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 Third, the remaining owners do not want to be in business with a withdrawn, and now inactive, "partner" nor with a deceased owner's spouse or children.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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Julius Giarmarco, J.D., LL.M, is an estate planning attorney and chairs the Trusts and Estates Practice Group of Giarmarco, Mullins & Horton, P.C., in Troy, Michigan. For more articles on estate and business succession planning, please visit the author’s website and click on “Advisor Resources”.