How to Protect Your Nest Egg from Birds of Prey

June 1, 2004
by William M. Hansen, J.D. LL.M. s every small business owner worst nightmare: You spend your lifetime building your business, then lose it all because

by William M. Hansen, J.D. LL.M.

It’s every small business owner’s worst nightmare: You spend your lifetime building your business, then lose it all because you dropped the ball on estate and succession planning.

As a small business owner, you don’t need to be told how important it is to have an updated estate plan. However, that doesn’t mean you have one. Why not? Because, let’s face it: Estate and succession planning is not something people like to think about. After all, you’re still 25 years old at heart, and the future is a long way off, right?

The goal of this article isn’t to make you feel old and worried. The goal is to give you information about the estate planning and business succession tools you need to protect your loved ones.

First, we’ll cover the basic estate planning documents you need to make your estate plan current. Next, we will focus on business succession planning techniques. These include how to plan for your mortality, and lifetime exit strategies, whether you wish to sell the business or gift it to family members.

Planning for Incapacity

If you become incapacitated without prior planning, a guardian will be appointed by a local probate judge to look over your financial and personal affairs. Even if you’re married, your spouse will not necessarily have the authority to make medical decisions on your behalf. Here are the documents you need to prevent this undesirable situation:

Durable power of attorney. To avoid a court-appointed guardianship, sign a durable power of attorney. This allows you to name a person (called an “attorney in fact”) to manage your financial affairs during your lifetime, even if you become incapacitated. Make sure you trust the person you appoint, because he or she will, in essence, step into your shoes for your financial affairs. The power of attorney stops at your death, unless you revoke it earlier.

Health care directive. This document allows you to name an agent to make medical decisions on your behalf, in the event you are unable to communicate directly with your physician. You may also give specific instructions to your agent about your desired care. Some states use two documents — a living will and a medical power of attorney — to accomplish these same goals.

Planning for Your Death

Nobody likes to think about one’s own mortality, but you’ve worked too hard to build your estate not to have some say in how it will be distributed. Remember, it’s your money, and you can leave it to whomever you want, however you want. There’s only one person you can’t disinherit without his or her permission, and that’s your spouse.

Here are a few basic concepts about how property passes at the time of death. First, your will only controls the disposition of those assets titled in your name alone, without a beneficiary. For instance, if you own an asset in joint tenancy with another person, that person will inherit that account from you automatically, regardless of what your will says, because that account is not owned by you alone. Likewise, if you have an account with a named beneficiary who survives you, then that account will pass directly to that person, again regardless of what your will says.

Last will and testament. If your business is a sole proprietorship, it’s crucial to have an updated will or revocable living trust that reflects your wishes about your estate, including the business. Through these documents, you may give directions to your executor regarding continued business operations, or the sale of the business. You may also consider giving key employees or family members the option to purchase the business from your estate.

Many of my clients want to avoid probate, to minimize fees and expenses, and to keep their affairs private. If this is true for you, consider using a revocable living trust as a substitute for your will. A revocable living trust is a popular estate planning tool that allows you to distribute your estate like a will, but allows you to avoid the expenses, time delays, and other drawbacks typically involved in probate.

Business Succession

Business owners have unique planning issues when it comes to succession. The business is most likely the owner’s largest asset, is typically not liquid, and may rapidly lose value if it’s not properly managed. Because of this, you can’t delay planning until you near retirement.

The following are some critical business succession issues.

When to start planning? There are two stages to succession planning: planning for premature death, and lifetime exit strategies. Since none of us know which day may be our last, it’s imperative to plan for the unthinkable right now. As far as the “plannable,” (that is, a planned future sale or gift of the business), planning should typically begin five to seven years before the desired exit date.

Form a business succession team. When you begin the planning process, it’s critical that you form a team of professionals that will help guide you through the process. The team should include a CPA, an attorney trained in this area, a business valuation expert, and a financial advisor.

Liquidity planning. You must anticipate liquidity needs that may arise at the time of your death. Will your family need additional funds when you die? Will a replacement need to be hired? Will estate taxes be owed? Since each of these expenses may be substantial, you must determine how to pay for them. Life insurance is usually the best source of funds to meet these expenses. Although life insurance proceeds are income tax free, the face amount of the policy may be subject to estate taxes unless properly owned. Consider setting up an irrevocable trust to own such a policy.

Buy-sell agreement. If you co-own your business, it’s essential that you have a buy-sell agreement. Think about it — what would happen if your partner died without planning? You might become a partner with his or her spouse or children. Is that what you want? The surviving owner may be at odds with the heirs of the deceased owner because of divergent interests: The heirs may want to get as much money out of the business as possible, while the surviving owner may want to keep it and grow it.

A buy-sell agreement will force the estate of the deceased owner to sell his or her interest in the business to the surviving owner at a mutually agreed upon price. This provides a willing buyer for the estate of the deceased owner, and ensures that the surviving owner can control and run the business without interference by others.

A well-structured buy-sell agreement can also force a sale of an owner’s interest for other “triggering events” such as disability, bankruptcy, divorce, and involuntary termination of employment. The agreement should spell out payment terms and the payment obligation should be funded with life insurance and disability insurance. Life insurance provides the heirs of the deceased owner with a cash inheritance, and allows the surviving owner to pay off the liability without bankrupting the company.

Mediation/arbitration. Co-owners should also consider entering into a control agreement that will set forth, among other things, what will happen if they have a falling out. In this case, it’s highly recommended that the owners include a mediation/arbitration provision in the agreement. This provision requires the owners to first mediate any shareholder disputes that may arise, and to go through arbitration if mediation fails. The point here is to keep attorney fees to a minimum.

Business Succession: Exit Planning

On to more happy thoughts : exiting the business either by sale or gift.

Selling to a third party. When you sell your business to a third party, you’ll want to get capital gains tax treatment, while the buyer will want to buy the business’ assets so he or she can depreciate the assets and avoid assuming the business’ potential liabilities.

How can these divergent interests be resolved? Typically, assets will be purchased, but the purchase price will be adjusted to accommodate both parties’ competing interests. To postpone capital gains taxes, the transaction could be structured as an installment sale.

Selling to a co-owner. Typically, this transaction will involve the purchase of stock, rather than assets. The buyer will usually have the company purchase the seller’s stock through a stock redemption. It doesn’t matter to the seller whether the buyer or company purchases his stock, while the buyer prefers to have the company redeem the stock since the cash is usually in the corporation.

Deductible Buy-out. If the owner wants to sell the business to his children, then he may first establish a deferred compensation plan for himself, prior to gifting stock to the children. The business may then be gifted to the children, who, in turn, will pay the business owner deferred compensation after the owner retires. Such payments are deductible by the company, and are taxed as ordinary income to the owner upon receipt.

Gifting the business to the children. A business owner may often want to pass the business on to the next generation. Here are some tax considerations.

The donee receives the gift free from income taxes. Be mindful of gift taxes. Gift taxes are imposed on the donor of the gift. A donor can give an unlimited amount to a U.S. citizen spouse. Each donor may annually gift up to $11,000 per donee, without gift tax consequences. Each donor has a $1 million lifetime exemption on gifts exceeding the $11,000 annual exclusion rule. The more you give during life, the less you have subject to estate tax at the time of death. Your donee assumes your basis in the gifted property for capital gains tax purposes.

If you want to begin gifting an interest in the business to a child, consider gifting a minority interest. Alternatively, consider recapitalizing the business into voting and non-voting interests, and give the non-voting interests to the child. “S” corporations can only have one class of stock, but the tax laws state that differences in voting rights alone does not create a second class of stock.

Don’t forget: Once you gift an interest in your business to a child, you now have a co-owner. You now need a buy-sell agreement to restrict the child’s ability to transfer the business interest without your approval .

How do you treat the children equitably? Not all of the children will want to go into the family business. Yet you want to treat all the children fairly. The key here is to remember that fairly doesn’t necessarily mean equally.

Two common methods to treat children fairly include:

  • Give business assets to a child who is active in the business, and the non-business assets to the non-active child
  • Purchase life insurance naming the non-active child as beneficiary and give the business assets to the active child.

A third option is to gift some stock to the active child and an equal amount of other assets to the non-active children. At death, leave the estate equally to all the children. The business will then redeem the remaining stock owned by the estate and the redemption proceeds will be distributed equally to all the children. If you choose this third option, be sure to purchase life insurance on yourself to aid the redemption.

What to do with the real estate? In many cases the business owner owns the real estate upon which the business operates. In this case, it is highly recommended to leave the real estate to the child who will remain active in the business, and other assets to the other children. If the business real estate is left to all the children, disputes may arise over rent because of the childrens’ competing interests.

If you want to begin gifting the business’ real estate to the active child (or children), a family limited partnership is an excellent tool to facilitate the gift. The limited partnership allows you to gift non-voting interests in the form of limited partnership units to the child, while maintaining control over the partnership property.

You’ve worked too hard to build up your business not to pass it on the way you want. A well-designed estate and business succession plan protects your family and gives you an exit strategy that will get you the most out of the business. Get your planning team together and take action now. n

William M. Hansen is a principal of William M. Hansen & Associates, PLLC, a Minneapolis, MN law firm that specializes in estate planning issues. He can be reached at 763/398-5800, e-mail [email protected], or visit his firm’s website at He presented this information at a Nexstar™ Super Meeting. For more information about Nexstar, visit