Departments — September/October 2006

Succession Planning — STEP Toward a Smoother Transition

Setting up a shared tax and equity partnership can provide an attractive exit strategy that solves several business succession problems

Thom Bowen, CFP, CLU, ChFC FINANCIAL ADVISER Thom Bowen, CFP, is a financial adviser with Securian Advisors MidAmerica, Tulsa, Okla., and has specialized in work for the commercial construction industry since 1990. Website: www.securianmidamerica.com

As a business owner, do you have an exit strategy? Do you intend to sell the business at some point to related or unrelated key employees or an unrelated third party?

It's well documented that an effective succession strategy is a challenge. An effective strategy may include a fair market-value sales price, continuation of business success for buyers and employees, perpetuity of the business culture and values, or some of the seller's other key objectives.

The primary challenge is receiving a fair market value for a closely held business. A third-party prospective buyer realizes that the talents and relationships that represent the good-will value are tied to the owner. Therefore, without an employment contract to retain the owner, the value is reduced, not to mention that the seller may want to avoid any sort of employment contract.

An alternative is to sell the business to key employees, rather than to a third party. This approach provides easily identified buyers whose expertise and familiarity with the business can enhance its chances for ongoing success. The outgoing owner may be interested in the company's ongoing success, both financially and psychologically.

The problem with a sale to key employees is that they rarely have capital for a down payment, much less the purchase of a business. Another challenge is tax risk. The seller will be subject to capital gains, and perhaps ordinary income taxes, on sales proceeds.

The buyer is purchasing the business with after-tax dollars and therefore at an increased cost. Default risks present yet another challenge. If the buyer is making installment payments, those sales proceeds may ultimately be dependent upon the ongoing success of the business.

A Solution

The shared tax and equity partnership (STEP) may provide an attractive exit strategy that addresses these challenges. STEP would provide the following advantages:

• It establishes a mechanism to share opportunity, equity and responsibility with key employees without sharing ownership in the core company.
• It provides a current-year income tax deduction to the core company.
• It offers tax-favorable sale proceeds to the selling owner when he/she is ready to exit;
• It sets up "golden handcuffs" for key employees to keep them from prematurely leaving the business.
• It offers flexibility that allows the current owner to decide who participates and customizes the specifics of his or her exit strategy.
• It creates a device that facilitates a carefully planned transition of the company.

The Basics

Here's how the STEP works. A limited liability corporation or a limited liability partnership is set up, with the business owner as the managing partner and a minimum interest in the partnership, like 1%. The other 99% interest is owned among the top key employees, as limited partners with no voting rights.

The owner transfers a piece of property (equipment, machinery, real estate) into the STEP LLP. The core company makes the tax deductible lease payments to the STEP LLP for use of the property.

Because of the ownership split in the LLP, the key employees bear the tax burden on most of the lease payments. The increased tax liability now is in exchange for a future equity opportunity in the core company and provides an effective litmus test to see which key employees are serious prospective owners.

The STEP deposits the lease revenue to a sinking fund that will eventually become seed capital toward buying the owner out of the core company. Default risk is reduced, and the issue of lack of capital is addressed.

Cash-value life insurance provides an effective funding vehicle for the sinking fund. The cash values grow tax-deferred, and, at the time of sale, the policy can be transferred to the seller free of income tax. If insurance is used, the insureds should be the younger employees so that the insurance cost is minimized and the case value maximized.

The STEP offers flexibility in the event of key personnel turnover, and a properly drafted STEP document will provide buyout provisions in the event of termination of a key employee. It will also have a provision for additional key employees to join the STEP, at the owner's discretion.

The STEP can provide for an efficient business transition and an exit strategy for the small business owner. It addresses key employee retention, tax risk and capital risk, and it helps ensure ongoing success of the company.