An Alternative To A Buy-Sell Agreement

							An Alternative To A Buy-Sell Agreement
estate planning,life insurance,family business
An Alternative To A Buy-Sell Agreement

The advantages of a buy-sell agreement are well known to owners of
closely-held businesses and their advisors. First, a buy-sell agreement
creates a "market" for what would otherwise be an unmarketable asset.
Second, a buy-sell agreement assures that the financial security of the
deceased or withdrawing owner's family will not be tied to the future
success of the business. This is particularly important to the business
owner who feels that the business will likely flounder in his/her
absence. Third, the remaining owners do not want to be in business with a
withdrawn, and now inactive, "partner" nor with a deceased owner's spouse
or children. Finally, if properly designed and drafted, a buy-sell
agreement can help fix the value of a deceased owner's interest for
estate tax purposes.

However, there are many situations in which the owners of a family
business (with active and inactive children) may not want a buy-sell
agreement. For example, if the value of the business is rising rapidly,
it may become too expensive for the active children to fund the buy-sell
agreement. This is particularly true where, because of age or health, a
business owner is either uninsurable or highly rated. In such case, the
buy-sell agreement can provide for an extended installment pay-out. But,
this results in a deceased owner's spouse (and inactive children) being
subject to the risk of the active children's business acumen. It also
raises the possibility that there will be insufficient cash to pay estate
taxes and to meet the needs of the deceased owner's surviving spouse.

Another such situation is when an upstart business is likely to have a
bright future. This could be the result of a technology breakthrough, a
new and very favorable long-term contract, or the gaining popularity of a
new product or idea. The momentum of such growth may have little to do
with the business acumen or effort of the active children. In such case,
the forced buy-out of a deceased senior member's interest may unfairly
deprive the decedent's spouse and active children of the fair value of
the growing business.

In addition, selling the business to the active children may be a double-
edged sword. On the one hand, it's possible that the children who
purchase the business will end up with a larger inheritance if the
business flourishes. Conversely, if the business flounders, the inactive
children may end up with more than the active children. Finally, for
those business owners who desire that all of their children be treated
equally, a buy-sell agreement may not make sense.

Following are the steps family business owners can follow when the
decision is made to leave the business to all of their children, but to
allow the active children to run the business without interference from
the inactive children:

- Recapitalize the business so that there are voting interests and non-
voting interests, with the non-voting interests representing 90%-95% of
the issued and outstanding interests.
- Bequeath the non-voting interests equally among all of the children. To
help reduce estate taxes, gift non-voting interests during the business
owner's lifetime. In either case, transfer to generation-skipping trusts
to protect the children from creditors, divorce and their own estate
taxes.

- Hold the voting interests in trust for all children, but appoint the
active children the "special trustees" to vote those interests. Depending
on the facts and circumstances, this trust can be created at the business
owner's death or upon the death of the survivor of the business owner and
his/her spouse. The active children, as special trustees, will have a
fiduciary duty to act in the best interests of the trust beneficiaries
and to manage the affairs of the business in a prudent and unbiased
manner. They should also have the power to sell the business if they deem
a sale is in the best interests of the trust beneficiaries. While this
arrangement leaves the active children in complete control of the
business, their fiduciary obligations must be considered in each and
every action that they take.

- Specify in the trust agreement the salaries, bonuses and fringe
benefits that the active children will be entitled to receive from the
business, as well as their managerial duties and responsibilities.
Dividends (profits) can be paid to the beneficiaries when appropriate.

- Specify in the trust agreement what is to happen to the business should
all the special trustees die, become disabled, or resign. For example,
should the business be put up for sale at such time? Should the voting
interests be distributed to all children equally? Or, should the special
trustees be permitted to appoint their successors (based on certain
objective criteria such as prior experience with the business)?

The no-sell/buy-sell also works well in a second generation family
business. Let's assume two brothers, Frank and Jesse, have inherited a
family business and both have children who are active in the business. If
Frank and Jesse enter into a standard buy-sell agreement, the last
brother standing (and eventually his children) ends up with the business.
Instead, as described above, Frank can bequeath his voting and non-voting
interests (in trust) to his children, and then name his brother as the
"special trustee" to vote the voting interests. Jesse can do likewise.

One of the keys to making sure that the no-sell/buy-sell works
successfully is to ensure that there will be sufficient liquid funds to
support the business owner's surviving spouse and to cover the
anticipated estate tax liability at the death of the surviving spouse.
Providing the surviving spouse with an adequate source of income will
also reduce the pressure on the business to produce the same. The
premiums that would have been paid to fund a buy-sell agreement with life
insurance can instead be used to fund an irrevocable life insurance trust
(ILIT) on the business owner's life. The benefits of this approach
include the following:
- The insurance proceeds will provide the deceased business owner's
spouse and family with income and principal as needed, while keeping the
family business in the family.

- The assets owned by the ILIT will not be subject to creditor claims
coming through the business, the deceased business owner, or the ILIT
beneficiaries.

- The life insurance proceeds will be received by the ILIT both income
and estate tax free.

- If established to provide generation-skipping advantages, ILIT assets
will escape estate taxation in the estates of future generations.

- At the death of the business owner's surviving spouse, the funds in the
ILIT could be used to purchase assets from the business owner's estate,
thereby providing the estate with sufficient liquidity to pay its federal
estate taxes and administration expenses.

While the no-sell/buy-sell may not work for everyone, it is a unique and
potentially beneficial alternative to the traditional automatic buy-out
upon the death or retirement of the business owner. The benefits to the
participants, including the surviving owners, can be substantial. No
longer need the last man standing be the big winner.

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