business owner basics

Small Business [email protected]

Ameriprise FinancialDaniel J. Lensing, CRPC®

Financial Advisor14755 No. Outer Forty

Chesterfield, MO 63017636-534-2097

September 11, 2008

Table of ContentsBusiness Life Cycles and Business Planning ................................................................................................... 4

What are business life cycles, and what is their relationship to business planning? .............................. 4

What are the traits associated with each life cycle stage? ......................................................................4

Which goals and planning tips are most appropriate for each stage? .................................................... 4

What is business planning? .................................................................................................................... 5

What is the business-planning cycle? .....................................................................................................5

Computing the Business Balance Sheet ...........................................................................................................7

What is a balance sheet? .........................................................................................................................7

How is the balance sheet computed? ...................................................................................................... 7

Does any additional information need to be reported? ............................................................................ 9

Post-balance sheet disclosures ............................................................................................................... 9

Cash Flow/Balance Sheet Requirements ......................................................................................................... 10

What is it? ................................................................................................................................................ 10

Cash flow/balance sheet requirements ....................................................................................................10

When can it be used? .............................................................................................................................. 11

Strengths ..................................................................................................................................................11

Tradeoffs ..................................................................................................................................................12

How to do it .............................................................................................................................................. 12

Choosing an Entity ............................................................................................................................................13

What is an entity? .....................................................................................................................................13

What are the primary attributes of the various entities? ...........................................................................13

What are the primary types of entities from which you can choose? .......................................................15

Determining the Value of Your Business .......................................................................................................... 17

What is valuation? ....................................................................................................................................17

What is the importance of determining taxable value? ............................................................................ 17

Why a valuation might be needed ............................................................................................................17

Valuation issues .......................................................................................................................................18

Ameriprise Financial of 33

September 11, 2008

See disclaimer on final page

Different definitions of value .....................................................................................................................20

How do you determine the taxable value of your business? ....................................................................21

Asset Approach Valuation .................................................................................................................................22

What is it? ................................................................................................................................................ 22

When is it used? .......................................................................................................................................22

How is it used? .........................................................................................................................................22

Income Approach Valuation ..............................................................................................................................23

What is it? ................................................................................................................................................ 23

When is it used? .......................................................................................................................................23

How is it used? .........................................................................................................................................23

Market Approach Valuation ...............................................................................................................................24

Definition .................................................................................................................................................. 24

When is it used? .......................................................................................................................................24

Comparisons can be difficult ....................................................................................................................24

How is it used? .........................................................................................................................................25

Business Valuation Diagram .............................................................................................................................26

Planning for Succession of a Business Interest ................................................................................................27

Business succession planning--what is it? ...............................................................................................27

Transferring your business interest with a buy-sell agreement ................................................................27

Sell your business interest ....................................................................................................................... 27

Transfer your business interest through lifetime gifts ...............................................................................28

Transfer your business interest at death through your will or trust .......................................................... 29

Choosing the right type of succession plan ..............................................................................................29

Planning for Business Succession Checklist .................................................................................................... 30


September 11, 2008


Business Life Cycles and Business Planning

What are business life cycles, and what is their relationship to business planning?

Generally, businesses pass through three stages before reaching the final stage of decline. The time it takes to reach or to pass through each stage varies by business. It is important that you properly identify the life cycle stage of your business so that you can plan appropriately and establish realistic goals for the future. The four life cycle stages for a business are start-up, growth, maturity, and decline.

What are the traits associated with each life cycle stage?

Each stage has unique characteristics.

Start-up

Start-ups are businesses that have yet to come into existence or have yet to turn a complete revenue cycle . At this stage, the owner (or owners) needs to invest a great deal of time, effort, energy, and money into the business to create a stable customer base, to buy inventory, and to engage in other business activities before revenues are generated. The start-up stage is generally characterized by innovation, high risk, and low profit margins.

Growth

When businesses leave the start-up stage, they typically start to grow. Although a company can always use more cash, most growing firms can get by on their own limited resources. The business owner understands his or her business at this point, as well as the key competitors. Major customers have been identified. Often, additional help is needed in production, manufacturing, operations, or sales. Ideally, during this stage, consumer demand is established and increases, the company experiences increasing sales, profit margins increase, and a market is established.

Maturity

When businesses crack the local market and manage their affairs efficiently, they become mature. Mature firms have achieved a certain amount of name recognition. Contacts are well-established, sales require less effort, the business produces a reliable stream of cash, and borrowing becomes easier. At this point, intensive marketing may be needed to increase or maintain market position, and there is little product innovation. Profit margins tend to stabilize.

Decline

During this final stage, the market begins to shrink. There is usually no product innovation, businesses cut costs to maintain profits, and profit margins are thin.

Which goals and planning tips are most appropriate for each stage?

By knowing which life cycle stage your business is in, you can plan effectively.

Start-up

The challenges facing a start-up are very clear. You must learn your business, establish and expand your customer base, and begin to grow. During this initial stage, you should prepare a business plan , determine the structure of your business, and begin to think about investment management and tax management. Planning is essential, but you must also call on customers and do everything that you can to generate cash.


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For information about cash flow, see Maximizing Business Cash Flow .

Growth

At this stage, your goal is to become an established firm in the market. Indeed, you want to become the preferred company. Other goals include expanding your business through capital reinvestment or outside financing, attracting and retaining key employees, providing insurance and employee benefit plans , and reviewing retirement plans . It is still important to maintain a cash reserve and to watch expenses, however, to guard against unforeseen problems.

For more information, see Planning for Business Expansion . See also Maintaining a Cash Reserve .

Maturity

The main risk at this stage is complacency and failure to adapt to a changing environment. You need to stay competitive and become innovative. Budgets, moreover, become very important. Move your investments into productive areas of your business and withdraw them from areas of low return. Expenses should be scrutinized. Also during this stage, you should focus on enhancing and managing employee benefit programs, setting up nonqualified plans for key employees, developing a business protection strategy, and updating your business's valuation.

For more information, see Improving Operational Efficiency .

Decline

At this stage, you should be concerned with ensuring the proper succession of your business or considering the possible sale or merger of your business. You may also be concerned with stock incentive programs for you and your employees to spur profits. In addition, you may wish to explore ways to minimize estate and gift taxes .

For more information, see Planning for Succession of a Business Interest . Clearly, the particular stage of growth of your business dictates planning for it. Firms may stall, regress, or fail at any point. Before creating any plan for your firm, therefore, you must determine which stage it is in and become familiar with the issues that come into play at that particular stage.

What is business planning?

Business planning involves making decisions about the future of your business. Plans force owners to consider the long term as well as the short term. Many businesses construct five-year plans, and nearly all create annual budgets. Plans help to improve business control, to allocate resources most effectively, and to communicate the potential of your business to lenders and customers.

What is the business-planning cycle?

If you're starting up a small business, there are a number of plans you can draw up. In particular, however, there are four annual plans that deserve particular note. The first is a personal plan, the second is a strategic plan, the third is an annual operating plan, and the fourth is a forecast. Of course, you'll probably also want to create a formal business plan , which is a fairly standard document used to apply for venture capital or to attract other sources of capital, such as a Small Business Association (SBA) loan . Although similar to strategic plans, formal business plans are more detailed.

Personal plan

This is not really a formal document. It's just a thought process that enables you to determine why you are in business and what you want from your firm. What are your goals and expectations? In addition, of course, you'll want to develop a personal cash-spending plan at this point, which should correspond to the cash you'll withdraw from the business for personal use. To do so, you'll need to analyze your personal spending, income, and savings reserves.


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For information about personal budgeting, see Budgeting .

Strategic plan

The strategic plan maps out where the firm should be several years from now. Financial projections are general and usually cover five years. You need to develop specific strategies today to meet your long-term goals. Annual budgets must conform to long-term goals. Strategic plans usually start with a mission statement and then analyze both the external business environment and the inner workings of the company itself. You recognize your company's strengths and weaknesses and map out a course to take the company from its current position to its desired position.

Annual operating plan

This is really the budget. You use detailed financial projections to show why the firm is ahead of or behind planned performance. You'll need to include sales, cost of sales, labor expense, and other expenses.

For more information, see Measuring Business Performance .

Forecasts

Forecasts are quick, informal revisions to the plan. Unforeseen circumstances can force changes in the full-year plan. Many businesses forecast year-end results when the business is halfway through the year. Others create a forecast each month.

For more information, see Measuring Business Performance . All of the aforementioned planning tools can help you to achieve your overall business goals.

For information about formal business plans, see The Business Plan .


September 11, 2008


Computing the Business Balance Sheet

What is a balance sheet?

A balance sheet is a statement of a company's assets, liabilities, and equity at a specific point in time (sometimes referred to as a "snapshot"). The balance sheet shows, in dollars, what the business owns (assets), what it owes (liabilities), and its owners' ownership interest (equity or net worth). The balance sheet is often accompanied by the income statement, which reflects the performance of a business over a specified period of time in terms of revenue, expenses, and net income or loss. Together, these reports are called the financial statement.

The balance sheet is an important financial report that successful businesses review on a monthly basis. It provides information about the nature and amounts of investments in company resources, obligations to creditors, and the owner's equity in net resources. In addition, by calculating certain business finance ratios using data from the balance sheet and income statement, a company can identify its weaknesses and implement improvements.

Caution: The balance sheet does not reflect current value because accountants use a historical cost basis for valuing and reporting assets and liabilities. Additionally, some items on the balance sheet are merely estimates (e.g., allowance for bad debts, accumulated depreciation, and accumulated amortization). Also, some items of value to the business are not recorded on the balance sheet at all (e.g., the value of the company's human resources). Be sure to keep these limitations in mind when evaluating the information provided by your company's balance sheet.

Tip: All corporations and certain partnerships are required to file a balance sheet with their tax return. Items reported on Schedule L (Forms 1065, 1120, and 1120S) should agree with the balance sheet in the company books.

How is the balance sheet computed?

The balance sheet is divided into three general categories: assets, liabilities, and owner's equity (sometimes referred to as "net worth"). This financial report is called a "balance sheet" because, if all the accounting is done correctly, the sheet balances. That is, assets will equal liabilities plus owner's equity (this is sometimes referred to as the "accounting equation"). Therefore, there are four basic steps to computing the balance sheet.

Technical Note: Assets are defined as the probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. Liabilities are defined as probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. Owner's equity is defined as the residual interest in the assets of an entity that remains after deducting its liabilities.

Compute total assets

List and add your company's assets. These are usually broken into three categories: current, fixed, and intangible. Assets typically include the following:

• Current Cash

• Accounts receivable

• Allowance for bad debts

• Inventory


September 11, 2008


• Accumulated depreciation

• Prepaid expenses

• Loans to shareholders

• Fixed Equipment

• Buildings

• Land

• Accumulated amortization

• Intangibles Goodwill

Compute liabilities

List and add your company's liabilities. These are generally broken into two categories: current and long-term. Liabilities typically include the following:

• Current Accounts payable

• Wages payable

• Notes payable

• Payroll taxes payable

• Long-term Nonrecourse loans

• Loans from shareholders

Compute owner's equity (net worth)

Owner's equity (net worth) generally includes the following:

1. Capital stock

2. Paid-in or surplus capital

3. Treasury stock

4. Retained earnings

5. Net current income

Tip: Net worth is a key measure of your company's strength.

Compute the accounting equation

Assets should equal liabilities plus owner's equity.


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Does any additional information need to be reported?

The balance sheet is not complete unless certain supplemental information is provided with the listing of assets, liabilities, and owner's equity. There are four types of supplemental information that a company must disclose.

Contingencies

Contingencies are events that have an uncertain outcome and that may have a material effect on financial position.

Valuation and accounting methods

There are a variety of valuation and accounting methods that a company can use. For example, inventory can be valued using first in, first out (FIFO), last in, first out (LIFO), or weighted average. Depreciation can be calculated under the tax laws using ACRES, MACRES, or the straight-line method.

Contractual situations

Explanations of certain restrictions or covenants that attach to specific assets or liabilities must be disclosed.

Post-balance sheet disclosures

Certain events that occur after the balance sheet date, but before the financial statements have been issued, must be disclosed.


September 11, 2008


Cash Flow/Balance Sheet Requirements

What is it?

When selling your business--whether to a family member, a key employee, or a third party--you effectively become a lender to the business unless the sale is entirely for cash. Most ownership transfers are structured so that you exchange stock for an interest-bearing installment note, or you receive payments through a supplemental pension plan funded from future business earnings. You can also receive payments under a noncompetition agreement, under a post-sale consulting contract, or from royalty fees. Whenever you depend on receiving future payments, you run the risk of not collecting those funds. However, there are ways to secure the income stream you will depend on in the future. One approach is to establish cash flow/balance sheet requirements or key ratios for the business.

Cash flow/balance sheet requirements

Cash flow requirements

Cash flow is generally defined as earnings before interest, taxes, and depreciation (EBITD). You should consider requiring the business to maintain enough cash to cover EBITD at least 1.0 time. For greater security, you can raise the factor (e.g., some banks and other lenders require 1.25 to 1.5 times EBITD). If the borrower falls below the agreed-upon coverage requirement, it triggers default.

For example, if Avid Enterprises' average annual EBITD is $450,000, Avid will need to increase its cash flow to $562,500 to maintain coverage at 1.25 times EBITD.

Balance sheet requirements

You can also require the business to maintain certain key balance sheet ratios. These can include the current ratio, the quick ratio, and the debt-to-equity ratio. These ratios should be measured periodically and compared to industry standards. You should generally want key financial ratios to meet or exceed industry standards.

Caution: Understanding and evaluating financial ratios can be a difficult skill to master. You can't go just by the numbers. You need to exercise good business judgment in understanding what they're telling you.

Current ratio--The current ratio (total current assets divided by total current liabilities) is a liquidity ratio that measures the ability of the business to meet its current debts.

For example, Avid Enterprises would calculate its current ratio as follows:

Current Ratio = Current Assets / Current Liabilities

Therefore:

Current Ratio = $800,000 / $575,000 = 1.39 times

Compared to an industry-standard current ratio of 2.3 times, Avid's current ratio of 1.39 times indicates that its safety net for meeting short-term obligations is relatively low. This could signal a liquidity problem. However, since the ratio is greater than 1.0, the situation could be well in hand. As with all ratio analysis, Avid must exercise care in understanding and evaluating this ratio.


September 11, 2008


Quick ratio--The quick ratio, also called the acid-test ratio, is calculated as the sum of cash plus marketable securities plus net accounts receivable, all divided by current liabilities. The quick ratio is an even more stringent measure than the current ratio of the business's ability to meet its current debts. A satisfactory current ratio, for example, may not disclose that a portion of current assets is tied up in slow-moving inventories. Eliminating the cost of inventories, along with prepaid expenses, provides better information for the short-term creditor.

For example, Avid Enterprises' quick ratio is calculated as follows:

Quick Ratio = Cash + Marketable Securities + Net Receivables / Current Liabilities

Therefore:

Quick Ratio = $490,000 / $575,000 = .85 times

Avid's quick ratio of .85 times is low compared to the industry standard of 1.2 times. This indicates that Avid could have problems meeting its short-term debt obligations unless it can convert long-term assets to current assets, obtain additional financing, or boost its earnings.

Debt-to-equity ratio--The debt-to-equity ratio is calculated as total debt divided by total equity. Total debt includes both current liabilities as well as long-term debt. This ratio, called a coverage ratio, tells creditors how well-protected they are if the company becomes insolvent. Creditors prefer a low debt-to-equity ratio. This ratio has a strong effect on the company's ability to obtain additional financing.

For example, Avid's debt-to-equity ratio is as follows:

Debt-to-Equity Ratio = Total Debt / Total Equity

Therefore:

Debt-to-Equity Ratio = $1,300,000 / $2,250,000 = 58%

Compared to the industry standard of 38 percent, Avid is a highly leveraged company and could have difficulty obtaining additional debt financing.

When can it be used?

You can set cash flow/balance sheet requirements to secure your future income stream when you're transferring ownership of a company through a deferred payment plan, such as an installment note or a supplemental pension plan. These financial standards can also apply to payments received under a noncompetition agreement, under a post-sale consulting contract, or from royalty fees.

Strengths

By establishing cash flow/balance sheet requirements, you set financial standards that can strengthen your personal financial security during the deferred payment period.


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Tradeoffs

You need to balance your concern for personal financial security during the deferred payment period with the objective of perpetuating a competitive business. You don't want to handicap the business with excessive cash requirements so it can't carry on. You only want to ensure that if the business starts to fail, you get it back while it still retains value that you can sell to another buyer.

How to do it

Have the business's accountants determine an average historical cash flow. Even if the business is in a cyclical industry, the historical average can take this into account. To avoid having a low seasonal cash flow accidentally trigger a default, you can periodically test the coverage and set the default as four or more quarters below the norm.

You can help the buyer strengthen the business's cash flow position by structuring more of your payment as a tax-deductible expense, such as a noncompetition agreement or a post-sale consulting contract, rather than as a long-term debt. If an existing lender requires specific debt-to-equity ratios to be maintained, along with current or quick ratios, write these requirements into your sales contract. The remedies for default or cross-default are different depending on the structure of the deal.

• For an installment note, a breach could cause foreclosure on collateral .

Caution: A current or future lender will probably insist on subordination of an installment note.

• For a supplemental pension plan, a breach could trigger a call-down provision through the rabbi trust, if it was funded. Even an unfunded trust could include a "springing" provision that requires funds to be deposited.

• For a noncompetition agreement, a breach of cash flow/balance sheet requirements could void the agreement without requiring you to pay a penalty to the buyer.


September 11, 2008


Choosing an Entity

What is an entity?

To start a business, you must first decide what form your business will take--in other words, you must choose an entity. You, the business owner, create the entity. You give the entity its existence and its name. It may live independently of you. It may sue or be sued. It may even be fined if it behaves illegally. Depending upon its type, the entity may be taxed on its income. A business entity is usually, though not always, a group of persons joined together for a particular purpose--an organization. A corporation and a partnership are examples of business entities. Though such entities may have many owners, each is nonetheless considered a single entity, separate from its owners. (A sole proprietorship, however, is considered an extension of the owner.)

What are the primary attributes of the various entities?

In choosing your entity, you must carefully consider the attributes of each type of entity. Which of these attributes you seek for your business will determine the entity you choose. The seven primary attributes are as follows: formalities of existence, limited liability, pass-through tax treatment, centralized management, sharing profits and control, continuity of life, and the free transferability of interests.

Formalities of existence

Some types of entities are simple and inexpensive to form and maintain. To establish a sole proprietorship, for example, all you need to do is start your business. Contrast this to a corporation, which must file documents with the state, adopt rules for self-government, elect corporate managers (the board of directors), and hold shareholder meetings. If you do not wish to spend a lot of money forming or maintaining your business, consider an entity that has few formalities of existence, such as a sole proprietorship, for example.

Limited liability

An entity offers limited liability if an owner can lose nothing more than his or her investment. In other words, the owner's personal assets are insulated and cannot be used to satisfy the entity's liabilities (debts). So, if you do not wish to put all of your personal assets at risk, think about an entity that offers limited liability, such as a corporation, for example.

Pass-through taxation

In a pass-through entity, only the owners are taxed, not the entity. For example, when a partnership (a pass-through entity) earns and/or allocates profits to the partners, the partners are taxed, not the partnership. Contrast this to a C corporation, which is a separate taxpaying entity. With a C corporation, the same profits may be taxed twice. The corporation is taxed on its profits when earned. Then the shareholders are taxed when (or if) these profits are distributed to them as dividends. This is known as double taxation, the avoidance of which is usually a primary reason for choosing a pass-through entity. If you plan to have the profits of the business distributed as soon as they are earned, or if you are interested in starting a business that will permit you to deduct business losses from your personal income, you should consider a pass-through entity, such as a partnership or S corporation, for example.

Example(s): As an oversimplified example, assume that shareholder A is in the 35 percent individual tax bracket and is the sole shareholder of XYZ corporation. XYZ is a C corporation in the 34 percent corporate tax bracket. As a C corporation (not a pass-through entity) with $100,000 in profits and assuming no deductions, XYZ's corporate tax would be $34,000 (34 percent of $100,000). The remaining $66,000, if distributed to shareholder A as a dividend, will be taxed again at 15 percent: 0.15 x $66,000 = $9,900 in taxes. When combined, the tax rate for the corporation and the shareholder would equal 43.9 percent for a total of $43,900 in taxes.


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Example(s): If instead XYZ were an S corporation (a pass-through entity), only the shareholder would be taxed. Shareholder A would pay $35,000 (35 percent of $100,000) in income tax. Total taxes paid on the $100,000 would be $8,900 less than it would in the scenario above.

Caution: For tax years beginning prior to January 1, 2003, dividends were taxed as ordinary income. The Jobs and Growth Tax Relief Reconciliation Act of 2003 and the Tax Increase Prevention and Reconciliation Act of 2005, in an attempt to mitigate some of the burden of double taxation, provide that dividends received by an individual shareholder from domestic corporations and qualified foreign corporations are taxed at the rates that apply to capital gains. This applies to tax years beginning after 2002 and before 2011.

Centralized management

Some entities permit centralized management, others do not. An entity has centralized management if a person or a relatively small group of persons is responsible for management decisions. A corporation has centralized management because the board of directors is responsible for making all management decisions. In most instances, because each partner in a partnership is bound by (responsible for) the decisions of other partners, a partnership typically does not have centralized management. If you only plan to give a few people decision-making power, which usually results in quicker decisions, then you should choose an entity with centralized management.

Flexibility in sharing profits and control

Some entities are more flexible than others in sharing profits and control with their owners. A C corporation can generally sell its stock to any willing buyer (barring shareholder agreements to the contrary). The number of owners is unlimited. A C corporation may issue classes of stock with differing rights regarding the distribution of corporate profits to shareholders (e.g., preferred stock). An S corporation can issue stock with different voting rights, but all stock must have equal rights regarding the distribution of profits. Shareholders of an S corporation must meet eligibility requirements, and the maximum number of shareholders is 100. If you would like to have control over how profits are distributed and who has control over the corporation, you should choose an entity that allows you to do so.

Continuity of life

Some entities can "live" forever. This is called continuity of life. An entity does not possess this attribute if the death, bankruptcy, retirement, insanity, or resignation of an owner can cause it to end (dissolve). A sole proprietorship generally ends at the death of the sole proprietor (no continuity of life). A corporation typically has continuity of life because it remains a corporation despite the purchase and sale of shares and the resulting change in shareholders. A partnership, on the other hand, does not technically possess continuity of life because the withdrawal of a partner results in dissolution of the partnership (though not necessarily the business operation). Though the other partners may choose to continue the business, the old partnership no longer exists and a new one is formed. Continuation of the business can be planned for, so this isn't necessarily a real problem, just something you may want to be aware of and consider.

Free transferability of interests

You should consider the ease with which ownership interests may be transferred. Free transferability of interests exists when owners are permitted to sell their ownership interests to others without restriction. For example, if you would like to be able to sell your ownership interest at any time without restriction (barring shareholder agreements to the contrary), you might think about a C corporation, which allows shareholders to buy and sell stock freely to any individual or entity. If this is not important to you, however, you may be content with an S corporation, which has some legal restrictions on the sale of stock that set eligibility criteria and limit the number of shareholders. Some forms of partnership are restricted by statute to specific professions, which could limit your ability to sell (or buy) an ownership interest without harm to the entity structure and its treatment under the law and the tax code.


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What are the primary types of entities from which you can choose?

Your choice of entity is especially important to Uncle Sam when it comes time to pay taxes. Some businesses are taxed as separate entities while others are not. When an entity is taxed separately, it is said to be subject to double taxation. For example, the C corporation is taxed when it earns profits, and then the owner-shareholders are taxed when those profits are distributed to them in the form of a dividend--a double tax.

Some businesses are not taxed as separate entities, however. Instead, these entities pass the profits or losses on to the owners, who report the income on their personal tax returns. From a tax standpoint, entities can be categorized as either double-tax or pass-through (single-tax) entities. Some entity forms are allowed an election to be taxed as one form or another. The C corporation is a double-tax entity. By definition, sole proprietorships (SP), general partnerships, limited partnerships, S corporations, limited liability companies (LLC), and limited liability partnerships (LLP) are pass-through entities, although an LLC can elect to be taxed as a corporation. Professional corporations (PC) may be either, depending upon whether an S election is filed.

Double-tax entity

• C corporation --This entity consists of one or more owners. These owners--who purchased stock (a "piece" of the business) from the corporation--are known as shareholders. This type of entity offers limited liability, centralized management, and free transferability of interests. The shareholders are generally protected from the creditors of the C corporation and only risk the loss of their investments (what they paid for their stocks). The management in a C corporation is centralized in the board of directors, though the shareholders indirectly participate in management by electing directors and voting on certain corporate issues. By definition of law, the shareholders may buy and sell their stocks virtually without restriction (free transferability), although contracts among the owners often restrict this ability.

Pass-through entities

• Sole proprietorship (SP) --An SP is a one-owner/one-operator business. The primary advantage of this type of business is its simplicity. Generally, a person need only begin doing business to be considered a sole proprietor. The sole proprietorship is not taxed as a separate entity. Instead, the sole proprietor reports the business's profits and losses on his or her personal tax return. On the other hand, however, the owner is personally liable for all liabilities of the business. If you choose this type of entity, don't forget to buy liability insurance.

• General partnership --A general partnership must consist of at least two owners (partners), although there is no limit to the number of partners in the partnership. Forming a general partnership is generally simple and inexpensive. There may be fewer formalities to follow than with a corporation. There is no entity level taxation on the partnership. Instead the individual partners are taxed on the profits. The general partnership doesn't offer limited liability. Moreover, a general partnership will typically not allow you to freely sell your interest.

• Limited partnership --A limited partnership combines limited liability and centralized management, often associated with a C corporation, with a pass-through taxation feature. This entity consists of two types of partners: general and limited. Only limited partners receive liability protection. If the limited partners participate in management, their liability protection is lost. Only the general partners can manage the partnership. In return for the ability to manage the partnership, general partners remain personally liable.

• S corporation --Like a limited partnership, an S corporation combines limited liability with pass-through taxation. Unfortunately, an S corporation is limited to 100 shareholders. Although stock with different voting rights may be issued, different classes such as preferred and common are not allowed. Stock ownership is typically restricted to individuals, estates, and certain trusts. If stock is sold to an ineligible shareholder (such as a partnership) the corporation loses its "S" status and the (tax) benefits that go along with it.


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• Limited liability company (LLC) --An LLC can be taxed as either a corporation or a partnership. If taxed as a partnership (the typical choice), an LLC will offer limited liability and pass-through taxation without some of the disadvantages of a limited partnership or an S corporation. For example, owners of an LLC (called members) can contribute to management without compromising their limited liability protection. Unlike an S corporation, an LLC is not restricted regarding the type or number of owners, or the types of stock that can be issued.

• Limited liability partnership (LLP) --An LLP is an entity form with similarities to both the general partnership and limited liability companies. This form offers more liability protection to the partners than a general partnership, but sometimes less than an LLC. The LLP is designed for those professions that face malpractice suits, and may be adopted in those states, if available, that don't allow certain professionals to form LLCs.

• Professional corporation (PC) --The professional corporation (PC) is a corporation. It is treated as a single entity, it raises its own money by selling stock to shareholders, and it usually handles its profits by either distributing the profits to shareholders or reinvesting the profits in the business. It can assume the basic tax features of either a C corporation or an S corporation. This type of corporation is unique primarily because its shareholders must generally be members of a licensed profession. Each state, by statute, defines the professions that may form a PC.

After you have chosen your entity, be prepared to reassess that choice as your business evolves. Major changes in the work force, sales, profits, or the law may necessitate a change of entity. If, for example, you had chosen an S corporation only to decide years later that you wish to have many more than 100 shareholders, you may have to consider changing your entity to a C corporation. For more information, see the separate discussion Reconsidering Choice of Entity.


September 11, 2008


Determining the Value of Your Business

What is valuation?

Assignment of price or dollar value

The basic concept of valuation is to determine a justifiable dollar value or price for a total or partial interest in your closely held business. It is the process of answering the question, " How much is your closely held business worth? " Business valuation plays a critical role in determining gift and estate tax liability and/or the appropriate selling price for an interest. Because valuing a business is so important, you should be very careful when selecting an appraiser.

What is the importance of determining taxable value?

Business valuation key component to estate or succession planning

Business valuation is a critical component to your estate or business succession planning. Your business may be your largest asset, and if you plan to engage in either one of these types of planning, at some point you will need to determine the taxable value of your business interest. An incorrect value (i.e., one that is underestimated) could cause you to miss out on tax-saving strategies, while a value that is inflated could result in an investment of time and money in unnecessary planning.

The IRS is very interested in taxable value

Perhaps a key reason to be concerned about the taxable value of your business is the Internal Revenue Service (IRS), which is always on the lookout for sales at below and even above fair market value. If you sell something for less than fair market value, the IRS could deem the transaction a combination sale and gift and charge you gift tax on the difference between the value you received and the value the IRS calculated. Likewise, a sale at above fair market value could be deemed a gift (subject to gift tax) from the buyer to you.

Your tax liability depends on it

The value applied to your business bears an important and direct relationship to the amount of tax you will owe, whether it be capital gains tax resulting from a sale, gift tax on shares you have given away, or estate tax on property you own at your death. If the value determined by the IRS is different than the value your tax was calculated on, you (or your estate) could be liable for additional tax.

Why a valuation might be needed

May be no active market to set price

The valuation of large, publicly traded companies such as those found on the New York or the American Stock Exchanges is usually set by the buyers and sellers in the market through active trading. This price is generally accepted as the fair market value. With a closely held business, however, there isn't an active market for the stock, so valuation becomes much more challenging. A determination of the value of your business should be conducted for gift or estate tax purposes or to engage in the sale of your business.

Determine capital gain

When you sell your business, the difference between your basis and the price you receive is your capital gain. Your gain must be reported and is subject to capital gain tax. A properly conducted business valuation can ensure that the price at which your interest is sold represents fair market value and that your tax liability is correct.


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Sale of business to family member

You may be selling your business interest to a family member. You should be aware that the IRS tends to carefully examine this type of sale in search of disguised gifts. If the IRS determines a higher value for your business than the sale price you used, you might very well be liable for gift tax on the difference between the two values. Further, it usually takes a couple of years before the IRS challenges the value, and your additional tax liability may be compounded by accrued interest and penalties. A valuation by a qualified appraiser could avoid this potential problem.

Sale of business to outsider

If you are planning to sell your business to a nonfamily party, you may want to receive the highest amount possible. An independent evaluation may help you to achieve this objective while at the same time assuring the buyer that the price being paid is fair. Without a valuation from an independent, qualified appraiser, it might be harder to attract buyers due to the perception that the business is being overvalued by the seller. The timing and circumstances of the sale will also have an impact on the value. A forced liquidation or sale (one where the money is needed fast) will generally result in a lower valuation and price received.

Transfer of business under buy-sell agreement

If you have a buy-sell agreement for your business, you already have a buyer for your interest upon the occurrence of certain events. If correctly done, your buy-sell may have been specially drafted to establish taxable value. The terms of your buy-sell may require a periodic valuation of the business. When an interest changes hands under the agreement, a valuation is needed for the price exchanging hands, which sets the tax basis for the buyer and the capital gain of the seller.

Transfer of interest by gift

Part of your estate planning strategy may be to transfer your business interest by gift. Gifts of a certain size are not subject to gift tax. In order to determine if you must pay gift tax (and, if so, how much), you need to know the value of the gift. Any time a business interest is transferred by gift, a valuation should be conducted to document the gift tax value and reduce the risk of the IRS changing the value of the gift upon a later audit.

Tip: Do the valuation as closely as possible to the date of the gift.

Estate tax purposes

A business valuation may be required when an owner dies. A valuation at this point can ensure that all applicable discounts are reflected in the value. It is also of major importance in determining the estate tax liability. The last thing your estate needs is to be subjected to an IRS audit and have poor (or no) documentation of the business valuation used in the estate tax return. If the business has a buy-sell agreement, a valuation may be needed to calculate the price at which the interest will be sold to the buyer named in the agreement.

Valuation issues

Appraisal versus value

An appraisal is the process of determining value and represents an opinion. The result of the appraisal analysis is the assignment of a value based on a specific point in time. There is no one process and generally no one definitive value for a business. It is possible for a business to have different values, depending on the purpose of the evaluation and the interpretation of the criteria examined. Because there is no single method or definition, it is important that the appraisal report contain a specific definition of value and the assumptions used in the analysis.

Multiple approaches to determining value

There is more than one way to approach a business valuation. The nature of the business itself may indicate that one way is more appropriate than another, and while there are general rules, it is still more art than science.


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Furthermore, appraisers are at their own discretion in determining if intangibles, fair market values or liquidation values will be used. Appraisers using the same named approaches may use different techniques to determine the value. As a result, sometimes multiple, independent valuations are conducted, and an average result is used. The table below shows three common valuation methods:

Method Methodology

Income approach Value is based on expected income generation

Asset approach Value is determined on basis of business assets

Market approach Value is based on past sales of shares of this or a similar business

Valuation may be discounted

The value of certain ownership interests may be discounted (reduced), depending on certain conditions. Sometimes, a minority stock interest in a closely held corporation is granted a discount for estate tax purposes when it is included in the owner's gross estate. The discount is granted because the minority interest itself carries no ability to influence corporate decisions or policy, which in turn reduces its marketability to anyone but the controlling shareholders.

A minority interest that cannot influence policy but is large enough to represent a swing vote could have a valuation discount disputed by the IRS.

Valuation can be disputed

A lot of factors can affect the value of a business. Disputes between taxpayers and the IRS involving the valuation of property occur relatively frequently. To complicate things, even the IRS acknowledges that there is no one, true, fair market value for a closely held business, so the area is open to interpretation. Moreover, not only might the valuation be subject to dispute, but inaccurate valuations for tax purposes could be subject to civil and criminal penalties.

Timing is important

Transactions are valued by the IRS on the date of the transfer. To reduce the chance of the IRS calculating a value that differs greatly from the value you paid tax on, your valuation should be determined (and documented) as closely to the transaction date as possible.

Event Valuation Date Type of Tax

Gift Date of completion of gift transfer Gift tax

Sale Date of sale Capital gains tax

Death Date of death OR alternate valuation date six months after death Estate tax


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Tip: It is important to get an accurate appraisal of the value of a business interest any time the business is transferred as a result of lifetime gift, sale, or bequest.

Different definitions of value

Fair market value

Fair market value (FMV) is the price at which property would change hands between a willing buyer and a willing seller (who are independent, nonfamily members), where both parties have reasonable knowledge of the relevant facts, and neither party is under any compulsion to buy or sell. This is the definition frequently used by the IRS.

Fair value

Fair value is different from fair market value, and as used here, it is different from the accounting definition. In business valuation, fair value is a statutory standard generally applied in cases involving dissenting shareholders and sometimes in suits involving corporate dissolution, merger, sale, or auction. The determination of fair value is usually applied to minority interests when the minority shareholders believe they won't receive full consideration for their shares under the merger, sale, or dissolution. The minority shareholders have their shares appraised and receive an amount of cash equal to the fair value in exchange for the shares.

Investment value

Investment value is specific to an owner (or prospective owner) and includes consideration of factors such as the owner's knowledge, abilities, related business interests, and expectation of earning potential and risk. A business will likely have different investment values to different people, depending on specific factors (i.e., the value is in the eyes of the beholder).

Intrinsic or fundamental value

Intrinsic value is a term that carries different meanings to different professionals. In some cases, it is used to refer to fair market value, fair value, investment value, or even some other type of value. Sometimes it is used to refer to the analysis of an investment banker, security analyst, or financial manager or analyst. The point is, this term has several meanings and interpretations, so it is very important that any valuation including this term have a very specific definition of its usage.

Going concern value

A going concern value considers factors specific to the business, both physical and intangible. Consideration is given to the existing infrastructure, goodwill, reputation, trained workforce, licensing, and/or plant capabilities of the business. The valuation is based on the assumption that the business will continue to be a viable operating entity and as such should bear a higher value than the sum of the values of its collective assets.

Liquidation or breakup value

Liquidation value is a determination of the proceeds (net of selling costs) realized if a company ceased operating and sold off the assets. There are two types of liquidation, and the specific situation will affect the valuation. An orderly liquidation involves the sale of assets over a period of time to maximize proceeds. A forced liquidation, on the other hand, means selling the assets as quickly as possible (often by auction) and often at a lower value than might otherwise be achieved if more time were available.

Book value

Book value is an accounting term that can apply to a specific asset or an entire company. An asset's book value equals the historical cost minus any allowances for depreciation, amortization, or unrealized losses. The book value for a company is the shareholders' equity, calculated from the balance sheet as the excess of total assets over total liabilities.


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How do you determine the taxable value of your business?

Find a qualified appraiser

Determining the value of your business is not something you should attempt on your own, especially in light of the fact that the IRS could challenge your valuation. There are appraisers who specialize in determining the value of businesses. Before you flip open the phone book and randomly choose one, however, please take a look at Selecting an Appraiser for some tips. Your CPA may even be one of these specialists or know someone who is.

Don't use an old appraisal

You may have had your business appraised in the past for another purpose. As tempting as it might be, don't use an old appraisal now. The purpose of the appraisal can affect the valuation assigned, and time can change the factors that go into the appraisal calculation. See How Much Is Your Closely Held Business Worth? for more information.


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Asset Approach Valuation

What is it?

Under the asset approach, the fair market value for the closely held business is determined based on the value of its assets.

When is it used?

Sometimes a business is only worth what it owns. The asset approach is used for such businesses. Generally, these would include:

• Businesses that don't engage in significant activities, like investment or holding companies

• Businesses that are generating losses

• Businesses that are in (or will be in) liquidation

The asset approach generally isn't appropriate for an active business because the business is probably worth more than just its assets. However, some appraisers would argue that the asset approach is appropriate where an active business isn't using its assets to their full potential and the business would be worth more if liquidated.

How is it used?

An appraiser using the asset approach in its simplest form determines the value of the assets that the business owns, subtracts outstanding liabilities, and concludes that the remainder is what the business is worth. Appraisers are at their discretion in determining if intangibles, fair market values, or liquidation values will be used. Appraisers using the same named approach may use different techniques to determine the value.

Technical Note: While there are no set definitions for the asset approach, there are some general methods that your appraiser might use:

• Adjusted net assets method: Determine value of assets and subtract liabilities

• Adjusted book value method: Determine book value of assets, then add value of intangible assets

• Liquidation value: Determine value that assets could be sold for in a liquidation sale


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Income Approach Valuation

What is it?

Under the income approach valuation, the fair market value of a closely held business is determined based on how much income the business is expected to generate in the future.

The appraiser thinks of the business as a goose that lays golden eggs. How much would you pay for the goose? Find out how many golden eggs the goose lays, consider the chances that the goose will stop laying eggs, and make a valuation decision.

When is it used?

In most cases, the income a business generates is the best way of determining what the business is worth. The income method is therefore probably the most common valuation approach, especially in valuing small, operating businesses. Specifically, this approach is used on service businesses or other noncapital-dependent businesses.

Generally, the primary alternative to the income approach is the market approach. Some appraisers believe that the Internal Revenue Service (IRS) prefers the market approach, especially if the business is comparable in some way to a publicly traded business. The preference for the market approach may be motivated by the fact that the market approach often results in a higher value.

How is it used?

In general terms, the appraiser will consider how much income the business generates now, consider the odds that the business will continue to generate that much income in the future, and then decide how much such an income stream is worth. Appraisers use discretion in determining which factors will be used. Appraisers using the same named approach may use different techniques to determine the value.

Technical Note: While there are no set definitions for the income approach, there are some general methods that your appraiser might use:

• The capitalization of earnings or discounted earnings method: Determine earnings, then capitalize those earnings--calculating how much an investor would expect to earn on such an investment.

• The capitalization of income method: Determine some income number (possibly before-tax income, after-tax income, net income, gross income, or operating income), multiply that amount by a percentage that accurately anticipates growth, then determine how much money a rational investor would invest to get that return.

• The discounted cash flow or discounted income method: Determine how much money the business will generate in the future and discount that to its present value.

Caution: You and the IRS are most likely to disagree on the capitalization or discount rate that is applied. This is probably because a small shift in the rate can have a dramatic difference in the fair market value. Since there is no objectively correct rate, the best you can do is carefully select an appraiser to decide the rate you will use.


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Market Approach Valuation

Definition

Under the market approach valuation, the fair market value of the business is determined based on what people have paid for shares of this business in the past or for shares of comparable businesses.

The appraiser tries to determine what investors in the stock market would pay for this business, based on what they actually have paid for shares of this or a comparable company.

When is it used?

The market approach can be used for any type of business, but it will usually be appropriate only if the appraiser can find a comparable sale. There are generally only comparable sales in two situations:

There have been recent sales of shares in the business

If shares in your company have been sold in the past, that sale might be evidence of what the business is worth.

For instance, if you bought your business last year for $500,000, it is probably logical to conclude that it is worth around $500,000 now. Similarly, if your partner sold his one-third share of the business for $1.2 million, that is strong evidence that your one-sixth share of the business is worth $600,000. This assumes, of course, that the original transactions were at arm's length.

Your business is comparable to a publicly traded business

If your company has enough similarity to a company that has been sold (either in parts, in stock sales, or as a whole in a merger or acquisition), an appraiser might conclude that the value of that company is evidence of what your company is worth.

The market approach is very similar to the approach used to value houses. If a three-bedroom, 2,000-square-foot house next door sells for $300,000, and a three-bedroom, 2,150-square-foot house down the block sells for $310,000, an appraiser will logically conclude that your 2,100-square-foot three-bedroom house has a fair market value near $310,000.

Comparisons can be difficult

The problem, of course, is that there are more differences between closely held businesses than houses. Is one 700-square-foot hamburger restaurant (Billy's Burger Barn) worth about the same as another? Is one hamburger franchise worth about the same as another? Most experts would agree that the market approach works best with larger closely held businesses that have the characteristics (like size and marketability) of a public company.

The difficulty in finding a public company that is comparable to a closely held company is even more pronounced, based on several factors:

• Few public companies are as small as the average closely held business

• Taking a public company as a representative sample is probably not statistically accurate, since there are many more (perhaps 100 times more) closely held businesses than public companies

• Many closely held businesses don't have a comparable public counterpart

• Closely held businesses aren't as diversified as public companies (which significantly increases the risk inherent in a closely held business)


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• Public companies generally don't have one majority shareholder, which is often one of the most significant elements of a closely held business

The value of the shares of a public company may be affected by market factors not relevant to a closely held business.

How is it used?

The guideline company method

Identify a comparable company and then use a formula (like multiple of earnings or percentage of book value) to adjust its value to the value of the business in question. This involves discovering the guideline company's price-to-net earnings ratio, price-to-cash flow ratio, price-to-sales ratio, and price-to-book value ratio, and using those to determine your price. This information probably isn't available from private companies, so comparison is usually made to public companies.

For instance, if a publicly traded clothing retailer is worth $100 million, and that amount is seven times its cash flow, then a comparable closely held business with $100,000 in cash flow would have a value of $700,000.

The value will also have to be adjusted to take other variations, like a lack of marketability for a closely held business, into account.

The industry method

In certain industries, experts have concluded that the value of any company in that business can be determined by looking at a standard ratio.

For example, an expert concludes that your radio station is worth five times its annual advertising revenue. Your radio station is therefore worth five times its $200,000 advertising revenue, or $1 million.

Actual sales

Look at recent sales of interests in a guideline business and adjust. However, the fact that most such transactions are between family members probably makes this method unacceptable.


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Business Valuation Diagram


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Planning for Succession of a Business Interest

Business succession planning--what is it?

One of the important decisions a business owner must face is when and how to step out of the business--in other words, business succession planning. Do you expect to retire from your business? Do you have a plan in place? What would happen to your business if you were to die today? Do you have children you hope to bring into the business? These are questions only you can answer, and your answers will lead you and your financial and legal advisors to a course of action. When you develop a succession plan for your business you have two basic choices: you can sell your business, or you can give it away. Once you choose to either sell or gift, you can structure your plan to go into effect during your lifetime or at your death.

Transferring your business interest with a buy-sell agreement

You can transfer your business interest with a buy-sell agreement, a legal contract that prearranges the sale of your business interest. It allows you to keep control of your interest until the occurrence of an event specified in the agreement, such as your death, disability, or retirement. A buy-sell agreement can help you to solve the problems inherent in attempting to sell a closely held business. When you structure your agreement, you can tailor it to your needs.

With a buy-sell agreement, you choose the events requiring a sale

When you draft your buy-sell agreement, you establish the triggering events, meaning those events under which the sale can or must happen. Common triggering events include death, disability, or retirement. Other events like divorce or bankruptcy can also be included as triggering events under a buy-sell agreement.

A buy-sell agreement provides a ready buyer for your interest

At the occurrence of the triggering event, the buyer is obligated to buy your interest from you or your estate. The buyer can be a person, a group (such as co-owners), the business itself, or a combination. You (or your family or estate) are spared the task of trying to find a buyer when you are ready to sell.

Price and sale terms are prearranged

A major function of the buy-sell agreement is the establishment of the pricing mechanism for the sale of the business interest. The payment method is typically also determined at the time the agreement is drafted. The major sale negotiation is conducted at a time when there is no pressure to sell. This eliminates the need for a fire sale when you retire, become ill, or die; and it may result in greater overall fairness in the deal.

A buy-sell agreement can interfere with other estate planning

Once you are bound under a buy-sell agreement, you can't sell or give your business to anyone except the buyer named in the agreement without the buyer's consent. This could restrict your ability to reduce the size of your estate through lifetime gifts of your business interest, unless you carefully consider and coordinate your estate planning goals with the terms of your buy-sell agreement.

Sell your business interest

The major benefits when you sell your business interest are control and cash: you keep control of your interest or business assets until you are ready to let go, and you decide how much or how little you want to sell.


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Selling allows you to receive cash (or convertible assets) and choose the timing

When you sell your business interest or assets, you receive cash (or assets you can convert to cash) that can be used to maintain your lifestyle or pay your estate expenses. You can choose when you want to sell--now, at your retirement, at your death, or at some point in-between. You can sell your interest during your lifetime, and receive cash to use for your retirement, a new business venture, or that trip around the world you've been putting off. When done at your death, an asset sale can provide cash for your estate to use in paying your final expenses or for distribution to your beneficiaries.

A limited market means a sale could be difficult

There is often no market for the sale of a closely held business, which could make finding a buyer for your interest difficult. Some assets, such as equipment, may have a specialized use or a short time frame of technological usefulness. If your business is a service business, it may be hard to find a buyer for intangible assets such as your customer list. The level of competition in your geographic area or business field could also affect your ability to find a buyer. When the sale occurs after your death, your family or estate may be at a distinct disadvantage when negotiating with a potential buyer. The interested buyer can be expected to try to take advantage of your family's need for cash to settle your estate expenses and offer a price that is below a fair market value. A buy-sell agreement might be the solution to prevent this from happening, because it guarantees a buyer for your interest.

Size of business interest, estate could make sale difficult

The larger the size of your business interest, the more difficult it may be to find a buyer with access to sufficient cash or credit on short notice. In addition, the larger the size of your business relative to your entire estate, the greater the need for cash to settle your estate expenses. Again, transferring your business interest with a buy-sell agreement might help you to solve these potential problems. Smaller business interests are not without their own problems. Buyers may be reluctant to purchase a minority interest because such an interest doesn't carry with it the ability to control the business.

Transfer your business interest through lifetime gifts

You can transfer your business interest through lifetime gifts by doing just that--making gifts during your lifetime. You can choose to make smaller gifts of portions of your business interest over a period of time or make a gift in total at your retirement.

Lifetime gifting reduces the value of your estate and could lower your estate taxes

A lifetime gifting program removes the value of the business from your estate as you make gifts to the recipient. The benefit to you is a reduction in the value of your total estate, thus the possibility of lower estate taxes at your death. Not only do you remove the value of the gift itself from your estate, but you also remove the future appreciation on the gift and taxes that would be associated with the gain.

Lifetime gifting allows you to take advantage of the annual gift tax exclusion, which may help you reduce total gift and estate taxes

You could make gifts of unrestricted stock over a period of time by arranging the gifting program to maximize the annual gift tax exclusion, which allows you to gift up to $12,000 per donee without incurring federal gift tax (although you may have to pay state gift tax). The benefit to you is a tax-free, systematic reduction in the size of your estate. When you make gifts of portions of your stock, you ultimately pay less total gift tax than if you made one large gift, thanks to the valuation discount.

Lifetime gifting requires you to give up part or all of your business

As you make gifts of your business interest, you might also be giving up some of your ownership control over the business, while the recipient of the gift gains control. If you have co-owners, your relative percentage of control will diminish. If you are the majority stockholder, it might take a long time before you are in a position of


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significantly less control. If you hold equal ownership with co-owners, it may not take long before you become a minority shareholder.

Transfer your business interest at death through your will or trust

If you wish to keep control of your business until your death and transfer your interest to someone at that time, you could transfer your business interest at death through your will or trust. This method of business succession can be effective when the intended receiver of your bequest is currently active in your business and would be able to carry on the business activities.

Will provisions can authorize the continuation of your business

A will provision can direct the executor of your estate to continue your business for a specified period of time or purpose, thus granting permission to carry out activities that otherwise may not be allowed. If the business is continued, the executor may be held personally liable for losses of the business. Caution should be taken by authorizing the executor to incorporate the business, which may limit liability to the activities of the continued business. After your death, the business can be maintained until your family can take control and continued income from your business can be provided to your family and heirs.

With a living trust, you can see your continuation plan in action

A living trust would allow you to make a revocable transfer of your business interest, providing you with the opportunity to see your continuation plan in action while you are alive. You can see your successor management operating the business while you are afforded continued control and input. This gives you the chance to be completely satisfied with your decision before it becomes irrevocable at your death.

A living trust can provide income to you or your heirs

Depending upon the structure of your living trust, you may receive an income from the trust during your retirement until your death. At your death, the business may provide income to your family or heirs or the business can be maintained until your family or heirs can take over.

Use of a trust can be efficient and private

When you establish a living trust, it requires you to organize your property during your lifetime. In doing so, your assets are transferred at death in an orderly fashion as you intended and not at the discretion of the court. The use of a trust will be less expensive overall, because your assets pass from the trust directly to the people you designate to receive them, avoiding the costly probate court process. This would be considered a private transaction, keeping the transfer free of any publicity.

Choosing the right type of succession plan

The various succession strategies can be used to achieve specific goals for your business interest. Depending upon your particular situation, one or more of these tools may be appropriate for you. The tricky part is, how do you decide? Take a look at our decision tools which were created to help you analyze and compare the various business succession strategies. Once you have narrowed down your choices, meet with your attorney and tax or financial planner to develop your personal business succession plan.


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Planning for Business Succession Checklist

General information Yes No N/A

1. Has relevant personal information been gathered? • Personal details• Family details• Name of other participants in the business

2. Has personal financial situation been assessed? • Income• Expenses• Assets• Liabilities

3. If business is a separate entity, has its financial situation been assessed? • Type of entity (e.g., corporation, partnership)• Income• Expenses• Assets• Liabilities• Owners' equity

4. Has professional team been assembled? • Accountant• Attorney• Insurance professional

Notes:

Business succession planning basics Yes No N/A

1. Are there other owners of the business?

2. Is there a legal, written business succession plan in place?

3. Has a short-term contingency plan been prepared that maps out procedure for the continuation of business operations?

4. Has a successor management team been chosen?

5. Have methods of retaining key employees during transition been discussed?

6. Has plan been discussed with family members and key employees?

7. Has equalizing estate distributions to children been discussed?

8. If no business succession plan is in place, have various strategies and goals been discussed?


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Notes:

Selling a business interest Yes No N/A

1. Is selling the business to family an option?

2. If selling the business to family is an option, have financing options been considered? • Private annuity• Installment sale• Self-canceling installment note• Buy-sell agreement• Coordinate sale with gifts• Family limited partnership

3. Is selling the business to nonfamily an option? • Selling shares or assets• Using a buy-sell agreement to sell to nonfamily• Selling to another corporation• Selling to an employee stock ownership plan (ESOP)

Notes:

Lifetime gifting Yes No N/A

1. Has transferring the business with lifetime gifts been considered? • Outright gifts• Trusts• Charitable remainder trusts• Transfer using another entity

Notes:

Other strategies Yes No N/A

1. Have other transfer strategies been discussed? • Grantor retained trusts• Retained interest


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Notes:

Buy-sell agreements Yes No N/A

1. Is a buy-sell agreement an option? • Entity purchase• Cross purchase• Wait and see• Section 302 stock redemption• Section 303 stock redemption• One-way• Trusteed cross purchase

2. If a buy-sell agreement is an option, have ways to fund the agreement been discussed? • Life insurance• Disability insurance• Cash• Borrowings

Notes:


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[email protected]

Ameriprise FinancialDaniel J. Lensing, CRPC®

Financial Advisor14755 No. Outer Forty

Chesterfield, MO 63017636-534-2097

The information contained in this material is being provided for general education purposes and with the understanding that it is not intended to be used or interpreted as specific legal, tax or investment advice. It does not address or account for your individual investor circumstances. Investment decisions should always be made based on your specific financial needs and objectives, goals, time horizon and risk tolerance.

The information contained in this communication, including attachments, may be provided to support the marketing of a particular product or service. You cannot rely on this to avoid tax penalties that may be imposed under the Internal Revenue Code. Consult your tax advisor or attorney regarding tax issues specific to your circumstances.

Neither Ameriprise Financial Services, Inc. nor any of its employees or representatives are authorized to give legal or tax advice. You are encouraged to seek the guidance of your own personal legal or tax counsel. Ameriprise Financial Services, Inc. Member FINRA and SIPC.

The information in this document is provided by a third party and has been obtained from sources believed to be reliable, but accuracy and completeness cannot be guaranteed by Ameriprise Financial Services, Inc. While the publisher has been diligent in attempting to provide accurate information, the accuracy of the information cannot be guaranteed. Laws and regulations change frequently, and are subject to differing legal interpretations. Accordingly, neither the publisher nor any of its licensees or their distributees shall be liable for any loss or damage caused, or alleged to have been caused, by the use or reliance upon this service.

Prepared by Forefield Inc. Copyright 2008 Forefield Inc.

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