The end of the year brings the opportunity for tax and legal planning for business owners, including so-called “succession planning.” This type of planning looks to the future and asks “What is the best exit strategy for the owners of the business and what steps should be taken now to achieve the desired exit plan?” The exit plan may include preparing the company for a future sale, planning for the retirement of the owner or planning for the unexpected death or disability of the owner. Failure to undertake this type of planning may result in a forced liquidation of the business in the event of the owner’s untimely death or disability. We recommend that an exit plan should be reviewed and analyzed each year by the owners and their advisors and revised as appropriate.

Set forth below are several select key developments that impact succession planning for business owners, which we wish to share with you. These developments are as follows:

Life Insurance

Company–owned life insurance is frequently purchased to insure the life of one or more of the owners of the business. Upon the death of the insured, the life insurance proceeds would be paid to the Company (or a business insurance trust) as the beneficiary of the policy. The life insurance proceeds are generally income tax-free to the Company. The Company uses the proceeds to redeem the insured owner’s shares through the use of a Buy-Sell Agreement. This structure permits the surviving owners to acquire the deceased owner’s shares, and for the deceased owner’s family to receive the life insurance proceeds income tax-free. This structure differs from a so-called “cross-purchase” arrangement where each shareholder is the owner and beneficiary of a life insurance policy on the life of each of the other shareholders.

In 2006, Congress added a notice, consent and reporting requirement for company-owned policies acquired after August 17, 2006. §101(j) of the Internal Revenue Code (“Code”). Under these requirements, a company is required to provide written notice to the insured-employee that the company intends to insure the employee’s life and that the company will be the beneficiary of the policy. The notice must specify the maximum face amount for which the employee could be insured when the policy is issued. The employee must then consent in writing to being insured and to the possible continuation of the coverage after the employment relationship terminates. Failure to comply with these requirements will cause the life insurance proceeds in excess of the company’s premium cost to be taxable as ordinary income to the company. Moreover, it is critical that the notice and consent requirements be completed prior to the date the policy is issued. Furthermore, the company must report annually its compliance with these requirements under §6039I(a) of the Code.

Deferred Compensation Requirements

Developing and retaining key employees are important components to succession plans. In this regard, key employees are often viewed as one of the most valuable assets of the business and a key ingredient to the continued success of the business, including the period after owner’s departure. To attract and retain key employees, incentive compensation is frequently used since it aligns the interests of the owners and the key employees. Year-end bonuses, profits interest, stock options, “phantom equity,” or stock grants are examples of incentive compensation.

Establishing an incentive compensation arrangement for key employees requires compliance with §409A of the Code. Under these new requirements (which generally became effective January 2005), deferred compensation arrangements must be in writing and can only be paid upon the occurrence of certain specific events, including the employee’s death, disability, retirement; a change in control of the company; in accordance with a fixed pre-established payment schedule; or on account of the employee’s hardship. There are numerous compliance requirements. Failure to comply may result in a twenty percent (20%) penalty tax imposed on the employee (in addition to the regular income tax due on such compensation). While the ultimate liability falls on the employee, the employer typically undertakes the legal steps necessary to ensure compliance with §409A requirements.

Minimize Taxes on Sale of the Business

An owner’s planned departure from the business may center on the anticipated sale of the business in the future. A sale of the business to a third party has the advantage that all or a substantial portion of the purchase price will be paid to the seller at closing. However, as with any sale transaction, the sale proceeds are subject to income taxes on the gain realized by the seller. Structuring the sale transaction to minimize income taxes is critical for the owner to realize the highest net proceeds from the sale. This is especially true if the company is a C Corporation, since an asset sale may result in two (2) layers of tax on the cash proceeds. The combined effective tax rate (federal and state) for these taxes may exceed sixty percent (60%).

One approach to deal with the sale of assets by a C Corporation is to structure the transaction as, in part, a sale of the “personal goodwill” of the owner if the owner has strong, long-standing relationships with customers and other conditions are met. This approach may result in reducing the effective tax rate (federal and state) to approximately twenty percent (20%) on the sale proceeds attributable to the personal goodwill of the owner. Other strategies include treating a portion of the purchase price as a non-competition payment to the owner or as consulting fees.

Asset Protection for Beneficiaries

Use of a revocable trust for estate planning by the owner may have the added advantage of creating asset protection for the owner’s beneficiaries. For example, if the family business is transferred to the trust, upon the owner’s death the family business may remain in trust and have protection against creditors of the beneficiaries. A wholly discretionary trust should provide the maximum amount of asset protection. A wholly discretionary trust is one that is irrevocable, grants the trustee broad discretion to determine the timing and amount of distributions to beneficiaries, and meets other requirements. To establish a wholly discretionary trust the beneficiary cannot be the trustee or a co-trustee. If it is desired that the beneficiary also serve as a trustee or a co-trustee, significant asset protection for the beneficiary may still be provided, but the trust assets may be subject to support claims by the beneficiary’s spouse (for example in the case of a divorce) or child support payments unless the trust document is drafted to avoid this result.

Meyers Roman Friedberg & Lewis has represented numerous family businesses in developing succession plans. If you have any questions about the particular matters discussed in this Client Alert or any other matters relating to business succession, please contact Mario J. Fazio (, Scott M. Lewis (, or Peter D. Brosse (

IRS CIRCULAR 230 DISCLAIMER: To the extent that this written communication may address certain tax issues, this written communication is not intended or written to be used, and cannot be used by any persons to avoid any potential tax penalties that may be asserted by the Internal Revenue Service.

The information in this Client Alert is a summary of complex legal issues and may not address all of the issues relating to a specific fact. In addition, the information contained herein focuses on Ohio and applicable federal law and may not apply to other jurisdictions. Accordingly, this Client Alert is not intended to be legal advice, which should always be obtained in consultation with an attorney.