)
  • ▪ The terms for a buyout that would not unduly financially stress the child in the business, or the business’s viability itself, after the founder ceases involvement for any reason (retires, disabled, dies)
  • ▪ A formula that could be used to adjust and calculate buyout values in the future.

Redemption Insurance Funded Buyout on Death

Life insurance is commonly used to transition a closely held business. Such a plan must, however, consider all forms of the founder’s cessation—not only death, but also disability, a reduced workload, and full retirement.

The business could buy and pay for life insurance on the founder and, upon death, receive proceeds used to purchase the founder’s interests in the business. This could be structured to then leave the child in the business as the sole owner. If the business redeems the founder’s shares, then the remaining family members would benefit from that cash without entanglement with the child running the business.

It is worth noting that a recent court decision, Connelly v. IRS, No. 21-3683 (8th Cir. 2023), held that the value of the insurance death benefit had to be included in the value of the business, as reported by the founder’s estate.

Cross-Purchase Insurance Funded Buyout on Death

The child in the business could buy and pay for life insurance on the founder’s life and, upon the founder’s death, receive proceeds used to purchase the founder’s interests in the business under a cross-purchase arrangement. This could then be structured to leave the child in the business as the sole owner.

Such an approach entails several questions:

  • ▪ Does the child in the business have the cash flow to pay for the insurance?
  • ▪ Will this be a symmetrical arrangement, with the founder buying the child’s shares if the child predeceases?
  • ▪ In the alternative, if the child prede-ceases the founder, will there be a buyout agreement that mandates a sale of all business interests and a division of proceeds based upon the parent and child’s ownership interests at that point in time?

Disability Insurance Funded Buyout

This approach is used infrequently because of the cost of disability buyout insurance, but it may be an option to consider. Even if it is not feasible, pricing the coverage may inform other decisions.

The child in the business, or the business itself, could purchase disability buyout insurance that pays off in the event the founder is disabled; those proceeds could be required under the terms of a buyout agreement to be paid to the founder (or guardian) and the founder would be required to sell those shares to the child in the business.

In most situations, an alternative arrangement for funding the buyout is needed because the insurance will be too costly. It could also be arranged with a payment over time supported by a note.

Lifetime Buyout by Child in the Business

An agreement could be structured so that the child in the business buys founder’s shares while the founder is still alive. This may be fairer to the child if they are personally and actively growing the business, as it facilitates the value being established before the child increases it further. The price might be based on appraised value with terms (e.g., 10% down and the balance with a self-amortizing note over a term of years) that makes the payments reasonable for the rest of the family and palatable to the child, while considering the business’s cash flow. This might even be structured in tranches so that if business or personal circumstances change, the founder can adjust future sales. This might be accomplished by having 10% of the founder’s sales sold in year one, and the terms of sale reevaluated in each future year. If another child wishes to enter the business later, there would still be equity to sell to that child as well.

A better approach might be to sell to a grantor trust, thus avoiding capital gains and assuring that the equity is in a trust that might benefit any or all children as circumstances warrant.

Sale to Third Party

Selling the business to a third party might be an option, but requires consideration of the timing and triggering events. Should parameters be provided in the governing documents? For example, a sale must be at a fair arm’s length price (i.e., no sweetheart compensation), must be effected within three to six months, and must be operated effectively until then. This approach might only be an option if something happens to the child in the business. If something happens to both the founder and the child designated as successor, the only option might be to sell the business.

At some stage, the founder may have neither the interest nor the ability to run or sell the business. A comprehensive succession plan should consider this possibility. It may be as simple as naming someone as a successor manager of the LLC operating the business if neither the founder nor a child can serve, and empowering that person to operate the business pending a sale. The directive may be for that person to immediately list the business for sale and operate it only until that is accomplished, with a stated goal of selling the business as quickly as possible. The odds of this may be remote, but even unlikely scenarios do occur, and this and other contingencies are relatively simple and inexpensive to address in a comprehensive buy-sell plan.

Sale for a Private Annuity

Although sales for a private annuity have traditionally been used as part of estate planning to reduce the value of the estate, this technique can also ensure a founder has a cash flow for life when transitioning the business.

Martin M. Shenkman, JD, CPA, PFS, AEP is an attorney at Shenkman Law in New York, N.Y.