Estate Planning for the Family Business

By Brant M. Keller

Family-owned companies represent more than 90 percent of the businesses in the United States today. They also can be the most difficult asset to transfer intact for the benefit of the spouse and family of the owner. For example, the forced sale of a closely held business to pay taxes and/or debts is a nightmare for the owner of a business, whose biggest fear is that the company he or she worked so hard to build will not be there for family members. For retention and continuation, therefore, it is essential that the owner plan to provide liquidity at an unpredictable moment in the future.

Effective in 1998, The Family-Owned Business Exclusion provides additional protection, exempting up to $1.3 million in combination with the amount for the Unified Credit ($675,000 in 2000). However, because the rule is so complex in nature, there's no guarantee that all family-owned businesses will qualify.

In general, a family-owned business must meet the following to qualify for the deduction:

Ownership and Material Participation - The decedent or family members must have owned and materially participated in the business for at least 5 of the 8 years prior to death.

Location of Business - The principal place of business must be located in the United States.

Percentage of Estate Assets - The qualified family-owned business must make up more than 50 percent of the decedent's adjusted gross estate.

Decedent, Executor, and Heirs - At the time of death, the decedent must have been either a U.S. citizen or resident. The executor must choose to have the deduction apply to the estate, and each qualified heir with an interest in the business must sign a recapture agreement.

Ownership Percentage - At the time of death, the decedent must have had an ownership interest. The percentage of which varies by the number of families participating.

Business owners often plow much of their profit back to grow the company, which will be their major asset at death. These owners should therefore plan to have cash available to their families in the event of death or unforeseen circumstances.

Parent and Child Business

Planning for the family-owned business is often more complex when the business is operated by a parent and adult child together. This type of business frequently provides the primary income for both generations.

If one of the operators dies, the other often can just pick up the reins and continue to run the business while providing income for both generations. However, when both of the active family members are gone, the company has no capable successor. The family is left with no option but to sell or liquidate the business. Thus, not just one but both families lose their income.

In addition, the owners of closely held businesses may have more than one child active in the business. These children spend their lives helping build the business not only for income, but also in the hopes of carrying on after the parents' death. Problems arise when there are also children not active in the business. Since this type of business generally comprises the bulk of the estate, it is often difficult to leave the business to one or two children without disinheriting the remaining child or children. Without liquidity and advanced planning, the business will usually end up in a state of joint ownership with the inactive children participating in the business profits.

In the usual family business situation, where the parent is the majority owner, there may be little choice but to have insurance on that parent to provide the necessary liquidity (or a survivorship policy on both parents) in the event of his or her death.

Losing Key Employees

Another concern for a business is the loss of a key employee; replacing that person or persons can present special challenges. Many small businesses with a few key employees can absorb the loss of one without disastrous effects on the business, but the simultaneous loss of two employees could cripple the same business. Again, providing liquidity is critical, and business owners often use insurance to leverage smaller dollars initially and provide larger dollars when necessary.

Some business owners make the fundamental mistake of purchasing individual policies for multiple key employees. Survivorship life addresses the situation precisely. It avoids the purchase of unnecessary individual policies on each key employee while protecting against the event which might destroy the business.

Using Life Insurance

When choosing the type of life insurance to use, consideration must be given to the need trying to be filled; for example, the key person, estate settlement or business buy out, etc. Generally, cash value-driven policies work best and often can be used as an asset of the business when applying for loans. Three common types of insurance used in today's economic environment include universal life, variable life and variable universal life. Ownership considerations and beneficiary designations are key to determining which policy to choose.

Advanced planning is critical for the business owner and their family. Assembling the proper estate planning team is also important. A certified financial planner is useful in coordinating your estate plan with your tax attorney and tax advisor, thus paving the way for a successful transition of what may be the largest and most precious asset, the family business.

Brant M. Keller, CFS, CFP, is the managing member of Financial Advisory Consultants, LLC., a registered investment advisor specializing in fee based asset management and integrated estate and tax planning. He also hosts a radio show, "Money Matters," from 8-9 a.m. every Sunday on WGUF 98.9 FM.