Estate planning for family businesses, working farms and ranches

 

By Sandra W. Reed

Attorney Sandra W. Reed answers your life planning questions.

Attorney Sandra W. Reed answers your life planning questions.

An agreement establishing the parameters of ownership, management and rights to sell or to purchase the equity position of other owners is a fundamental estate planning tool for those owning a family business, working farm or ranch with multiple owners. Often called a Buy-Sell Agreement or just a Buy-Sell, not all agreements are created equal. Nor should they be.

These agreements should deal with numerous issues but most emphatically need to address problems arising upon death, disability, divorce or sale to a third party. In addition to these essentials, the agreement may need to provide a way to limit competition by providing restrictions on disclosing certain confidential information, on hiring away employees and on luring customers from the original business.

Many family businesses, working farms and ranches employ the owners in the business. The Buy-Sell can determine the terms under which an owner/employee can be terminated or forced to retire. The agreement should provide for what actions will be taken if an owner decides to seek other employment or retire. Under this circumstance, the remaining owners may not want the departing owner to continue to own an interest in the entity, particularly if the owner is going to work with a competitor.

Dealing with Death

Granting the entity or individual owners the right to purchase the interest of an owner at his or her death is frequently appropriate. If the interest of the deceased is not bought out at his or her death, the business owners may find themselves in partnership with a spouse or child with whom they would rather not be dealing.

Dealing with Disability

The Buy-Sell should stipulate the adjustments in management that would be required if one owner becomes disabled and cannot carry out the functions he or she previously shouldered.

Dealing with Divorce

The Buy-Sell should provide that each owner has the right to purchase any community property interest held by a spouse in the event of divorce.  In addition, the agreement needs to provide that, if the divorcing owner does not purchase the departing spouse’s interest, the other owners have the right to do so. This prevents the prospect of having an ex-spouse involved in the business.

Dealing with Disposal to Third Party

The owners of a family business should consider granting  a first option on purchase of an owner’s interest in case one owner decides to dispose of his or her interest to a third party, even a family member. The original owners have chosen to go into business with each other and may not be eager to share ownership with others, even other kin.

Dealing with Deadlock

A Buy-Sell Agreement should contain a mechanism for resolving the deadlock when owners with equal power disagree about a decision. A typical agreement will address deadlock by including what is often referred to as a push-pull provision. A push-pull provision dealing with valuation and sale gives one owner the right to value the business and other owners the option to sell at that value or buy out the interest of the owner setting the value at that figure.

Dealing with Valuation

It is crucial the Buy-Sell include the method of valuing the business as a whole and then determining the value of each owner’s interest. If the owners set an agreed value and then determine that individual’s equity based upon that particular owner’s percentage of ownership, the value does not have to be revisited from year to year. This method eliminates the need for multiple appraisals.

However, it may be advisable to get an independent assessment to set value because individual owners may have differing motives in setting the value at a higher or lower figure. For instance, if the business owners are mother and father, son and daughter, the younger owners may prefer the value for purposes of buyout to be lower than the parents, who might wish to set the buyout figure at a higher amount.

Dealing with Estate Tax

A highly successful family business, working farm or ranch may need to incorporate estate tax planning into the Buy-Sell. Currently, the exemption for estate tax is $5.34 million for an individual. With a married couple, the IRS allows a surviving spouse to use any unused portion of the deceased spouse’s exemption. This means that a married couple can shelter $10.68 million from estate tax. Those lucky enough to fall into the bracket of having assets valued above that amount need to be aware that the sums in excess of the exemption are taxed at 40 percent. This high level of taxation is a motivation to plan to minimize or eliminate estate tax.

If estate tax planning is needed, it is important not to set the value of the business at an artificially low level because the IRS focuses a sharp eye on valuations of family operations. If the IRS believes a business is valued too low, the service will disregard the value replacing the stated value with fair market value, the value used for estate tax purposes. Fair market value is defined as “the price at which a willing buyer and a willing seller, neither under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.”

Funding the Buy-Out

A life insurance policy on each owner can provide the funding necessary to buy out the deceased owner’s interest.  However, if an owner is uninsurable, the business should escrow funds each year to pay some cash for the deceased’s interest.  If the sum set aside does not cover the entire purchase price, the remainder could be paid through a promissory note.

Buy-Sell in Conclusion

Whatever provisions are ultimately, it is prudent life care planning for the multiple owner enterprise to consult with a lawyer knowledgeable in drafting the Buy-Sell Agreement.

Sandra W. Reed is an attorney practicing in Glen Rose, of counsel with the Fort Worth elder law firm of Katten & Benson.  Phone: 254-797-0211;  email:  swreed2@yahoo.com.                                                                   

 

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