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How to pick a business succession strategy

Help clients take BOLD action on business succession

All business owners eventually leave their business

Proper preparation can:

  • Strengthen and grow a business over time.
  • Allow a business owner to realize value from their hard work and the goodwill they’ve built.
  • Successfully transition ownership to someone else.

There are two business succession paths. A planful approach prepares for leaving the business during the owner’s lifetime. A contingency approach prepares for life events that force departure, such as death, disability or divorce.

Who will buy the business?

Identifying a potential buyer is the first priority in a business transition. Business owners not planning to sell in the near future probably have not identified a person or entity to take ownership.

A business may have several potential buyers, each with certain considerations:

Potential buyerConsideration
Current co-ownerThere may be obligations to co-owners for taking over ownership of the business
Key employeeA key employee may be the best candidate for taking over ownership
Family memberFamily members deserve to share in the wealth created by the business
Outside partyAn outside interest will seek to negotiate the purchase price downward

When will the owner transition?

Next, the selling owner must set a timeline for transition. When does the owner expect to leave the business?

This is important

Without adequate preparation, the business owner’s premature death can negatively impact:

 

  • The value of the business
  • Business continuity
  • Relationships with the deceased owner’s family members
  • Ownership
  • Vendor and account relationships
  • Cash flow


Strategies that call for transition during the owner’s lifetime will require time to generate funds and to transfer expertise, relationships and goodwill.

Summary of transition strategies used during the owner’s lifetime

StrategyDescriptionsConsiderations

Outright gifts

Seller gifts business to family member or an irrevocable trust

  • Potential gift taxes
  • Equity issues for non-business family members

Self-canceling installment note

Installment sale that is canceled at owner’s death

Need higher price or higher interest rate since risk of early death may provide financial windfall to buyer

Sale to defective trust

Trust purchases with note back to seller

  • Income paid back
  • Highly appreciating assets
  • Freezes estate
  • Tax risk

Grantor Retained Annuity Trust (GRAT)

Gift to grantor retained annuity trust income paid to grantor

If death occurs during trust period, entire fair market value is included in estate
Income from GRAT can be used for life insurance premiums

Charitable Remainder Trust (CRT)

Transfer to an irrevocable trust where the donor receives an income stream and a charity receives the remainder interest

  • Valuation required
  • Tax deduction


Your client’s goal may be to transfer at death. This presents you with an opportunity to help the business owner prepare for a successful transfer.

Summary of transition strategies used at death

StrategyDescriptionConsiderations
Bequests

Seller bequeaths the business to family members according to the terms of the business owner’s estate planning documents

  • Step-up in basis
  • Will be included in the client’s estate
  • Equity issues for non-business family members
Estate equalization

Parents bequeath the business to one child, and other assets are given to other children

  • Step-up in basis
  • Handles the equity issues for the non-business family members
  • Equal versus fair to the non-business family members
  • Uses life insurance

Buy-sell agreement with other owners

A business owner negotiates a pre-determined sale to other business owners upon certain life events

  • Step-up in basis
  • Guarantees a buyer
  • Creates liquidity for decedent’s family
  • Helps avoid conflict of interest between decedent’s family and current ownership

Family buy-sell agreement

Family member purchases the business from the other non-business family members

  • Step-up in basis
  • Handles the equity issues for the family members not involved in the business
  • Purchasing family member must have the ability to purchase the business from children not involved in the business
  • Uses life insurance

Testamentary Charitable Lead Annuity Trust (CLAT)

Seller transfers the business to family in a testamentary charitable trust, providing income to charity for a term, then balance to family

  • Estate tax charitable deduction
  • Family must wait to receive business
  • Special considerations for S corporation
  • Follow with a stock redemption if not prearranged sale

How will the owner transition?

Combining strategies can help retiring business owners turn their hard work and goodwill into cash at retirement.

Summary of transition strategies

StrategyDescriptionConsiderations

Stock sale

Buyer purchases stock from the seller

  • Valuation issues
  • Generally better for seller

Asset sale

Buyer purchases business assets from the seller

  • Buyer receives stepped-up basis in all assets
  • Generally better for buyer

Installment note

Buyer makes payments for more than one year

  • Flexible
  • Minimal capital
  • Prorates gain
  • Issue of related party rules
  • Creates market

Employee Stock Ownership Plan (ESOP)

Qualified profit-sharing plan funded with employer stock

  • Expensive
  • Tax deductions for the seller
  • Annual valuations
  • Qualified employee benefit

Earn outs

Seller “earns” part of the sale price based on business performance

  • Used if the buyer and seller disagree about future performance of the business
  • Applies to a limited period and only a percentage of the purchase

Part sale/gift

Part of the business may be sold to a family member and the remainder gifted

  • Typically applies to a family business
  • An analysis should be completed to determine if the sellers need money from the sale for retirement

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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.

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.

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.

Icon of a gift box

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.

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.

View table

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

Life insurance products contain charges, such as Cost of Insurance Charge, Cash Extra Charge, and Additional Agreements Charge (which we refer to as mortality charges), and Premium Charge, Monthly Policy Charge, Policy Issue Charge, Transaction Charge, Index Segment Charge, and Surrender Charge (which we refer to as expense charges). These charges may increase over time, and these policies may contain restrictions, such as surrender periods. Policyholders could lose money in these products. 

Long-term care insurance may cover care such as nursing care, home and community-based care, and informal care. Please ensure that your clients consult a tax advisor regarding long-term care benefit payments, or when taking a loan or withdrawal from a life insurance contract.

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 10-2025

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