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How to pick a business succession strategy

Factors influencing how an owner may wish to transfer the business

There are many factors and questions to consider when a business owner transfers the business.

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Related owners

The business owner’s family likely feel they deserve to share in the wealth the business has created. Additional challenges sometimes arise when family members own a business together.

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Transfers to key executives

Key people in the organization may be best positioned to take over the business and manage it well. These individuals are likely most willing to invest time, resources and effort in purchasing the operation.

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Bonus shares

Granting shares as a bonus can be a way of transferring ownership to a key employee. This can make an eventual sale more complicated. The key employee must also include the value of those shares as income in the year of the bonus. The key employee will be taxed on the value of the shares but will have relatively little control of the shares or their marketability.

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Gifting shares

Business shares can only be gifted to a family member. For example, it would not be unusual for a mother who owns a business to give shares to her children. There is no income tax associated with such a gift. The children take the income tax basis of the mother’s shares. To maintain family harmony, estate equalization techniques could be used for children not in the business.

How many owners are there?

The number of people who own the company will determine the continuation strategy to present to your client. A sole proprietor may only need an arrangement where a key employee or family member will take over the business at the owner’s death. A life insurance policy would be placed on the owner’s life for the funds to complete a one-way buy-sell at the owner’s death.

Two owners can usually negotiate a sale with a cross purchase buy-sell arrangement.

Ownership of a company may consist of any number of individuals in various percentages. These owners can be any age, and may range in health from very fit to uninsurable. The possibilities are limitless, but several strategies can help ensure business stability, continuity, value and a smooth transition.

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Does the owner have buy-sell arrangements?

Business owners are typically extremely busy with the operations of their company. Often, years pass without any updates to shareholder, partnership or operating agreements. These agreements usually contain provisions that address buy-sell obligations that would be triggered by certain events. If these agreements are not reviewed and updated from time to time, surprises may occur if the owner dies or becomes disabled.

A comprehensive buy-sell review should be conducted periodically. The business owners should be aware of the general nature of the buy-sell, and especially of such critical components as events covered, the valuation method used and the payment terms if an event occurs.

A business owner client who has buy-sell arrangements in place that have not been recently reviewed presents an excellent sales opportunity.

Are family members involved in ownership?

If family members are involved, there may be gift and estate tax consequences. These can be addressed through strategies of gifting with discounts, various trusts or buyout provisions involving the family members.

Choosing a business succession strategy

This easy-to-follow table outlines the attributes, advantages and disadvantages of different types of businesses to help your clients determine the appropriate buy-sell strategies for their business entity.

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Combining retirement with buy-sell strategies

Cross purchase and entity redemption buy-sell arrangements can cause income taxation if the client is trying to combine retirement income strategies.

Entity redemption

In entity redemption, a business owns life insurance policies on the owners. If the owners were to retire or dissolve the business, the distribution of life insurance policies with cash value to the owners will be a taxable event. The taxation will depend on the type of business entity:

C corporation

Any life insurance policy distributions from a C corporation will be taxable to the recipient as a dividend or salary. 

The amount taxable is the “fair market value.” At the point of distribution, the corporation must recognize any gain to the extent that the cash value of the policy exceeds the corporation’s premium payments. However, the corporation is entitled to a deduction (under Section 162) equal to the amount of distributed cash value the executive includes in income.

S corporation

If an S corporation provides a policy to the insured owner as a distribution, any gain will be recognized to the corporation as if the property were sold at fair market value. (Fair market value is generally considered the difference between the policy’s cost basis and its cash value without reduction for surrender charges.) All gains will pass through to the owner as ordinary income under the built-in gain rules.


Generally distributions of property from a partnership to a partner are tax–free unless those distributions are considered compensation to the owner.

Cross purchase

In a cross purchase, business owners personally own policies on the lives of other owners.

At retirement, if the owners were to transfer the policies to the insureds, each owner would recognize taxable gain (the difference between the price they paid for the asset they are trading and the value of the asset they are receiving).

A owns a policy on B

$5,000 premium for 10 years = $50,000 

cost basis and $80,000 cash surrender value (CSV)

B owns a policy on A

$5,000 premium for 10 years = $50,000 cost basis and $70,000 cash surrender value (CSV)

Tax ramifications of uncrossing the policies:

  • Each has a cost basis of $50,000
  • A has $20,000 taxable gain ($70,000 CSV - $50,000 cash basis)
  • B has $30,000 taxable gain ($80,000 CSV - $50,000 cash basis)

This is a hypothetical example for illustrative purposes only.

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Life insurance products contain fees, such as mortality and expense charges, (which may increase over time) and may contain restrictions, such as surrender periods.

Please keep in mind that the primary reason for purchasing life insurance is the death benefit.

Additional agreements may be available. Agreements may be subject to additional costs and restrictions. Agreements may not be available in all states or may exist under a different name in various states and may not be available in combination with other agreements.

Policy loans and withdrawals may create an adverse tax result in the event of lapse or policy surrender and will reduce both the surrender value and death benefit. Withdrawals may be subject to taxation within the first fifteen years of the contract. Clients should consult their tax advisor when considering taking a policy loan or withdrawal.

The Policy Design chosen may impact the tax status of the policy. If too much premium is paid, the policy could become a modified endowment contract (MEC). Distributions from a MEC may be taxable and if the taxpayer is under the age of 59 ½ may also be subject to an additional 10% penalty tax.    

An annuity is intended to be a long-term, tax-deferred retirement vehicle. Earnings are taxable as ordinary income when distributed, and if withdrawn before age 59½, may be subject to a 10% federal tax penalty. If the annuity will fund an IRA or other tax qualified plan, the tax deferral feature offers no additional value. Qualified distributions from a Roth IRA are generally excluded from gross income, but taxes and penalties may apply to non-qualified distributions. Please consult a tax advisor for specific information. There are charges and expenses associated with annuities, such as surrender charges (deferred sales charges) for early withdrawals.

This information may contain a general discussion of the relevant federal tax laws. It is not intended for, nor can it be used by any taxpayer for the purpose of avoiding federal tax penalties. This information is provided to support the promotion or marketing of ideas that may benefit a taxpayer. Taxpayers should seek the advice of their own tax and legal advisors regarding any tax and legal issues applicable to their specific circumstances.

For financial professional use only. Not for use with the public. This material may not be reproduced in any form where it is accessible to the general public.

DOFU 10-2022