Estate and Business Succession Planning for Small Business Owners

Get tips on how to update your estate plan to ensure your small business is passed on as you wish.

Small business owners have many pressing issues to worry about, from making payroll to securing supplies and attracting customers. Planning for what would happen to their business if they decide to retire or something goes haywire—their business partner decides to leave, or they pass away and haven't made continuity plans—understandably gets back-burnered, Don't leave your business unprepared—takes steps now to ensure smooth transitions and the longevity of the business you've worked so hard to build up.

This article summarizes the plans (known as "business succession planning") that you can consider to protect your business and ensure its continuation. We'll list the life events that can trigger unanticipated or unpleasant consequences for the business or its owners, and explain how you can address them.

The Business Owner Retires

When you're ready and financially able to stop working, you'll retire. You're probably familiar with how an employee would plan for retirement income—most commonly with a 401(K) and maybe a pension. Self-employed owners have a unique option, called a grantor retained annuity trust (GRAT), which allows a business owner to transfer the business to a trust. The owner enjoys an income stream for a limited period of time. Once the time period for the trust ends, the designated beneficiaries of the trust will receive the remaining business assets. GRATs are complicated and you should consult with an attorney to learn whether a GRAT is appropriate for you.

Employees commonly use 401(K) plans to prepare for retirement, but some business owners do not need to work for someone else to participate in a 401(K). Self-employed business owners and their spouses, whose businesses do not have employees, can set up a Solo 401(K), also called an Individual 401(K). A Solo 401(K), designed for a single participant, can be used to build a retirement fund from your contributions made as both an employee and an employer of your business. Your contributions as an employee come from salary deferrals taken from your paycheck before taxes, and your contributions as an employer come from a calculated percentage of the net business profits. Limits on the annual contributions you can make as an employee and employer apply. If you are self-employed and your business has no employees, a Solo 401(K) could help you build a solid retirement fund.

Your Partner Leaves the Business

Your partner might have plans for retirement or might unexpectedly leave the business. Whether anticipated or not, protect your business in the event your partner leaves. For businesses operating as partnerships, a buy-sell agreement addresses who takes over a partner's interest if that partner dies, retires, or becomes incapacitated. A buy-sell agreement also typically outlines how to value the partner's interest and how to pay for it. For example, a buy-sell agreement might specify that the remaining partners will purchase the deceased partner's interest using a loan or life insurance proceeds.

Specific types of buy-sell agreements include cross-purchase agreements and entity-purchase agreements. Cross-purchase agreements require partners to purchase life insurance policies on each other. If a partner dies, the remaining partners use the life insurance proceeds to buy the deceased partner's share from the deceased partner's estate. Entity-purchase agreements require the business to purchase life insurance policies on each of the partners. If a partner dies, the business uses the life insurance proceeds to buy out the deceased partner's share.

The Business Owner Dies

Decide now whether you want your business to continue operating after you die. If you do, you'll need to make a business succession plan. Without a plan in place, the business might not survive due to inadequate leadership, disruption in operations, or confusion about your intentions. A solid business succession plan, made in coordination with your estate plan, can address these potential pitfalls and might also provide estate and gift tax savings.

Business Successors

If you want your business to survive you, identify now those best suited to take over management roles when you die. Preparing and training your successors ahead of time will help your business run smoothly after your death.

Probate Avoidance

Many business owners ensure a smooth transition of their business by structuring their estate plans to avoid probate. Typically, businesses transferred by will or by law in the absence of a will are subject to probate. Probate can be a slow and expensive process, which can result in disruptions to business operations. Placing your business within a living trust will avoid probate. You'll need the help of an attorney to create the trust and transfer the business to it. After your death, the trustee (the person you have chosen to carry out your wishes) will distribute the business according to the terms of your trust, without the need for probate.

Legacy Protection

Forming a family limited partnership (FLP) or family limited liability company (family LLC) can protect your legacy by ensuring your business remains in the family. In the operating agreements for these entities, you can designate family members to succeed to management roles when you die. You can also restrict members from transferring their interests outside of the family, so the business will continue to be family-owned.

Estate and Gift Taxes

FLPs and family LLCs also provide certain estate and gift tax advantages when you transfer your business to your children. Here's the issue: The tax code allows you to make tax-free gifts to your children up to a maximum amount. After that, taxes kick in. While you're normally very happy to have your business valued as high as possible, this is one situation where less is more. When the value is low, you'll reach the maximum tax-free number less quickly, meaning you can transfer more control.

The Internal Revenue Service (IRS) helps you out here, by allowing FLPs and family LLCs to discount the value of ownership transfers. The justification is that because the shares aren't marketable (few investors are interested in joining a family business) and will not be large enough to raise the possibility of control, the shares are less valuable than, say, a share of a publicly-traded stock. These discounts can amount up to 40%. FLPs and family LLCs provide a way for you to gradually transfer non-managing interests to your children during your lifetime, while you retain control of the business and maximize the amount you transfer tax-free.

Discuss Your Estate and Business Succession Plans

Once you have established your business succession plan, discuss your intentions with your family and business partners or managers. Preparing the next generation ahead of time can prevent confusion and discord, as well as facilitate a smooth transition to new management. An effective estate and business succession plan will ensure your business and legacy live on.

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