The last thing that most entrepreneurs think about when planning the future growth and success of a business venture is how to preserve and protect what they have worked so hard to achieve in the event of their death. At best, many executives have only a basic will or perhaps a trust aimed primarily at protecting their children in the event of a common disaster, together with as much life insurance as they have been persuaded to buy over the years. Such an estate plan does not address either the issues that arise in any estate that contains a significant business element or the concerns that a business will face as a result of the loss. Issues such as transition of control, valuation and continuation of the business and funding of estate taxes are critical not just to the estate of the deceased shareholder and his or her family but also to the very survival of the business itself.
High technology companies often go through a three phase cycle: the start up phase, an operational period, and an exit. Estate planning for key shareholders is important during each of these three phases, but the legal strategy to minimize cost to the estate and disruption to the business may be different in each part of the cycle.
During the start up phase, a business will emerge from being a mere idea to a marketable product or service. The operational phase consists of producing the product or service and marketing the business. The proper focus of an estate plan for business owners during these two phases must be valuation and liquidity. This is because it is rare, even in the case of a corporation owned by one individual, that the shares of the corporation will have no value. Should a sole or key shareholder die, the shareholder’s estate will include a value for the stock of the business that the shareholder held at death. The value at that time will depend largely on the product’s stage of development, and will be determined without regard to any lack of liquidity of the stock. In practical terms this means that the business owner’s estate may be subject to tax on paper value, forcing the estate to look to the business or even sell the business interest to finance estate taxes. There are certain relief provisions under the Internal Revenue Code available to estates consisting largely of interests in closely held businesses, but since these provisions provide only for deferral of payment, and not elimination of the tax liability, the financial issues eventually must still be addressed. In order to prepare for and minimize the potential problems associated with these hindsight valuations, periodic written assessments of present and projected values, together with the variables and assumptions upon which they are based, should be completed and reviewed with both business and tax consultants.
The operational phase of a business life cycle presents many of the same issues with regard to valuation and liquidity, together with additional concerns regarding providing for the continued management of the business and control of ownership. Again, advance planning is required to deal with these issues and produce the result that the owners seek to obtain. Should there be more than one owner actively involved in the business, the issues of transfer of stock control, replacing lost expertise and providing fair value to an estate should in most cases be dealt with in a shareholder agreement. Generally treated as a pure business agreement, this type of arrangement actually can serve as an excellent vehicle for combining business and estate planning concerns of the various interested parties in a less rigid setting than formal estate documents.
The exit phase and the period following might seem to be the most easily addressed from the perspective of estate tax planning, but this often is not case. Unless cash is the sole consideration, the issue merely shifts from valuing a going concern to valuing a structured buyout. Any non-contingent value that is to be received by the seller is part of the seller’s estate whether or not the buyer ultimately makes the payments. The irony here may be that by bringing suit to collect if the buyer does not pay, the seller’s estate is admitting that an amount is owed, which will then be includable in the estate. Moreover, since there is no longer an operating business, the opportunities for deferral of the payment under the applicable regulations are not available.
This article is intended to highlight some of the areas in which estate and business considerations interact. The important thing to remember is that while estate and business planning are aimed at essentially the same goal — your financial well being — neither should be attempted independent of the other since unanticipated interactions can have adverse consequences.